[ Music ] >> The first set of ratios that we're going to talk about are the liquidity ratios. Okay? So those are the ratios that allow us to measure how liquid the balance sheet of a company is. Okay? So, the first liquidity ratio that we're going to compute and analyze is what we think-- what we call the current ratio. Okay? So the current ratio is very simple. It's just the ratio of current assets divided by current liabilities. Okay? As a way of illustration, let us compute this ratio for Cablevision, and for B/E Aerospace. Okay? So let's go here to the balance sheet. Here you can see that you have-- here you actually have the real balance sheet for Cablevision for three years. Okay? We're going to do is we're going to focus only on the recent year for now, but if you are doing this, you know, for another application like you may want to analyze a liquidity for more years, for our teaching purpose we're just going to focus on the most recent data. Okay? So let's go here. And think about how we would compute the liquidity-- the current ratio, right? So that should be really very simple. You have here the date of the most recent data on the company's total current assets, and you have the most recent data on the company's current liabilities. So the current ratio is simply the ratio of current assets by current liabilities which is 788 [phonetic] divided by 73-- 1737, okay? So this is in the millions, so this means that Cablevision has $1.8 billion in current assets and $1.7 billion in current liabilities, so this ratio is approximately equal to one. Okay? So Cablevision has the same amount of current assets as they have current liabilities. Okay? So now let's go to B/E Aerospace, all right? Same information. You have the balance sheet for the last three years, okay? Okay let's focus on the latest information we have. Okay? And here you have information on the current assets; current liabilities okay? So, again, we can compute to the ratio current assets divided by current liabilities would be 1723 again this is in millions, so that it means that they have $1.8 billion in current assets. And $800 million in current liabilities, so you would get a current ratio of approximately 2.15. So here we have done the calculation, right? Now let's think about it. B/E Aerospace seems to have a much larger current ratio then what Cablevision has. Right? So it's 2.15, significantly larger, right? Does that mean that B Aerospace has more liquidity than Cablevision? Right? Now what we need to do is we have to start thinking about the details a little bit more. Okay? And which will soon realize is that the main reason why B/E Aerospace has as high liquidity ratio is because they have quite a bit of inventory. Right? Out of the $1.7 billion in current assets that they have, $970 million is inventory. Okay? So let's take that information and think about the following question: right, so why is B/E's ratio so high, right? Inventory, you know, it does this really measure liquidity? Okay, right? Is inventory a really illiquid asset? Does it, you know, does regulation mean that B/E has more liquidity than Cablevision has? [ Silence ] So what we need to think about is, what is liquidity, right? What are we trying to measure? Right? And so the notion of liquidity, that something very important in finance of course, right? Liquidity measures how easy it is to transform an asset into cash. Right? So how fast can we generate cash from an asset, how easy it is, how much cash are we going to get for an asset? Okay? So that's the notion of liquidity, right? So really what we're trying to understand is whether a company like B/E Aerospace has sufficient current assets to cover its current liabilities. Okay? Right? So, is inventory really illiquid asset? Okay, so if you think about that, right? Of course, companies can try to sell inventory. Right, if you run into a liquidity problem, you know you have some inventory, you can use that to raise cash, but you might have problems. Right? Liquidating inventory to raise cash is going to disrupt the business. Think about B/E Aerospace for example. The reason they have inventory, right, is because they have to keep seats, you know, aircraft seats for example, to sell to airlines, right? And if they have to liquidate inventory, you know, that's going to disrupt their business and in addition, the company may not really get the good price when it does that. Right? The inventory, you know, the aircraft seat they may be some very specific to, you know, a particular airline, if you're going to sell it to a different airline, you may not get a lot of cash that. Okay? Actually, there is some evidence in the corporate finance literature this very interesting paper by Berger, Ofek, and Swary, which was published a few years ago, what these authors did is they gathered data on how much money the amount that firms we're able to obtain when they sold their assets. Okay? When they had to sell assets because they were discontinuing operations. So these are companies that went bankrupt, for example, and what they did is they looked at how much did they get for their current assets? All right? You know, intuitively, right, cash, right, is one. Okay? So if you liquidate cash, you know cash is cash, so they got one for that. Receivables they got $.72 per dollar. So what this number means is that for each dollar of receivables that they had, they were able to raise 72-- 72 percent. Okay? So if they had $100 million in receivables, they raised $72 million in cash. Inventory was the lowest, right? So inventory just generated $50 million in cash out of $100 million. So 55 percent. Okay? So, you know, inventory is somewhat liquid, but it's not perfectly liquid. Right? So that's why we have to think about additional liquidity ratios. Okay? So we have some liquidity ratios that take this illiquidity of inventory into account, okay? There are two ratios we're going to think about. The first one is the quick ratio, which uses only cash and receivables. And then we're going to have the cash ratio, which looks only at cash. Okay? You're ignoring even receivables since receivables are not perfectly liquid, let's just take the most liquid asset which is cash, and think about that. Okay? So, recalculating these ratios using these different measures, what we do, now you have DirecTV by the way, right? So now you have DirecTV's balance sheet here. Okay? In addition to Cablevision. So what you would do for example, to calculate the quick ratio, is just take the first two numbers, cash plus receivables, okay? And divide it by total current liabilities. Okay? And, so notice that really what you're doing is you're ignoring everything else that is in the balance sheet. You're assuming that is not liquid. Okay? You only take the assets that you know are going to be generating some liquidity for you. That's the idea. Okay? Of computing this quick ratio. So here you have an example, right, so if you do this for the DirecTV using that data that I just gave, okay? Here's what you should find. That DirecTV's quick ratio should be about 0.9. Okay? If you just take cash in receivables and divide by current liabilities, right. So that means that DirecTV has, you know, 90 percent of its current liabilities in cash and receivables. Okay? We're going to talk about later what does that mean. Okay. So here are all the calculations using that data, and you know, I encourage you to do it on your own, and check to make sure you can get the same numbers. We have the cash ratio, the quick ratio, and the current ratio for Cablevision and DirecTV. We're not going to talk about the B/E Aerospace anymore, you know, the reason why it was there is just to illustrate that inventory issue. Now let's compare these two companies that are in the same industry okay? So those are the liquidity ratios. Right? You can see that if you look at this comparison, it's easy to see that DirecTV has a higher ratios; has more liquidity then Cablevision has. Okay? Since we're talking about that, let's think about the following question: what is a good ratio? Okay? Remember, the question we are asking is can the company pay for short-term liabilities without relying on cash flow? Right. Just looking at balance sheet items. What that means, is that, you know, one is a reasonable standard to look at. Okay? Current ratios should be above one. Right? That means you have more assets and liabilities. Okay? Quick ratios should also be close to one at least close to one why? Because we don't want to rely too much on inventory. Right? So inventory is tricky, so what we conclude is that quick ratios should also be close to one. Ideally, you don't want your quick ratio to fall too much below one. The cash ratio, you know, how large the cash ratio needs to be, that's a more complicated question. Depends on how liquid the receivables are and some other considerations on Module 2, we're going to be talking more about short-term cash management. I think we're going to have more to say about that, but you know, of course the general ideas that are high cash ratio is a good thing in terms of liquidity, but perhaps it doesn't have to be quite above one. Okay? How does liquidity deteriorate? If you say company with low liquidity, how can that happen? Right? I mean, if you think about it, liquidity is about comparing short-term liabilities to short-term assets, right? So one way that a company can reduce its liquidity is by increasing short-term debt to invest in long-term assets. Right? So if you raise short-term debt and invest in long-term assets, you're going to lower your liquidity, or if you use of your cash, right? If you take some of your cash to invest in a capital expenditure, you're again going to lower your liquidity, and that's an issue we're going to go back to in one of the examples in Module 2. So is coming up as well.. We're going to talk about one example where that consideration is going to be important. And finally, performance. Right? Performance is going to be related to everything. So if a company does poorly, cash holdings are likely to go down, liquidity's going to go down, and the company may have to think about readjusting its liquidity ratios. [ Silence ]