Hello, I'm Professor Brian Bouche, welcome back. In this video, we're going to talk about liquidity ratios, both short term and long term liquidity. And then we'll apply those ratios to the pain view technology case. Let's get started. Here's an overview of all the liquidity ratios we're going to look at. And you can put them into three buckets, two short term buckets and one long term bucket. First, we have a number of ratios that are going to tell us whether we have enough assets that are going to turn into cash to cover our liabilities in the next period. Then the next bucket we'll look at specifically whether we have enough liquidity to meet interest obligations. And the third bucket is going to be the long-term liquidity ratios, and these are going to be more about the notion of riskiness. Is the firm too highly levered? Is there potential risk of bankruptcy down the road that may cause equity investors to lose their investment? What's the company's borrowing capacity? Those are all the questions that this set of ratios will get at. So go into that first bucket of short term equity ratios, we're trying to answer the question, does the company have enough cash coming in to cover obligations to pay out cash in the near term? Ideally, all the ratios that we look at would be over one, which means there's more cash coming in than when cash we have to pay out. But again, you'd have to benchmark this with the industry, the firm across time, because for some industries these are not greater than one. The first ratio is called the current ratio, it's current assets over current liabilities. And basically what this is trying to get at, is if current assets are going to turn into cash in the next year, current liabilities have to be paid in cash in the next year. Do we have enough assets turn in the cash, to cover the liabilities that we have to meet in cash? One drawback to this ratio is, as we know not all current assets turn into cash. Some of them are things like prepaid rents, which never turn into cash. Some are inventory, which take a longer time to turn into cash. So there's another ratio called the quick ratio, which is just (Cash + Receivables) / Current Liabilities. Much more conservative ratios saying do you have enough assets that are either cash, or going to turn into cash very quickly to cover your current liabilities. One more ratio is cash flow from operations to current liabilities, so we divide cash from operations by average current liabilities. This is more backward looking. It's saying over the past year did you have enough cash generated from operations to cover your average level of current liabilities? So here's what the ratios look like for Plainview. So why don't I put up the pause sign and you can take a look at them. Okay, I guess there are no insights or questions from the virtual students, so I'll go on myself. Starting with the current ratio it looks very healthy. It's trended upwards from 2.4 to 3.6. The 3.6 means that Plainview has 3 and a half times as much current assets as it does current liabilities. Now as we talked about, a problem with this measure is that inventory and prepays are not necessarily going to turn into cash. So we have the quick ratio, which is Cash + Accounts Receivable over Current Liabilities that also looks good. It's been trending upward and it's now actually over one. When we look at the Cash Flow to Current Liabilities it's not quite as strong. We see the volatility in cash flow that we've seen earlier in our ratio analysis and this is trending down. But overall I think we can say that Plainview's short-term liquidity position looks pretty strong. They seem to have enough cash that's going to come in to cover the payments they need to make out. Next we're going to look at the interest coverage ratios. Here the question is does the company have enough cash coming in from operations to cover its interest obligations. And again ideally these ratios will all be over 1. The first ratio is the interest coverage ratio, which is operating income before depreciation, divided by interest expense. So this is a picture of interest coverage from an accrual accounting perspective. So if we look at the sales revenue we take out cost of goods sold, we take out SG&A, and then we ignore depreciation, since that's not ever going to be a cash flow. Is that operating income enough to cover what we have in interest expense? We also have a purely cash based measure. So cash interest coverage is Cash from Operations + Cash Interest Paid + Cash Taxes. What we're doing there is those are subtracted from cash from operations, but we want to add them back to get pure cash from operating the business. So the question is, is that cash from operating the business enough to cover the cash interest paid. So here are the interest coverage rations for Plainview. I will put up the pause sign and you can take a look. Hm, nothing again from the virtual students? Why don't we go and check on them? Hm, what does that say? Dear Professor, sorry, we are studying for the exam. See you next video! Your students. Okay, I guess I have been going on too long about ratio analysis, and I do realize you've got an exam to do. So just give me a few more minutes and I'll wrap this up. Okay, so let me go through the Interest Coverage Ratios. The Interest Coverage Ratio looks really strong, there's an upward trend, and now it's 6.9, which means that Plainview's operating income before depreciation is almost seven times as much as its interest expense. When we look at the cash interest coverage, it also looks strong except for that one year where there was the negative cash from operations. But the current ratio is 3.8, which means that Plainview's operations is generating 3.8 times as much cash as they need to cover their cash interest costs. So it looks like, in general, Plainview's in a good position, in terms of generating cash to cover its interest obligations. Now, we're going to look at long term liquidity ratios. These ratios are going to tell us something about how does the company finance its growth, as well as provide measure of bankruptcy risk. The idea is that the higher the company's leverage, the bigger the risk that it may have to default on its debt payments. And then the company gets forced into bankruptcy hurting the equity investors. First ratio is debt to equity, which is just total liabilities over shareholder's equity. So, for each dollar of investment from shareholders, how many dollars of liabilities has the company taken on? Sometimes we put total assets in the denominator and we'll especially do that if shareholders' equity is really small because that could distort this ratio. The next ratio specifically looks at long term borrowing. So it's long term debit equity, total long term debt divided by shareholders equity. And this is getting at how the company is financing its long term growth. Is it using equity or is it using long term borrowing? And the final ratio is a little tweak on that, it's long term debt to tangible asset. So (Total Long-Term Debt) / (Total Assets- Intangible Assets), intangible assets are things like contractual rights. They're not physical assets, they're not property plant equipment. So essentially, we're trying to get a measure of things like property plant equipment, accounts receivable inventory. And we're trying to get a measure of that because those are the kind of assets that can be collatoralized. In other words, you can borrow the money with those assets as collateral, whereas intangible assets are harder to collateralize. So its the borrowing capacity that the company has based on its collateralizable assets, if collateralizable is a word. So here are the long term debt ratios for Plainview. Let me put up the pause sign and you can take a look. Let's take a look at these long-term-debt ratios for Plainview. In this case, lower ratios are generally better than higher ratios, because they would indicate less risk, more borrowing capacity to fund growth. So Plainview's debt to equity has risen over this period. But it's still only 1.05, which means that for every dollar of equity investment Plainview has about a dollar in liabilities, which is a fairly low leverage ratio. If we look specifically at long term debt to equity, we see that this went up for a little bit. Probably, as they were expanding and building in factories and then has come back down, n is less than one. Similarly, for a long term debt to tangible assets, the ratio went up a little bit, came back down. These are still pretty low ratios indicating that Plainview has a lot of debt capacity that they could use to borrow more money to fund further growth. So, the conclusion for Plainview from liquidity ratios is, that they're in a strong short term cash position, quick ratio is greater than 1. They generally have high interest coverage ratios. They've managed their long term leverage well through their expansion and growth. There's been some small increases in debt-to-equity and long term debt-to-tangible assets ratios, but they're still not that big. And if we compared them to other companies in the industry we would see that they're probably in line with what other companies have. So liquidity is not a major concern for Plainview Technology. And that's a rap for the Plainview Technology case. We have looked at all the major ratios that people tend to use. And so hopefully you can now add these tools to your toolbox when you're analyzing financial statements. I'll see you next time.
