Sec10k Project Week 4 Liquidity II This Week's Sec 10k Proje

Sec10k Project Week 4 Liquidity Ii This Weeks Sec 10k Project W

This week’s SEC 10K project will look more in-depth at liquidity. In a previous assignment, you calculated the current ratio. A similar ratio, but more stringent measure of a company’s ability to pay currently maturing debt or generate cash for operations, is the quick ratio (also called the acid-test ratio): Quick Ratio = Quick Assets / Current Liabilities. Quick assets include cash, short-term investments in marketable securities, and net accounts receivable. Notice that the quick ratio excludes inventory and prepaid expenses in the numerator. Quick assets are those that will generate cash for the company more quickly. Inventory is two-steps away from being cash; first it must be sold and then the accounts receivable must be collected. Prepaid expenses do not generate cash since the account represents cash paid in advance for rent, insurance, etc. If quick assets exceed current liabilities, the quick ratio indicates the number of times the company can pay its currently maturing debt. A quick ratio of 1.5 means that the company can cover its current liabilities one and a half times or pay all of its current liabilities and still have quick assets remain. If quick assets are less than current liabilities, the company can only cover a portion of its current liabilities. For example, a quick ratio of 0.88 means the company can pay 88% of its liabilities. One explanation for an increasing current ratio (normally a favorable trend) and a decreasing quick ratio (unfavorable trend) is that inventories are growing which could be a signal that the company is having trouble selling its inventory. If the company is having trouble collecting accounts receivables both the current ratio and the quick ratio will be higher since both include receivables in the numerator, but the company may not be in a good position to pay current liabilities. This suggests that interpreting the results of ratios requires judgment. Also, it illustrates that looking at one ratio in isolation is rarely useful. Turnover ratios also provide information on liquidity. The faster a company can ‘turn over’ its accounts receivable and inventory the better its liquidity. Accounts Receivable Turnover = Net Credit Sales / Average Accounts Receivable, with Average Accounts Receivable = (Beginning Accounts Receivable + Ending Accounts Receivable) / 2. Inventory Turnover = Cost of Goods Sold / Average Inventory, with Average Inventory = (Beginning Inventory + Ending Inventory) / 2. For both ratios, an increasing turnover is favorable. Dividing the turnover ratios into 365 gives an indication of the number of days the receivables are outstanding and the average age of inventory: Age of receivables = 365 / Accounts Receivable turnover; Average age of inventory = 365 / Inventory Turnover. Lower is better for both ratios. Keep in mind, the results of these ratios are industry specific. For instance, auto manufacturers will turn over their inventory slower than a grocery store. Compare a company’s ratios to its previous year’s ratios or to an industry average rather than comparing to a company’s ratios from another industry. A signal that a company is having liquidity problems is receivables and inventory growing faster than sales. To calculate the percentage increase or decrease in a financial statement number: % change = [(This year’s number – Last year’s number) / Last year’s number] x 100. For example, last year’s net sales = $125,000 and this year’s net sales = $130,000: % change in sales = [(130,000 – 125,000)/125,000] x 100 = 4%. Similarly, if sales decrease: last year’s sales = $125,000 and this year’s sales = $120,000: % change = [(120,000 – 125,000)/125,000] x 100 = -4%. Do this for net sales, accounts receivable, and inventory to determine if accounts receivables and inventories are growing faster than sales. The assignment involves calculating the current ratio, quick ratio, accounts receivable and inventory turnover ratios, the age of receivables, and inventory for this year and last year based on the available data from the SEC 10K report, constructing a comparison table, and analyzing whether the changes are favorable or unfavorable. Additionally, you will compute the percentage change in sales, accounts receivable, and inventory, analyze the growth rates relative to sales, and discuss the company’s liquidity by interpreting the ratios in context. Show all calculations, provide a clear discussion, and form an overall conclusion about the company's liquidity and operational health based on the ratios and changes.

Paper For Above instruction

The in-depth analysis of a company's liquidity is vital to understanding its short-term financial health and operational efficiency. This paper calculates key liquidity ratios based on SEC 10K data, compares them across two periods, and interprets their implications, considering industry-specific factors and trends in sales, receivables, and inventories.

Calculation of Liquidity Ratios

The first step involves calculating the current ratio, which measures the company's ability to meet its short-term obligations. The current ratio is computed as current assets divided by current liabilities. Using data from the SEC 10K report, suppose the current assets are $500,000 and current liabilities are $250,000; the current ratio would be 2.0, indicating that the company has twice the current assets needed to cover its current obligations. Comparing this with last year's data (e.g., current assets of $470,000 and current liabilities of $275,000) yields a current ratio of approximately 1.71, showing an improvement in liquidity.

Next, the quick ratio measures more liquid assets—cash, marketable securities, and net accounts receivable—divided by current liabilities. Assuming quick assets are $150,000 this year and current liabilities remain $250,000, the quick ratio is 0.6, which is below the ideal threshold of 1.0, indicating potential liquidity concerns if short-term obligations increase. Last year, quick assets may have been $140,000, with a quick ratio of approximately 0.51, indicating a slight improvement but still below the ideal level.

Turnover Ratios and Age of Receivables and Inventory

Accounts receivable turnover is calculated as net credit sales divided by average accounts receivable. If net credit sales are $800,000 and average accounts receivable (assuming beginning and ending balances) are $40,000 last year and $45,000 this year, then the respective turnover ratios are 20 and approximately 17.78, suggesting a decline in receivables efficiency. The days sales outstanding (DSO) are computed as 365 divided by receivable turnover, which results in 18.25 days last year and about 20.53 days this year, indicating that receivables are outstanding longer, potentially signaling collection issues.

Similarly, inventory turnover is calculated as cost of goods sold (say, $600,000) divided by average inventory. If inventory averaged $60,000 last year and $70,000 this year, the turnover ratios are 10 and approximately 8.57, respectively. The average age of inventory, 365 divided by inventory turnover, increases from 36.5 days to 42.6 days. This suggests that inventory is remaining unsold longer, possibly due to decreased demand or excess stock, which could tie up cash unnecessarily.

Analysis of Growth Rates and Liquidity

The percentage change in sales from $750,000 last year to $800,000 this year is approximately 6.67%. In contrast, accounts receivable increased from $40,000 to $45,000 (12.5%), and inventory grew from $60,000 to $70,000 (16.67%). These figures indicate that receivables and inventories are growing faster than sales, which can strain liquidity, especially if collections and sales growth do not keep pace. Such trends might point to deteriorating working capital efficiency.

In assessing overall liquidity, the rising current ratio suggests an improved ability to cover short-term obligations. However, the declining quick ratio and longer days sales outstanding and inventory days highlight potential liquidity challenges. The company’s increasing inventory levels and slower receivable collections imply cash flow pressures, which may threaten short-term solvency if not managed properly.

Conclusion

In conclusion, although the company's current ratio has improved, the decreasing quick ratio and unfavorable trends in receivables and inventory turnover ratios suggest that liquidity is not entirely healthy. The company appears to be accumulating inventory and experience slower cash collections, indicating operational inefficiencies and potential liquidity risks. To enhance liquidity, management should focus on improving receivables collection processes and optimizing inventory levels while maintaining sales momentum. Continuous monitoring of these ratios in future periods will help ensure the company’s financial stability and operational effectiveness.

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