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Principles of finance a la shmoop liquidity and cash stash as we all know [Briefcase of liquidity and cash]

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liquidity rules the world and well it does so not even in a cool water world

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sorta way ok so much attention to this notion of liquidity which until you

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started this video you might have thought was about whether or not your [Person opens can of cola]

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diet coke needed refilling well why does liquidity matter so much

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well because without it you can't pay your employees, your rent, your heating

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bill, liquidity is just handy cash such that if you have a lot of it well then

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your company can handle not only its normal monthly bills but also prolonged

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periods of a harsh economic or industry environment it can also handle your [Samsung galaxy note on fire]

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company stumbling through a bad product launch, a lawsuit and you know any other

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curveballs that come your way so said another way if you have a lot of

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liquidity you have an easy time accessing your own cash or converting

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your inventory or assets into cash quickly and you have a high ratio of

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easy cash to costs so step back and think logically about what a [Man giving presentation of mathematical model of liquidity]

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mathematical equation in liquidity might involve well your company has a thousand

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employees, employees have an average salary of 70 grand a year

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so with benefits you provide as a company it costs you about a hundred

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grand a year to employ that $70,000 a year take-home employee do the

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multiplication and you have a hundred million dollars of ongoing employee [Formula of employee costs]

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costs you check through your other main expenses, rents 10 million a year

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computers, food, coffee, travel and everything else about 20 million those

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are the fixed recurring costs right well you have to pay them each year whether

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you'll want to or not unless you decide to a drive your company's lower but when [Man driving car and falls asleep]

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you calculate liquidity ratios you don't presume diminution of production meaning

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you're going at full capacity just like you always were..You then look at the

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variable costs what does all this mean well you spend 50 million dollars a year [Variable cost examples]

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on marketing could you cut back on marketing sure but then sales would

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probably get hit a year or two or three later without a new plastic stamping

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plant Barbie will have no iPhone 22 and well you'll sell a lot fewer of her [Girl holding a barbie doll]

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eventually.. so you really hate to cut back especially when your competitors

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will seize that opportunity to you know poke you in the eye or they'll poke you [Girl pokes man in the eye]

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somewhere worse... well let's pretend we're a mutual fund company we

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don't make anything other than good decisions and these are all of our

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expenses to operate the company that's 100 million dollars in employee costs 10

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million in rent 20 million in coffee we love our coffee and 50 million bucks [Company expenses list]

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in marketing all right the total expenses are 180 million so how do you

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conceptually define liquid here like if you had on your balance sheet net of 180

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million dollars just sitting there untouched unless Armageddon hit, would [Asteroid strikes Earth]

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you feel liquid well yeah probably at least in most industries but what about

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our mutual fund company well in that world you live and die based on the

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health or lack thereof in the stock market and markets can get really ugly

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for very long periods of time very fast and as you probably remember the 1970s [Dow Jones industrial average stock graph]

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saw very little market appreciation and that was for a whole decade well even in

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a bad market a mutual fund company collects its fees but if the market is

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low they collect fewer fees so for a conservative mutual fund company how

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many years of expenses well do they need to have assuming zero revenues to feel

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liquid one year, two year, three years.. you know well probably somewhere in there is

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the right answer it's you gotta have a lot for Armageddon because well you fear [Explosion occurs in the distance of a wasteland]

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the nuke in which case well if we really did get nuked we'd have myriad of other

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things to worry about beyond cash liquidity let's put some mathematical

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meat on the bones and map out a means for viewing liquidity and don't get [Man chopping meat]

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caught up in $5 words and fancy weird accounting terms when you think about

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basic concepts like can I pay my freakin bills.. that concept is easy you pay your

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rent or you live in your Prius the first pit stop on the liquidity track is the [Man sleeping in a Prius]

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current ratio... current means within the next year or less it's

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a balance sheet term and we covered it in an earlier video and recall that

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current assets mean basically cash, marketable securities like shares of

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goog, government bonds, ounces of gold, accounts receivable presumably people

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will pay you within the next year note that a lot of companies carry

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accounts receivable as a net number meaning that they net out the doubtful

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accounts the deadbeats ie those likely to not pay because of the middle finger [Girl working and giving the middle finger]

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thing or because they went bankrupt usually there is some history behind

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this number like well in the last five years the company averaged 5% bad

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accounts so if they're actually owed 100 million dollars the company would show

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accounts receivable as 95 million having netted out the likely deadbeats

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Another key metric you'll need to know about is accounts receivable

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turnover that is you sell something to a customer who has to pay you in 90 days [Customer and employer trading cash]

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well it's great that you made that sale but that sale cost you liquidity and

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that you had to use your cash for inventory assembly shipping contracts

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and so on. So at the moment of sale the sale sucked up liquidity and you can [Sale sucked up by vacuum]

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imagine if you were net 365 days to pay you instead of 90 days to pay you

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you could get very illiquid very fast so metering and measuring how quickly your

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accounts receivable pay you is a really big idea the ratio is calculated as [Accounts turnover ratio example]

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annual credit sales over accounts receivable at the beginning of the year

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right well inventory is a liquid asset usually but as you hopefully remember

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from the other video we did on such great subject inventory can and probably

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should be held on the balance sheet at a discount to what the company paid for it [Pro tip erased from shmoop board]

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that is if you bought a million cups at a dime each and you had to suddenly turn

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them into cash could you really get a dime a cup from them? No, almost certainly

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not the would-be buyers would smell your desperation and use more roll-on next [Security guard escorting boy away]

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time and there isn't a natural you know liquid market for semi used drinking

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cups smart companies negotiate with their vendors a return policy something

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on the order of have the right to send back to you half of whatever I bought

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and get back 95% of what I paid you no questions asked or something like that

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and if so you just do the math and carry the net number or net value of that [Inventory net value highlighted]

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inventory on your books but the key idea here is that inventory isn't always

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liquid and often when it is converted into cash in an emergency situation

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there's a steep discount or penalty you pay...So the four elements that

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comprise current assets, cash, securities, accounts receivable and liquid inventory [Man discussing current assets]

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alright well if you need help remembering this it's CSARI like a

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little Csar alright now go on about your business

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So how did the current ratio get born well a current asset and a current

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liability had a smack down and then they danced yeah it was a mating ritual where [Man and woman dancing]

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current assets climbed on top of current liabilities and they did a calculation

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specifically they created a little baby current ratio yeah it's a cute little

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bug of an accounting term which basically describes how fast we are

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paying our bills relative to collecting our bills.... let's think about

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this if we had a ratio of 1:1 that would imply that like five minutes after we [Bill transfers from supplier to CEO]

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collected a bill we paid the bills that we owe what happens if someone who owes

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us money says I'm not gonna pay you sue me..well we might win but it'll take us

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months or years going to court and dealing with lawyers and judges and a [Judges and lawyer in court]

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bizarre American legal system and will likely go bankrupt long before we

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collect the fourteen thousand two hundred thirty two dollars we are owed

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in fact in the real world the common tool large companies often use against

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smaller ones with little to no leverage our maneuvers like this where they just [Boy making smaller boy hit himself]

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hold up the back of their hand and tell the little company they're gonna sue

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them read between the lines we're not gonna pay you so a one-to-one current

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ratio is bad bad bad news all right what's a good ratio well, think

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about 3:1 if we're analyzing a company and note it pays its bills

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really quickly well that's a sign the company feels great about the cash

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position that it'll have plenty of dough left over at the end of the month to pay

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rent and not have to work out of the back of the corporate pickup truck...[Boy selling lemonade in a pick up truck]

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Well what about a current ratio of 20:1 what does that mean well that means

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you have tons of current assets few current liabilities mmm does that mean

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there's too much money tied up in inventory well maybe so we don't know

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what the right number is we have to compare everything relative to our peer

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group the industry everyone else because while ding-ding-ding these numbers don't

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exist in a vacuum that is if your company has 10 million dollars of

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revenue with current assets of 1.5 billion in current liabilities of 1 [Current assets and revenues of 20:1 ratio]

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billion well that's a 1.5 to 1 current ratio just on the edge of bad but look

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at the magnitude how is it that you have only 10 million dollars of revenue and

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such huge balance sheet items.. well one tiny wrinkle to the bat and while you're

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dead meat there's another ratio that speaks directly to liquidity, the quick [Nesquik cereal box]

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ratio not to be confused with the Nesquik ratio which is way tastier

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well this one's called the quick ratio as a reflection of some hand out

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in front vendor saying pay me Seymour and then you being able to quickly pay [Seymour pays man]

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them see how that works clever well the quick ratio is all about immediate cash

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quick cash that is how quickly could you come up with whatever amount of cash

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either for defensive or offensive purposes.. so what does that mean

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defensive or offensive purposes well defense you lose a lawsuit and if you

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agree to pay it all off immediately you can pay half of what the judge ordered [Person pays lawsuit to judge]

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you to pay agree to not appeal and well then the lawsuit goes away all right

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then there's offense a competitor wants to get out ASAP from the business to

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sell maybe the founder is in the middle of a midlife crisis or a nasty divorce

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or both and just took delivery of his convertible red porsche if you pay X

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dollars today ish all in cash you can have his business for a steal so we

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bludgeoned you with what comprised current assets, cash securities, accounts

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receivable and inventory which of these is not like the other yep inventory if [Man giving presentation on current assets]

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you need cash quick you don't want to have to be selling inventory in a panic

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sale out there selling inventory usually ain't all that quick

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and while technically it's a current asset the notion of current is broadly

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defined when it comes to a thousand spare, say tractor treads yeah usually [Arrow points to tractor treads]

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there's no category for tractor treads on eBay well in some texts wall street

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bars and bean counter coffee counters the quick ratio is also called the acid

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test but if someone quotes you acid test check to be sure they're wearing

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shoes it's highly likely they attended Woodstock another ratio well we have to

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think about is DSOs well it's calculated as accounts receivable over sales made

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on credit ooh what does that mean? well, you'll notice if you aren't

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asleep yet that this is sort of the inverse ratio of the account receivable

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turnover calculation that we just did anyway DSO's are the average number of

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days it takes us to collect our bills that is bills sent out on credit if

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they're paid in cash while the DSO would be won and again everything's all [DSO calculation example]

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relative a big DSO number means that it's taking us forever to collect our

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bills that's not a good sign usually but a jet engine company might make a sale [People moving a jet engine]

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and not deliver the full engine for two years albeit with partial payments along

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the way so you can't compare it with a lemonade stands DSOs [Boy standing by a lemonade stand]

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the basic idea here is just that if you are collecting your bills relatively

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quickly that's good if you're not that's bad and in real life most financial

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managers pay a lot more attention to relative trends within a company than

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they do what the external world is doing meaning that if last quarter DSOs were

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37 and suddenly this quarter they're forty-one well then Houston we may have

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a problem... an expensive one [Engineers working on a rocket]

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