The current ratio expresses the relationship between current assets and current liabilities. As debts come due, they must be paid out of current assets. Therefore, short-term creditors frequently compare the amount of current assets with the amount of current liabilities. The current ratio indicates a company’s short-run debtpaying ability. It is a measure of liquidity and of solvency.
A strong current ratio provides considerable assurance that a company will be able to meet its obligations coming due in the near future. The current ratio for Seacliff Company is computed as follows:A widely used rule of thumb is that a current ratio of 2 to I or better is satisfactory, although significant differences exist across industries. By this standard, Seacliff Company’s current ratio appears quite strong. Creditors tend to feel that the higher the current ratio the better.
From a managerial point of view, however, too high a current ratio may indicate that capital is not being used productively in the business. Quick Ratio Because inventories and prepaid expenses are further removed from conversion into cash than other current assets
•.the quick ratio is sometimes computed as a supplement to the current ratio, The quick ratio compares the’ highly liquid current assets (cash, marketable securities, and receivables) with c.urrent liabilities. Seacliff Company has no marketable securities; its quick ratio is computed as follows:.
Here again the analysis reveals a favorable trend and a strong position. If the credit periods extended to customers and granted by creditors are roughly equal, a quick ratio of 1.0 or better is considered satisfactory. Unused Lines of Credit From the viewpoint of a shoit-te~ creditor, a company’s unused lines of credit represent a resource almost as liquid as cash.
An unused line of credit means that a bank has agreed in advance to lend the company any amount, up to the specified limit. As long as this line of credit remains available. creditors know that the business can borrow cash quickly and easily for any purpose, including payments of creditors’ claims. Existing unused lines of credit are disclosed in notes accompanying the financial stalements.
Short-term creditors would view Seacliff’s $35,000 line’ of credit (Note 2 to the financial statements) as significantly enhancing the company’s .liquidity. 4
Cash Flow Ana!ysis We often have stressed the importance of a company being able to generate sufficient cash flows from its operations. In 2000, Seacliff generated net cash flows of $95,000 , from its operating activities-a relatively “normal” amount, considering that net income for the year was $90,000. This $95,000 remained after payment of interest to creditorsand amounted to more than three times the dividends paid to stockholders. Thus in 2000 the net cash flows from operating activities appeared quite sufficient to ensure that Seacliff could pay its interest obligations and also pay dividends. In ‘200 I, however, net cash flows from operating activities declined to only $19,000, an amount far below the company’s $75,000 net income and less than one-half of the amount of dividends paid. ·Stockholders and creditors alike.would view this dramatic decline in cash flows as a negative and potentially dangerous development. A reconciliation of Seacliff’s net income in 2001 with its net cash-flows from operating activities is shown as follows (As explained in Chapter 13, the FASB requires companies to provide this type of reconciliation either in the statement of cash flows or in a supplemental schedule.)
The primary reasons for Seacliff’s low net operating cash flows appear to be the growth in uncollected accounts receivable «nd inventories, combined with the substantial reduction in accrued liabilities.
Given the significant increase in sales during 2001, the increase in accounts receivable is to be expected. The large reduction in accrued liabilities probably is a one-time event, not likely to recur next year. The large increase in inventory, however, may have reduced Seacliff’s liquidity unnecessarily. Seacliff’s financial position, particularly its short-term liquidity, would appear considerably stronger if its increased sales volume were supported by a higher inventory turnover rate, instead of a larger inventory.Usefulness, of Notes to Financial Statements
A set of financial statements normally is accompanied by several, notes, disclosing information useful in interpreting the statements. Users should view these notes as an integral part of the financial statements. In preceding we have identified many items that are disclosed in notes accompanying the financial statements. Among the most useful are the following:
• Accounting policies and methods
• Unused lines of credit
• Significant commitments and loss contingencies
• Current values of financial instruments (if different from the carrying values shown in the statements) Dividends in arrears
• Concentrations of credit risk
• Assets pledged to secure specific liabi.l,ities The notes accompanying Seacl.ff”» financial statements are quite clean-that is, they contain 110 surprises or cause for concern. Of course, the unused line of credit disclosed in Note 2 would be of interest to anyone evaluating the company’s short-term debt-paying ability