Hello, I'm professor Brian Bushee. 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 Plainview 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 a 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 liquidity ratios. We're trying to answer the question does the company have enough cash coming in to cover its obligations to pay out cash in the near term? Ideally all the ratios that we look at would be over 1, which means there's more cash coming in than 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 1. 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 turning into 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 plus receivables divided by current liabilities. Much more conservative ratios saying do you have assets that 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 three and a half times as much current assets as it does liabilities. Now as we talked about, a problem with this measure is that inventory and prepaids are not necessarily going to turn into cash. So we have the quick ratio, which is cash plus accounts receivable over current liabilities. That also looks good. It's been trending upward and it's now actually over 1. When we look at the cash flow to current liabilities ratio, 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 would 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, and 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 plus cash interest paid plus 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. Nothing again from the virtual students? Why don't we go and check on them? What does that say? Dear Professor, sorry we are studying for the exam. See you the 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 the company's financing its growth, as well as provide a measure of bankruptcy risk. The idea is 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 shareholders' equity. So for each dollar of investment by 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 shareholder's equity is really small because that could distort this ratio. The next ratio specifically looks at long-term borrowing. So it's long-term debt to equity, total long-term debt divided by total shareholder's 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's a little tweak on that. It's long-term debt to tangible assets, so total long-term debt divided by total assets minus 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 collateralized. In other words you can borrow the money with those assets as collateral, whereas intangible assets are harder to collateralize. So it's the borrowing capacity that the company has based on its collateralizable assets, if collateralizable is the word. So here are the long-term debt ratios for Plainview. Let me go ahead and 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 the new factories, and then has come back down and is less than 1. Similarly for 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 the liquidity ratios is that they're in a strong short-term cash position. Quick ratio is greater than one, 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 asset 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 wrap 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.