Metrics (Liquidity) and a Review of Accounting in 2006 (#28)
/In this episode, we review the key accounting events during the past year, and also discuss the key metrics for liquidity. Key points discussed concerning accounting events are:
Enron and Worldcom jail terms were handed down.
There were a series of stock option manipulation frauds.
The SEC issued new compensation disclosure rules.
FIN 46 was issued, involving off-balance sheet reporting requirements.
Issues with the existing lease and pension accounting standards were discussed.
The industry dealt with ongoing complaints about the requirements of Sarbanes-Oxley section 404, pertaining to systems of control.
Key points relating to the metrics for liquidity are:
The current ratio is not a useful indicator of liquidity, since it includes inventory, which is not liquid.
The quick ratio is better, since it removes inventory from the calculation.
A comparison of sales to assets can be plotted on a trend line; the proportion should be about the same over time.
The days of working capital ratio indicates the amount of working capital needed to support one day of sales.
The accounts receivable collection period indicates the average number of days during which an invoice is outstanding, before it is collected.
A comparison of sales to inventory can be plotted on a trend line, to indicate the ongoing investment level of a business in inventory.
The accounts payable days measurement can be plotted on a trend line to highlight any changes in payables duration.
The risky assets conversion ratio shows the percentage of low-value assets on a company’s balance sheet.