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Principles of Finance: Unit 4, Liquidity and Cash Stash 9 Views


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What are liquidity and cash stash? Well, they have to do with having quick, easy cash on hand.

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Transcript

00:00

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

00:08

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

00:13

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

00:18

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

00:22

diet coke needed refilling well why does liquidity matter so much

00:26

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

00:30

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

00:35

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

00:39

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

00:45

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

00:50

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

00:54

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

00:58

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

01:03

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

01:08

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

01:12

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

01:16

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

01:20

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

01:24

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

01:28

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

01:32

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

01:35

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

01:39

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

01:44

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

01:50

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

01:54

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

01:58

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

02:03

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

02:08

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

02:13

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

02:17

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

02:24

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

02:26

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

02:31

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

02:35

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

02:39

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

02:43

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

02:48

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

02:53

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

02:56

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

03:00

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

03:04

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

03:10

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

03:15

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

03:19

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

03:24

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

03:29

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

03:33

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

03:37

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

03:41

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

03:44

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

03:49

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

03:53

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

03:58

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

04:03

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

04:08

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

04:12

current assets mean basically cash, marketable securities like shares of

04:17

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

04:22

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

04:26

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

04:31

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

04:35

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

04:39

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

04:43

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

04:47

accounts receivable as 95 million having netted out the likely deadbeats

04:52

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

04:56

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

05:01

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

05:06

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

05:10

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

05:16

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

05:21

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

05:26

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

05:32

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

05:37

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

05:42

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

05:46

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

05:51

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

05:55

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

06:00

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

06:06

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

06:11

cups smart companies negotiate with their vendors a return policy something

06:15

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

06:20

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

06:25

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

06:29

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

06:32

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

06:36

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

06:42

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

06:47

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

06:51

little Csar alright now go on about your business

06:54

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

06:59

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

07:04

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

07:09

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

07:13

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

07:17

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

07:21

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

07:25

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

07:30

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

07:36

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

07:39

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

07:43

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

07:46

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

07:50

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

07:54

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

07:58

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

08:01

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

08:06

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

08:09

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

08:13

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

08:16

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

08:20

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

08:24

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

08:28

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

08:32

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

08:36

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

08:40

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

08:44

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

08:49

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

08:55

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

08:59

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

09:04

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

09:09

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

09:14

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

09:17

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

09:23

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

09:27

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

09:32

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

09:36

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

09:41

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

09:45

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

09:50

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

09:55

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

09:59

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

10:05

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

10:11

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

10:15

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

10:20

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

10:26

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

10:30

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

10:34

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

10:38

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

10:43

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

10:48

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

10:53

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

10:57

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

11:03

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

11:07

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

11:11

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

11:16

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

11:21

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

11:25

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

11:29

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

11:34

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

11:38

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

11:41

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

11:44

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

11:49

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

11:53

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

11:57

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

12:03

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

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