ShmoopTube

Where Monty Python meets your 10th grade teacher.

Search Thousands of Shmoop Videos


Principles of Finance Videos 166 videos

Principles of Finance: Unit 1, Company Formation, Structure, Inception
97 Views

How is a company... born? Can it be performed via C-section? Is there a midwife present? Do its parents get in a fight over what to name it? In thi...

Principles of Finance: Unit 1, Intro: Company Formation, Structure, and Inception: Unit Intro
43 Views

Company Formation, Structure, and Inception: Unit Intro. Sorry, Leo DiCaprio fans—we're not going to be breaking down the plot of Inception. We'r...

Principles of Finance: Unit 1, Alex, That’s Finance Potpourri for $500
67 Views

Okay, so you want to be a company financial manager. It's basically up to you to make money for the shareholders. It would also be swell if you mad...

See All

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


Share It!


Description:

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

Language:
English Language

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]

Related Videos

GED Social Studies 1.1 Civics and Government
39794 Views

GED Social Studies 1.1 Civics and Government

Fake News
11938 Views

How do you tell fake news from real news?

Finance: What is Bankruptcy?
260 Views

What is bankruptcy? Deadbeats who can't pay their bills declare bankruptcy. Either they borrowed too much money, or the business fell apart. They t...

Finance: What is a Dividend?
1777 Views

What's a dividend? At will, the board of directors can pay a dividend on common stock. Usually, that payout is some percentage less than 100 of ear...

Finance: How Are Risks and Rewards Related?
589 Views

How are risk and reward related? Take more risk, expect more reward. A lottery ticket might be worth a billion dollars, but if the odds are one in...