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:
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Enron and Worldcom jail terms were handed down.
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There were a series of stock option manipulation frauds.
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The SEC issued new compensation disclosure rules.
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FIN 46 was issued, involving off-balance sheet reporting requirements.
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Issues with the existing lease and pension accounting standards were discussed.
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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:
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The current ratio is not a useful indicator of liquidity, since it includes inventory, which is not liquid.
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The quick ratio is better, since it removes inventory from the calculation.
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A comparison of sales to assets can be plotted on a trend line; the proportion should be about the same over time.
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The days of working capital ratio indicates the amount of working capital needed to support one day of sales.
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The accounts receivable collection period indicates the average number of days during which an invoice is outstanding, before it is collected.
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A comparison of sales to inventory can be plotted on a trend line, to indicate the ongoing investment level of a business in inventory.
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The accounts payable days measurement can be plotted on a trend line to highlight any changes in payables duration.
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The risky assets conversion ratio shows the percentage of low-value assets on a company’s balance sheet.