mod11lec52

Welcome, so in the previous class we were discussing the models of cash management and we talked about the two models that is a certainty model and the uncertainty model and we try to learn that how to find out the optimum balance of cash or maybe say a range of the cash where the firm will be comfortable and means both the objectives of maintaining sufficient liquidity and avoiding the technical insolvency can be achieved. I told you in the previous class that now we will be moving to the payables management or the management of accounts payable that is the say current liabilities. But before that we will discuss some more things with regard to this cash management or especially able to call it as liquidity management. We have talked about the liquidity earlier also and where we talked about that to manage to maintain the liquidity sufficient liquidity in the firm. The firm must have pure cash and the backup liquidity so that is in terms of the marketable securities. So, that is say okay that yes we can have cash and we can have the backup liquidity in the form of the marketable securities. But there are certain other important concepts also to deal with the liquidity and to say understand the liquidity position of the firm and that we will talk today liquidity management little more about the liquidity management. And one more thing I will talk to you I thought that it is important to talk to you is about the window dressing that is with regard to the say again say studying the liquidity position of the firm. Sometime firms indulge into the window dressing and with the help of window dressing they improve the ratios. So, we should be careful and we should be capable of finding it out whether the firm has improved its current and quick ratio just by window dressing or by really say they have that much of the liquidity which is depicted by the current ratio and the quick ratio. So, we will talk these two things before we move to the management of accounts payable. So, when you talk about the liquidity management we normally study 3 ratios and these 3 ratios I think you have we have already discussed these ratios at length in the past also. And the quick means review of the liquidity position of the firm can be had with the help of these 3 ratios that is the current ratio. Then this is the first ratio then we go for the quick ratio and then third one is the super quick ratio we call it as super quick ratio or sometime we call it as cash ratio also we call it as cash ratio also. So, these are the 3 ratios we calculate we try to calculate the current ratio where the rule of thumb is that is 1.33 is to 1 earlier it was how much 2 is to 1 but now it is revised and it has been brought down from the 2 is to 1 to 1.33 is to 1. So, this is the current ratio we have discussed this ratio at length many times. Then we have the quick ratio quick ratio earlier means the current rule of thumb is that is 1 point sorry 1 is to 1 this ratio should be earlier rule was 1.5 is to 1 and the super quick ratio is now the current rule is earlier rule was it the current rule first we discussed that is it is 0.5 is to 1 earlier the rule was 1 is to 1. So, we have changed the rule of thumb for the interpretation of these ratios or understanding the liquidity position of the firm. But say these 3 ratios are not sufficient to depict the liquidity of the firm say for example in the current ratio we take all current assets divide them by current liabilities and try to find out how many times the current assets are of the current liabilities simple quick ratio be subtract from the current total current assets only inventory. And then we see that other than inventory how many quick assets are there which are called as quick assets not current assets. So, how many or what is the amount of the quick assets in the firm divide them with the current liabilities and then we calculate the ratio. And in the super quick ratio we normally take the pure liquidity and the backup liquidity that is cash and marketable securities and dividing them by the current liabilities. So, we assume that 50% of your current equal to the 50% of the total current liabilities firm must keep cash plus the backup liquidity in the form of short term securities very short term securities which are called as marketable securities right. So, these 3 ratios normally we calculate work out while we try to study the liquidity position of the firm apart from that there are certain other liquidity ratios also. Say for example receivables turnover ratio we calculate the receivables turnover ratio where we calculate the turnover of the accounts receivables and for calculating that receivables turnover ratio what we do is that is we take the say sometime the credit sales or we take sometime we take the total sales. And on the basis of that we calculate these ratios when you calculate it with the help of the say receivables turnover ratio we take gross sales right and divided by the average receivables opening and the closing balance of the say accounts receivables. So, we divide the gross sales and we interpret that higher the ratio better it is higher the amount of the numerator that is a gross sales as compared to the denominator that is the average accounts receivables. So, we presume that the firm is maintaining sufficient liquidity similarly we have the other ratio that is called as the inventory turnover ratio we also study it under 2 parts that is under the resource turnover ratio also and sometime we study it under the liquidity ratio also because liquidity of the firm can be studied with the help of the with the help of this inventory also how quickly we are converting our inventory into sales or cash. So, we call it as inventory turnover ratio inventory turnover ratio and for calculating this we take the COGS COGS divided by the average inventory normally we take the inventory of finished goods. But sometime we can take the total inventory also of the raw material then the work in process and then the finished goods. So, this is another ratio we study or work out for studying the liquidity position of the firm and this is with regard to the assets current assets because accounts receivables is also a current asset inventory is also a current asset and to know the liquidity position of the firm we try to calculate the creditors turnover ratio or accounts payable turnover ratio where we take the purchases or maybe sometime we take the total purchases if the credit purchase is not possible to be taken then you take the total purchases and then is you take here is the average accounts payable right. So, these are the 6 ratios 1, 2, 3 sorry this was 4 this is 5 and this is 6 ratios. So, these 6 ratios we have been talking in the past also and while studying the say financial structure of the firm we have referred to these some of these ratios at that time also. So, till this date might be you have studied or understood that by say for studying the liquidity position of the firm we should calculate these 6 ratios starting with the current ratios and then say knowing about the turnover of the accounts receivables and the inventory and then the accounts payable and apart from the current ratio we calculate the quick ratio and the super quick ratio and the rule of thumbs are better described in the literature. So, this gives us the overall liquidity position of the firm so I would add here one more ratio which experts suggest financial experts suggest that apart from studying these 6 ratios we should calculate one more ratio to know the liquidity of the firm. And if you calculate that ratio that will give you the better picture of the liquidity position of the firm. So, you go for these 6 ratios or you calculate these first 3 ratios current ratio, quick ratio and super quick ratio and apart from that you calculate one more ratio which I am going to discuss with you now and then that will give you the better picture and as a say further analysis if you want to go for then the turnovers of the inventory receivables and payables can also be studied. So, this total bunch of 7 ratios will make the say study of the liquidity position of the firm possible and that will give you much better idea that any supplier if you want to supply to the firm or say any bank want to say extend the loan working capital loan or may be through CC limit if they want to extend the financial help to the company. So, that will be possible but they want to make sure that yes firm should be able to pay off our obligations as and when they become due so there should be sufficient liquidity. So, to study that liquidity position or to understand the liquidity position of the firm we can study this total bunch of the 7 ratios. So, which one is now the 7th ratio that 7th ratio is called as a NLR net liquidity ratio net liquidity ratio. Net liquidity ratio is what this is it can be calculated with the help of cash plus marketable securities plus unused CC limit minus this is all in numerator minus trade creditors means sundry creditors and outstanding expenses or the expense credits outstanding expenses this all means total of cash plus marketable securities plus unused CC limit minus trade creditors and outstanding expenses that is called as expense credit to be divided by total assets. If you calculate this ratio and try to understand the liquidity position of the firm which is called as a net liquidity ratio should be able to know more about the liquidity and this will be helping us to understand the net liquidity position of the firm net liquidity of the firm. Here now what we are taking we are taking extra item here is that is the unused CC limits we have discussed the concept of CC limit at length and say for example there is there are 2 balances in the CC limit there can be 2 balances when any bank sanction the CC limit for example say we call it as 10 lakhs right. So, this is a 10 lakhs limit is there so in this limit means this account is opened by the bank in its own branch companies account is open that is a CC limit account and condition is that firm now will not have any other current account in any other branch may be of same bank or the other banks whatever the total receipt and payments of the firm will be now they will be routed through this account right. So, for example you have say 10 lakhs limit is sanctioned by the banks it means 10 lakhs rupees will be available to the firm any time firm can write the cheques against this balance and they can make use of this money. For example firm write say here say first cheque of rupees say how much 2 lakhs rupees right. So, now the balance of the firm will come down to 8 lakhs rupees right next day the firm receives 3 lakhs rupees that is the from its buyers on credit. So, the balance of the firm will become 11 lakhs rupees right so this way the balance of the firm keep on or balance of the CC limit account keep on fluctuating sometime it becomes more than the sanction amount if the receipts are more than the payments. Sometime it is less than the sanction amount when the payments are more than the receipts. So, for example if there is a CC limit sanctioned to the bank by the bank to the firm which is 10 lakhs rupees firm has used only 2 lakhs rupees and this 8 lakhs rupees is still available with the firm it means this should also be added into the total current assets which are cash assets I would say not current assets cash asset cash is cash marketable security is the backup liquidity or near cash. Similarly the CC limit is also the near cash CC limit is also the near cash so we should count this also because this is as good as cash or as good as the cash lying in any bank account. If the firm has to make any payment to anybody and if this 8 lakhs rupees is available in the bank and no other source of the funding is there no other source of finance is there then firm can simply write a cheque of 2 lakhs rupees 3 lakhs rupees up to 8 lakhs rupees they do not need to worry about because they have the CC limit and a positive balance sufficient balance of the 8 lakhs rupees is available in the CC limit account right. So, experts say that while calculating the NLR net liquidity ratio cash plus marketable securities plus unused CC limit should also be added. And from that whatever the current liabilities are you subtract that that is the normally the current liabilities are to only sundry creditors and the expense creditors. Expense creditors are say wages of the workers salaries of the employees say outstanding bills of the electricity water maybe sometime taxes also. So, they all should be which are short term in nature should be subtracted so what you will be left with finally if you do like this you will be left with the net current assets divided by the total assets. So, what is the ratio of the net current asset to the total assets if you interpret this ratio from the point of view of the lender then he wants that this ratio should be as high as possible level of current assets should be as high as possible as compared to total assets. But from the point of view of the firm itself they would say that yes we are ready to maintain a level of NCAS net current assets but it should be we should be allowed to maintain a optimum amount of the net current assets. Because again you are maintaining cash you are maintaining marketable securities so cash is almost not generating anything however marketable security generate some return and unused CC limit is not causing any cost. So, they would like to make maximum use of the CC limit they would like to have maximum return from the marketable securities and they would like to keep minimum balance as the cash. So, from the firm's point of view if you interpret the ratio if you are the borrower tomorrow and if you go to the bank and bank ask for this ratio NLR then you say that yes we are maintaining a sufficient handsome NLR net liquidity ratio. But if the bank insists for more then we can convince the bank that is not in the interest of the firm to have high level of the cash because it is unproductive. And if you are a lender then you should insist for that the NLR should be sufficiently high so that there is a sufficient liquidity prevailing in the firm and that liquidity can be used at any particular point of time as and when that is of any requirement right. So, this is the NLR we should calculate and interpretation will depend upon if you are a borrower it will be different if you are lender then it will be different and how you have to interpret it I have discussed with you just now right. Now there is one more ratio before we close the discussion on the liquidity there is one more ratio which should be calculated. And this ratio is called as adjusted current ratio adjusted current ratio till now we have been calculating a simple current ratio when the simple current ratio what you do is current assets divided by the current liabilities and we say that the ratio should be 1.33 is to 1 right. This is a simple I am talking about this this ratio is this is a simple current ratio and when you talk about the adjusted current ratio how you have to calculate the adjusted current ratio. We have to adjust all individual current assets and current liabilities to their turnovers. Keeping inventory in the balance sheet having receivables in the balance sheet having cash in the balance sheet does not give you a simple picture or a very a picture which is easily understandable. So, we should relate these current assets to its inventory sorry turnover ratios. You are keeping inventory nothing wrong in that but how quickly we are converting the inventory into cash or sales and sales into cash. You have accounts receivables credit sales no harm we can have it but how quickly we are converting those credit sales into cash. You are having the cash but what is the turnover of the cash how quickly you are using this cash. So, in case of inventory especially in case of inventory and receivables their working out their turnover is most important. And if you adjust the all individual current assets according to their turnover then that will reflect the much better picture so how we have to calculate the adjusted current ratio. For calculating the adjusted current ratio I will give you a model that we have to use this model. So, you can say adjusted we have to adjust the individual current assets and the current liabilities. So, it means for adjusting that we have to calculate the adjusted individual current asset oblique current liabilities current asset oblique current liabilities and how to adjust that that will be adjusted in a way that is current asset or current liability right. It can be current asset or it can be current liability and put a bracket here and that is 1-1 by turnover turnover of asset or liability sorry I would write it here as a current asset or the current liability. We write it here as the turnover of the current asset oblique current liability and close the bracket here right. So, you have to adjust the current assets to their turnovers similarly the current liabilities to their turnover. So, the real value will be reflected after adjusting these current assets individually all the current assets and the current liabilities and after that whatever the value of the current assets you find you have to calculate the current ratio then you will be able to find out that what is the actual realizable value of these current assets we are keeping inventory but how fast you are converting this inventory into sales that is a million dollar question. And similarly the accounts receivables how quickly we are converting that into cash that is again a very important question to be answered. So, use the turnover of these assets and once the turnover is available then you can make use of these current assets and current liabilities and then you can calculate the current ratio. So, how to adjust the individual current assets we have seen it this is a model available here. So, I will take a small example here say for example we have accounts receivables we take here as rupees 1200 and we have the accounts receivables turnover ratio and that is 24 how you calculated that is the gross sales we calculated gross sales divided by the average receivables. So, for example here I am taking your gross sales are say 3000 and your average receivables are 300. So, it means the say your receivables turnover ratio is how many times we can see here it is that is this 10 times right this ratio is 10 times so we can calculate this way you have to calculate it. So, we have for example assumed here that accounts receivables balance here is 1200 and accounts receivables turnover ratio is 24 that is 24 times here we calculate this ratio in terms of times this is 24 times. So, how we can adjust it you will have to see the model says current asset or current liability it is a current asset now 1200 into that is 1- 1 by turnover of the current asset accounts receivables is how much 24 right and then it is this value if you solve this how much it comes out as 1200 into 0.958 and if you multiply this it will work out as 1150. So, it means when you adjust your current assets to its turnover the real value will be real realizable value will be reflected and those current assets which were in the absolute form were shown in the balance sheet as 1200 rupees. So, if you have adjusted that against the turnover of your accounts receivables then we have found out is that if you relate it to the turnover then it should not be counted as 1200 but it should be counted as 1150 right for example if your say turnover changes if the turnover comes down to 12 times if it is 12 times how much it will become it will be something like 0.916 and if you multiply it this will become how much 11 rupees 1100 right this is 1150. So, it means higher the turnover more will be the value of the current asset adjusted value of the current asset lesser the turnover of the current asset lower will be the value reflected after adjusting the current assets. So, when the turnover was 24 your value was means when your gross sales level is very high right and your average receivables means average receivables accounts receivables is quite low. So, we can interpret it that as compared to the gross sales of the firm credit sales amount is very very low. So, that is acceptable nobody can do the business entirely on cash right. But when the ratio is 12 as against 24 then we would say that the level of credit sales as compared to the total sales is very high. So, the firm who is forced to sell more on the credit rather than on cash there raises the doubt that it raises the doubt that the firms overall credibility is not good in the market. So, their liquidity position is questionable so rather than taking the plain current assets or the current liabilities you take the adjusted current assets and current liabilities and then try to find out this ratio and that ratio will be reflecting the true liquidity position of the firm rather than a plain liquidity ratio rather than a plain liquidity ratio. So, it means that is very important to adjust these ratios against your turnovers right. Similarly you can adjust all current liabilities you are just the accounts receivables you are just the expense credits which are true current liabilities and then you try to find out that what is my now the net current ratio that is adjusted current ratio after adjusting it to the turnover after adjusting it to the turnover. So, this is a one more new development recently has taken place that rather than calculating a simple and plain current ratio you calculate the adjusted current ratio and adjust all current assets individually. So, you will adjust here now the accounts receivables we have found out is 1150 right maybe if you adjust the inventory inventory maybe say actually it is a 1500 but that may work out as 1300 so what will happen your current assets will be changing their value will be reflecting as the lesser value as compared to their say value which is appearing in the balance sheet and same thing you can do in case of the current liabilities and then you adjust the individual current assets current liabilities and then current calculate the adjusted current ratio and then interpret it. And in case of the adjusted current ratio also rule of thumb will be again that is the same that is 1.33 is to 1 that will not change. Simple difference is in case of the simple current ratio you are not adjusting the current asset and current liabilities whereas in the adjusted current ratio you are adjusting the current assets and current liabilities to its turnover. And then you are calculating the current ratio to understand the true liquidity position of the firm whereas in both the cases the rule of thumb of 1.33 is to 1 will remain the same right. So, these are the 2 important ratios to be studied while understanding the liquidity position of the firm one is the net liquidity ratio and second one is the say your adjusted current ratio. So, and other issues we have already talked about that is the these ratios we have already talked about is that is your say current ratio, quick ratio, super quick ratio then is the receivables turnover ratio, inventory turnover ratio, creditors turnover ratio. So, here I would add here that is a current ratio you can make it not 7 we are making it a list of 7th one is NLR net liquidity ratio and rather than in case of the current assets along with the current assets current ratio you calculate the adjusted current ratio also. So, this way the current ratio is plain and current ratio is adjusted you calculate these ratios and then you will be able to find out what is the real liquidity position of the firm. So, in the practical situation if you calculate these 7, 8 ratios you would be through with the liquidity position of the firm and would be very easy for you to understand that whether the firm will be able to pay off its obligations on time as and when they become due or there will be the possibility of technical insolvency. Because every lender wants it whether he is a lender of funds or he is a lender of material or a lender of services every lender he is ready to do business on credit he is ready to extend the credit he is ready to extend the supplies on credit he is ready to lend the same services on credit. But his payment should be secured and that is only possible when the liquidity position is ok or acceptable. So, for example in case of the Kingfisher airline sometime back it happened that suddenly it became bankrupt and even the salaries of the employees were not paid. So, it means it was a question of employees who never had means ever had thought about that is such a good brand name Kingfisher will fall flat suddenly and they will not even getting their salary they will be losing the job and whatever the time period they have worked for they will not get the salaries for that. So, for example if they any of them had even iota of doubt they would have gone for the say studying the liquidity position of the firm and they could have come to know that overall liquidity position of the firm is not good and they are not means they should not expect even the payment of their salaries and the job is at the stake. So, similarly if any company's overall financial behaviour seems to be undesirable in that case also we can do one thing that we should say because balance sheet is a very open document balance sheet is open document is a public document it cannot be a hidden document nobody can hide that. So, you maybe as employee maybe as a supplier or maybe as a lender as a banker easily can calculate these ratios and in many cases these ratios are not to be calculated by the suppliers or the service lenders or by the say lenders. This task is left to the firm itself when any firm goes to the bank with the request that lenders the funds CC limit or working capital loan or maybe the long term loan or maybe the discounting of the credit sale bills. Banks ask them that you calculate these ratios and give us the total liquidity analysis after doing it give us the total liquidity analysis bank employees or bank officers only look at that analysis how they have done it then they compare it with the balance sheet and if both the figures are comparable means details are available everything is available. Then we can understand that yes the firm is reliable its liquidity position is acceptable and we can go ahead with the extending of credit to the firm that is quite possible. So, in case of the bankers firms do it and then after doing this analysis they go to the bank. In case of suppliers relationship suppliers when they are say quite say you can call it as financially sound and they do not have only reason to depend upon the company who is asking them to buy from any supplier on credit. In that case bigger suppliers ask the potential or the prospective buyers to do the liquidity analysis themselves of their liquidity analysis themselves and then finally say come with that analysed balance sheet and calculate these ratios some of the ratios and then they will look at make the analysis. So, it means you should have an idea as a student of working capital management how to study the overall liquidity position of the firm you should have a clear cut idea that we should calculate these 7 ratios. And especially should be able to tell the person concerned that we should not rely upon a plain current ratio but we should calculate the adjusted current ratio right. So, this is all about the liquidity position and understanding the liquidity position of a firm and how to do it these are some ratios which may help us this is one. Now the second thing will talk today is that is about the window dressing. I just talk to you about the window dressing that sometime to maintain the pseudo liquidity by the firms and to fool the lenders they go or they take the help of the window dressing. Now how what is the window dressing how the firms do the window dressing that all I will discuss with you in the next class. Thank you very much.