Content area
Full text
A credit analyst in your office has just completed a financial analysis of Smith, Inc., a prospective customer. Some of her analysis, along with abridged financial statement data for the company, appears in Table 1. You must take this information and make a recommendation about whether to extend a trade credit line. Before leaving the information with you, the analyst mentioned that she takes much comfort in the fact that both the current and quick ratios are exceedingly high and she recommends approval of the line.
Is approval the correct decision? Of course, you will only know with hindsight if you extend credit. However, from your vantage point you must assess whether the current and quick ratios capture Smith's ability to avoid cash flow problems. In the previous article,"The Current and Quick Ratios: Are They Only Window Dressing?", I showed that these two ratios possess little useful information.
Some Background
Analysis of liquidity from a cash conversion cycle perspective is very different than from a current or quick ratio perspective. You calculate current and quick ratios for a point in time-the balance sheet date. Thus, they are static measures. The cash conversion cycle approach is dynamic in that it looks at cash flows occurring over time.
Think of cash as the net outcome of the activities of a business. When a firm functions efficiently, cash moves smoothly through the ordering of material and labor to produce products, to the manufacturing and warehousing of finished products, to the selling of products on credit, and finally to the collecting of outstanding accounts. In this stable environment, management concerns itself with what to do with residual cash. If something disrupts the cash-to-inventory-to-receivables-to-cash cycle, financing...