PAGE1FINANCIALMANAGEMENTANDANALYSISOFFINANCIALSTATEMENTSAuthor(s):C.O.HardyandS.P.MeechFinancialManagementandAnalysisisanintroductiontotheconcepts,tools,andapplicationsoffinance.Thepurposeofthistextbookistocommunicatethefundamentalsoffinancialmanagementandfinancialanalysis.Thistextbookiswritteninawaythatwillenablestudentswhoarejustbeginningtheirstudyoffinancetounderstandfinancialdecision-makinganditsroleinthedecision-makingprocessoftheentirefirm.Throughoutthetextbook,you’llseehowweviewfinance.Weseefinancialdecision-makingasanintegralpartofthefirm’sdecision-making,notasaseparatefunction.Financialdecision-makinginvolvescoordinationamongpersonnelspecializinginaccounting,marketing,andproductionaspectsofthefirm.Theprinciplesandtoolsoffinanceareapplicabletoallformsandsizesofbusinessenterprises,notonlytolargecorporations.Justastherearespecialproblemsandopportunitiesforsmallfamily-ownedbusinesses(suchaswheretoobtainfinancing),therearespecialproblemsandopportunitiesforlargecorporations(suchasagencyproblemsthatarisewhenmanagementofthefirmisseparatedfromthefirm’sowners).Butonlyfundamentalsoffinancialmanagementarethesameregardlessofthesizeorformofthebusiness.Forexample,adollartodayisworthmorethanadollaroneyearfromtoday,whetheryouaremakingdecisionsforasoleproprietorshiporalargecorporation.Weviewtheprinciplesandtoolsoffinanceasapplicabletofirmsaroundtheglobe,notjusttoU.S.businessenterprises.Whilecustomsandlawsmaydifferamongnations,theprinciples,theories,andtoolsoffinancialmanagementdonot.Forexample,inevaluatingwhethertobuyaparticularpieceofequipment,youmustevaluatewhathappenstothefirm’sfuturecashflows(Howmuchwilltheybe?Whenwilltheyoccur?Howuncertainarethey?)whetherthefirmislocatedintheUnitedStates,GreatBritain,orelsewhere.Inaddition,webelievethatastrongfoundationinfinanceprinciplesandtherelatedmathematicaltoolsarenecessaryforyoutounderstandhowinvestingandfinancingdecisionsaremade.Butbuildingthatfoundationneednotbestrenuous.Onewaythatwetrytohelpyoubuildthatfoundationistopresenttheprinciplesandtheoriesoffinanceusingintuition,insteadofwithproofsandtheorems.Forexample,wewalkyouthroughtheintuitionofcapitalstructuretheorywithnumericalandrealworldexamples,notequationsandproofs.Anotherwetrytoassistyouistoapproachthetoolsoffinanceusingcareful,step-by-stepexamplesandnumerousgraphs.FinancialManagementandAnalysisispresentedinsevenparts.Thefirsttwoparts(PartsOneandTwo)coverthebasics,includingtheobjectiveoffinancialmanagement,valuationprinciples,andtherelationbetweenriskandreturn.Financialdecision-makingiscoveredinPartsThree,Four,andFivewherewepresentlong-terminvestmentmanagement(commonlyreferredtoascapitalbudgeting),themanagementoflong-termsourcesoffunds,andworkingcapitalmanagement.PartSixcoversfinancialstatementanalysiswhichincludesfinancialratioanalysis,earningsanalysis,andcashflowanalysis.Thelastpart(PartSeven)coversseveralspecializedtopics:internationalfinancialmanagement,borrowingviastructuredfinancialtransactions(i.e.,assetsecuritization),projectfinancing,equipmentleasing,andfinancialplanningandstrategy.Logicalstructure,Thetextbeginswiththebasicprinciplesandtools,followedbylong-terminvestmentandfinancingdecisions.Thefirsttwopartslayoutthebasics;PartThreethenfocusesonthe“l(fā)eftside”ofthebalancesheet(theassets)andthePartFouristhe“rightside”ofthebalancesheet(theliabilitiesandequity).Workingcapitaldecisions,whicharemadetosupporttheday-to-dayoperationsofthefirm,arediscussedinPartFive.PartSixprovidesthetoolsforanalyzingafirm’sfinancialstatements.Inthelastchapterofthebook,youarebroughtbackfull-circletotheobjectiveoffinancialmanagement:themaximizationofowners’wealth.Graphicalillustrations,Graphsandillustrationshavebeencarefullyanddeliberatelydevelopedtodepictandprovidevisualreinforcementofmathematicalconcepts.Forexample,weshowthegrowthofabankbalancethroughcompoundinterestseveralways:mathematically,inatime-line,andwithabargraph.Applications,Asmuchaspossible,wedevelopconceptsandmathematicsusingexamplesofactualpractice.Forexample,wefirstpresentfinancialanalysisusingasimplifiedsetoffinancialstatementsforafictitiouscompany.Afteryou’velearnedthebasicsusingthefictitiouscompany,wedemonstratefinancialanalysistoolsusingdatafromWal-MartStores,Inc.Actualexampleshelpyoubettergraspandretainmajorconceptsandtools.Weintegrateover100actualcompanyexamplesthroughoutthetext,soyou’renotapttomissthem.Consideringboththeexamplesthroughoutthetextandtheresearchquestionsandproblems,youareexposedtohundredsofactualcompanies.Extensivecoverageoffinancialstatementanalysis.Whilemosttextbooksprovidesomecoverageoffinancialstatementanalysis,wehaveprovidedyouwithmuchmoredetailinPartSixofthetextbook.Chapter6andthethreechaptersinPartSixallowaninstructortofocusonfinancialstatementanalysis.Extensivecoverageofalternativedebtinstruments.Becauseoftheinnovationsinthedebtmarket,alternativeformsdebtinstrumentscanbeissuedbyacorporation.InChapter15,youareintroducedtotheseinstruments.Wethendevoteonechaptertothemostpopularalternativetocorporatebondissuance,thecreationandissuanceofasset-backedsecurities.Coverageofleasingandprojectfinancing.Weprovidein-depthcoverageofleasinginChapter27,demystifyingtheclaimsabouttheadvantagesanddisadvantagesofleasingyoutoooftenreadaboutinsometextbooksandprofessionalarticles.Projectfinancinghasgrowninimportancefornotonlycorporationsbutforcountriesseekingtodevelopinfrastructurefacilities.Chapter28providesthebasicprinciplesforunderstandingprojectfinancing.Earlyintroductiontoderivativeinstruments.Derivativeinstruments(futures,swaps,andoptions)playanimportantroleinfinance.YouareintroducedtotheseinstrumentsinChapter4.Whilederivativeinstrumentsareviewedascomplexinstruments,youareprovidedwithanintroductionthatmakescleartheirbasicinvestmentcharacteristics.Bytheearlyintroductionofderivativeinstruments,youwillbeabletoappreciatethedifficultiesofevaluatingsecuritiesthathaveembeddedoptions(Chapter9),howtherearerealoptionsembeddedincapitalbudgetingdecisions(Chapter14),andhowderivativeinstrumentscanbeusedtoreduceortohedgethecostofborrowing(Chapter15).Stand-alonenatureofthechapters.Eachchapteriswrittensothatchaptersmayeasilyberearrangedtofitdifferentcoursestructures.Concepts,terminology,andnotationarepresentedineachchaptersothatnochapterisdependentuponanother.Thismeansthatinstructorscantailortheuseofthisbooktofittheirparticulartimeframeforthecourseandtheirstudents’preparation(forexample,ifstudentsenterthecoursewithsufficientbackgroundinaccountingandtaxation,Chapters5and6canbeskipped).Webelievethatourapproachtothesubjectmatteroffinancialmanagementandanalysiswillhelpyouunderstandthekeyissuesandprovidethefoundationfordevelopingaskillsetnecessarytodealwithrealworldfinancialproblems.IntroductiontoFinancialManagementandAnalysisFinanceistheapplicationofeconomicprinciplesandconceptstobusinessdecision-makingandproblemsolving.Thefieldoffinancecanbeconsideredtocomprisethreebroadcategories:financialmanagement,investments,andfinancialinstitutions:Financialmanagement.Sometimescalledcorporatefinanceorbusinessfinance,thisareaoffinanceisconcernedprimarilywithfinancialdecision-makingwithinabusinessentity.Financialmanagementdecisionsincludemaintainingcashbalances,extendingcredit,acquiringotherfirms,borrowingfrombanks,andissuingstocksandbonds.Investments,Thisareaoffinancefocusesonthebehavioroffinancialmarketsandthepricingofsecurities.Aninvestmentmanager’stasks,forexample,mayincludevaluingcommonstocks,selectingsecuritiesforapensionfund,ormeasuringaportfolio’sperformance.Financialinstitutions,Thisareaoffinancedealswithbanksandotherfirmsthatspecializeinbringingthesuppliersoffundstogetherwiththeusersoffunds.Forexample,amanagerofabankmaymakedecisionsregardinggrantingloans,managingcashbalances,settinginterestratesonloans,anddealingwithgovernmentregulations.Nomattertheparticularcategoryoffinance,businesssituationsthatcallfortheapplicationofthetheoriesandtoolsoffinancegenerallyinvolveeitherinvesting(usingfunds)orfinancing(raisingfunds).Managerswhoworkinanyofthesethreeareasrelyonthesamebasicknowledgeoffinance.Inthisbook,weintroduceyoutothiscommonbodyofknowledgeandshowhowitisusedinfinancialdecision-making.Thoughtheemphasisofthisbookisfinancialmanagement,thebasicprinciplesandtoolsalsoapplytotheareasofinvestmentsandfinancialinstitutions.Inthisintroductorychapter,we’llconsiderthetypesofdecisionsfinancialmanagersmake,theroleoffinancialanalysis,theformsofbusinessownership,andtheobjectiveofmanagers’decisions.Finally,wewilldescribetherelationshipbetweenownersandmanagers.FINANCIALMANAGEMENTFinancialmanagementencompassesmanydifferenttypesofdecisions.Wecanclassifythesedecisionsintothreegroups:investmentdecisions,financingdecisions,anddecisionsthatinvolvebothinvestingandfinancing.Investmentdecisionsareconcernedwiththeuseoffunds—thebuying,holding,orsellingofalltypesofassets:Shouldwebuyanewdiestampingmachine?Shouldweintroduceanewproductline?Selltheoldproductionfacility?Buyanexistingcompany?Buildawarehouse?Keepourcashinthebank?Financingdecisionsareconcernedwiththeacquisitionoffundstobeusedforinvestingandfinancingday-to-dayoperations.Shouldmanagersusethemoneyraisedthroughthefirms’revenues?Shouldtheyseekmoneyfromoutsideofthebusiness?Acompany’soperationsandinvestmentcanbefinancedfromoutsidethebusinessbyincurringdebts,suchasthoughbankloansandthesaleofbonds,orbysellingownershipinterests.Becauseeachmethodoffinancingobligatesthebusinessindifferentways,financingdecisionsareveryimportant.Manybusinessdecisionssimultaneouslyinvolvebothinvestingandfinancing.Forexample,acompanymaywishtoacquireanotherfirm—aninvestmentdecision.However,thesuccessoftheacquisitionmaydependonhowitisfinanced:byborrowingcashtomeetthepurchaseprice,bysellingadditionalsharesofstock,orbyexchangingexistingsharesofstock.Ifmanagersdecidetoborrowmoney,theborrowedfundsmustberepaidwithinaspecifiedperiodoftime.Creditors(thoselendingthemoney)generallydonotshareinthecontrolofprofitsoftheborrowingfirm.If,ontheotherhand,managersdecidetoraisefundsbysellingownershipinterests,thesefundsneverhavetobepaidback.However,suchasaledilutesthecontrolof(andprofitsaccruingto)thecurrentowners.Whetherafinancialdecisioninvolvesinvesting,financing,orboth,italsowillbeconcernedwithtwospecificfactors:expectedreturnandrisk.Andthroughoutyourstudyoffinance,youwillbeconcernedwiththesefactors.Expectedreturnisthedifferencebetweenpotentialbenefitsandpotentialcosts.Riskisthedegreeofuncertaintyassociatedwiththeseexpectedreturns.FinancialAnalysisFinancialanalysisisatooloffinancialmanagement.Itconsistsoftheevaluationofthefinancialconditionandoperatingperformanceofabusinessfirm,anindustry,oreventheeconomy,andtheforecastingofitsfutureconditionandperformance.Itis,inotherwords,ameansforexaminingriskandexpectedreturn.Dataforfinancialanalysismaycomefromotherareaswithinthefirm,suchasmarketingandproductiondepartments,fromthefirm’sownaccountingdata,orfromfinancialinformationvendorssuchasBloombergFinancialMarkets,Moody’sInvestorsService,Standard&Poor’sCorporation,FitchRatings,andValueLine,aswellasfromgovernmentpublications,suchastheFederalReserveBulletin.FinancialpublicationssuchasBusinessWeek,Forbes,Fortune,andtheWallStreetJournalalsopublishfinancialdata(concerningindividualfirms)andeconomicdata(concerningindustries,markets,andeconomies),muchofwhichisnowalsoavailableontheInternet.Withinthefirm,financialanalysismaybeusednotonlytoevaluatetheperformanceofthefirm,butalsoitsdivisionsordepartmentsanditsproductlines.Analysesmaybeperformedbothperiodicallyandasneeded,notonlytoensureinformedinvestingandfinancingdecisions,butalsoasanaidinimplementingpersonnelpoliciesandrewardssystems.Outsidethefirm,financialanalysismaybeusedtodeterminethecreditworthinessofanewcustomer,toevaluatetheabilityofasuppliertoholdtotheconditionsofalong-termcontract,andtoevaluatethemarketperformanceofcompetitors.Firmsandinvestorsthatdonothavetheexpertise,thetime,ortheresourcestoperformfinancialanalysisontheirownmaypurchaseanalysesfromcompaniesthatspecializeinprovidingthisservice.Suchcompaniescanprovidereportsrangingfromdetailedwrittenanalysestosimplecreditworthinessratingsforbusinesses.Asanexample,Dun&Bradstreet,afinancialservicesfirm,evaluatesthecreditworthinessofmanyfirms,fromsmalllocalbusinessestomajorcorporations.Asanotherexample,threecompanies—Moody’sInvestorsService,Standard&Poor’s,andFitch—evaluatethecreditqualityofdebtobligationsissuedbycorporationsandexpresstheseviewsintheformofaratingthatispublishedinthereportsavailablefromthesethreeorganizations.TheFinancialRatiosWeneedtousefinancialratiosinanalyzingfinancialstatements.—Theanalysisofcomparativefinancialstatementscannotbemadereallyeffectiveunlessittakestheformofastudyofrelationshipsbetweenitemsinthestatements.Itisoflittlevalue,forexample,toknowthat,onagivendate,theSmithCompanyhasacashbalanceof$1oooo.Butsupposeweknowthatthisbalanceisonly-IVpercentofallcurrentliabilitieswhereasayearagocashwas25percentofallcurrentliabilities.Sincethebankersforthecompanyusuallyrequireacashbalanceagainstbanklines,usedorunused,of20percent,wecanseeatoncethatthefirm'scashconditionisexhibitingaquestionabletendency.Wemaymakecomparisonsbetweenitemsinthecomparativefinancialstatementsasfollows:1.Betweenitemsinthecomparativebalancesheeta)Betweenitemsinthebalancesheetforonedate,e.g.,cashmaybecomparedwithcurrentliabilitiesb)Betweenaniteminthebalancesheetforonedateandthesameiteminthebalancesheetforanotherdate,e.g.,cashtodaymaybecomparedwithcashayearagoc)Ofratios,ormathematicalproportions,betweentwoitemsinthebalancesheetforonedateandalikeratiointhebalancesheetforanotherdate,e.g.,theratioofcashtocurrentliabilitiestodaymaybecomparedwithalikeratioayearagoandthetrendofcashconditionnoted2.Betweenitemsinthecomparativestatementofincomeandexpensea)Betweenitemsinthestatementforagivenperiodb)Betweenoneiteminthisperiod'sstatementandthesameiteminlastperiod'sstatementc)Ofratiosbetweenitemsinthisperiod'sstatementandsimilarratiosinlastperiod'sstatement3.Betweenitemsinthecomparativebalancesheetanditemsinthecomparativestatementofincomeandexpensea)Betweenitemsinthesestatementsforagivenperiod,e.g.,netprofitforthisyearmaybecalculatedasapercentageofnetworthforthisyearb)Ofratiosbetweenitemsinthetwostatementsforaperiodofyears,e.g.,theratioofnetprofittonetworththisyearmay-becomparedwithlikeratiosforlastyear,andfortheyearsprecedingthatOurcomparativeanalysiswillgaininsignificanceifwetaketheforegoingcomparisonsorratiosand;inturn,comparethemwith:I.Suchdataasareabsentfromthecomparativestatementsbutareofimportanceinjudgingaconcern'sfinancialhistoryandcondition,forexample,thestageofthebusinesscycle.2.SimilarratiosderivedfromanalysisofthecomparativestatementsofcompetingconcernsorofconcernsinsimilarlinesofbusinessWhatfinancialratiosareusedinanalyzingfinancialstatements.-Comparativeanalysisofcomparativefinancialstatementsmaybeexpressedbymathematicalratiosbetweentheitemscompared,forexample,aconcern'scashpositionmaybetestedbydividingtheitemofcashbythetotalofcurrentliabilityitemsandusingthequotienttoexpresstheresultofthetest.Eachratiomaybeexpressedintwoways,forexample,theratioofsalestofixedassetsmaybeexpressedastheratiooffixedassetstosales.Weshallexpresseachratioinsuchawaythatincreasesfromperiodtoperiodwillbefavorableanddecreasesunfavorabletofinancialcondition.Weshallusethefollowingfinancialratiosinanalyzingcomparativefinancialstatements:I.Working-capitalratios1.Theratioofcurrentassetstocurrentliabilities2.Theratioofcashtototalcurrentliabilities3.Theratioofcash,salablesecurities,notesandaccountsreceivabletototalcurrentliabilities4.Theratioofsalestoreceivables,i.e.,theturnoverofreceivables5.Theratioofcostofgoodssoldtomerchandiseinventory,i.e.,theturnoverofinventory6.Theratioofaccountsreceivabletonotesreceivable7.Theratioofreceivablestoinventory8.Theratioofnetworkingcapitaltoinventory9.TheratioofnotespayabletoaccountspayableIO.TheratioofinventorytoaccountspayableII.Fixedandintangiblecapitalratios1.Theratioofsalestofixedassets,i.e.,theturnoveroffixedcapital2.Theratioofsalestointangibleassets,i.e.,theturnoverofintangibles3.Theratioofannualdepreciationandobsolescencechargestotheassetsagainstwhichdepreciationiswrittenoff4.TheratioofnetworthtofixedassetsIII.Capitalizationratios1.Theratioofnetworthtodebt.2.Theratioofcapitalstocktototalcapitalization.3.TheratiooffixedassetstofundeddebtIV.Incomeandexpenseratios1.Theratioofnetoperatingprofittosales2.Theratioofnetoperatingprofittototalcapital3.Theratioofsalestooperatingcostsandexpenses4.Theratioofnetprofittosales5.Theratioofnetprofittonetworth6.Theratioofsalestofinancialexpenses7.Theratioofborrowedcapitaltocapitalcosts8.Theratioofincomeoninvestmentstoinvestments9.Theratioofnon-operatingincometonetoperatingprofit10.Theratioofnetoperatingprofittonon-operatingexpense11.Theratioofnetprofittocapitalstock12.Theratioofnetprofitreinvestedtototalnetprofitavailablefordividendsoncommonstock13.TheratioofprofitavailableforinteresttointerestexpensesThisclassificationoffinancialratiosispermanentnotexhaustive.-Otherratiosmaybeusedforpurposeslaterindicated.Furthermore,someoftheratiosreflecttheefficiencywithwhichabusinesshasuseditscapitalwhileothersreflectefficiencyinfinancingcapitalneeds.Theratiosofsalestoreceivables,inventory,fixedandintangiblecapital;theratiosofnetoperatingprofittototalcapitalandtosales;andtheratiosofsalestooperatingcostsandexpensesreflectefficiencyintheuseofcapital.'Mostoftheotherratiosreflectfinancialefficiency.B.TechniqueofFinancialStatementAnalysisArethestatementsadequateingeneral?-Beforeattemptingcomparativeanalysisofgivenfinancialstatementswewishtobesurethatthestatementsarereasonablyadequateforthepurpose.Theyshould,ofcourse,beascompleteaspossible.Theyshouldalsobeofrecentdate.Ifnot,theirusemustbelimitedtotheperiodwhichtheycover.Conclusionsconcerning1923conditionscannotsafelybebasedupon1921statements.Doesthecomparativebalancesheetreflectaseasonablesituation?Ifso,itisimportanttoknowfinancialconditionsatboththehighandlowpointsoftheseason.Wemustavoidundulyfavorablejudgmentofthebusinessatthelowpointwhenassetsareveryliquidanddebtislow,andundulyunfavorablejudgmentatthehighpointwhenassetsarelessliquidanddebtlikelytoberelativelyhigh.Doesthebalancesheetforanydatereflecttheestimatedfinancialconditionafterthesaleofaproposednewissueofsecurities?Ifso,inordertoascertaintheactualfinancialconditionatthatdateitisnecessarytosubtracttheamountofthesecurityissuefromnetworth,ifthe.issueisofstock,orfromliabilities,ifbondsaretobesold.Alikeamountmustalsobesubtractedfromassetsorliabilitiesdependinguponhowtheestimatedproceedsoftheissuearereflectedinthestatement.Arethestatementsauditedorunaudited?Itisoftensaidthatauditedstatements,thatis,completeauditsratherthanstatements"rubberstamped"bycertifiedpublicaccountants,aredesirablewhentheycanbeobtained.Thisistrue,butthestatementanalystshouldbecertainthatthegivenauditingfilm'sreputationisbeyondreproach.Isworking-capitalsituationfavorable?-Ifthecomparativestatementstobeanalyzedarereasonablyadequateforthepurpose,thenextstepistoanalyzetheconcern'sworking-capitaltrendandposition.Wemaybeginbyascertainingtheratioofcurrentassetstocurrentliabilities.Thisratioaffords-atestoftheconcern'sprobableabilitytopaycurrentobligationswithoutimpairingitsnetworkingcapital.Itis,inpart,ameasureofabilitytoborrowadditionalworkingcapitalortorenewshort-termloanswithoutdifficulty.Thelargertheexcessofcurrentassetsovercurrentliabilitiesthesmallertheriskoflosstoshort-termcreditorsandthebetterthecreditofthebusiness,otherthingsbeingequal.Aratiooftwodollarsofcurrentassetstoonedollarofcurrentliabilitiesisthe"rule-of-thumb"ratiogenerallyconsideredsatisfactory,assumingallcurrentassetsareconservativelyvaluedandallcurrentliabilitiesrevealed.Therule-of-thumbcurrentratioisnotasatisfactorytestofworking-capitalpositionandtrend.Acurrentratiooflessthantwodollarsforonedollarmaybeadequate,oracurrentratioofmorethantwodollarsforonedollarmaybeinadequate.Itdepends,foronething,upontheliquidityofthecurrentassets.Theliquidityofcurrentassetsvarieswithcashposition.-Thelargertheproportionofcurrentassetsintheformofcashthemoreliquidarethecurrentassetsasawhole.Generallyspeaking,cashshouldequalatleast20percentoftotalcurrentliabilities(dividecashbytotalcurrentliabilities).Bankerstypicallyrequireaconcerntomaintainbankbalancesequalto20percentofcreditlineswhetherusedorunused.Open-creditlinesarenotshownonthebalancesheet,hencethetotalofcurrentliabilities(insteadofnotespayabletobanks)isusedintestingcashposition.Likethetwo-for-onecurrentratio,the20percentcashratioismoreorlessarule-of-thumbstandard.Thecashbalancethatwillbesatisfactorydependsupontermsofsale,termsofpurchase,anduponinventoryturnover.Afirmsellinggoodsforcashwillfindcashinflowmorenearlymeetingcashoutflowthanwillafirmsellinggoodsoncredit.Abusinesswhichpayscashforallpurchaseswillneedmorereadymoneythanonewhichbuysonlongtermsofcredit.Themorerapidlytheinventoryissoldthemorenearlywillcashinflowequalcashoutflow,otherthingsequal.Needsforcashbalanceswillbeaffectedbythestageofthebusinesscycle.Heavycashbalanceshelptosustainbankcreditandpayexpenseswhenaperiodofliquidationanddepressiondepletesworkingcapitalandbringsaslumpinsales.Thegreatertheeffectsofchangesinthecycleuponagivenconcernthemorethoughtthefinancialexecutivewillneedtogivetothesizeofhiscashbalances.Differencesinfinancialpoliciesbetweendifferentconcernswillaffectthesizeofcashbalancescarried.Oneconcernmaydeemitgoodpolicytocarryasmanyopen-banklinesasitcanget,whileanothermaycarryonlyenoughlinestomeetreasonablycertainneedsforloans.Thecashbalanceofthefirstfirmislikelytobemuchlargerthanthatofthesecondfirm.Theliquidityofcurrentassetsvarieswithabilitytomeet"acidtest."-Liquidityofcurrentassetsvarieswiththeratioofcash,salablesecurities,notesandaccountsreceivable(lessadequatereservesforbaddebts),tototalcurrentliabilities(dividethetotalofthefirstfouritemsbytotalcurrentliabilities).Thisistheso-called"acidtest"oftheliquidityofcurrentcondition.AratioofI:Iisconsideredsatisfactorysincecurrentliabilitiescanreadilybepaidandcreditorsrisknothingontheuncertainvaluesofmerchandiseinventory.Alessthan1:1ratiomaybeadequateifreceivablesarequicklycollectedandifinventoryisreadilyandquicklysold,thatis,ifitsturnoverisrapidandiftherisksofchangesinpricearesmall.Theliquidityofcurrentassetsvarieswithliquidityofreceivables.Thismaybeascertainedbydividingannualsalesbyaveragereceivablesorbyreceivablesatthecloseoftheyearunlessatthatdatereceivablesdonotrepresentthenormalamountofcreditextendedtocustomers.Termsofsalemustbeconsideredinjudgingtheturnoverofreceivables.Forexample,ifsalesfortheyearare$1,200,000andaveragereceivablesamountto$100,000,theturnoverofreceivablesis$1,200,000/$100,000=12.Now,ifcredittermstocustomersarenetinthirtydayswecanseethatreceivablesarepaidpromptly.Considerationshouldalsobegivenmarketconditionsandthestageofthebusinesscycle.Termsofcreditareusuallylongerinfarmingsectionsthaninindustrialcenters.Collectionsaregoodinprosperoustimesbutslowinp