12.8 Analysis

From our previous discussion in the cash and receivables chapter, recall that one way to evaluate a company’s liquidity is to calculate the quick ratio. This ratio relates the company’s highly liquid assets (“quick” assets) to its current liabilities. This is an important measure because a company’s credit rating and reputation can suffer if it cannot pay its current obligations when they come due. Recall from revenue chapter that our analysis of Best Coffee and Donuts Inc. revealed a quick ratio of 0.45 in 2021. Ratios in isolation are not particularly meaningful as they need to be compared to a benchmark. However, in this case, a quick ratio of 0.45 is not to be viewed as a positive result, as it implies that the company does not have enough highly liquid assets to cover its currently maturing obligations.

Another measure that can be used to evaluate liquidity is the days’ payables outstanding ratio. This ratio is the mirror image of the days’ sales uncollected ratio calculated previously. The days’ payables outstanding ratio measures how long it takes the company to pay its outstanding payables. The ratio is calculated using the following formula:

Days’ payables outstanding =

Purchases on credit is usually not separately disclosed on the financial statements. Often, the cost of sales figure can be used as an estimate of this amount. However, the individual characteristics of the company would need to be examined to determine if this is a reasonable assumption. If we assume that Best Coffee and Donuts Inc.’s cost of sales in 2021 is $1,594,739, then the ratio is calculated as follows:

Days’ payables outstanding =

Although it is difficult to make any conclusive statement, this calculation shows that the company has been paying its outstanding payables somewhat slowly. To be fully meaningful, we would need to know the creditors’ normal credit terms and industry averages, and we would want to calculate the trend over several years. However, it is common for many creditors to allow 30 days for payment, so it would appear that Best Coffee and Donuts Inc. is exceeding these terms. Further analysis is needed to determine why this is happening, and whether this is damaging the company’s relationship with its creditors.

For ratio analysis to be meaningful, a deeper understanding of the business is required. Best Coffee and Donuts Inc. primarily sells fast food and settles most of its transactions in cash or near cash (i.e., debit and credit cards). In this industry, inventory items would be converted fairly quickly to cash, as perishable items cannot be held for long periods of time. Thus, although the quick ratio appears low, this may not be a serious problem due to the rapid conversion of inventory to cash. However, the fact that the company has been paying its accounts payable slowly may indicate a problem. It is important to consider broader data, including historical trend analysis and industry averages, before drawing further conclusions, though.