Hi thanksmate-ga,
First, let's define all the terminology used in the questions:
Working capital - the difference between current assets and current
liabilities (excluding short-term debt). Current assets may or may not
include cash and cash equivalents, depending on the company.
Current assets - Value of cash, accounts receivable, inventories,
marketable securities and other assets that could be converted to cash
in less than 1 year.
Current ratio - indicator of short-term debt-paying ability.
Determined by dividing current assets by current liabilities. The
higher the ratio, the more liquid the company.
Liquid - Easily traded or converted to cash.
Liquidity - A high level of trading activity, allowing buying and
selling with minimum price disturbance. Also, a market characterized
by the ability to buy and sell with relative ease.
All of the above terms were defined in Campbell R. Harvey's
Hypertextual Finance Glossary. Just select the first letter of the
term you are looking for and presto! The main page is located at:
http://www.duke.edu/~charvey/Classes/wpg/glossary.htm
Now on to your questions:
Question #1: Compute working capital and current ratio for both companies (based
on the information provided below only):
Working Capital = Current Assets - Current Liabilities
Working Capital (PepsiCo):
(receivables + cash + inventories + misc current assets) - (Accounts
payable + income tax payable)
= (1704 + 964 + 899 + 514) - (3399 + 156)
= 4081 - 3555
= $526 million
Working Capital (Coca-Cola):
(cash + inventories + securities + misc current assets + receivables)
- (Accounts payable + income tax payable + current maturities)
= (1611 + 1076 + 201 + 1794 + (1798 - 26)) - (3714 + 769 + 261)
= 6454 - 4744
= $1710 million
Current Ratio = Current Assets / Current Liabilities
Current Ratio (PepsiCo) = 4081 / 3555 = 1.148
Current Ratio (Coca-cola) = 6454 / 4744 = 1.360
Question #2: On the basis of your answers to 1, which company appears
to be more liquid?
Since working capital cannot allow us to compare between companies, we
need to use the current ratios in order to compare. By considering
what the current ratio actually means, we can see that if PepsiCo
suddenly had to all of its short-term creditors, it would be able to
do so and have a surplus of 14.8% of current assets. A similar analogy
for Coca-Cola yields a surplus of 36.0% in current assets. Therefore
we can say that Coca-Cola is more liquid based on its current ratio.
Question #3: What other factors affect a company?s liquidity in addition to its
working capital and current ratio?
While the two measures we have used so far are very common measures of
liquidity, there are other aspects that need to be considered as well.
Although an asset may qualify as a "current asset", it may actually be
more liquid than another asset with the same classification. For
example, what is more liquid: $1000 in cash or in inventory? Of course
cash is most liquid as it has already been converted to cash without
losing any value! In this way, we can come up with a rough 'liquidity
order' of current assets.
The quick ratio, which is similar to the current ratio, does not
consider inventory to be a current asset. The cash ratio goes to the
extreme and considers only cash as a liquid measure.
Question #4: Comment on the composition of each company?s current assets and how
this composition affects its liquidity.
From the last question, we can see that a current asset may not always
tell the whole story. The first thing we can do is compare the actual
amount of cash each firm holds: we see that Coca-cola has 67% more
cash than PepsiCo. Marketable securities, considered to be almost as
liquid as cash (due to the active markets that exist for securities)
do not even exist in PepsiCo's balance sheet. Prepaid expenses,
although considered a current asset class, are often very difficult to
sell off in a short time - it requires you to sell back to the
provider of the service (usually at a loss) or sell your contract to
another buyer (which may be difficult to find given the service).
Coca-cola has a very large amount tied up in prepaid expenses, whereas
PepsiCo is not quite as heavily invested in that area. Inventories of
the two companies are comparable, and this reflects the similar nature
of business that the two companies generally operate within (in terms
of inventory cycles). Overall, asset structure is very important for
remaining liquid and should be analyzed on a line-by-line basis for
very large corporations (when each line carries such a large value).
Hopefully this helps you understand liquidity and short-term finance
better - if you do not understand any of the information above please
do post a clarification :)
Cheers!
answerguru-ga |
Clarification of Answer by
answerguru-ga
on
23 Nov 2003 23:44 PST
Hi again thanksmate-ga,
According to your answer clarification request from Question 279592, I
have adjusted my answers to meet the revised definition you have
provided:
Question #1: Compute working capital and current ratio for both companies (based
on the information provided below only):
Working Capital = Current Assets - Current Liabilities
Working Capital (PepsiCo):
(receivables + cash + inventories + misc current assets + Short-term
investments) - (Accounts payable + income tax payable + Short-term
borrowings)
= (1704 + 964 + 899 + 514 + 92) - (3399 + 156 + 233)
= 4173 - 3788
= $385 million
Working Capital (Coca-Cola):
(cash + inventories + securities + misc current assets + receivables)
- (Accounts payable + income tax payable + current maturities + loans
and notes payable)
= (1611 + 1076 + 201 + 1794 + (1798 - 26)) - (3714 + 769 + 261 + 5112)
= 6454 - 9856
= -$3402 million
Current Ratio = Current Assets / Current Liabilities
Current Ratio (PepsiCo) = 4173 / 3788 = 1.10
Current Ratio (Coca-cola) = 6454 / 9856 = 0.65
Question #2: On the basis of your answers to 1, which company appears
to be more liquid?
Since working capital cannot allow us to compare between companies, we
need to use the current ratios in order to compare. By considering
what the current ratio actually means, we can see that if PepsiCo
suddenly had to all of its short-term creditors, it would be able to
do so and have a surplus of 10% of current assets. A similar analogy
for Coca-Cola yields a deficit of 35.0% in current assets. Therefore
we can say that Coca-Cola is far less liquid based on its current
ratio than PepsiCo and would not even be able to repay its current
liabilities with current assets.
Question #3: What other factors affect a company?s liquidity in addition to its
working capital and current ratio?
While the two measures we have used so far are very common measures of
liquidity, there are other aspects that need to be considered as well.
Although an asset may qualify as a "current asset", it may actually be
more liquid than another asset with the same classification. For
example, what is more liquid: $1000 in cash or in inventory? Of course
cash is most liquid as it has already been converted to cash without
losing any value! In this way, we can come up with a rough 'liquidity
order' of current assets.
The quick ratio, which is similar to the current ratio, does not
consider inventory to be a current asset. The cash ratio goes to the
extreme and considers only cash as a liquid measure.
Question #4: Comment on the composition of each company?s current assets and how
this composition affects its liquidity.
From the last question, we can see that a current asset may not always
tell the whole story. The first thing we can do is compare the actual
amount of cash each firm holds: we see that Coca-cola has 67% more
cash than PepsiCo. Marketable securities, considered to be almost as
liquid as cash (due to the active markets that exist for securities)
may exist in PepsiCo's balance sheet under the title of "short term
investments", implying that the firm need not be committed to said
investments for an extended time period. However, we know that
Coca-cola has at least double that amount in stated marketable
securities, whereas Pepsico's "short term investments" may not have as
active a market in which to sell. Prepaid expenses, although
considered a current asset class, are often very difficult to sell off
in a short time - it requires you to sell back to the provider of the
service (usually at a loss) or sell your contract to another buyer
(which may be difficult to find given the service). Coca-cola has a
very large amount tied up in prepaid expenses, whereas PepsiCo is not
quite as heavily invested in that area. Inventories of the two
companies are comparable, and this reflects the similar nature of
business that the two companies generally operate within (in terms of
inventory cycles). Overall, asset structure is very important for
remaining liquid and should be analyzed on a line-by-line basis for
very large corporations (when each line carries such a large value).
I hope that this meets your definition of working capital now -
sometimes I wish all the "experts" could agree on standard definitions
of these formulas :)
answerguru-ga
|
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