Financial health

Solvency questions come in two forms. Can the company meet what falls due, which is a question about levels on one day. And how long is its own cash tied up before it returns, which is a question about speed over a year.

The two are one subject. A business whose cash comes back quickly needs less of it standing by, so the liquidity level a company requires is set by the speed of its own cycle. That is why the ratios and the working capital measures sit in the same course rather than in two.

Neither of them contains the date the money is due, and that is the gap the middle of this course fills.

Seven lessons, in three groups.

The first two are levels. The quick ratio, because it is the shortest version of the first question and because whole industries sit below its supposed pass mark in good health. Then the three ways of measuring debt, where the useful work is not the arithmetic but the four decisions somebody made about what counts as debt before the arithmetic started.

The next two are what the levels leave out. The maturity schedule, because companies rarely fail from owing too much and often fail from owing it on a date when the market has closed. Then leases, because a standard that took effect for fiscal years beginning after 15 December 2018 moved a large obligation from a footnote onto the balance sheet, and every ratio in the first two lessons stepped at companies whose operations had not changed.

The last three are speeds. Inventory turnover and asset turnover, the two measures most often misread as quality measures. Then the cash conversion cycle, which ties three working capital figures into one number of days, runs backwards when growth stops, and can stay perfectly flat while two of its three components deteriorate.

Every ratio here is read off a balance sheet, and a balance sheet is a measurement of one day that the company chose. Each lesson says what that costs, and each one ends by naming what it cannot tell you.

Where this sits

Third of nine courses. It assumes Reading financial statements and Accounting quality. It comes before the returns course rather than after it because a return on capital divides by the balance sheet, and what is on the balance sheet changed in 2019 when operating leases arrived on it. Quality and returns follows.