In this session, we will talk about two financial ratios: liquidity and leverage. So, the liquidity ratios are related to this question, can we pay our bills? So, it's about the company's ability to meet its financial obligations like paying debt, payroll, payments to vendors, taxes, and so on. So, these ratios are especially important for early stage startups. There are two ratios. The first one is the current ratio, and it's the ratio between the current assets and current liabilities. So, it's related to the question, are current assets sufficient to pay current liabilities? In the case of a Costco, it's close to one. There is a second ratio called a quick ratio. In quick ratio, you don't consider inventory because it takes time to sell your inventory. So, you compare current assets minus inventory with current liabilities. So, it's a more conservative measure of liquidity than current ratio because you don't consider inventory. It's also called the acid test because it's a more difficult test. Usually, a quick ratio above one is considered good, but in the case of Costco, it's only 0.4. So, is this ratio good enough for Costco? Let's look at that. So, this slide shows the cash conversion cycle of Costco from year 2012 to 2016. Let's look at the DII, days in inventory, and DPO. That's the days payable outstanding. So, if you look at these two numbers, they are very close. What do they mean? That means Costco pays accounts payable after they sell their inventories. Let's look at what Costco set on their annual report. Costco generally sells inventory before it is required to pay for it. So, that means they sell the inventory and then pay for their inventory to their vendors. It also says that the inventory is financed through payment terms provided by suppliers. That means, usually pays 30 days after rather than by Costco's working capital. So, we now know that Costco pays accounts payable after inventories are sold. So, for Costco, quick ratio is not important. Now let's look at the leverage ratios. These ratios show how extensively a company is using debt. Maybe debt has a negative image, but that could allow a company to grow beyond what invested capital would allow. Moreover, a company can deduct the interest payments on debt from its taxable income. In financial world, the word for debt is "leverage" because a business can use a modest amount of capital to build up a larger amount of assets through debt. So, it's like a leverage as shown in this picture. One of the leverage ratios we often use is debt-to-equity ratio, and we compare the total liabilities with shareholders' equity. This ratio shows how much debt a company has relative to its investor equity. When a lender considers giving loans, it wants a lower number. Costco has debt-to-equity ratio of about 0.43. That means it has a low number for debt compared to the equity. Another ratio for leverage is interest coverage, and it compares operating profit with annual interest charges. Also, it compares the profit with the interest charges. Costco has 27.6. That means it generates much more profit compared to the interest it has to pay. So, this table shows liquidity and leverage ratios of Costco and Walmart, and both companies have the current ratios of about close to one. We know that for Costco, quick ratio is not important, and the Walmart has even lower quick ratio, and probably also for Walmart, a quick ratio may not be that important. Both companies have a debt-to-equity ratios of less than one. So, that's good. Both companies have a high number for interest coverage. That's also good. So, the liquidity and the leverage ratios cannot explain the big difference in the price to earning ratios of Costco and Walmart. Now let's compare the growth rates of these two companies. The revenue growth rate, especially for Walmart, is going down to almost zero. For operating profits, Walmart shows the negative growth rates. So, the difference in growth rates between the two companies could explain the different price to earning ratio. By the way, you should be careful that Costco also shows a decreasing growth rate for revenue and operating profit there recently. So, let's look at the use of a financial ratios. For bankers, they are interested in debt-to-equity ratios because they are interested in whether a company will be able to pay back their loan. For founders, all the financial ratios, especially gross margin, inventory turn, and receivable days. When they decide whether or not to give credit to a new customer, they are interested in and looking at the current asset and current liability ratio because they are interested in knowing whether the company can pay its current liabilities. For shareholders and would-be acquirers, they are interested in price-to-earnings and also the net income compared to shareholders equity. So, in summary, when we compare Costco and Walmart, both companies have adequate liquidity and leverage ratios, and the different growth rates between the two companies maybe the reason for Costco's higher P/E ratio.
