There are a wide range of tools used to evaluate financial stability in the gaming industry. They can run from such simplistic tools as positive net income or cash flow to the analysis of balance sheet and income statement ratios for positive and negative trends. The analysis of a balance sheet is normally looked at from the perspective of short-term liquidity and long-term solvency.
Short-term liquidity traditionally involves the analysis of current assets and current liabilities. Current assets are resources that are capable of being turned into cash within one year. Current liabilities are obligations that must be paid within one year and are normally paid with current assets, which are converted to cash. Does the company have the ability to meet its current commitment?
Analysis of long-term solvency measures the use of long-term assets, liabilities and stockholders’ equity. Is it highly leveraged and does it have the ability to meet future debt payments while replacing its assets? Does the company have the capability to meet other long-term commitments?
Both liquidity and solvency are used to determine the financial stability of casino properties. This article looks at measurements used to evaluate financial liquidity. A future article will continue this series on evaluating financial stability with a look at measurements for financial solvency.
Traditional Ratios
Financial liquidity reflects a company’s ability to generate enough cash to pay its current and maturing obligations. Whereas casino bankroll requirements are limited to measuring gaming liquidity, financial liquidity measurements evaluate all segments of the property, including the casino, hotel and other non-gaming operations. The concern is whether the property is generating enough revenues or has enough assets (cash or cash equivalents) to meet ongoing operating expenses, which are essential to the maintenance of continuous and stable casino operations. This includes the ability to pay all local, state and federal taxes, including the tax on gross revenues when due. Liquidity ratios and trends of these ratios provide the foundation for this element of financial stability.
A common gaming regulator approach in the determination of financial liquidity is to establish that there is positive income, or cash flow. But of greater importance should be the analysis of liquidity ratios and liquidity ratio trends. Financial analysts in all industries use the two most common liquidity ratios: the current ratio and the acid test, or quick ratio. The ratios are made up of the following balance sheet accounts:
• Current Ratio = Current Assets / Current Liabilities
• Acid Test or Quick Ratio = Quick Assets / Current Liabilities
Current Ratio
Current assets represent assets that are cash or can be converted to cash within 12 months. Current liabilities represent obligations that must be paid within 12 months. Since those obligations are to be paid with current assets, typically the common thought is that the current ratio should be greater than one in order to pay for those obligations. It is assumed that the higher the ratio, the more protection a company has against liquidity problems. It is also assumed that a negative trend in this ratio over a period of time should begin to cause concern.
Acid Test or Quick Ratio
The quick ratio takes a more liquid approach in evaluating a company’s ability to meet its current commitments. It acknowledges that there are some current assets that may not be converted to cash that quickly. The common assets taken out of the current assets are inventories and prepaid expenses. In many cases, prepaid expenses cannot be converted to cash. During down times in the economy, inventories could actually increase as a result of falling sales.
There are problems associated with these traditional ratios. The use of the current and quick ratios implicitly assumes that the current assets will be converted to cash. In reality, firms do not actually liquidate their current assets to pay their current liabilities. Minimum levels of inventories and receivables are always needed to maintain operations. The traditional ratios, therefore, measure the “margin of safety” provided by the cash resources relative to obligations rather than expected cash flows.
Alternatives to Traditional Ratios
While the balance sheet does provide a company’s existing cash and current asset position, textbook authors such as Kieso and Weygandt1 hold that using only the balance sheet and traditional ratios to ascertain liquidity does not provide sufficient information about a company’s ability to meet its current obligations.
The classic illustration of the problem is shown in the bankruptcy of W.T. Grant. Before it filed for bankruptcy, W.T. Grant showed seven consistent years of profits and even some periods of earnings growth. Its current ratios were always reasonable for the industry, and it reported reasonable amounts of working capital provided by operations. The major problem was that too much of its working capital was tied up in receivables and inventories. Kieso suggests that an analysis of cash flow statements would have alerted analysts years in advance. A review of the company’s net cash flow from operating activities would have shown the significant lack of liquidity.
The problem is that there is still a large group of analysts who rely on income statements and balance sheets for all of their information. While the statement of cash flows has been around for 20 years2, effective cash flow ratios are still evolving. Many still do not realize what type of information is provided by the statement of cash flows.
Statement of Cash Flows
The primary purpose of the statement of cash flows is to provide relevant information about a company’s cash receipts and cash payments during a specified time frame.3 The cash flow information is presented by three categories, or activities, of cash flows. These are: 1) operating activities, 2) investing activities, and 3) financing activities. The evaluation of liquidity is made based on an analysis of operating activities so, at this time, the discussion of the statement of cash flow is limited to operating activities and cash flow from operations (CFO).
CFO represents the first component in the cash flows statement. It is the net of all cash that has come into the firm generated by normal operating revenues, minus all cash going out of the firm to meet current operating expenses as well as any current liabilities coming due. CFO represents all cash inflows and outflows from operations during the year. A positive operating cash flow says that the company has been able to meet all of its current obligations and has cash leftover to meet other needs. Thus, an argument can be made that, while the current ratio provides an indication of the ability to meet current obligations, the CFO provides an actual indication for a specified time period. The company actually met its current obligations by having a positive CFO. A negative cash flow from operations means a company has to look at other sources of cash (investing or financing) to meet current obligations. Investing or financing sources will eventually dry up if operations are not successful. Of course, the evaluation of cash flows is also a function of the stage of development of the company.4
There is currently no clear consensus on the relevant cash flow ratios. The following ratios have been associated with discussions on financial liquidity: CFO: Net Income and CFO: Current Liabilities.
CFO to Net Income
As the W.T. Grant example so clearly shows, earnings as reflected in the income statement will not always result in positive cash flows. This is because the income statement is based on accrual accounting, not cash accounting. For example, a company sells a machine for $50,000 with payment being made over five years. Revenue of $50,000 is recognized in the year of the sale even though only $10,000 was received in cash. It is therefore imperative that the association between cash flows and income be recognized. A comparison of the CFO with the income from operations (taken from the income statement) can highlight the differences between cash flows and accruals provided by the income statement.
It is expected that the ratio (CFO / net income) should always be greater than 1 because the major differences are the result of depreciation and amortization, and non-cash flow items. In general, CFO should be positive and increase over time because, in the long run, it provides the resources to service debt, invest in growth and reward shareholders. Major swings in different directions should be cause for investigation.
CFO to Current Liabilities
Cash flows from operations represent the excess cash available to meet future cash needs. One of these future cash flow needs is the payment of current liabilities. The comparison of CFO to current liabilities represents an overall measure of the capability to meet future liability commitments. A positive (greater than 1) ratio provides evidence that these current commitments should be easily met. But it is more than likely that this ratio will be less than 1.5 An analysis of the ratio for the gaming industry showed that the normal ratio was dependent on the size of the enterprise. What is more important is the tracking of trends associated with this ratio. This ratio, from a trend perspective, provides information on the direction of the cash flows relative to increases in current liabilities. If the trend is negative, it could mean that revenues are not being converted into cash quick enough to meet current liabilities.
Liquidity Ratio Norms
Gaming regulators are concerned about the financial stability of the gaming properties within their state. If they determine that a property is financially impaired, they may appoint a trustee to run the property. But a perusal of state gaming websites found that few provide information on the measurements or ratios being used to evaluate financial stability or financial liquidity. Some states, such as Nevada, New Jersey and South Dakota, provide the current ratio in their gaming abstracts or statistics. None have specifically stated which liquidity ratios they are using to reach a conclusion on whether gaming properties are in compliance with financial stability requirements. The disclosure of such information could go a long way toward the standardization of common ratios for evaluating financial liquidity.
Footnotes
1 Kieso, D., J. Weygandt and T. Warfield, 2007. Intermediate Accounting. 12th Ed., John Wiley & Sons, Inc., New York, pp.191.
2 Financial Accounting Standards Board. 1987. Statement of Financial Accounting Standards No. 95 Statement of Cash Flows. FASB, Stamford, CT.
3 Ibid.
4 See for example, Kimmel, P.D., J. J. Weygandt, and D. E. Kieso, 2006. Financial Accounting: Tools for Business Decision Making, 4th ed. (New York: John Wiley & Sons)
5 Mills, J, and L Bible, 2002, “Incorporating Cash Flow Analysis for Evaluating Casino Financial Stability,” Journal of International Casino Studies, August.
John Mills is currently a Professor of Accounting at the University of Nevada, Reno. He is also the Director of the Master of Accountancy Program at UNR. He can be reached at jmills[at]unr.edu or at
(775) 784-6884.
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