Accounting for Business

Chapter 7: Ratio Analysis 2: Liquidity,

Working Capital and Long-Term Financial
Stability

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 Liquidity and Cash Flow
• Liquidity = entities’ ability to raise cash to pay off liabilities as
they become due for payment
• Entities unable to generate cash from which to meet their
debts will not survive
• The faster entities turn their sales into cash the better it is
– Retailers turn sales into cash very quickly as customers pay cash for
goods
– Manufacturers sell to their customers on credit and so have to wait
for payment

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 Cash Flow Cycle for Retailers

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 Cash Flow Cycle for Manufacturers

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 Assessing Liquidity (1): Short-Term Liquidity Ratios
Current and quick ratio

• Compare current assets with current liabilities to assess

the ability of short-term assets to cover short-term
liabilities

• Current assets generate cash from sales of inventory

and from trade receivables paying what they owe

• This cash is then used to meet current liabilities as they

become due for payment
© Peter Scott, 2019. All rights reserved.
 Current and Quick Ratios: Calculation

Current ratio = Current assets

Current liabilities

Quick ratio = (Current assets – inventory)

Current liabilities

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 Current Ratio: Information and Problems
• Tells users how many £s of current assets an entity has
for each £ of liabilities
• Only a snapshot of an entity’s short-term liquidity at one
day in the year
• Cash circulates constantly as new sales are made,
receivables pay and payables are paid
• Ignores the timing of future cash receipts and payments
• A low current ratio is not necessarily an indication of
short-term liquidity problems
© Peter Scott, 2019. All rights reserved.
 Quick Ratio: Information and Problems
• Ignores inventory as inventory is assumed to be difficult to
sell and so not easily convertible into cash
• Uses current assets that are either already cash or quickly
convertible into cash (trade receivables = a contractual right
to receive cash for sales already made) in the assessment of
short-term liquidity
• How realistic is the assumption that inventory will not sell
quickly?
– Depends on each entity’s industrial sector and production of goods to
order rather than stockpiling production

© Peter Scott, 2019. All rights reserved.

 Assessing Liquidity (2): Working Capital Ratios
• Working capital = current assets (inventory, trade
receivables and cash) – current liabilities (trade payables)

• Working capital ratios look at how quickly inventory is

sold, how quickly trade receivables are turned into cash
and how quickly trade payables are paid
– Aim to overcome problems posed in liquidity assessment by static
current and quick ratios by looking at the speed of cash movement

© Peter Scott, 2019. All rights reserved.

 Inventory Days
Inventory days = Inventory x 365
Cost of sales
Inventory Days Ratio:
• Measures the average stockholding period
• How long an entity holds inventory before it is sold
• The lower the inventory days the better
• Consider future demand, potential shortages, bulk discounts,
insurance and storage when calculating optimum inventory
levels

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 Receivables Days
Receivables days = Trade receivables x 365
Credit sales
Receivables Days Ratio:
• Determines the average credit period taken by credit
customers
• Evaluates the efficiency of an entity’s credit control and
the speed with which credit sales are turned into cash
• Where this ratio increases, take steps to speed up cash
receipts from customers
© Peter Scott, 2019. All rights reserved.
 Payables Days
Payables days = Trade payables x 365
Cost of sales
Payables Days:
• Determines the average credit period taken by an entity from
its suppliers
• Measures how quickly an entity is paying for its purchases
made on credit
• Ideally, as trade receivables pay what they owe, the cash is
then used to pay trade payables

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 The Cash Conversion Cycle
Cash conversion cycle =

inventory days + receivables days – payables days

• How quickly inventory is turned into trade receivables

• How quickly trade receivables are turned into cash with which to pay trade
payables

• The shorter the cash conversion cycle:

– The better working capital is being managed

– The more readily cash is available to meet liabilities

• Conversely, the longer the cash conversion cycle:

– The higher the investment required in working capital

– The higher emergency sources of cash will need to be in order to pay liabilities as they fall
due

© Peter Scott, 2019. All rights reserved.

Long-Term Solvency and Financial Stability (1)
• Users assess entities’ ability to meet liabilities in the
short term through:
– Current and quick ratios

– Working capital ratios

– Cash conversion cycle

– Estimating daily cash inflows and outflows

• What about long-term solvency and financial stability

assessment?

© Peter Scott, 2019. All rights reserved.

Long-Term Solvency and Financial Stability (2)
• Any evaluation of an entity’s ability to survive must
consider long-term solvency and financial stability
• Long-term solvency = an organization’s ability to meet
the interest on and repayment of long-term, non-
current liabilities as they fall due
• Financial stability: the avoidance of excessive
borrowings, consistency of demand for products or
services and the ability to innovate to stay relevant

© Peter Scott, 2019. All rights reserved.

 Long-Term Solvency Ratios: Gearing
Gearing = Long + Short-Term Borrowings x 100
Equity
• Expresses total borrowings as a % of equity
• Gearing is often perceived as a measure of risk
– The higher the borrowings, the higher the risk entities will
not be able to service their debts:
• Through the payment of interest or
• By repaying those borrowings when they become due

© Peter Scott, 2019. All rights reserved.

 Long-Term Solvency Ratios: Debt Ratio

Debt ratio = Total Liabilities

Total Assets

• Measures the £s of liabilities per £ of assets

• The lower the ratio, the more secure the entity

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 Long-Term Solvency Ratios: Interest Cover
Interest cover = Profit Before Interest and Tax

Interest Expense

• Assesses how many times interest payable on borrowings

can be paid from operating profit

• A measure of the affordability of interest on borrowings

• The higher the figure the better: a high figure indicates an

ability to continue meeting interest payments from profits
in the future
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 Example: Antigoneia Plc
• Antigoneia Plc: Statements of Profit or Loss for the Years Ended 30 April 2019 and 30 April 2018

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 Example: Antigoneia Plc
Antigoneia Plc: Statements of Financial Position at 30 April 2019 and 30 April 2018

© Peter Scott, 2019. All rights reserved.

 Antigoneia Plc: Liquidity Ratios
• Current ratio 2019: £6,745 ÷ £4,970 = 1.36:1
• Current ratio 2018: £4,475 ÷ £4,520 = 0.99:1

Quick ratio:
• 2019: (£6,745 – £2,870) ÷ £4,970 = 0.78:1
• 2018: (£4,475 – £2,350) ÷ £4,520 = 0.47:1

• Ratios below “recommended” levels

• But company trades for cash and buys on credit
• And so has a very short cash flow cycle

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 Antigoneia Plc: Working Capital Ratios

Inventory days: inventory ÷ cost of sales x 365

• 2019: £2,870 ÷ £20,625 x 365 = 50.79 days
• 2018: £2,350 ÷ £19,250 x 365 = 44.56 days

Receivables days: N/A: trading is for cash only, so there are no

trade receivables.

Payables days: trade payables ÷ cost of sales x 365

• 2019: £1,820 ÷ £20,625 x 365 = 32.21 days
• 2018: £1,560 ÷ £19,250 x 365 = 29.58 days

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 Antigoneia Plc: Cash Conversion Cycle
Inventory days + receivables days – payables days
• 2019: 50.79 + 0 – 32.21 = 18.58 days
• 2018: 44.56 + 0 – 29.58 = 14.98 days

• Cash paid out before inventory is sold

• Inventory days rising: obsolete inventory that is more difficult to
sell? New season goods in early?
• Company has cash to cover all trade payables
• Cash is constantly coming in from sales to meet liabilities as they
fall due

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 Antigoneia Plc: Long-Term Solvency Ratios

Gearing ratio:
• 2019: £15,240 ÷ £16,424 x 100% = 92.79%
• 2018: £10,000 ÷ £15,325 x 100% = 65.25%

• Debt ratio: 2019: £20,210 ÷ £36,634 = 0.55:1

• Debt ratio: 2018: £14,520 ÷ £29,845 = 0.49:1

• Interest cover: 2019: £4,482 ÷ £800 = 5.60 times

• Interest cover: 2018: £4,630 ÷ £500 = 9.26 times
© Peter Scott, 2019. All rights reserved.