17.1 Analysis & Interpretation of FS - Efficiency, Liquidity & Solvency Ratios Flashcards
What are efficiency ratios
- How well our working capital is functioning
- Looking at current assets
What are inventory ratios
Inventory turnover
Inventory turnover = Cost of sales / Inventories = x times
* Number of times inventory turns over in a year
* Higher the figure the faster the turnover and generally better performance
Inventory days
Inventory days = Inventory / Cost of sales × 365 = x days
* Time taken to sell inventory
* Lower the better
But depends on industry (supermarket vs antique dealer)
What is Just In Time
- Inventory management system will massively affect inventory ratios
- JIT suggests that inventory should be minimised to keep costs e.g. storage, to a minimum.
- However, this does need to be balanced against:
o Offering product availability (stock outs may force your customers to buy from your competitors)
o Choice to customers.
o What is appropriate to the industry should be considered.
What are the trade receivables ratios
Trade receivables turnover
Trade receivables turnover = Credit sales / Trade receivables
Trade receivables days
Trade receivables days = (Trade receivables /
Credit sales) × 365
* Measures the time taken to collect money from customers for sales made on credit
* Typically in B2B transactions 30 days credit is given
*See notes to accounts for trade receivables as the SFP figure has other non trade receivables
What are the trade payables ratios
Trade payables turnover
Trade payables turnover = Credit purchases / Trade payables
Trade receivables days
Trade payables days = (Trade payables /Credit purchases) × 365
* How long it takes to pay suppliers
* Receivable and payable days should roughly be in balance
*In exam unlikely to have purchases so use the cost of sales figure
What is the working capital cycle (cash cycle)
Working capital cycle:
Inventory turnover period (days) +
Receivables collection period (days) -
Payables payment period (days)
Shows the amount of time between incurring production costs and receiving cash returns for them
What is overtrading
- Overtrading occurs when a business expands too quickly without having the financial resources to support such a quick expansion
- Common in new business when they have the sales but can’t get the money in to pay their suppliers
- If suitable sources of finance are not obtained, overtrading can lead to business failure
- Overtrading can occur even if a business is profitable, as it is an issue of working capital and cash flow management
What are the solvency ratios
Can be divided into:
1. Short term solvency ratios which are often called liquidity ratios
2. Long term solvency ratios
* Looking at if the company has the money to keep going and pay everyone
* Evaluating the solvency of of a company is part of the process of assessing its financial management
* Borrowing helps increase the asset base beyond the amount that could be funded by equity alone
o But borrowing too much can lead to high costs
* Financial leverage helps increase ROE (if return is greater than costs)
What are short term solvency / liquidity ratios
- As well as earning profits, business need to generate cash to pay creditors, lender, employees etc
- Generally, profitability and cash generation go hand in hand
- Liquidity ratios focus on the sort term position
o Looking as SFP and therefore closing figures - Liquidity ratios are a particular interest to creditors
What is the current ratio
Current ratio = Current assets / Current liabilities = x:1
- A current ratio great than 1:1 suggests that the company can pay its current liabilities from its current assets
- Traditionally it should be 2:1 but now more 1.5:1
o Don’t want it too high as current assets aren’t doing anything
o Don’t want more than 3 or 4:1
o Cash can be invested even short term
o Or could be more lenient to debtors - But this is only a benchmark and depends on the nature of the sector
How can the current ratio be windowdressed
Companies can ‘window dress’ liquidity ratios:
* Cash = 100; inventory = 100; trade receivables = 100; trade payables = 200
* Current Ratio = 300/200 = 1.5:1
But if all of the cash is used to pay TP:
* Current Ratio = (100+100)/100 = 2:1
Second ratio appears stronger but now the entity has no cash
Therefore must also look at raw figures too
What is the acid test or quick ratio
Quick ratio = (Current assets - Inventories) / (Current liabilities) = x:1
- Traditionally should be 1:1 but now between 1:1 and 0.7:1
o Depends on the nature of the sector
o Wouldn’t find for service based industries - Stock may take time to sell
o Especially if the company or sector is experiencing difficulties
o Often not liquid
Especially WIP stock - May also remove prepaid expenses which do not generate cash or other similar categories of current assets
What is long term solvency
- Gearing is often referred to as leverage
o Leverage means the use of non-ordinary equity sources of financing (debt)
o Is influenced by the company’s debt financing policy - Long term solvency ratios assist consideration of the ability of a firm to meet long term obligations
- Balance of debt financing to equity financing
o Do want a balance of the two - Debt is often cheaper than equity but increases risk
- Interest is tax deductible but dividends are not
o As dividends are an appropriation of profit after tax
What is gearing
- Gearing ratios assess
o Riskiness of a company
o The sensitivity of earnings and therefore dividends to changes in profitability and activity levels - Gearing ratio calculations usually include preference share capital as part of debt, because preference shares have a right to a fixed rate of dividend which is payable in priority over dividend payments to ordinary shareholders.
- Gearing will include all interest-bearing debt, and can be calculated on a
o debt/equity basis or a
o debt/(debt+equity) base - Don’t want more than 50% as means you have more debt than equity
- But do want some gearing as debt is tax deductible
What is the debt to equity ratio
D/E ratio = (Loans + Preference share capital) / (Ordinary share capital + Reserves + NCI)
