Accounting - Liqudity

Question 1

What are Liquidity ratios?

Answer 1

The ability of a company to pay its ST debts. Does a company have the ability to meet operating requirements from working capital?

Question 2

What are the Liquidity Ratios?

Answer 2

1) Current Ratio/Working capital Ratio
2) Quick (Acid) Test
3) Working Capital Cycle
- Receivables collection period
- Payment payable period
- Inventory Days

Question 3

What is Working Capital / Current Ratio?

Interpretation?

Answer 3

Current Ratio = Current Assets / Current Liabilities

• Over 1 = good (sufficient ST assets to cover ST debt, low cash flow pressure)
• Under 1 = negative working capital - support may be needed
• 2+ = suggests company may not be re-investing assets in the most productive way
• 1-2 = desirable but every business is different

Question 4

Problems with Current Ratio?

Answer 4

1) OVERDRAFTS - overdrafts = ST financing and therefore included in CL’s but frequently these are repayable after 1 year
2) INVENTORY - Inventory is part of CA, therefore it is assumed it can be converted into cash within 1 year
3) CASH FLOW TIMING - Ratio does not account for cash flow timing
4) STATIC- Ratio is static and shows the b/s at one point in time- therefore company could window dress. Working capital ration is used to reduce criticism that CR is static
5) COMPARISON - can vary with sectors, therefore hard to compare

Question 5

Quick Test Ratio?

Answer 5

Current Assets - Inventory / Current Liabilities

Question 6

How does Current ratio and Quick test differ?

Answer 6

Removes the problem of CA including inventory which may be liquid or not.

Quick Test is more stringent and shows if a company can cover ST liabilities without selling inventory

Question 7

Interpretation of Quick Test?

Answer 7

over 1 = good (but varies with industry - over 1.5 is best)

under 1 - may be a sign of liquidity problems and trigger concern

Question 8

If QR is less than WCR?

Answer 8

Current assets are dependant on inventory (e.g retail stores)

Question 9

What is Working Capital?

Answer 9

WC = CA - CL (ability to service ST liabilities)

Question 10

What is Working Capital Cycle?

Answer 10

3 rations which consider the velocity of cash flow within the company

cash —> Cost of Raw materials —> Cost of labour —> Finished goods —-> Generate sales —- Cash

Question 11

how can a company increase profitability ?

Answer 11

Increase efficiency of WCC

Question 12

How can company increase efficiency of WCC?

Answer 12

1. DECREASE STOCK - use “just in time” Inventory
2. DEBTORS - ensure they pay on time
3. CREDITORS - delay payment as long as possible

Question 13

What are the 3 ratios for WCC?

Answer 13

1. Receivable collection period
2. payable payment period
3. Inventory days

Question 14

What is Receivable collection period ratio?

Answer 14

RCP = Trade Receivables / Revenue * 365 days

Question 15

What is RCP?

Answer 15

How quickly a company can realise its receivables - illustrates percentage of sales revenue which is UNPAID

Question 16

Interpretation of RCP?

Answer 16

Static number - therefore can be distorted intentionally or unintentionally (dependant if company is in normal trading period when prepared - if company is seasonal level of receivables can increase or decrease during the year!)

Question 17

What is Payment Period Period ratio?

Answer 17

PPP = Trade Payable / COGS * 365 days

Question 18

What isPPP?

Answer 18

How quickly a company is settling its liabilities?

Question 19

What if PPP is less than RCP?

Answer 19

cash is leaving the company faster than it is coming in and can lead to liquidity trap

Question 20

What is Inventory days ratio?

Answer 20

Inv Days = Inventory / COGS * 365

or

Inv days = 365/ inv turnover

Question 21

What is Inv Turnover?

Answer 21

how many times could the company sell the entire inventory?

Inv Turnover = COGS /Av . inv

Question 22

What should you company inventory turnover to…

Answer 22

Industry Average but will vary with sector

Question 23

Interpretation of Inv Days

Answer 23

High = implies poor sales and excess inventory (increased storage costs) & opportunity cost of tying up working capital in inventory as 0% return vs return from CA e.g money market

Low = either strong sales or ineffective buying

BUT WILL VARY WITH SECTOR

Question 24

3 Implications of WCC

Answer 24

1) STATIC - b/s is static and therefore can give unrepresentative view esp for seasonal business
2) COGS - if COGS not available can use revenue but would distort the ration and therefore could be more useful to track trends
3) SECTOR - inv days will vary with sector (perishable goods = low but vineyared would be high) therefore need to examine business circumstances when interpretating ration.