Accounting - Liqudity Flashcards
What are Liquidity ratios?
The ability of a company to pay its ST debts. Does a company have the ability to meet operating requirements from working capital?
What are the Liquidity Ratios?
1) Current Ratio/Working capital Ratio
2) Quick (Acid) Test
3) Working Capital Cycle
- Receivables collection period
- Payment payable period
- Inventory Days
What is Working Capital / Current Ratio?
Interpretation?
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
Problems with Current Ratio?
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
Quick Test Ratio?
Current Assets - Inventory / Current Liabilities
How does Current ratio and Quick test differ?
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
Interpretation of Quick Test?
over 1 = good (but varies with industry - over 1.5 is best)
under 1 - may be a sign of liquidity problems and trigger concern
If QR is less than WCR?
Current assets are dependant on inventory (e.g retail stores)
What is Working Capital?
WC = CA - CL (ability to service ST liabilities)
What is Working Capital Cycle?
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
how can a company increase profitability ?
Increase efficiency of WCC
How can company increase efficiency of WCC?
- DECREASE STOCK - use “just in time” Inventory
- DEBTORS - ensure they pay on time
- CREDITORS - delay payment as long as possible
What are the 3 ratios for WCC?
- Receivable collection period
- payable payment period
- Inventory days
What is Receivable collection period ratio?
RCP = Trade Receivables / Revenue * 365 days
What is RCP?
How quickly a company can realise its receivables - illustrates percentage of sales revenue which is UNPAID
Interpretation of RCP?
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!)
What is Payment Period Period ratio?
PPP = Trade Payable / COGS * 365 days
What isPPP?
How quickly a company is settling its liabilities?
What if PPP is less than RCP?
cash is leaving the company faster than it is coming in and can lead to liquidity trap
What is Inventory days ratio?
Inv Days = Inventory / COGS * 365
or
Inv days = 365/ inv turnover
What is Inv Turnover?
how many times could the company sell the entire inventory?
Inv Turnover = COGS /Av . inv
What should you company inventory turnover to…
Industry Average but will vary with sector
Interpretation of Inv Days
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
3 Implications of WCC
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.
