Financial Indicators.. Liquidity Ratios Flashcards
Current ratio
Current Assets : Current Liabilities
Inventories Payables
Receivables Cash Bank overdraft
- How much of current assets does the business have for every R1 of current liability?
- Is the business liquid?
- How does the result compare with the previous year?
- Will the business be able to pay its short-term debts?
What can a higher ratio be attributed to?
• High stock levels
• Obsolete stock
• Inventory is valued at prices higher that than the realistic value
• Increase in debtors through credit sales
• Increase in cash through loans
What can a lower ratio be attributed to:
• Decrease in any of the current assets
Or
• Increase in any of the current liabilities
Acid Test Ratio
CurrentAssets–Inventories:CurrentLiabilities
Receivables Payables
Cash Bank overdraft
The acid Test Ratio is calculated to:
• Assess the ability of the business to pay off its short-term debts without having to sell its stock (inventory)
• How much of current assets excluding stock does the business have for every R1 of current liability?
Why is stock excluded?
•Obsolete stock can not be converted to cash quickly
•Stock may be over priced and cannot be sold quickly
•Generally,stock can not be converted to cash quickly
•To determine the extent to which the business has invested in stock.
Other factors that can affect the ratio:
•Cash invested in Fixed Deposits
•Debtors are taking too long to pay
•Creditors are being paid too soon.
How does the result compare with the previous year?
If it decreased it means that money is held in stock.
Will the business be able to pay its short-term debts?
The lower the acid test ratio means that the business won’t be able to pay off their short term debts efficiently.
Rate of Stock Turnover
Cost of sales
Average stock
Answer = x times per year
The Rate of Stock Turnover is calculated to check the liquidity and operating efficiency of the business by determining the number of time stock is replaced in a year.
A high stock turnover rate is advantageous and would result in:
• Increased sales (Turnover)
• Increased cash sales would improve cash
flow (Money is available more quickly)
• Increase in turnover would lead to profits
being realized more quickly
A lower stock turnover rate could be as a result of: • Stockpiling due to ageing, poor quality or changes in fashion • Wrong purchases • Wrong purchase policy (When must stock be replaced) • Poor sales • Economic circumstances
Consequences of stock piling:
• Incur costs for storage (rent etc.) Profits decrease
• Cash is tied to stock that cannot be sold easily
because it is outdated. Affects liquidity How does this result compare with the previous year?
Period for which enough stock on hand
Average stock x 365
Cost of sales
Answer – x days
The period for which enough Stock is on Hand is calculated to help the business in planning and replenishing stock. This process involves:
• Adhering to the purchasing policies
• Timeous placing of orders
• Checking up on availability of stock
If the period is long it indicates that more working capital is tied up in stock
(Working Capital = Current Assess- Current Liabilities)
It must be noted that the type of business will also influence the period e.g.
• Clothing may be replaced seasonally. Approximately four time a year
• Groceries and other food items may be replaced more rapidly that is, daily or weekly
How does this result compare with the previous year?
Debtors’ average collection period
Average Debtors x 365
Credit Sales
Answer = X days
The debtors’ collection period is calculated to determine whether debtors are complying with the credit terms policy. If the collection period exceeds the terms for collection in the policy, it means that the credit terms policy is not efficient and the consequences are as follow: • The business would not have sufficient cash to meet its financial obligations for e.g. payment to creditors, paying salaries and other operating expenses. • The business would have to borrow as a result cash flow constraints and would have to pay interest on overdraft. • Compare the result with the previous year and if the payment has worsened, it means that there is a regression in credit regulation.
If the collection period complies with the credit terms policy or it is shorter than the terms for collection it means that:
•Offer settlement discounts
•Charge interest on overdue accounts
•Regular communication with debtors to settle their account. Communicate by:
•Sending out monthly statements
•Following-up telephonically or by SMS
•Escalating the account to senior credit controller if payment is not forthcoming.
N.B. Debtors ’Collection period must be shorter that the Payment Period
Important:
How does this result compare with the credit terms policy? How does this result compare with the previous year?
Creditors’ Average Payment period
Average Creditors x 365
Credit Purchases
Answer = x Days
The creditors’ payment period is calculated to determine the following: • Whether there is compliance with the credit terms facilities arranged with creditors • Whether it is in keeping with the internal payment policy of the business so that: Ø Settlement discounts are received Ø Interestisnotchargedonoverdueaccounts Ø Supplies are not halted due to late payment A longer period of payment is always better because Ø It does not create financial constraints on the business Ø Surplus cash could be invested and interest could be earned on it (Money Market account, 32-day call account etc.)
