Liquidity ratios and the current ratio

Liquidity ratios measure a business's ability to convert assets into cash to meet short-term obligations. They help assess whether a firm has sufficient working capital to cover immediate debts without facing insolvency.

The concept of liquidity in business

Liquidity of assets refers to how quickly an asset can be converted into cash. Cash itself is highly liquid, while non-current assets like factories are not. Inventories and receivables fall in between.

If current assets are insufficient to pay current liabilities when due, the business may become insolvent, forcing it to seek emergency funds, cease operations, or enter liquidation.

The current ratio

The current ratio, also known as the working capital ratio, compares current assets to current liabilities.

$\text{Current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$

Where:

• Current assets = Items like cash, inventories, and receivables (£)
• Current liabilities = Short-term debts like payables and loans (£)

Interpreting the current ratio:

• A ratio above 1 indicates that current assets exceed current liabilities, suggesting good liquidity.
• An ideal ratio is often around 1.7 to 2.2, as it accounts for the fact that not all inventories can be sold immediately.
• A ratio much below 1.6 may signal liquidity issues, making it hard to meet obligations.
• Ratios are useful for comparing performance over time or against competitors.

Worked example - Calculating the current ratio

A business has current assets of £55,000 and current liabilities of £30,000. Calculate the current ratio and interpret what it means for the business's liquidity.

Step 1: Identify the values

• Current assets = £55,000
• Current liabilities = £30,000

Step 2: Apply the current ratio formula

$\text{Current ratio}=\frac{\pounds \mathrm{55,000}}{\pounds \mathrm{30,000}}$

Step 3: Calculate the current ratio

$\text{Current ratio}=1.83$

Step 4: Interpretation

A current ratio of 1.83 suggests good liquidity, as the business has £1.83 in current assets for every £1 of current liabilities, indicating it can likely meet short-term debts.

Profitability ratios and return on capital employed (ROCE)

Profitability ratios evaluate how effectively a business generates profit from its resources. Return on capital employed (ROCE) is widely regarded as the most comprehensive profitability measure, showing the return generated from invested capital.

Return on capital employed (ROCE)

$\text{ROCE}=\frac{\text{operating profit}}{\text{total equity + non-current liabilities}}\times 100$

Where:

• Operating profit = Profit before interest and tax, from the income statement (£)
• Total equity = Owners' investment, from the balance sheet (£)
• Non-current liabilities = Long-term debts, from the balance sheet (£)

Interpreting ROCE:

• ROCE indicates the percentage return on the capital invested in the business.
• A higher ROCE is preferable, as it shows efficient use of capital to generate profit.
• Compare ROCE to bank interest rates; if ROCE is lower, the investment may not be worthwhile.
• Trends in ROCE over time or against industry averages help assess performance.

Worked example - Calculating return on capital employed (ROCE)

A company reports an operating profit of £150,000, total equity of £500,000, and non-current liabilities of £250,000. Calculate the ROCE.

Step 1: Identify the values

• Operating profit = £150,000
• Total equity = £500,000
• Non-current liabilities = £250,000

Step 2: Calculate capital employed

Capital employed = total equity + non-current liabilities = £500,000 + £250,000 = £750,000

Step 3: Apply the ROCE formula

$\text{ROCE}=\frac{\pounds \mathrm{150,000}}{\pounds \mathrm{750,000}}\times 100=20\%$

Step 4: Interpretation

A ROCE of 20% means the business generates a 20% return on every £1 of capital employed, indicating strong profitability if it exceeds typical bank interest rates.

Efficiency ratios including inventory turnover, payables days, and receivables days

Efficiency ratios, also known as performance or activity ratios, assess how well a business manages its resources to generate revenue. They focus on the effective use of assets like inventories, payables, and receivables.

Inventory turnover ratio

This ratio shows how many times a business sells and replaces its average inventory over a year.

$\text{Inventory turnover ratio}=\frac{\text{cost of sales}}{\text{cost of average inventory held}}$

Where:

• Cost of sales = Total cost of goods sold, from the income statement (£)
• Cost of average inventory held = Average value of stock at cost price, from the balance sheet (£)

Interpreting the inventory turnover ratio:

• A higher ratio indicates efficient stock management, with stock being sold quickly.
• Typical ratios vary by industry; for example, a fresh produce seller might have a high ratio like 280, while a heavy machinery firm might have a low ratio like 5.
• Analyse whether the ratio ensures enough stock to meet demand without excess that ties up capital.
• Tools like aged stock analysis can help sell older items before they become obsolete.

Payables days ratio

This ratio measures the average time taken to pay suppliers.

$\text{Payables days ratio}=\frac{\text{payables}}{\text{cost of sales}}\times 365$

Where:

• Payables = Amount owed to suppliers, from the balance sheet (£)
• Cost of sales = Total cost of goods sold, from the income statement (£)

Interpreting the payables days ratio:

• A higher number means the business takes longer to pay, which can improve cash flow but may strain supplier relationships.
• Trends over time can reveal payment difficulties if the ratio rises sharply.
• Businesses often aim to extend payables days strategically to optimise working capital.

Receivables days ratio

This ratio indicates the average time customers take to pay for credit sales.

$\text{Receivables days ratio}=\frac{\text{receivables}}{\text{sales revenue}}\times 365$

Where:

• Receivables = Amount owed by customers, from the balance sheet (£)
• Sales revenue = Total income from sales, from the income statement (£)

Interpreting the receivables days ratio:

• A lower number is better, as it means faster cash collection, improving cash flow.
• "Good" values depend on the sector; retail might aim for under 25 days, while manufacturing could accept 65-85 days.
• Rising trends may signal issues like extended credit terms or collection problems.
• Aged receivables analysis helps prioritise overdue payments.

Worked example - Calculating efficiency ratios

A firm has cost of sales of £350,000, average inventory held of £70,000, payables of £50,000, receivables of £75,000, and sales revenue of £500,000. Calculate the inventory turnover, payables days, and receivables days ratios.

Step 1: Identify the values

• Cost of sales = £350,000
• Average inventory held = £70,000
• Payables = £50,000
• Receivables = £75,000
• Sales revenue = £500,000

Step 2: Calculate inventory turnover ratio

$\text{Inventory turnover ratio}=\frac{\pounds \mathrm{350,000}}{\pounds \mathrm{70,000}}=5$

Step 3: Calculate payables days ratio

$\text{Payables days ratio}=\frac{\pounds \mathrm{50,000}}{\pounds \mathrm{350,000}}\times 365=52\text{ days}$

Step 4: Calculate receivables days ratio

$\text{Receivables days ratio}=\frac{\pounds \mathrm{75,000}}{\pounds \mathrm{500,000}}\times 365=55\text{ days}$

Step 5: Interpretation

The firm turns over its inventory 5 times a year, takes 52 days to pay suppliers, and waits 55 days for customer payments, suggesting balanced efficiency in managing stock and credit.

Ways to improve financial ratios

Businesses can take targeted actions to enhance their ratios, improving overall performance and financial health.