Interpreting Accounts - Liquidity Ratios

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In this revision presentation we look at liquidity ratios - which assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due.

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Interpreting Accounts - Liquidity Ratios

  1. 1. Liquidity Ratios
  2. 2. Liquidity ratios Assess whether a business Assess whether a business has sufficient cash or has sufficient cash orequivalent current assets toequivalent current assets to be able to pay its debts as be able to pay its debts as they fall due they fall due
  3. 3. Current ratio Current assetsCurrent ratio = Current liabilitiesExampleExample Current assets = £6,945k Current assets = £6,945k Current liabilities = £3,750k Current liabilities = £3,750k Current ratio = 1.85 Current ratio = 1.85
  4. 4. Evaluating the current ratio• Interpreting the results – Ratio of 1.5-2.0 would suggest efficient management of working capital – Low ratio (e.g. below 1) indicates cash problems – High ratio: too much working capital?• Look out for – Industry norms (e.g. supermarkets operate with low current ratios because they low debtors) – Trend (change in ratio) is perhaps most important
  5. 5. Acid test ratio Current assets less stocksCurrent ratio = Current liabilitiesExampleExample Current assets = £5,620k Current assets = £5,620k Current liabilities = £3,750k Current liabilities = £3,750k Acid test ratio = 1.50 Acid test ratio = 1.50
  6. 6. Evaluating the Acid test ratio• Interpreting the results – A good warning sign of liquidity problems for businesses that usually hold stocks – Significantly less than 1 is often bad news• Look out for – Less relevant for business with high stock turnover – Trend: significant deterioration in the ratio can indicate a liquidity problem
  7. 7. Gearing ratio Long-term liabilitiesGearing (%) = x 100 Capital employedExampleExample Long-term liabilities= £1,200k Long-term liabilities= £1,200k Current liabilities = £5,655k Current liabilities = £5,655k Acid test ratio = 21.2% Acid test ratio = 21.2%
  8. 8. Evaluating the gearing ratio• Interpreting the result – Focuses on long-term financial stability of business – High gearing (>50%) suggests potential problems in financing (interest & capital repayments) – However gearing is not necessarily bad! Debt is often cheaper than equity• Look out for – Increased gearing & deterioration in other liquidity and/or financial efficiency ratios
  9. 9. Managing GearingReduce Gearing Increase GearingFocus on profit improvement (e.g. Focus on growth – invest incost minimisation revenue growth rather than profitRepay long-term loans Convert short-term debt into long- term loansRetain profits rather than pay Buy-back ordinary sharesdividendsIssue more shares Pay increased dividends out of retained earningsConvert loans into equity Issue preference shares or debentures
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