Basic Business Calculations – Liquidity Ratios

Do you know how well your business is doing? Do you glance over your financial statements once a month and give yourself a pat on the back if all figure are in the positive or do you actually compare each month’s financials with previous months to get an accurate indication of the health of the business? You’d be surprised at how many business owners don’t even look at their financial statements, never mind analyse them. In this article series we’re going to take you through 4 groups of accounting ratios which we can use to evaluate the financial performance of a business.

These calculations are simple and easy – even for business owners who’d rather stick pins in their eyes than interpret financial figures. Perform the calculations each month and store the results in an excel document so that you can compare to previous month’s results and previous years financial records. This will help you identify problem areas before they become BIG problems and BIG headaches.

The 4 accounting ratios are:

1. Liquidity Ratio’s
2. Solvency Ratio’s
3. Efficiency Ratio’s
4. Profitability Ratio’s

Part 1 – Liquidity Ratios

Liquidity ratios measure the ability of your business to generate cash to pay its expenses. For this reason, liquidity ratio’s are often referred to as Working Capital Ratios. As a business owner or manager, these ratios are particularly important as they provide critical information about whether or not you can pay your short-term debts. This kind of information is required by banks when a company applies for a loan and can often determine whether the loan is granted or rejected. As part of the loan agreement, a bank might also stipulate that the company maintains a certain ratio so in this case it would be vital to keep tabs on liquidity ratios.

There are two types of liquidity ratios:

• Current ratio – current assets divided by current liabilities. This evaluates whether you have sufficient assets to cover your liabilities.
• Quick or acid-test ratio – current assets (excluding stock / inventory) divided by current liabilities. This evaluates whether you have sufficient assets to cover liabilities, irrespective of sales.

The Current Ratio

• Current Assets / Current Liabilities = Current Ratio

The current ratio looks at short-term solvency. It evaluates whether you have sufficient assets to cover your current liabilities.

The ratio is always written in the format X: Y, where X is the total amount of current assets and Y is the total amount of current liabilities.

What is a good current ratio then?

A ratio of 2:1 shows you have twice as many current assets as current liabilities and this is a good sign as it means your business can generate cash to meet its short-term debts.

What are some reasons for a decline in the ratio?

• Decrease in current assets
• Increase in short-term debt
• A combination of the above

A decline in the ratio reflects a decrease in the ability of a company to generate cash to pay its expenses.

How can I improve my Current Ratio?

• Pay off some current liabilities

Example:

Current assets total – R120 000 (including R60 000 cash)

Current liabilities total – R60,000

Current Ratio – 2:1.

Using half your cash to pay off half the current debt just prior to the balance sheet date improves this ratio to 3:1 (R90 000 current assets to R30 000 current liabilities).

• Take out a long-term loan to repay short-term debt. This can help to improve the ratio.

Example:

Current assets total – R50,000

Current liabilities total – R40,000,

Current ratio – 5:4

Take out a long-term loan for R15 000 to pay off R15 000 of short-term debt. Current assets will still be R50 000 and current liabilities will be R25 000, which improves the current ratio to 2:1.

In order to improve the current ratio, one needs to improve current assets and decrease current liabilities.

The Quick or Acid-Test Ratio

• (Current Assets – Inventory)/Current Liabilities = Acid-Test Ratio

The quick or acid-test ratio is virtually identical to the current ratio except that stock/inventory is subtracted from current assets before being compared to current liabilities.

You may ask “why subtract the stock?”. Well, in order to generate cash from inventory, sales need to be made. So this ratio looks at a company’s ability to settle current liabilities without depending on sales or in other words it looks at your cash flow. If the acid-test ratio declines over time, whilst still maintaining a stable current ratio, it may indicate that the business has put too much money into stock.

Example:

Current assets: R120 000 (Inventory = R90 000)

Current liabilities: R30 000

Acid test ratio: 1:1

A ratio of 1:1 shows that your cash flow is good and you are able to settle your current liabilities irrespective of sales.

How can I improve my Quick / Acid-Test Ratio?

Sell stock ie. Convert inventory to cash

The acid-test ratio can also be improved by the same actions used to improve the current ratio:

• Increase current assets (sales of stock and not necessarily investing too much in stock)
• Decrease short-term debt

And lastly just remember that these ratios give you an overview of your liquidity and ability to meet your short-term debts. They do not tell you whether you will be able to pay your invoices when due. In order to determine this information you will need to draw up a cash flow forecast.