These are the balance sheet figures for Cosy Furnishers Ltd at 31/12/2011. Debtors £16,000 Creditors £28,000 Stocks £22,000 Cash £2,000 Overdraft £24,000 Which of these terms are assets? Which of these are liabilities?

Answers Assets Liabilities Debtors Creditors Stock Overdraft Cash

Ratio Analysis LIQUIDITY RATIOS

Learning Objectives £ To calculate the two liquidity ratios (E-D) ££ To interpret and explain the two ratios (C-B) £££ To recommend and suggest improvements (A-A*)

You might have noticed that both the Gross Profit and Net Profit ratios used the Profit & Loss Account to get their figures. The next two ratios use the Balance Sheet.

Current Ratio It helps a business understand how easily they can meet all of their liabilities.

It checks whether the business has enough money available to pay for all of the debts if it was required to pay them straight away. It is giving us a measure of the LIQUIDITY.

Current Ratio CURRENT ASSETS CURRENT LIABILITIES

Have a go . . . £ £ 235,000 CURRENT ASSETS Debtors 75,000 £ £ CURRENT ASSETS Debtors 75,000 Cash at Bank 20,000 Stock 140,000 235,000 CURRENT LIABILITIES Creditors 25,000 Overdraft 55,000 80,000

So then we divide £235,000 by £80,000 and we get the answer of 2.9 Ok but is 2.9 any good?

Well any answer between 1. 5 and 2 Well any answer between 1.5 and 2.0 is excellent as this means that the business has enough money available to pay all of its debts.

In our example, the business actually has even more than this at 2.9. This means that it has nearly three times more current assets than current liabilities! This is good...but it needs to be careful as too high a figure might mean that that there is too much money just lying about and not being used effectively in the business

If the Current Ratio was LOWER than 1 If the Current Ratio was LOWER than 1.5 then the business might have problems paying back all of its debts! 2.94:1 means for every £1 that the business owes they have £2.94 that they own

What’s the Acid Test Ratio all about?

Acid test ratio This ratio again uses the Balance Sheet for its figures. This time we TAKE AWAY STOCK from our Current Assets before dividing the value by our Current Liabilities. CURRENT ASSETS - STOCK CURRENT LIABILITIES

Have a go . . . £ £ CURRENT ASSETS Debtors 75,000 Cash at Bank 20,000 £ £ CURRENT ASSETS Debtors 75,000 Cash at Bank 20,000 Stock 140,000 235,000 CURRENT LIABILITIES Creditors 25,000 Overdraft 55,000 80,000

Answer = £235,000 - £140,000 =£95,000 £95,000 / £80,000 = 1.19

The reason why we take away stock from our current assets is that stock is known to be ILLIQUID. This is a fancy way of saying that stock usually takes a long time to sell and to turn into cash.

You should show the examiner that you understand that stock can be very difficult to sell quickly. Say that stock is ILLIQUID that should impress them!

The Current Ratio value of 2 The Current Ratio value of 2.9 made us believe that the business could meet all of its debts quickly. It is only now when we use the Acid Test Ratio that we can see that in fact the business has most of its money tied up in stock! If the creditors all asked for their money back then the business would have a big problem.  

Remember ALWAYS think about: The industry the business is in What its figures were for last year. It might actually be doing better!

How could a business improve their liquidity? Think Time How could a business improve their liquidity?

Answers Early Payment discounts Reducing customer payment time Extending creditors payment time

Practice Time

Answer current ratio = current assets/current liabilities acid test ratio = current assets – stock/current liabilities acid test ratio = £90,000 – £30,000/£60,000 = £60,000/£60,000 = 1:1

But what does it mean? Write 3 sentences explaining what the ratios mean for Winter Ltd