1. Analysis and Interpretation Liquidity
YEAR 12 ACCOUNTING
Analysis and Interpretation
Liquidity

2. CLASSIFICATION OF RATIOS/PERCENTAGES
We are looking at this today!!!

3. How to evaluate businesses’ results?
Please follow the steps as follows:
Calculate Percentages/Ratios
Explain the meaning of the Percentage/Ratios
Unsatisfactory Trend
Look at the financial statements and formula and identify what has been changed?
Identify the trend
Satisfactory Trend
Look at the financial statements and formula and identify what has been changed?
Why was there a change in the financial statements?
Provide a recommendation/s to overcome the unsatisfactory trend.
Why was there a change in the financial statements?

4. Liquidity
Liquidity means the ability of a business to repay short-term debts and to meet unexpected needs of cash.
Short-term means within 12 months.

5. Measures of Liquidity
The following ratios are under the area of Liquidity:
Current Ratio
Liquid Ratio

6. 2:1 Current Ratio BENCHMARK
Meaning: It means for every $1 of current liabilities, there are $X current assets available to pay the current liabilities in the next months. It tells users that the business is able/unable to settle its debts in the next accounting period.

7. Example
If the current ratio in 2005 was 2.5:1. Try to write the meaning of the ratio.
This means for every $1 of current liabilities, there were $2.5 of current assets available to pay current liabilities within the next 12 months. This tells users that the business is ABLE to pay its debts which are due within the next 12 months.

8. Calculation 2005 2006 Current Assets Cash on Hand 500 Bank 3,000 N/A
A/Receivable
12,000
10,000
Inventory
20,000
18,000
Prepayment
800
36,300
600
29,100
Current Liabilities
Accounts Payable
15,000
14,000
Bank (secured $1,000)
4,500
18,500

9. Calculation
2005
2006
Current Ratio

10. Satisfactory/Unsatisfactory Ratio
The current ratio in 2006 showed a
SATISFACTORY or UNSATISFACTORY result.
The next step is to describe the reason with
using the Balance Sheet.

11. Identify the trend The Current Ratio showed a
SATISFACTORY or UNSATISFACTORY trend.

12. Reason
Remember, we need to include the following when providing reason/s:
Information from the financial statements
Reasons behind the information (you need to give an example)

13. Reason for trend (surface level)
The reason for the unsatisfactory ratio is there has been a significant decrease in the bank balance (ie from a positive balance to an overdraft).

14. Reason for trend (deep level)
An increase in the bank overdraft can be caused by the following:
Excessive Cash Drawings by the owner;
Purchase of a piece of property, plant and equipment for cash;
Repayment of a Non Current Liabilities
This answer is not good enough because
we have not yet answered WHY

15. Recommendations
To overcome this unsatisfactory ratio, either INCREASE current assets or DECREASE current liabilities, such as:
Purchase PPE by borrowing a long term loan (to reduce the big outflow of cash suddenly)
Dispose of any old PPE to obtain cash
Owner’s can make an extra cash contribution
Reduce the level of cash drawings
Borrow a long term loan to ease the shortage of cash

16. Is an over-high current ratio (like 5:1) a good thing?
No, because this tells users that the business cannot use its excess cash efficiently to generate further income.
Excess cash means the amount of cash left over after settling all liabilities due within the next 12 months.
Businesses should invest their excess cash into investments, such as shares, term deposits etc to earn interest.

17. Liquid Ratio BENCHMARK 1:1 Liquid Assets Liquid Liabilities
Liquid Ratio measures a business’s ability to repay its debts which are due immediately (i.e. within 2 – 3 months).

18. Meaning
This means for every $1 of liquid liabilities, there is $X.XX of liquid assets available to pay liquid liabilities within the next 2 – 3 months, which tells users that the business is able/unable to repay debts which are due in the next 2 – 3 months.
For example: Liquid Ratio in 2005 was 1.5:1. It means for every $1 of liquid liabilities, there is $1.50 of liquid assets available to pay liquid liabilities within the next 2 – 3 months, which means the business is ABLE to repay debts which are due in the next 2 – 3 months.

19. Calculation 2005 2006 Current Assets Cash on Hand 500 Bank 3,000 N/A
A/Receivable
12,000
10,000
Inventory
20,000
18,000
Prepayment
800
36,300
600
29,100
Current Liabilities
Accounts Payable
15,000
14,000
Bank (secured $1,000)
4,500
18,500

20. Calculation
2005
2006
Liquid Ratio

21. Satisfactory/Unsatisfactory Ratio
The liquid ratio in 2006 showed a
SATISFACTORY or UNSATISFACTORY result.
The next step is to describe the reason with
using the Balance Sheet.

22. Identify the trend The Liquid Ratio showed a
SATISFACTORY or UNSATISFACTORY trend.

23. Reason for trend (surface level)
The reason of an unsatisfactory ratio is :
A high level of inventory on hand despite the level of inventory of hand showing a decreasing trend (inventory could not turn into cash in the next 2 – 3 months) and
A significant increase in the bank overdraft. (from a positive balance to overdraft).

24. Reason for trend (deep level)
Possible reasons for having too much inventory on hand:
Poor purchase policy, such as buying inventory without double checking the level of stock on hand.
Charge products at excessive high price, which means people are less able to afford to buy the products.
An increase in bank overdraft can be caused by the following:
Excessive Cash Drawings by the owner;
Purchase of a property, plant and equipment by cash;

25. Recommendations
To overcome an unsatisfactory ratio, can be achieved by the following:
Purchase of PPE by borrowing a long term loan (to reduce the big outflow of cash suddenly)
Dispose of any old PPE to obtain cash
Owner to contribute extra cash
Reduce the level of cash drawings
Borrow a long term loan for easing the shortage of cash
Sell inventory at a lower price to get rid of inventory
Review the purchase policy to ensure no excess inventory is bought
Try to ask for a larger amount of secured bank overdraft