Answers to self-test questions
6.7 Assessing liquidity
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Exercise
What outline conclusions can you draw about LMN’s management of its working capital and non-current asset resources in Years 2 and 3?
Solution
Debtor (receivables) levels appear to be increasing out of control, although this may be a deliberate and controlled increase as part of a policy to encourage increased sales revenue.
Inventory levels appear to have reduced. This indicates efficient control of working capital, although sales may be forgone if customer requirements cannot be met from inventory. The reduction in the inventory turnover period has contributed to the improvement in the company’s asset turnover.
Creditor (payables) levels have been reasonably well matched with debtors. However, supplier relationships may be harmed if the credit period becomes excessive. The increase in the period of credit taken from suppliers has contributed to the improvement in the company’s asset turnover.
The utilisation of fixed assets continues at approximately the same level. The level of investment in fixed assets has increased but the revenues have increased correspondingly and a broad conclusion can be drawn that it appears that the new assets are being used in an efficient way to generate revenue.
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The following ratios may be used to evaluate the organisation’s liquidity:
◆ Current ratio
◆ Acid test ratio (also called the quick ratio or the liquid ratio)
6.7.1 Current ratio
This ratio relates an organisation’s current assets to its current liabilities to assess its ability to meet its short-term obligations and is calculated as follows:
The current ratio for LMN for Year 2 is:
This means that the current assets cover the current liabilities twice at the end of Year 2.
40
20 2 times
Current ratio Current assets Current liabilities
Exercise
Calculate LMN’s current ratio for Year 3.
Solution
The current assets covered the current liabilities 1.3 times at the end of Year 3.
Current ratio 60
45 1.3 times
6.7.2 Is there an ‘ideal’ size for the current ratio?
The ‘ideal’ size for the current ratio depends on a number of factors, including the following:
◆ The past record for the company. It is preferable to look at the trend in the current ratio over a number of years. Generally, the higher the current ratio, the more liquid the organisation. Since
6.7.3 The acid test ratio
This ratio may also be called the quick ratio or the liquid ratio. It is used to give a more stringent assessment of an organisation’s liquidity.
In many organisations it may take quite a long time to convert inventories into cash. For example, the manufacturing process may
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liquidity is important to the organisation’s survival it may be a cause for concern if the current ratio is reducing. If the current ratio falls too low the organisation may be in danger of overtrading. This happens when the organisation enters into commitments which are in excess of its available short-term resources. However, if the current ratio is too high, funds may be unnecessarily tied up in inventories or receivables that could be used more efficiently elsewhere in the organisation.
◆ The type of business and the ‘norm’ for the industry. For example, a retailing company might be expected to have a lower current ratio than a manufacturing company. In fact, many retailing companies have a current ratio of less than 1.0, indicating that the current liabilities exceed the current assets, that is these companies have net current liabilities or negative working capital.
Exercise
Explain why retailing companies tend to have a lower current ratio than manufacturing companies.
Solution
The current asset balances of retailing companies tend to be relatively lower than the current asset balances of manufacturing companies for the following reasons:
◆ Retailing companies do not hold inventories of raw materials or work in progress.
◆ Retailing companies sell mostly on a cash basis and so have very few debtors (receivables) on their balance sheet.
Manufacturing companies may have to wait for several weeks before cash payment is received from their customers.
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Exercise
Calculate LMN’s acid test ratio for Years 2 and 3.
Solution
Year 2 28
20 1.4 times
Year 3 4445 0.98 times
In Year 2, LMN’s liquid assets covered its current liabilities 1.4 times.
However, in Year 3 the ratio has fallen below 1.0 therefore LMN would have to sell some of the inventory to meet all its current liabilities.
6.7.4 Using balance sheet information
The use of balance sheet data to assess liquidity presents the same problems as with the assessment of the efficiency of asset management. It is important to appreciate that the liquidity ratios that we have calculated in this section are based on balance sheet data. The balance sheet is like a photograph taken of the organisation at the end of the financial year.
Therefore the working capital balances may not be representative of the liquidity position during the year. There may have been exceptional events at the end of the year or the business may be seasonal, leading to higher or lower than average working capital balances at the end of the year.
be such that it takes several days or even weeks to produce a finished product, and on top of this customers may expect a lengthy period of credit. Therefore it could be argued that in this type of organisation, inventories are not a liquid asset: they cannot be quickly liquidated to meet current liabilities as they become due.
The ‘acid test’ of an organisation’s liquidity is whether it can cover its current liabilities without having to sell its inventories, and so this ratio includes only the more liquid assets in the calculation:
Acid test ratio Current assets excluding stock Current liabilities
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6.7.5 LMN’s liquidity ratios: Summary
The ratios that we have calculated for Years 2 and 3 are as follows:
Year 2 Year 3
Current ratio 2.0 times 1.30 times
Acid test ratio 1.4 times 0.98 times
Exercise
What outline conclusions can you draw about LMN’s short-term liquidity position at the end of Year 3?
Solution
We do not know what business LMN is in, therefore we cannot comment on what would be a suitable current ratio. However, the change in the two liquidity ratios may be a cause for concern. They have both deteriorated and in Year 3 it is not possible for LMN to meet its current liabilities without having to sell some inventory.
The Year 3 ratios in themselves are not necessarily too low and it is difficult to draw firm conclusions without knowing the sort of business that LMN is in. However, the change from Year 2 levels could indicate liquidity problems if it is not a controlled change. The company appears to be in danger of overtrading.
Since we have seen from earlier calculations that in Year 3 an average item is held for 33 days in inventory (the inventory turnover period) and then customers take an average of 58 days to settle their account (the receivables collection period) we might conclude that inventory is not a particularly liquid asset for LMN. They cannot rely on selling it quickly to generate cash rapidly to meet their short-term liabilities.
Therefore perhaps we should place more weight on the acid test ratio than on the current ratio when assessing this particular company’s liquidity. Accordingly, we might conclude that the company could be heading for liquidity problems when attempting to meet its short-term commitments.
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Notice how our interpretation of the liquidity ratios referred back to the information obtained from the efficiency ratios. Although you are calculating separate groups of ratios in order to give your analysis some structure, do not view each group of ratios in isolation. Each group can help you with the interpretation of the results of other groups of ratios.