The quick ratio recognises that some assets are closer to cash than others, so while cash, liquid short-term securities and debtors are included, stock is excluded from the numerator of the ratio. In the calculations in the model, debtors and cash are included in the
numerator and current liabilities are as previously defined. In terms of benchmarks, once again industry norms should be looked at but a figure of 1 is usually regarded favourably, although the ratio can be lower and remain acceptable. Like the current ratio, the result must be placed in the context of the story told by the business plan and the stage of development of the business.
The quick ratio for Newco mirrors the story already depicted by the current ratio. In the second half of the plan, the current and quick ratios suggest a business that does not face any major liquidity constraints, which is in contrast to the first half of the forecast. For year 7, the quick ratio is 3.8 and is calculated from the balance sheet as follows: (K13 +K14 +K17)
÷ K26.
Asset base
The net book value (nbv) of assets should be looked at for the forecast period. In year 7, the figure is $50,563 (balance sheet, cell K11). Many initial business plans overlook the need to replace machinery that has reached the end of its useful economic life, so that, as a result of depreciation, the nbvof assets by the end of the plan is clearly insufficient to support the level of activity conducted by the business. The business plan should show adequate levels of reinvestment to maintain the asset base of the business. This becomes of major significance when valuing the business.
A graph of the nbvof the assets of the business helps you to see whether the asset base is maintained. An alternative is to calculate the ratio of capital expenditure to depreciation.
For year 6 the result is 0.6 (J21 from the cash flow statement divided by J33 from the profit and loss account). To ensure that the asset base is being maintained, the ratio needs to be 1 or greater. The low level of this ratio and the declining level of the nbvof assets suggest that the business may not be investing sufficiently in the replacement of its fixed assets.
Asset turnover
This measure examines the capital intensity of the business. It looks at the level of assets required to support the sales of the business. A business which requires a lower asset base to deliver the same volume of sales will be, all things being equal, more attractive than a business with a higher asset base.
Asset turnover = sales net operating assets
Net operating assets are defined as total fixed assets and net current assets. Newco has a steady-state asset turnover ratio of just under 2. For year 6, the result is 1.7 (J11 from the profit and loss account divided by J30 from the balance sheet).
Debtor days
Debtor days, as stated in Chapter 6, are the days it takes to collect sales revenue from
Reviewing the balance sheet 191
debtors. They can be calculated from a set of financial statements as follows:
Debtor days =average debtors during the period
× 365 annual credit sales
For year 6:
24.1 =sum (balance sheet I13, J13, I14, J14)÷ 2
× 365 profit and loss J11
In many cases, analysts use total annual sales in place of annual sales on credit, as the former is readily available from a set of published accounts whereas the latter rarely is. As an increase in debtors, all else remaining the same, implies a reduction in cash, any business will hope to keep debtor days to as low a level as possible to minimise its working capital requirements.
In the model, debtor days were input.
Creditor days
Creditor days for some cost items were inputs into the model, but the following formula can be used to calculate the result from the financial statements:
Creditor days =average creditors during the period
× 365 total cost of purchases
In the calculation in the model, capital expenditure is included among the cost of purchases.
For year 6:
20.2 = balance sheet (sum of I20 to I23 and J20 to J23)÷ 2
× 365 profit and loss (J15 and J29) and cash flow (J21 and J22)
An increase in creditors, all else remaining the same, implies that more cash is being retained within the business and so is positive for cash flow. The business should seek to maintain good relations with its suppliers while attempting to increase the credit period they provide.
The creditor days calculation for Newco fluctuates as a result of the 180-day credit terms provided by the supplier of the widget patent. The average creditor days figure is around 20. The extension of creditor terms and reduction of debtor days would lead to a significant improvement in working capital.
Stock turnover
The definition of stock turnover is as follows:
Stock turnover days =value of closing stock
× 365 cost of sales
For year 6:
85.1 =balance sheet J15 +J16
× 365 profit and loss J15
An increase in stock, all else remaining the same, implies that less cash is being generated from sales and so represents a decrease in cash flow. Businesses should attempt to minimise their stock turnover days (in other words, they should maximise stock turnover) while ensuring that the business is capable of meeting demand.
In the case of Newco, stock turnover days rise rapidly throughout the forecast period, reaching a maximum of 190 days in 2012. Newco is carrying too much stock relative to its sales volumes and this is tying up cash within the business. Purchase assumptions for stocks should be examined to reduce the number of stock turnover days.