2.4 WORKING CAPITAL TRENDS
2.4.4 LIQUIDITY AND PROFITABILITY - RATIOS ANALYSIS
The final responsibility for controlling working capital typically resides with the highest financial manager. It is the job of the top financial manager, whatever the title, to design an overall control that properly reflects all components of working capital, and which places working capital in perspective vis-a-vis overall financial controlling (Smith, 1979).
2.4.4.1 Liquidity ratios
Current ratio: The current ratio is almost always the first financial ratio to be mentioned, and it is probably the most frequently used of the ratios. Since the ratio shows the number of times that the firm's short-term obligations could be paid if its short-term assets were converted to cash, the current ratio is used as an overall measure of the firm's liquidity. The financial manager, who monitors overall working capital, must have a perspective on how a firm's current ratio has varied over time, as well as how it compares with the current ratios of other firms in the industry. It is illustrated as: Current assets/ current liabilities
Quick ratio: The quick ratio or acid test ratio is similar to the current ratio except that inventory is subtracted from the current assets. The reason for excluding inventory is that it is the least liquid of the firm's current assets and may not be very helpful in meeting immediate financial obligations. The result is a value, which suggests a lower level of liquidity. It is illustrated as: Current assets-inventory/current liabilities.
Turnover ratios: These are also used to monitor and control liquidity because turnover ratios involve sales as well as the various current assets; they measure flows as well as levels of working capital.
Receivable turnover: Annual sales Year-end receivable
Inventory turnover: Cost of goods sold Average stock
2.4.4.2 Activity ratios
Activity ratios measure how efficiently a firm manages its assets. Efficiency is equated with rapid turnover (Neveu, 1989).
Inventory Turnover: This measures the number of times per year that a firm sells, or turns over its inventory. It is computed by dividing the dollar amount of cost of goods sold by the dollar values of inventories.
Total Asset Turnover: This measures the relationship between a dollar of sales and a dollar of assets, usually on a yearly basis. It is computed by dividing net sales by total assets.
Average collection period: This seeks to measure the average number of days it takes for a firm to collect its accounts receivable. This ratio relates the firm's daily credit sales to its short-term accounts receivable. It contains two steps:
Step one: Average credit sales per day = Total credit sales 360
Step two: Average collection period = Accounts Receivable
Average credit sales per day 2.4.4.3 Profitability ratios
The profitability position of the firm can also be portrayed by a number of different ratios.
The usual procedure is to compare after-tax earnings, with particular benchmarks from either the income statement or the balance sheet (Smith, 1979).
Profit margin: This ratio shows what portion of a dollar from customers remains after all constituencies- suppliers, employers, government, bankers etc. have been paid. It is portrayed as:
Profit margin = Earnings after tax Sales
Furthermore, earnings can be related to total assets or total equity, depending on whether the focus is on total resources used in the business or just those resources provided by the owners of the firm.
Return on Investment (Return on Assets): This measures the firm's profitability per dollar of the invested funds, which is illustrated as:
ROI (ROA) = Earnings after taxes Total assets
Return on Equity: This measures firm's profitability per dollar of equity capital. It is portrayed as:
ROE = Earnings after taxes Total equity 2.4.4.4 Composite ratios
Ensuring adequate liquidity for the firm and enhancing firm profitability were identified as two parts of the proper goal for managing working capital. In addition to monitoring these individual measures overtime, and making appropriate comparisons with other firms in the same industry, it is important to consider composite measures of liquidity and profitability for better control of working capital (Smith, 1979).
For liquidity the "days sales" ratios can be added in order to see how rapidly a dollar flows through the operating cycle of cash to inventory, to receivables, and back to cash. The shorter the length of the operating cycle, the more liquid the firm is judged to be. If the operating cycle gets longer overtime, then management should attempt to pinpoint the reason for the reduced liquidity. In contrast, procedures for reducing the length of the operating cycle are
useful, since liquidity is improved. The operating cycle framework also allows financial managers to evaluate where they should devote additional resources to improving firm liquidity.
Besides, for profitability the Du Pont system of financial control is the most well known composite ratio. It is expressed as follows:
Earnings after taxes = Earnings after taxes X Sales Total assets Sales Total assets Or Return on Assets = Profit margin X Total asset turnover
In subsequent levels of the Du Pont system, the income statement is used to break down earnings, while the balance sheet is used to breakdown the firm's total assets.