Financial position
1 Liquidity
The ability of a company to pay its obligations as and when they fall due (its liquidity) is a major concern of any credit analysis. Short term liquidity can be assessed by comparing current assets with current liabilities in a variety of forms:
Working Capital = Current Assets - Current Liabilities.
A working capital surplus represents a cushion of protection for current creditors; it indicates the amount by which the value of current assets could decrease still leaving enough to repay current liabilities from the sale of current assets.
The optimum amount of working capital varies considerably from company to company and from industry to industry, thus the nature of the company's business and the quality of its assets must be considered. Companies functioning within industry sectors with short production/sales cycles (e.g. supermarkets) can generally function satisfactorily with a much smaller amount of working capital than those with a long production cycle (e.g. heavy engineering).
2 Current ratio
A current ratio of over one indicates that a company has a higher level of current assets than current liabilities and should, therefore, be in a position to meet its short term obligations as and when they fall due. However, some companies function adequately on current ratios of less than one whilst others need a much higher ratio. Generally the more liquid the current assets are the higher this ratio will be.
Trends are difficult to analyse but generally higher ratios indicate greater liquidity. However, an increase may reflect a high level of unsaleable stock or overdue receivables whereas a decrease may result from greater efficiency.
Some factors to consider:
Asset quality
Seasonality
3 Quick ratio (acid test)
This quick ratio shows how easily a company can meet its current obligations using funds raised from quick assets (those assets which can be converted quickly into cash).
A comparison of the quick ratio and current ratios which shows increases in both, but with the current ratio increasing more, would indicate that the company has been building up stock.
4 Working capital
Inventory days
Shows how long a business is holding its inventory. A higher number of days inventory might indicate holdings of obsolete or unsaleable inventory, but it might also signify a purchase of raw materials now in anticipation of an increase in price later.
Trade receivables collection period
Providing revenue is evenly spread throughout the year the ratio will indicate how effectively debts are being collected.
An increase in the ratio of receivables to revenue could, providing the proportion of cash sales has not increased, indicate one of the following:-
Receivables are being given or are taking longer to pay. What are the terms of trade?
The total receivables figure includes long outstanding debts. Should provisions be made?
Trade payables payment period
If purchases are spread evenly throughout the year, this ratio will show the length of credit the company is taking. An increase in the ratio may indicate that more reliance is being placed upon the payables to finance the business. A drop in days may indicate that a company is taking cash discounts or may indicate suppliers are cutting credit terms because of the company's decreased creditworthiness.
Check the denominator of each of these before you calculate. Inventory days and the payables payment period are both measured against cost of sales, because that is what inventory is bought and held at; the receivables collection period is measured against revenue, because that is what customers were invoiced. Swapping revenue and cost of sales between them is the mistake made most often here.
5 Solvency/gearing/risk
Gearing ratio
An increase in the gearing ratio indicates that either borrowings are increasing faster than equity, or equity is falling more quickly than borrowings. In extreme cases, borrowings may be increasing while equity falls.
In the first case, this may be simply because the profit potential of any increased borrowing has not yet been realised, or that the increase in profitability arising from the use or the increase in borrowings is not being retained within the business.
Interest cover
Indicates the number of times profits exceed interest expense. This may indicate severe financial difficulties or that borrowings are too high for the company to support. Is the current year's profitability exceptional?
It is important to note that this is a ratio based on profitability not cashflow which would be a better indicator of company’s ability to pay interest.
Working capital
Xena has the following working capital ratios:
20X9 | 20X8 | |
Current ratio | 1.2:1 | 1.5:1 |
Receivables days | 75 days | 50 days |
Payables days | 30 days | 45 days |
Inventory turnover | 42 days | 35 days |
Which of the following statements is correct?
A | Xena’s liquidity and working capital has improved in 20X9 |
B | Xena is receiving cash from customers more quickly in 20X9 than in 20X8 |
C | Xena is suffering from a worsening liquidity position in 20X9 |
D | Xena is taking longer to pay suppliers in 20X9 than in 20X8 |
Show answerHide answer
Financial performance and working capital
SAF has experienced a period of rapid expansion in the last 6 months following the launch of a new product on 1 July 20X2. The following information is available from the management accounts of SAF:
6 months to 31 December 20X2 | 6 months to 30 June 20X2 | |
$000 | $000 | |
Inventories at period end | 1,220 | 460 |
Receivables at period end | 1,715 | 790 |
Cash and cash equivalents at period end | - | 150 |
Trade payables at period end | 1,190 | 580 |
Short-term borrowing at period end | 250 | - |
Revenue for the period | 3,100 | 2,000 |
Cost of sales for the period | 2,420 | 1,450 |
Analyse the financial performance and working capital position of SAF, including the calculation of five relevant ratios.
Show answerHide answer
Interpretation of financial statements: financial position
10 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
Open chapter practice