Hi, I’m Siu Ling Hui with Part 5 of a video
series about how your financials can help you manage and drive business success. In this video, we’ll look at the use of liquidity
ratios as business management tools. In an earlier video in this series, we discussed
how profitability ratios like Gross Profit Margin, Profit Before Tax Margin and so on
provide better insights into the performance of a business than just the raw profit numbers. A ratio shows the relationship between two
numbers – such as profit and sales. Ratios like profitability margins tell you
how efficient your business is in converting sales to profits. It allows you benchmark against your past
performance and against competitors or industry averages. Now let’s look at ratios about your business
liquidity or solvency. Liquidity is vital to the survival of a business. Liquidity ratios are used to assess the solvency
position of your business at a particular point in time. I stress the use of the word “position” because
these ratios are about your balance sheet. And the balance sheet is a snapshot of your
business at a specific point in time. These liquidity ratios are indicators as to
whether your business has the ability to meet its existing short term obligations and if
it can continue to do so even if something goes wrong. The two common measures of liquidity are the
Current Ratio and the Acid Test or Quick Ratio. We’ll look at what each one measures and then
discuss their uses and limitations as tools for managing business liquidity. First let’s develop two different scenarios
for Month 6. We’ll assume that sales are $12,000 this month
and keep the 80:20 credit to cash sales mix. The difference between the two scenarios will
be in debtor collections. For Scenario A, Debtors collections will be
$5,830. For Scenario B, we’ll have some slow paying
debtors and reduce collections down to $3,410. These debtor balances include Goods & Services
Tax – the equivalent of Value Added Tax. All other variables like inventory holdings,
supplier terms, wages and tax rates are the same as we’ve used in past examples. The Profit & Loss for the two scenarios are
identical. The impact of the speed of debtor collections
shows up in the balance sheet. Look at the Balance Sheets for the two scenarios. The difference is in the mix of Cash and Debtor
balances. Debtor collections in Scenario A are higher
than in Scenario B so obviously cash balances are higher in A and debtors are higher in
B. Now let’s look at the two most commonly used
liquidity ratios for these two scenarios. The Current Ratio is the ratio of Total Current
Assets to Total Current Liabilities. The “Current” category means that these items
are due within 12 months. At this stage, we don’t have any Non-Current
Assets or Non-Current Liabilities; that’s things that go beyond 12 months. The higher the ratio – that is, the greater
the amount of Current Assets relative to Current Liabilities – the more liquid or solvent the
business is deemed to be. You can see that the Current Ratio has decreased
from 2.5 as at 31st of May to 2.4 at 30th of June for both Scenarios even though the
mix of cash and debtors is quite different in the two June Scenarios. But the Current Ratio is not considered a
good measure of liquidity because it includes inventory. Inventory takes longer to turn to cash. It’s not considered a particularly liquid
asset. Because of the illiquid nature of inventory,
the Acid Test or Quick Ratio is considered to be a better measure of liquidity. With this ratio, Inventory is excluded from
Total Current Assets. You can see that the Acid Test or Quick Ratio
is lower than the Current Ratio because of the elimination of Inventory. It’s always useful to look at both Current
and Acid Test Ratios. A very big difference between the Current
Ratio and the Quick Ratio means that inventory is a pretty significant proportion of your
current assets. So how do the Current and Acid Test ratios
help you in managing your business? These ratios only provide an aerial view of
your business’ liquidity at a point in time. You can tell at a glance whether there’s liquidity
in the business or if it’s is bone dry. They provide a useful first pass assessment
of whether a business has potential solvency issues. That’s why financiers look at these ratios. High numbers for Current and Acid Test Ratios
imply that the business has a bigger buffer to cover its short term commitments even if
something went wrong. If a business has very low current and acid
test ratios, that should immediately ring alarm bells about the business’ liquidity
and its chances of survival. For example, if the Acid Test ratio is say,
1:1, that means business has only just enough cash and debtors to cover its short term liabilities. Maybe even less if there are other miscellaneous
items included in Current Assets. It means there is no wiggle room at all for
timing issues or things going wrong. Now, just because a business has healthy looking
liquidity ratios, it doesn’t necessarily mean that the business is very liquid. In an aerial view of a landscape, you can
see if there’s water around or not. But you can’t tell how deep the water is,
or whether the rivers have a healthy flow or are stagnant unless you go in closer. So it’s the same with a business. You need to look more closely at the quality
of the assets and liabilities that make up the Current and Quick Asset ratios. To do this, you use quality indicators like
Days Debtors, Days Creditors and Inventory Turnover. These ratios combine information from both
the Profit and Loss and the Balance Sheet. Let’s go through these 3 main liquidity “quality”
indicators before we look at how liquidity ratios are used as business management tools. Days Debtors, which is also called Days Receivables,
tells you the average time it takes for a business to collect its debtors. Shorter Days Debtors indicate greater efficiency
in debtor management. If Days Debtors are being calculated with
less than 12 months numbers, then you either annualise the sales figure or adjust the number
of days in the equation. So if you were using half year sales, then
you would either multiply the sales number by 2 or halve the 365 days in the equation. If sales are done on both credit and cash
terms, it’s better to use the credit sales figures rather than Total Sales figure. But if you calculating Days Debtors of your
competitors or industry average for benchmarking your business, you won’t be able to get that
level of breakdown of their sales numbers. So you would use the Total Sales figure to
calculate days debtors. And that’s perfectly ok as long as you compare
it with your Days Debtors calculated on the same basis. Now, instead of using the debtors balance
as at the end of the period to do this calculation, you can use the average of the debtors balances
at the start and end of the period. I prefer to use the Average Debtors as I think
it’s more reflective, particularly if the business is growing rapidly. If your business is subject to taxes like
Value Added Tax or Goods and Services Tax, these taxes are not included in the Sales
figures but they form part of debtors balances. So debtors balances must be adjusted to exclude
GST or VAT for this calculation. Days Creditors, which is also called Days
Payables, tells you the average time that a business takes to pay its trade creditors. The calculation works the same way as Days
Debtors except you are using Trade Creditors and Purchases figures. You’d do the same adjustments like annualising
purchases, using average creditors and adjusting for taxes like Goods & Services Tax or Value
Added Tax. If a business is showing a very high Days
Creditors number, it may be a sign of financial stress; that the business is stretching its
creditors to manage its cash flow. If you are considering extending credit terms
to a customer and you see a very high Days Creditors number in the customer’s financials….say,
more than 60 or 90 days or a figure that’s well above the industry average, you might
want to consider whether this customer is going to be a problem account for your business. Inventory turnover is an indicator of how
fast inventory is converted to sales. It’s the number of times you turn your stock
over in a year or other shorter period. With a highly seasonal business, annual inventory
turnover is not appropriate because you are lumping low and high seasons together. You have to fine tune the calculation to allow
for the effect of seasonality. High inventory turnover could mean one of
two things: efficient stock management which is good; or excessively low stock levels,
which is not good. Being out of stock on a recurring basis leads
to a loss of sales and over the long term, loss of customers to your competitors. Make sure you know the reason for high inventory
turnover in your business. Balance sheet liquidity ratios, used in combination
with quality liquidity ratios like days debtors and so on, enable you to track trends in your
business’ financial position over time. Raw numbers don’t give you insights into the
changes in the relationship between current assets and current liabilities, or changes
in the quality of critical assets like debtors and so on. By monitoring these ratios, you can take corrective
action as soon as you see adverse trends developing and stop emerging issues becoming a big problem. Seasonality can have a huge impact on the
ratios. So always assess the ratios in the context
of your business cycle. These ratios also allow you to benchmark your
business against your competitors or industry averages. With external benchmarking, keep in mind that
other businesses are not necessarily identical to your business and so you are often not
doing a strict “apples-with-apples” comparison. But this kind of benchmarking is still a useful
indicative guide as to how your business is tracking relative to others in your industry. Business insights from these ratios, particularly
Days Creditors, can be useful when you are deciding whether to extend credit terms to
a new customer or not. You don’t want to end up playing banker to
your customers. The key shortcoming of liquidity ratios, and
even the ratios like Days Debtors is that they lack the time dimension. Cash Flow – the life blood of all businesses
– is all about timing. The Current and Acid Test ratios don’t tell
you anything about the maturity profile of the Current Assets and Current Liabilities,
apart from the fact that they all fall due within 12 months. Now, 12 months is a long time in business. To use an extreme example: What if all the
liabilities were due to be paid tomorrow but none of the debtors are due to pay you for
another 2 weeks? Regardless of how healthy these ratios are,
if a business doesn’t have sufficient cash flow to meet its obligations as and when they
fall due, that business is insolvent. Even the Quality Liquidity Ratios like Days
Debtors and Days Creditors are still relatively “big picture” indicators. These ratios are useful as the basis for rational
forecasting of cash flows. I mean, you wouldn’t build forecasts based
on 30 days debtor collections if your business reality is that your historical Days Debtors
is 45 or 60 days. Effective cash flow management – and asset
quality management – requires that you have a really good handle on your debtors and the
state of your creditor payments. You get this through your Aged Debtors and
Aged Creditors reports. Let’s look at the Balance Sheet and Aged Debtors
for the two scenarios in Month 6. Earlier in this video, we made some assumptions
about two different scenarios for Month 6. In Scenario A, Debtor collections in Month
6 was $5,830 and in Scenario B it was $3,410. In this extract of the balance sheet for the
two scenarios, you can see that the Current Ratio and the Acid Test Ratio in both scenarios
are identical but there is a lot more cash in Scenario A. So even though these ratios
are identical for both scenarios, the Scenario A balance sheet really has much higher liquidity
than B because there’s more cash. If we calculate Days Debtors based on Average
Debtors and Credit Sales figures, you get a little more insight into the quality of
the liquidity positions of the two balance sheets. Debtors are slower – that’s a lower quality
– in Scenario B than in Scenario A. Now let’s look at what the Aged Debtors listings
show. Here’s a summary of the Aged Debtors listing
for Scenarios A and B. In Scenario B, you have debtors that are now past 60 days. But Days Debtors for Scenario B is 54, so
the Days Debtors ratio doesn’t fully reflect the issue of problematic debtors that are
now pushing out past 60 days. Let’s look at the detailed Aged Debtors for
Scenario A. There are four big customers that stretch their payments out past 30 days but
they are less than 60 days. That’s probably not much of an issue – so
far they are paying somewhere between 30 and 60 days. That’s kind of consistent with the Days Debtors
of 47 days. Here’s the Aged Debtors for Scenario B. In
this Scenario, the same big four customers are pushing their payments out past 60 days
even though Days Debtors shows as 54 days. They might be strong businesses but it’s your
cash flow they are tying up. Also, one or all of them might be financially
stretched and could potentially keep going out to 90 days and more or worse still, turn
into bad debts. This is why you cannot rely just on the acid
test ratio or even ratios like days debtors to manage cash flow. They are very high level numbers. They are fine for an overview, to identify
trends, or to flag possible issues. But you must get down to the nitty gritty
details of important assets like debtors so you can work out exactly where the potential
problems are. Let’s see what the all important Cash Flow
Statement shows you about Scenarios A and B. The liquidity ratios were the same in both
scenarios. Scenario B Days Debtors was 7 days longer
than in Scenario A. Doesn’t sound like a big deal, does it? But look at the Cash Flow. The cash flow impact of slow paying debtors
shows up immediately. In Scenario B, you have $7,150 of cash flow
being chewed up in Trade Debtors this month compared to $4,730 in Scenario A. Everything
else is the same between Scenario A and B. You still have the benefit of Trade Creditors
and all those payments payable to the Tax Office – that’s the provisions line – funding
your working capital. But the net cash flow from operations is only
$162 in Scenario B versus $2,582 in Scenario A. If your Cash Flow Statement shows big changes
in trade debtors, inventory and any other working capital items AND you see adverse
trends in your liquidity ratios, start digging deeper to find out what’s going on. Here’s a recap of what we’ve covered in this
training video. Liquidity ratios are useful for identifying
trends and benchmarking your business’ liquidity position. And I again stress the word position because
we are talking about comparing snapshots in time. And that’s the key limitation on their usefulness. You need to dig deeper into the quality of
the numbers that lie behind the balance sheet ratios. Ratios like Days Debtors, Days Creditors and
Inventory Turnover provide more insight about quality of the numbers. But the real test of solvency is cash flow:
Do you have enough cash coming in in time to cover your payment obligations? None of these ratios provide you with this
vital information about timing. Do not rely on ratios for cash flow management. Look at your Cash Flow Statement to see what’s
happening with your working capital. Use Aged Debtors and Aged Creditors reports
to get a good handle on these key balance sheet items. Use systems that allow you to get good insights
into what’s happening with your inventory. Inventory ties up cash. If you want more information about business
financial reviews, business planning or about financing in general, please put your questions
below in the Comments or contact me directly through my Contact Page at incontextfinance.com Master Your Cash Flow. Know your Finances so that you can Drive strong
sustainable business growth and Thrive. Thank you for watching. If this has been useful, please Like and Subscribe
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