Contents
1 Introduction
2 Balance Sheet
2.1 Definition
2.2 Balance Sheet Data
3 Liquidity
4 Financial Ratios
4.1 Current Ratio
4.2 Quick Ratio
4.3 Working Capital To Sales Ratio
4.4 Working Capital Days
5 Conclusion
6 References
Figures
Figure 1: Balance Sheet
Figure 2: Level of Liquidity
Figure 3: Current Ratio
Figure 4: Quick Ratio
Figure 5: Working Capital to Sales Ratio
Figure 6: Working Capital Days
Equations
Equation 1: Accounting Equation
Equation 2: Current Ratio
Equation 3: Quick Ratio
Equation 4: Working Capital to Sales Ratio
Equation 5: Working Capital Days
This essay will try to draw the readers attention to some of the different methods and various ratios that are used to analyse a company's financial position. In order to do so the writer gives some basic background information about the terms "Balance Sheet", "Liquidity" and "Ratio". There will be some examples given to illustrate the mathematical idea of such an analysis.
The paper opens with some information about "Balance Sheets" and explains the various positions in a financial statement. Terms such as "Assets" and "Liabilities" are being explained as they are essential to understand the following paragraphs about "Liquidity". After a short definition of the term "Liquidity" the author describes different ratios that are used to evaluate a company's financial position. The essay concentrates on four ratios:
Current Ratio
Quick Ratio
Working Capital to Sales Ratio
Working Capital Days
At the end of this paper the author values the positive and negative qualities of either ratio.
The balance sheet is a statement of a company's relative wealth or financial position at a given point in time. It is also called a statement of financial position. A balance sheet is a "snapshot" of the business at a given date in time. Therefore it gives only a fairly clear picture of the business at that moment. The balance sheet does not reveal in itself how the business arrived there or where it is going next. That is the reason why one has to look at the information from each of the other financial statements (and the historical information as well) to get the most benefit from the data.
The balance sheet lists the assets, the liabilities and the difference between the two. This variance is called owners' (or stockholders') equity or net worth. The accounting equation is the basis for the balance sheet.
ASSETS = LIABILITIES + OWNER'S EQUITY
Accounting Equation
The statement of financial position is prepared after all adjusting entries have been made in the general journal. All journal entries have been posted to the general ledger. The general ledger accounts have been footed to arrive at the period end totals.
Assets are generally divided into two groups: 1) current (short-term) assets and 2) fixed (long-term) assets. They are usually presented in order of liquidity, with the fixed assets appearing first. Liabilities are normally presented in order of their claim on the company's assets (i.e., liabilities due several years from now are presented before liabilities due within one year).
Equity is presented properly when each class of ownership is presented with all its relevant information. If retained earnings are restricted or appropriated, this should be shown. Financial statements normally do not show pennies. All amounts should be rounded to the nearest pound.
Balance Sheet
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Assets |
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Liabilities |
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A |
Called up Share |
A |
Capital and Reserves |
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I) Called up Share Capital |
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II) Share Premium Account |
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B |
Fixed Assets |
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III) Revaluation Reserve |
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I) Intangible Assets |
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IV) Other Reserves |
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II) Tangible Assets |
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V) Profit and Loss Account |
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III) Investments |
B |
Provisions for Liabilities and Charges |
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C |
Current Assets |
C |
Creditors |
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I) Stocks |
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1) Bank Loans and Overdrafts |
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II) Debtors |
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2) Trade Creditors |
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III) Investments |
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3) Other Creditors |
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IV) Cash at Bank and in Hands |
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D |
Prepayments and Accrued Income |
D |
Accruals and Deferred Income |
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Along with other financial information one should analyse balance sheet data frequently. One can check a company's financial position by analysing the given data through business and financial ratios. In many cases, ratios are constructed for each balance sheet for a number of years, so that one can make comparisons and spot important trends.
"The amount of time required to convert an asset into cash or pay liability." Liquidity describes how easily one can access the cash one puts into an investment. Some assets are more liquid than others. Cash is a highly liquid asset while Accounts Receivable and Stocks are somewhat less liquid.
One can withdraw money from a current account very easily without incurring any penalties for withdrawing the funds. Other accounts offer less liquidity and have penalties for withdrawing early. A Certificate of Deposit (CD) is an example of an investment that has this type of penalty if the CD is not held for its full term.
Accountants and financial professionals have developed a number of systematic ways of arranging and comparing the financial facts about a business. In order to measure the company's liquidity they have developed ratios that make balance sheets of different companies comparable to one another.
The true meaning of figures from the financial statements emerges only when they are compared to other figures. Such comparisons are the essence of why business and financial ratios have been developed. Various ratios can be established from key figures on the financial statements. Sometimes they are simply expressed in the format "x : y" and other times they are simply one number divided by another, with the answer expressed as a percentage.
When one compares changes in business ratios from period to period, one can pinpoint improvements in performance or developing problem areas. By comparing ratios to those in other businesses, one can see possibilities for improvement in key areas.
Long-term ratios generally measure the capital structure and the capital flow of a company. These ratios compare previous year's data with current year's results and support long-term decisions of a firms management. We find ratios such as:
Equity to Assets or Capital Ratio (total shareholder's equity divided by total assets)
Capital to Debt (relationship of stockholder's equity to total debt)
Growth in Assets ([current year's assets divided by previous year's assets] minus 1)
Return on Assets (net operating income (after tax) divided by total average assets)
and others ...
"The first test of a company's financial position is, 'Will it have sufficient cash over the immediate future to meet its short-term liabilities as they fall due?' " The company's day to day business results in money floating in from accounts receivable and out of the cash accounts. Inventory is being sold and at the same time stocks are being bought in order to keep up the production and / or selling. A company's management has constantly to watch the firms ability to pay of the bills when they fall due. Normally the total of short-term liabilities such as trade creditors and bank loans and overdrafts is greater than cash at bank and in hand. And therefore - in addition to the cash account - "we measure a firm's short-term liquidity position by comparing the values of current assets with its current liabilities."
When investing a cash surplus one has to consider the investments liquidity. If the amount and duration of a cash surplus are uncertain, then a company should consider only those investments that offer a high level of liquidity. On the other hand , if the amount of a surplus and the duration are fairly certain, then less liquid investments should be considered. The liquidity of an investment also effects the yield of the investment. An investment that is highly liquid, such as checking money market account, will generally result in a lower yield on the investment. On the other hand, an investment with a low level of liquidity, such as Certificates of Deposit, will generally provide a higher yield.
Liquidity ratios are therefore most commonly used to measure a company's ability to quickly generate the cash needed to pay its bills. Liquidity ratios are sometimes called working capital ratios because that is what they measure. Liquidity ratios are commonly examined by banks when they are evaluating a loan application. Sometimes the lender requires the continuation of a certain minimum ratio as part of the loan agreement.
An example may mirror why the comparison and usage of various figures from the financial reports is vital for the interpretation of balance sheet data:
For example, the company's income statement shows a net profit of £ 100.000. If this profit is earned on sales of £ 500.000, it may be very good; but if sales of £ 2.000.000 are required to produce the net profit of £ 100.000, the picture changes drastically. A £ 2.000.000 sales figure may seem impressive, but not if it takes £ 2.000.000 in assets to produce those sales. The true meaning of figures from the financial statements emerges only when they are compared to other figures.
This ratio is the most commonly used measure of short-term solvency. It indicates the amount of current assets, such as cash, accounts receivable, and inventory, that can be converted into cash to pay the short-term liabilities. Some institutions that lend money rely upon the current ratio in assessing the creditworthiness of a prospective borrower.
The current ratio is usually expressed in the "x : y" format. It is a simple comparison of the current assets and the current liabilities.
CURRENT RATIO =
Current Ratio"Among credit analysts it has always been a rough formula that the applicant for credit should show at least a two for one ratio between current assets and current liabilities on his financial statement." The majority of the US companies realise a ratio of 1,0 to 1,6.
One has to be careful in over-interpreting this ratio and there may be significant differences for the wide diversity of trades. Businesses having a rapid turnover , such as grocery trade, may have a current ratio lower than the two-for-one and still represent a better financial situation than a furniture dealer having a full two-for-one ratio. In the grocery trade there is a rapid turnover of goods for which the demand is universal so that in the event of liquidation the business would not suffer a substantial loss through decline in value of its inventories.
As the current ratio refers to balance sheet data and the balance sheet is only a snapshot of a businesses situation at a given point in time one can improve the current ratio by simply paying off
some current liabilities. For example, if the business's current assets total £ 60.000 (including £ 30.000 cash) and the current liabilities total £ 30.000, the current ratio is 2:1 . Using half the cash to pay off half the current debt just prior to the balance sheet date improves this ratio to 3:1 (£ 45.000 current assets to £ 15.000 current liabilities). If the business lacks the cash to reduce current debts, long-term borrowing to repay the short-term debt can also improve this ratio. For example, if the current assets total £ 50.000 and the current liabilities total £ 40.000, the poor 5:4 current ratio changes to a better 2:1 ratio if £ 15.000 of long-term debt is used to refinance an equal amount of short-term debt (£ 50.000 current assets to £ 25.000 current liabilities).
Some current assets are more liquid than others. The current ratio does not distinguish between the different types of assets. "A company could be getting into cash problems and still have a strong current ratio" This could e.g. happen if the inventory piles up without a chance of being sold easily to generate some cash.
The calculation of the quick ratio is similar to that of the current ratio. The difference between the two is that the quick ratio subtracts inventory from current assets and compares the resulting figure to current liabilities. The quick ratio is also known as the acid test.
QUICK RATIO =
Quick Ratio
Inventory can be turned into cash only through sales, so the quick ratio gives a better picture of the company's ability to meet its short-term obligations, regardless of the sales levels. Over a time, a stable current ratio with a declining quick ratio may indicate that inventory has built up too much.
"Thus, the acid test is the ratio of the highest grade and most liquid of the current assets to the total current liabilities. Wherever this ratio is at least 1:1 or better a favourable liquid position is indicated." The average value for the US companies is a value of 0,8 times.
The problem with the quick ratio as well as with the current ratio is that both methods are static. They reflect a company's financial situation at a fixed point in time only. In evaluating the current and the quick ratio, one should keep in mind that they give only a general picture of the business's ability to meet short-term obligations. They are not an indication of whether each specific obligation can be paid when due.
The term working capital is usually taken to mean the net current assets less the current liabilities. The working capital ratio expresses this value as a percentage of sales. The advantage of using this method is that the working capital ratio does not only take balance sheet data into account but also includes the value of the ongoing operations by including a value from the profit and loss account.
WORKING CAPITAL TO SALES RATIO =
Equation 4: Working Capital to Sales Ratio
The current ratio and the acid test use balance sheet data only. We can imagine a situation where current assets total £ 1.000.000 and current liabilities total £ 800.000. The resulting current ratio would be 1,25. It is the same ratio a company with £ 2.500 current assets and £ 2.000 current liabilities would achieve. Now imagine in both cases the sales would sum up to £ 1.250.000. In the first case the working capital ratio would have a value of 16% . While in the second case this ratio would total 0,04%. As we can easily see from this very low working capital to sales ratio, the level of business does not correspond to the firms capital resources. A falling working capital ratio can be a sign of overtrading. This expression "is used to describe a situation where there are not sufficient resources in the balance sheet to carry the level of existing business."
Generally the working capital to sales ratio totals between 0% and 21% for the majority of 50% of the UK companies (1992).
Working capital days are not measured like a ratio in the "x : y" format. It is very much more a figure that is extracted from the accounts receivable, accounts payable and inventory. Those are highly spontaneous and "react very quickly to changes in levels of company turnover."
The fact that there is a time gap between cash-out and cash-in creates in a company the need for working capital. The company will need money to fill this gap in order to be able to pay off the liabilities when they fall due. The amount needed is quantified by multiplying the increase in sales with the time gap and dividing the total by 365 days. This ratio is closely related to the problem of overtrading as we discussed in chapter 4.3. The increase of the level of business has to be in line with an increase of capital resources.
WORKING CAPITAL REQUIRED =
Working Capital Days
"Every increase of $ 1.000.000 will create a need for an additional [...] cash resources. This point is often missed by small rapidly growing companies who find themselves in cash difficulties in the midst of high sales and profits."
The figure 6 shows "the number of days that lapse from the time money is paid out to suppliers of materials until the corresponding cash is received back from the customer that buys the goods."
On day "0" the company receives goods. It sells these goods on day "44". But the customers will not pay their bills before day "85".
The company does not have to pay these stocks before day "26". Thus, they receive a credit of 26 days. But as the company does not collect its claims before day "85" there is a time gap of (85 minus 26) 59 days in which the need for working capital arises.
Financial ratios provide an objective basis for comparing the performance of a business with other businesses. They also provide a clear picture of a company's ability to generate a profit, pay its bills on timely basis and utilise its assets efficiently.
But there is the danger of over-interpreting the value of a ratio. A clear and undoubtful picture of a company's financial position only emerges when several analyses are being applied and all variables of all kind of influences on the business are taken into account. A frequent analysis and comparison with other companies is vital in valuating the own position and reliability on the money market.
Munn/Garcia/Woelfel; "Encyclopaedia of Banking & Finance"; Rolling Meadows/Illinois 1991; 9th Edition
Walsh, Ciaran; "Key Management - Ratios"; London 1996; 1st Edition
Wöhe, Dr. Dr. h.c. Günter; "Bilanzierung und Bilanzpolitik"; Munich 1987; 7th Edition
Vocabulary
financial ratio:
Kapitalkennzahlen
fixed assets:
Anlagevermögen
working capital:
Betriebskapital
current ratio:
=
quick ratio:
=
working capital to sales ratio:
Betriebskapital im Verhältnis zum Umsatz
working capital days:
benötigtes Betriebskapital in Tagen