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Working capital ratios

An executive must ensure that the organization is able to meet its obligations as they mature. Because investing in fixed assets and inventory and allowing extended credit to customers all consume cash, the executive must ensure that the use of the cash resources is controlled and that sufficient 'free' cash will be available to pay creditors. Current and liquidity ratios attempt to measure a company's ability to meet its short-term obligations as they fall due.

Current ratio

The current ratio is calculated by dividing current assets by current liabilities. Current assets are cash and assets expected to be converted into cash within one year; current liabilities are those that must be paid within one year. A company is in a good position to meet its current obligations if current assets exceed current liabilities.

Textbooks traditionally quote this ratio as having to be 2:1 or better if a company is to be sound and able to pay its way. This might be true for a small business, but larger companies have ratios of less than 2:1 and are still able to meet their debts when they fall due.

Liquidity ratio/quick ratio/acid test ratio

Current assets include inventories, stock and work in progress (WIP), which may be due to the nature of the business being slow moving and not readily convertible into cash. The liquidity ratio therefore takes these items out of the numerator, thus providing a more rigorous test of the company's ability to settle its obligations as they fall due.

Textbooks traditionally quoted this ratio as having to be 1:1, or better, if a company was to survive! That is, its cash-like assets (receivables and cash) must equal its current (immediately due) liabilities. There is a logic to this, but the ratio appropriate to a business will very much depend on the type of business. For example, a supermarket could survive on a ratio of much less than 1:1, whereas a manufacturer or contractor might need a ratio of 2:1 (the debtors may not be so current!).

For BT pic 2013 the figures are:

- current ratio 0.61:1

- liquidity ratio 0.60:1

which clearly makes the point that size matters. For example, large entities are in a better position to dictate payment terms, and also inventory levels are pretty irrelevant to BT; at least at the highest level, there is still 103m of inventory to be managed!

Gearing or leverage ratios

For BT pic the figure for 2013 is 102 per cent - more debt than equity, the principal reason being the 5,856m or 33 per cent of debt being pension liabilities. Gearing can also be expressed by the debt/equity ratio:

The numbers will be of a higher order, eg 20 per cent gearing = 1 to 4 debt/equity ratio, but the message conveyed by the ratio will be as for the gearing ratio.

Accor's gearing

Financial ratios

In general, the main financial ratios improved in 2012, reflecting the Group's transformation.

Gearing

Net debt totaled €421 million at December 31,2012 compared with €226 million atyear-end 2011, while gearing stood at 14.1% versus 6% a year earlier.

(Accor, 2012)

The transformation mentioned includes increasing gearing!

Gearing or leverage is a key element of pure financial strategies and is considered further in Chapter 12.

 
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