Year 12 Accounting

1. Year 12 Accounting Chapter 19 Evaluating Liquidity

2. Note • For end of year exam, students will not have to do any calculations of formulas for the accounting ratios (profitability and liquidity). However, you need to know what makes up the ratio - in other words, explain them.

3. ASSESSING LIQUIDITY • Chapter 18 discussed the tools and techniques that can be employed to evaluate profitability, with the aim of providing business owners with advice to aid their decision making. This chapter takes a similar approach, but concentrates instead on an assessment of liquidity. • Liquidity refers to the ability of a business to meet its debts as they fall due. Thus, we must begin by analysing the level of liquid funds that is available to meet short-term obligations. This will obviously include cash that is already on hand, but it will also include cash that can be generated (from stock and debtors). However, we must also analyse the speed at which that those liquid resources become available, so that we can assess whether the cash will be available in time to meet the firm’s short-term obligations.

4. Tools for assessing liquidity • The same types of tools that were used to assess profitability can be applied to an assessment of liquidity: • trends • benchmarks • variances • liquidity indicators. • When identifying trends and variances, the primary sources of information will be the Cash Flow Statement and Budgeted Cash Flow Statement, which detail the actual and expected inflows and outflows of cash. (This was covered in detail in Chapter 17.) In fact, the Budgeted Cash Flow Statement is essential to an analysis of liquidity, as it details all expected cash inflows and cash outflows, and states categorically whether the business will be able to meet its cash obligations for the coming year.

5. Tools for assessing liquidity • In Chapter 18, we assessed profitability against three key benchmarks, and these can be applied to assess liquidity: • liquidity in previous periods • budgeted liquidity • liquidity of similar business.

6. Tools for assessing liquidity • We will use the following indicators to assess the level of liquidity: • Working Capital Ratio (WCR) • Quick Asset Ratio (QAR) • Cash Flows Ratio (CFR) • and three efficiency indicators to assess the speed of liquidity: • Stock Turnover (STO) • Debtors Turnover (DTO) • Creditors Turnover (CTO).

7. WORKING CAPITAL RATIO (WCR) • The Working Capital Ratio (WCR) measures liquidity by comparing current assets and current liabilities. Specifically, it measures how many dollars of current assets are available to meet each dollar of current liabilities. • See Grant’s Glass p. 457.

8. Assessing the WCR • Satisfactory liquidity exists if the firm is able to meet all its short-term debts as they fall due, and this requires that the Working Capital Ratio is at least 1:1. This would indicate that there is at least $1 of current assets available to meet every $1 of current liabilities. • Grant’s Glasses actually has $1.50 worth of current assets for every dollar of current liabilities, so its level of liquidity is satisfactory. • A Working Capital Ratio of less than 1:1 indicates unsatisfactory liquidity; the business has insufficient current assets to meet its current liabilities, and may not be able to meet its debts as they fall due. If this situation is not addressed, and creditors and others are unable to be paid, the business may be forced into liquidation, with its assets sold to raise funds to pay off its debt.

9. Assessing the WCR • If the Working Capital Ratio is less than 1:1, the firm may experience difficulties in meeting its debts as they fall due. In order to avoid such difficulties, the owner may be required to: • make a (cash) capital contribution • seek additional finance by entering into (or extending) an overdraft facility • take out a loan.

10. Assessing the WCR • A business owner should also be wary of having a Working Capital Ratio that is too high, as this may indicate that the business has excess current assets that are idle, and not being employed effectively. • This can be apparent in a number of different current assets: • Bank Business bank accounts pay very small amounts of interest. A business would be better off investing excess cash in a fixed term deposit or alternative investment where the business will be able to earn a greater return on its funds.

11. Assessing the WCR • Stock A large amount of stock would be associated with additional storage costs, not to mention a greater chance of stock loss, damage and technical obsolescence (which could require a stock write down). • Debtors A large debtors figure might indicate an increasing group of ‘ageing’ debtors. The older a debt gets the less likely it is to be received and the greater the probability that the debt will go ‘bad’– i.e. become uncollectible. • In this situation, the owner may: • use excess cash by repaying debts, purchasing non-current assets, or taking extra drawings • allow stock levels to run down before re-ordering • contact debtors to collect amounts outstanding.

12. QUICK ASSET RATIO (QAR) • Underlying the use of the Working Capital Ratio to assess the level of liquidity is the assumption that all current assets can be liquidated immediately if cash is needed to meet short-term debts. However, there are some practical difficulties with this assumption. • Consider stock. Most trading businesses would already be trying to sell their stock as fast they can; there is no guarantee that all their stock will be able to be liquidated, just because the firm is facing liquidity problems. And there is virtually no chance of this happening immediately. Also, prepaid expenses cannot normally be converted back into cash. If the business has entered into a contract and paid for a twelve-month lease, it is unlikely to be able to ask for a refund. • At the same time, although a bank overdraft is a current liability, it is unlikely that it will be called in (for repayment) as long as it remains under the limit. This is an argument for excluding it as a debt that will require payment in the short-term. (If the overdraft is well below the limit, it may actually represent a source of funds). • In order to overcome these deficiencies, the Quick Asset Ratio (QAR) can be used as an alternative indicator of the level of liquidity. It measures the firm’s ability to meet its immediate debts using its immediate assets.

13. Quick Asset Formula • The Quick Asset Ratio is actually a modification of the Working Capital Ratio: it excludes stock and prepaid expenses from current assets as they may not be easily converted to cash in a time of crisis, and excludes any bank overdraft from current liabilities as this is unlikely to require repayment.

14. Quick Asset Formula • Although the Quick Asset Ratio is a slightly different measure of liquidity, the benchmarks for assessing its adequacy remain the same as those used to assess the Working Capital Ratio. That is, the Quick Asset Ratio should be at least 1:1, but can also be compared to the Quick Asset Ratio from previous periods or the budget to identify increases or decreases. • See a comparison of the Working Capital Ratio and Quick Asset Ratio is shown in Figure 19.2.

15. Quick Asset Formula • The Working Capital Ratio indicates that the business has $3 of Current Assets for every $1 of Current Liabilities, and as a result its liquidity is satisfactory: there should be sufficient current assets to meet its current liabilities as they fall due. • However, the Quick Asset Ratio indicates that the business does not have sufficient immediate liquidity, with only 75c of quick assets available to pay quick liabilities. With a Quick Asset Ratio of only 0.75:1, the firm may have difficulty meeting its short-term debts, and may suffer liquidity problems.

16. Wilson’s White Goods • See text p. 460. • In order to address the situation the business will need to either improve the level of quick assets by either improving debtors or trying to maintain a positive bank balance. It can also attempt to reduce the level of quick liabilities by reducing the level of creditors and accrued expenses. • Note although prepaid expenses are excluded from quick assets, accrued expenses are included as quick liabilities as they will still have to be repaid.

17. CASH FLOW RATIO (CFC) • One of the key problems with using WCR & QAR is that they rely on static items to measure future cash flows. • The CFC assesses liquidity by identifying actual cash from its Operating activities. Specifically, it measures the number of times average current liabilities can be met using the Net Cash Flows from Operations. • See formula p. 461. • See Jenny’s Jumpers example.

18. CASH FLOW RATIO (CFC) • There is no set benchmark at which the CFC can be considered satisfactory. • However, it can be compared to previous periods or the budgeted CFC or the CFC of similar businesses.

19. The Speed of Liquidity • A business can survive a period of unsatisfactory level of liquidity if the speed of its trading cycle is fast enough. • Our assessment of liquidity must also consider the speed of the firm’s: • Stock Turnover (STO) • Debtors Turnover (DTO) • Creditors Turnover (CTO)

20. Stock Turnover (STO) • Stock turnover assessors how effectively the firm has managed it stockholdings by calculating the average number of days taken to convert stock into sales. • Refer to formula on page 463. • Refer to Markwell Mirrors example. • Note an assessment of Stock Turnover must also consider the nature of the goods sold. Goods that are perishable, such as fresh produce, or susceptible to technological obsolescence should have a fast Stock Turnover so they are not subject to stock loss or write down issues.

21. Too Slow • If stock turnover is too slow, this could be caused by a decrease in the level of sales (due to general economic conditions, seasonal factors, stock quality or competition) or an increase in the level of stock on hand (due to ordering more stock that is required). • In this case, the business may need to employ strategies to increase sales and/or decrease the level of stock on hand.

22. Too Fast • It is also possible that stock turnover could be too fast. Although the business would be generating high sales, it may be because the selling price is too low, and this would be a loss of potential revenue and profit. • Alternatively, it may be because the firm is holding to little stop. This is the case, costs such as delivery may be higher because deliveries are more frequent and the business could lose the possibility of earning discounts of buying in bulk.

23. Stock Management • There are certain strategies a business owner can employ time shortstop is mates wisely to maximise the potential for sales. • Review sales to maintain an appropriate stock mix. • Promote the sale of complimentary goods. • Ensure stop is up-to-date. • Rotate stock. • Determine an appropriate level of stock on hand. • Strong marketing.

24. Debtors Turnover (DTO) • Businesses that make credit sales must wait first until the stock as salt and again until the cash is received from debtors. • See formula on page 466. • See again Markwell Mirrors example. • It is the credit terms offered to customers that should be used to determine whether Debtors Turnover is satisfactory.

25. Debtors Management • If Debtors turnover is too slow piano may consider implementing the following strategies. • Discounts for quick settlement. • Prompt invoicing. • Extensive credit checks. • Reminder notices. • Threat of legal action. • Debt collection agency. • Threats of not providing credit in the future.

26. Creditors Turnover (CTO) • If stock is purchased for cash, the business will leave itself no time to sell the stock and collect the cash before the payment must be made. On the other hand, credit purchases allow the firm some time to sell the stock and collect the cash before the creditors must be paid. • See formula on page 468. • See again Markwell Mirrors example.

27. Stock Turnover, Debtors Turnover & Creditors Turnover • The firm’s ability to pay its creditors will rely heavily on its ability to generate cash from its stock. • This means Creditors Turnover is reliant on stock turnover and if the business deals mainly on credit, Debtors Turnover. • Figure 19.7 shows this relationship between stock turnover, Debtors Turnover and Creditors Turnover.

28. Stock Turnover, Debtors Turnover & Creditors Turnover • The days between the purchase of stock and sale of stock are measured by the Stock Turnover, the days between the sale of stock and the receipt from the debtor are measured by the Debtors Turnover, and the days between the purchase of the stock and the payment to the creditor are measured by the Creditors Turnover.

29. Assessing Creditors Turnover • Creditors Turnover can be assessed against a previous period to identify increases or decreases, but in common with Debtors Turnover, it is credit terms offered by suppliers that should be used to determine whether creditors turnover is satisfactory. • If discounts are offered, and the cash is available, then paying early may be beneficial. However, if discounts and not available there’s no incentive to pay early, creditors turnover should be as close as possible to the credit terms.

30. Assessing Creditors Turnover • At the same time, Creditors Turnover should not exceed the credit terms of the offered by the supplier, or penalties maybe incurred, such as those outlined below. • Interest charges on late accounts. • Removal of credit facilities. • Reduction in credit rating.