Showing posts with label financial performance ratios. Show all posts
Showing posts with label financial performance ratios. Show all posts

Sunday 18 April 2010

Measure short-term solvency and liquidity

Short-term solvency is the ability to meet short term debts from liquid assets.  Liquid assets include money on short-term deposit and trade receivables, but not inventories, which cannot be quickly turned into cash.


LIQUIDITY versus PROFITABILITY

In the short term liquidity is more essential to financial stability than profitability.  Cash generated from operating activities is a major source of liquid funds, as measured by the statement of cash flows.  There may be other priorities for funds from operating activities, therefore it is important to have sufficient liquid assets to meet short-term debts.



CASH FLOW

The cash operating cycle is the length of time between paying out cash for inputs and receiving cash from sales.  It is a useful measure of the time taken to generate cash.  Cash flow forecasts enable businesses to predict and deal with liquidity problems before they arise.  It is one of the most important measures of future solvency.


THE CURRENT RATIO

Current ratio =  Current assets / Current liabilities

This is a standard test of short-term solvency and simply measure if a business can meet its current liabilities from its current assets.  Depending upon the nature of the business, the current ratio should usually be greater than 1, depending upon the speed of inventory turnover.



THE QUICK RATIO (or ACID TEST RATIO)

Quick ratio = (Current assets less inventory) / Current liabilities

This is a more reliable short-term solvency measure because inventory is not easily convertible into cash for many businesses.  This ratio should be close to 1, depending upon the business.


INTERPRETING LOW AND HIGH RATIOS

Don't interpret current and quick ratios too literally.  Different businesses operate in different ways.  Low ratios are not always indicative of insolvency risk and high ratios are not always healthy.

LOW RATIOS.


For example, a high volume retailer, such as a supermarket could have healthy liquidity but very low current and quick ratios.  Supermarkets have relatively low inventories as their goods are mainly perishable and turnover quickly.  They have minimal receivables as customers pay in cash.  In addition, their purchasing power results in long trade payable payment periods.  Therefore overall - relatively low current assets and relatively high current liabilities.

HIGH RATIOS.


A poorly managed business with slow-selling inventories and many outstanding receivables may have high current and quick ratios.

Short-term solvency is the ability to pay short-term debts from liquid assets.


Related posts:

Measuring Business Performance

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Measure Profitability

Measure Profitability

The business with the largest profit is not necessarily the best performer.  Profit should be measured in relation to the size of the investment required to achieve that level of profit.  Therefore, the best measure of profitability is 'return on investment'.



MEASURING 'RETURN'

Gross profit margin % =  Gross Profit / Revenue

This measures the margin made on top of direct costs.  A relatively high sales margin demonstrates the ability of a business either to charge a premium price or to control input costs.  It is useful when benchmarking against similar businesses in the same industry.

Net profit margin % = Operating profit / Revenue

This is similar to gross margin but takes account of operating expenses.  Net profit margin measures the ability to control costs.  Operating profit is preferred to other profit totals, as it exclude finance and taxation costs, which can vary between businesses and years.


MEASURING 'INVESTMENT'

The most common definition of 'investment' is capital employed, which is equity plus non-current liabilities (alternatively, total assets less current liabilities).  Capital employed is effectively the amount invested in a business by both shareholders and debt holders.

Asset turnover (times)  = Annual revenue / Capital employed

This shows how well the finance invested in a business, subsequently invested in assets, has been utilised to generate sales.  It measures the amount of revenue earned from each $1 invested.  Asset turnover demonstrates the number of times assets generate their value in terms of revenue each year.  It is sometimes referred to as a measure of activity.  A relatively high asset turnover could indicate efficient use of assets, although the measure is sensitive to the valuation of assets.


MEASURING RETURN ON INVESTMENT/CAPITAL EMPLOYED

'Return on Investment' (ROI) has many permutations, the most common of which are

  • return on capital employed (ROCE); 
  • return on net assets (RONA); 
  • return on total asset (ROTA); 
  • return on equity (ROE); and 
  • accounting rate of return (ARR).  
They are all essentially measuring the same thing - profit as a percentage of the investment required to achieve that profit.  ROI is also used in internal investment appraisal.

ROCE = Net profit margin x Asset turnover

ROCE = Operating profit / Revenue) x (Revenue / Capital employed)

Analysing the net profit margin or asset turnover will help to explain a high or low ROCE.

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Measuring Business Performance

Business success can be measured using ratios.  Financial performance ratios can facilitate performance measurement.  Let us look at the following:

Profitability
Short-term solvency and liquidity
Long-term solvency and stability
Investor ratios


Related posts:

Measuring Business Performance

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