Financial statemens and ratios: Part 1

Financial statemens and ratios: Part 1

Frederick, David

In the first of a two part series, David Frederick examines the importance of liquidity ratios to the credit manager.

financial statements are widely used by credit managers and third parties as a basis of granting credit to existing or new clients. Irrespective of what additional information is required before any decision on credit limits is made, it is necessary to consider the importance of financial statements in this decision-making process.

The principal financial statements used in the assessment process are the balance sheet and the profit & loss account. In addition you may have the benefit of the cashflow statement, the only statement to address the subject of cash, the key component to business survival. Despite the obsession with profit, businesses require cash for their sustainability. Cash is the oxygen of any business; hence the importance that credit personnel place on its effective management.

Despite the significance of cash, the financial statements can be a useful guide for assessing the suitability of clients for credit. In practice and for examination purposes, students should at least be able to participate in this assessment process with reference to three main areas:

* Liquidity

* Profitability

* Working capital management.

It is these three areas that will form the basis of this article and the one which follows. Other financial ratios such as gearing may also be examined before granting credit, but since this topic is outside the ICM Accounting syllabus, I will not be addressing it here.

Traditional financial statements, while very useful, have not been prepared with credit management in mind. They are prepared primarily for the stewardship function and to comply with company law and accounting regulations (this will be the subject of a future article).

To meet the needs of credit managers or any other user group, the information in the accounts has to be presented in an appropriate format. This usually takes the form of financial ratios. It is these ratios which credit managers routinely use to assist them in the decision making process.

Financial ratios are widely used across all sectors. It is often said that they provide a quick and useful means of assessing the performance of a business. Furthermore, it is possible to use the ratios in the following ways:

* to provide comparative annual analysis

* to provide inter-business comparison

* to provide comparison against sector or standard industrial classification standards.

As stated earlier the three groups of ratios under the spotlight are liquidity, profitability and working capital management.

Liquidity

The liquidity ratio is primarily concerned with the ability of a business to meet its debts as they fall due. As such, the focus is on the current assets and liabilities, which are due within one year. The importance of liquidity helps to underline my earlier comments on the importance of cash. If a business is unable to meet its debts as they fall due, irrespective of its profitability, its ultimate fate is one of death, otherwise known as liquidation. A testimony to this is the demise of small and large businesses during the last recession within the UK.

To assess the liquidity position of a business we can use two ratios, the current ratio and the acid test (also known as the quick ratio). The current ratio is found by dividing the current assets by the creditors due within one year. For example, in the case of Clarissagate Limited the current ratio for 2001 is 1.33:1. This indicates that the business can cover its liabilities with its current assets and has an additional 33 per cent of its current assets remaining.

This begs the question, is this good, bad or indifferent? The answer is that it depends. The dependent factors include the business sector in which Clarissagate trades and its general business strategy. However, over the years it has been widely accepted that a benchmark for the current ratio is 2:1. This does not mean any company with a less than 2:1 current ratio is unhealthy or that a ratio above 2:1 indicates a great company. It is necessary to address the business, its sector and the position of its trade cycle.

It is apparent that the current ratio is not a wholly suitable measure of liquidity because of the inclusion of stock within current assets. Converting stock into cash will often involve additional costs and/or some time delay. To overcome this problem of stock and liquidity, the acid test is used.

The acid test is calculated by dividing current assets, less stock, by the creditors due within one year. In 2000, the acid test ratio for Clarissagate Limited was 0.95:1. The value of the ratio indicates that the company is unable to meet its short term debts from its liquid assets because the creditors due within one year exceed the current assets. A general benchmark for the acid test is 1:1. However, the same qualifications apply to this ratio as to the current ratio. This is only a guide and should not be seen as a definitive measure of good or bad.

It is important to use both ratios for liquidity because of their relationship. A business with a large stock balance may appear very liquid using the current ratio, but the elimination of stock for the acid test may reveal a wholly different picture.

It may be argued that the liquidity ratios are the most important measures for credit managers, because they demonstrate the ability of a business to meet its debts. If the annual accounts show that the business is unable to meet its current debts it is doubtful whether this is a business to which credit should be extended. However, a balanced view will be achieved by using the three ratio groups collectively.

The profitability and working capital ratios will be examined next month.

David Frederick is a senior lecturer at London Guildhall University’s Department of Management and Professional Development.

Copyright Institute of Credit Management Ltd. Jun 2001

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