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Ratio Analysis No. 2

Higher/Int 2Business Management2009-2010

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Today’s Ratios Today we will look at the following ratios

in more detail:

Liquidity Current Ratio (Working Capital Ratio) Acid Test (Quick) Ratio

Efficiency Return on Capital Employed

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Current RatioA reminder of the ratio:

Current Assets : Current Liabilities

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Current RatioThis ratio checks to see if Current

Assets will cover Current Liabilities.

In other words, can the business meet its short term debts without having to borrow money?

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Current RatioWhat is a good figure?

The ratio of 2:1 represents a satisfactory liquidity position.

This means that for every £2 of current assets the organisation would have £1 of current liabilities.

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Current Ratio A higher ratio than 2:1 would indicate that

the organisation is holding assets in liquid form which may be better use invested in the organisation (e.g. new machinery).

Spare cash can be invested, even in the short term, and earn additional revenue for the organisation.

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Current Ratio If this ratio is allowed to fall then the business

may not be able to pay its creditors on time.

If this happens, no matter how profitable the organisation, it can still become bankrupt.

Bank overdrafts, for example, are repayable on demand.

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Current Ratio

Improvement of this ratio is a positive

sign when it comes from better use

and control of credit and banking.

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Current RatioHowever, if this ratio improves

because of increased stock holding this can signal a problem.

Having a large stock holding is inefficient, both in terms of money and wastage.

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Current Ratio How can an organisation improve the Current

Ratio?

An organisation can improve the current ratio by:

Increasing assets. (e.g. cash in the bank)

Decreasing liabilities. (e.g. value of trade creditors)

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Acid Test (Quick) RatioA reminder of the ratio:

(Current Assets - Stock) : Current Liabilities

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Acid Test (Quick) RatioThis ratio shows the ability of an

organisation to pay its short term debts in a crisis situation.

Can the organisation meet its short term debts without having to sell any stock?

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Acid Test (Quick) RatioThere is no guarantee that the stock that

the organisation holds can actually be sold.

Even if stock is sold, the cash is not necessarily available immediately (30 days).

In addition stock may have to be sold at a reduced price.

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Acid Test (Quick) Ratio

Even if stocks could be disposed of

immediately and cash received, the

organisation would have run into

difficulties with no stock left to trade

with.

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Acid Test (Quick) Ratio In order for an organisation to survive it

must have enough working capital to pay for its day to day bills.

A result of 1:1 from the ratio is ideal as it shows that current assets can cover current liabilities if required.

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Return on Capital EmployedA reminder of the ratio:

ROCE % = Net Profit Capital Employed

x 100 1

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Return on Capital Employed This ratio provides information in particular to

potential investors.

Should they invest in the company or place their money in a savings account at a bank.

Improvement in this ratio is a positive sign that will be due to better use of invested capital in the generation of profit.

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Return on Capital EmployedThis ratio uses the historic costs of the

organisation’s assets.

If asset values are inaccurate, then the capital employed figure will also be inaccurate.

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Return on Capital Employed Imagine two companies X and Y.

Company X reports a profit of £500,000. Company Y reports a profit of £1m.

If X earned £500,000 from capital of £4m. If Y earned £1m from capital of £10m.

Company X has made better use of resources, and will have a higher ROCE ratio.

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Task Using the example of Edward’s Electrical Supplies

Ltd, answer the questions based on the ratios covered today.

Remember that for your NAB and final exam, it is important that you are able to describe ratios, give reasons for the results and be able to offer suggestions on how the ratios can be improved.