Liquidity is just as important as profitability. A basic definition of the term is how quickly a company can raise cash in order to settles its debt. This can be measured in terms of the Current ratio and Quick ratio. For a quick reference liquid funds can be referred to as cash, short term investment and trade debtors. Based on the above calculation current ratio has fallen from 4.3 to 2.6, which can be considered to be quite significant, a fall of 1.7 can be seen. The basic idea behind this ratio is that a company should have enough current assets which give promise cash, in relation to its current liabilities. A ratio of 1 is expected, which has been the case for PQR, for three years. It is rather worrying over the time the company’s gross profit has increased; its current asset ratio has fallen. Which indicates the company is using more and more of its current assets to pay off its current liabilities.
An additional liquidity ratio has also and has been calculated. The Quick ratio which is exactly the same as current ratio, however stock is not taken into account. It has been argued in some companies’ stock turns over rather slowly in comparison to all the other current assets. However this is not the case for PQR, as stock has fallen from 1,000,000 to 800,000. Nevertheless with that in mind the calculated figures for the quick ratio have fluctuated. This basically indicates in some years stock turnover was slow and in other years it was high. Stock in 2004 turned over the slowest in comparison to the other two years.
Both these ratios give the company the indication of its liquidity; however in theory a Current ratio of 1.5 and Quick ratio of 0.8 is acceptable. Using this as a yard stick PQR’s ratios are some what way off. Due to the size of the ratio’s it can be argued the company is over investing in its working capital. It is tying up more funds then necessary, suggesting poor management.
Debtor days are a rough measure of the average length of time it takes for a company’s debtors to pay what they owe. Figures from the calculated ratio shows it has fallen quite significantly. As can be seen from, it started off from 61 days in 2002 and end up at 47 days in 2004. The company seems to have improved its credit control department whereby it may have introduced new internal controls. However in comparison to the amount of purchases it’s making it could be argued it is reasonable. Reference must be made to the usual terms of credit, which are estimated to be about 30 days. As it started of at 61 days it could be stated it was in a very bad situation where it was unable to obtain payment for at least two months. It could be assumed it was a fairly new company. Its initial planning of obtaining money for its sales was way out. This may represent poor management of funds. Then again if the company was just starting off it may want to allow generous credit terms.
Creditor day’s ratio often helps a company to assess its liquidity. The ratio calculated above has fluctuated, starting off at 33 days then increasing to 48 and then falling to 44 days. The increase from 2002 to 2003 shows that the company did not account for any long term finance in terms of current assets. However PQR made improvement from 2003 to 2004, has the credit days ratio fell, only slightly. Nevertheless it is a positive sign in relation to its credit control department.
Stock days started off at 136 days then falling considerably to 81 days in 2004. The company may well be turning over its stock very slowly; improvements were made in the latter years, as it was able to sell stock more quickly. As the table indicates the ratio fell by 55 days. It could be assumed the PQR was making better investment in stock in 2004 then in 2002. Further assumption can not be made as sufficient information is not available, however data on the actual size of the company and sector could be useful.
Further analysis can be made in relation to the efficiency ratios, as stock days can be added together with debtor days. This will indicate how quickly the company is able to turn stock into cash. Based on this thinking calculation can be made, where by in 2002 the company took 197 days (61 + 136) to obtain cash. This figure improved considerably as in 2004 PQR took 128 days (47 + 81). Again reflection can be made to the company’s internal controls, which must have improved.
Ratios are used to assess financial performance of a company by comparing the calculated figures between pervious years. Such an approach for analysis of company’s accounts will have its benefits and drawbacks. The major advantage is it enables meaningful information to be identified within financial statements. It allows the company to view whether aspects of the business are improving or declining. Ratio analysis covers a wide range of areas from profitability to investment. However like any other approach it does have its drawbacks. Probably the most important aspect of using ratios is that they do not give the answers to the assessment of how well the company has performed, they only raise questions. Ratio analysis allows managers to change figures, making users think a favourable position has arisen. Another drawback is there are various definitions to accounting ratios, different components can be applied. Therefore its reliability can be questioned.
In the end there is no right or wrong answer to the analysis of ratios, various calculations can be carried out. On its own it cannot be considered to be enough in terms of interpreting a company’s financial statements. An overall picture of the company is okay, improvements have been made especially with the efficiency ratios. Profitability and liquidity ratios seem quite stable.
Here's what a star student thought of this essay
Quality of writing
The presentation of the report is good, but this could be improved. Within each section, the student could state the numbers, such as '11% Increase In Profits' using bullet points and then discuss this in further detail below. This would make the presentation of the report more appealing to read which the exmainer will be able to read with ease.
Level of analysis
The report states that liquidity is the ability to raise cash. Although why would the business need cash? The report doesn't mention why the business would want cash, and how this may impact upon the business. The report could include 'The buisness would want a reasonable amount of cash within the buisness to ensure that there can pay all their expenses within a timely manner, otherwise there risk going to administration. In addition, the buisness may want to generate cash quickly if it's an fashion buisness, whereby all their products will need to be sold quickly for the next season, which there need cash to invest in their next product line'.
Response to question
In summary, the report is relatively a high standard. The report focuses on three areas of the buisness, and explains a little regrading each one. However some sections do not justify why the buisness may need a certain aspect or why the buisness may want to increase the amount of cash the buisness holds. The student has set out their letter out correctly, with using an 'TO', 'FROM', 'SUBJECT' and 'DATE'. This will gain the student 1 mark within the exam, and this might be small, although this is a good start. The student makes clear that there are going to be reviewing three aspects of the financial statements, these are Profitability, Liquidity and Efficiency. This allows the exmainer to understand what the student is going to state within the report, this is quite clear. The report makes clear that the efficiently of the buisness underlies with the amount of time it takes for the buisness to receive payment from their debtors. The student understands that the quicker the buisness receives money, the better this is for the company.