Working capital ratios

Introduction

Working capital ratios may help to indicate whether a company has too much working capital (over-capitalised) or too little (overtrading).

2.1 The current ratio and the quick ratio

The standard test of liquidity is the current ratio. It can be obtained from the statement of financial position.

A company should have enough current assets that give a promise of 'cash to come' to meet its

commitments to pay its current liabilities. Obviously, a ratio in excess of 1 should be expected; an ideal is probably about 2. Otherwise, there would be the prospect that the company might be unable to pay its debts on time. In practice, a ratio comfortably in excess of 1 should be expected, but what is 'comfortable' varies between different types of businesses.

Some manufacturing companies might hold large quantities of raw material inventories, which must be used in production to create finished goods. Finished goods might be warehoused for a long time, or sold on lengthy credit. In such businesses, where inventory turnover is slow, most inventories are not very easy to turn into liquid assets, because the cash cycle is so long. For these reasons, we calculate an additional liquidity ratio, known as the quick ratio or acid test ratio.

QUICK RATIO, or ACID TEST RATIO=

This ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company is in cash flow difficulties.

The current ratio and the quick ratio are known as liquidity ratios.

Question 1.1 Cash flow patterns

KEY TERM

KEY TERM

2.2 The receivables collection period 9/11

A rough measure of the average length of time it takes for a company's customers to pay is the 'receivable days' ratio.

Average (CIMA Official Terminology)

An equivalent measure is the receivables turnover period.

RECEIVABLES TURNOVER PERIOD =

year

The trade receivables are not the total figure for receivables in the statement of financial position, which includes prepayments and non-trade receivables. The trade receivables figure will be itemised in an analysis of the total receivables, in a note to the accounts.

The estimate of receivables days is only approximate.

(a) The statement of financial position value might be used instead of the average. However, don't forget that the statement of financial position value of receivables might be abnormally high or low compared with the 'normal' level the company usually has.

(b) Sales revenue in the income statement excludes sales tax, but the receivables figure in the

statement of financial position includes sales tax. We are not strictly comparing like with like. If the figures are too distorted by sales tax, adjustment will be needed.

(c) Average receivables may not be representative of year-end sales if sales are growing rapidly.

2.3 The payables payment period

Similar measures can be used for payables.

The payables payment period indicates the average time taken, in calendar days, to pay for supplies received on credit.

Average (CIMA Official Terminology)

PAYABLES PAYMENT PERIOD, or PAYABLES TURNOVER PERIOD =

year

If the credit purchases information is not readily available, cost of sales can be used instead. Don't forget however that some elements of cost of sales (for example, labour costs) are not relevant to trade

payables. Note also that credit purchases in the income statement do not include sales tax.

2.4 The inventory turnover period

The inventory turnover period shows how long goods are being kept in inventory.

Another ratio worth calculating is the inventory turnover period. This is another estimated figure, obtainable from published accounts, which indicates the average number of days that items of inventory are held for. As with the average receivable collection period, it is only an approximate figure; there may be distortions caused by seasonal variations in inventory levels. However it should be reliable enough for finding changes over time.

KEY TERMS KEY TERMS

INVENTORY TURNOVER =

The inventory turnover period can also be calculated:

INVENTORY TURNOVER PERIOD =

sales of Cost

Inventory × 365 days

A lengthening inventory turnover period indicates:

(a) A slowdown in trading, or

(b) A build-up in inventory levels, perhaps suggesting that the investment in inventories is becoming excessive

Where a business is manufacturing goods for resale, inventory turnover will have three components:

Raw materials:

Where average values are not available, closing values can be used.

Where no breakdown of inventories is supplied, just use the overall ratio:

sales of cost

inventory average

If we add together the inventory days and the receivable days, this should give us an indication of how soon inventory is convertible into cash, thereby giving a further indication of the company's liquidity.

All the ratios calculated above will vary industry by industry; hence comparisons of ratios calculated with other similar companies in the same industry are important. There are organisations which specialise in inter-firm comparison. A company submits its figures to one of these organisations and receives an analysis of the average ratios for its industry. It can then compare its own performance to that of the industry as a whole.

The receivables turnover period, payables turnover period and inventory turnover period are known as efficiency ratios.

The working capital cycle (covered in Section 1) can be calculated using the following formulae.

Days

Note that if you are provided with the statement of financial position figures for the start and end of a year (top line in each formula), you should calculate the average for the year. You add the two figures together and divide by two.

Exam skills

Remember that exam questions will probably ask you to discuss the results of any ratios that you calculate.

Another term you may come across is capital employed. This usually means non-current assets + current assets – current liabilities.

Section summary

Working capital ratios may help to indicate whether a company has too much working capital (over-capitalised) or too little (overtrading).

Current ratio =

(CIMA Official Terminology)

Receivables turnover period = Average trade receivables

Credit sales for the year × 365 days

Payables days ratio = Average trade payables

Average daily purchases on credit terms (CIMA Official Terminology)

Payables payment period, or payables turnover period = Average trade payables Purchases on credit

terms for year

× 365 days

Inventory turnover = Inventory

Average daily cost of sales in period or Average inventory Cost of sales