arrived at by dividing the current assets by the current liabilities, is the measure used. For High Note this is 21,108/4,908 = 4.30. The convention is to express this as 4.30 : 1 and the aim here is to have a ratio of between 1.5 : 1 and 2 : 1. Any lower and bills canât be met easily; much higher and money is being tied up unnecessarily.
Quick ratio (acid test)
This is a belt and braces ratio used to ensure that a business has sufficient ready cash or near cash to meet all its current liabilities. Items such as stock are stripped out as although these are assets, the money involved is not immediately available to pay bills. In effect the only liquid assets a business has are cash, debtors and any short-term investment such as bank deposits or government securities. For High Note this ratio is: 12,000/4,908 = 2.44 : 1. The ratio should be greater than 1 : 1 for a business to be sufficiently liquid.
Average collection period
We can see that High Noteâs current ratio is high, which is an indication that some elements of working capital are being used inefficiently. The business has $/£/â¬12,000 owed by customers on sales of $/£/â¬60,000 over a six-month period. The average period it takes High Note to collect money owed is calculated by dividing the sales made on credit by the money owed (debtors)and multiplying it by the time period, in days; in this case the sum is as follows: 12,000/60,000 à 182.5 = 36.5 days.
If the credit terms are cash with order or seven days, then something is going seriously wrong. If it is net 30 days then it is probably about right. In this example it has been assumed that all the sales were made on credit.
Average payment period
This ratio shows how long a company is taking on average to pay its suppliers. The calculation is as for average collection period, but substituting creditors for debtors and purchase for sales.
Days stock held
High Note is carrying $/£/â¬9,108 stock of sheet music, CDs etc and over the period it sold $/£/â¬30,000 of stock at cost (the cost of sales is $/£/â¬30,000 to support $/£/â¬60,000 of invoiced sales as the mark-up in this case is 100 per cent). Using a similar sum as with average collection period we can calculate that the stock being held is sufficient to support 55.41 days sales (9,108/10,000 à 182.5). If High Noteâs suppliers can make weekly deliveries then this is almost certainly too high a stock figure to hold. Cutting stock back from nearly eight weeks (55.41 days) to one week (seven days) would trim 48.41 days or $/£/â¬7,957.38 worth of stock out of working capital. This in turn would bring the current ratio down to 2.68 : 1.
Circulation of working capital
This is a measure used to evaluate the overall efficiency with which working capital is being used. That is the sales divided by the working capital (current assets â current liabilities). In this example that sum is: 60,000/16,420 = 3.65 times. In other words, we are turning over the working capital more than three and a half times each year. There are no hard and fast rules as to what is an acceptable ratio. Clearly the more times working capital is turned over, stock sold for example, the more chance a business has to make a profit on that activity.
Tests of solvency
These measures see how a company is managing its long-term liabilities. There are two principal ratios used here.
Leverage/gearing
This measures as a percentage the proportion of all borrowing, including long-term loans and bank overdrafts, to the total of shareholdersâ funds â share capital and all reserves. The gearing ratio is sometimes also known as the debt/equity ratio. For High Note this is: (4,908 + 10,000) / 18,800 = 14,908/18,800 = 0.79 : 1. In other words, for every $/£/â¬1 the shareholdershave invested in High Note they have borrowed a further 79p. This ratio is usually not expected to exceed 1 : 1 for long periods.
Interest
Quick ratio (acid test)
This is a belt and braces ratio used to ensure that a business has sufficient ready cash or near cash to meet all its current liabilities. Items such as stock are stripped out as although these are assets, the money involved is not immediately available to pay bills. In effect the only liquid assets a business has are cash, debtors and any short-term investment such as bank deposits or government securities. For High Note this ratio is: 12,000/4,908 = 2.44 : 1. The ratio should be greater than 1 : 1 for a business to be sufficiently liquid.
Average collection period
We can see that High Noteâs current ratio is high, which is an indication that some elements of working capital are being used inefficiently. The business has $/£/â¬12,000 owed by customers on sales of $/£/â¬60,000 over a six-month period. The average period it takes High Note to collect money owed is calculated by dividing the sales made on credit by the money owed (debtors)and multiplying it by the time period, in days; in this case the sum is as follows: 12,000/60,000 à 182.5 = 36.5 days.
If the credit terms are cash with order or seven days, then something is going seriously wrong. If it is net 30 days then it is probably about right. In this example it has been assumed that all the sales were made on credit.
Average payment period
This ratio shows how long a company is taking on average to pay its suppliers. The calculation is as for average collection period, but substituting creditors for debtors and purchase for sales.
Days stock held
High Note is carrying $/£/â¬9,108 stock of sheet music, CDs etc and over the period it sold $/£/â¬30,000 of stock at cost (the cost of sales is $/£/â¬30,000 to support $/£/â¬60,000 of invoiced sales as the mark-up in this case is 100 per cent). Using a similar sum as with average collection period we can calculate that the stock being held is sufficient to support 55.41 days sales (9,108/10,000 à 182.5). If High Noteâs suppliers can make weekly deliveries then this is almost certainly too high a stock figure to hold. Cutting stock back from nearly eight weeks (55.41 days) to one week (seven days) would trim 48.41 days or $/£/â¬7,957.38 worth of stock out of working capital. This in turn would bring the current ratio down to 2.68 : 1.
Circulation of working capital
This is a measure used to evaluate the overall efficiency with which working capital is being used. That is the sales divided by the working capital (current assets â current liabilities). In this example that sum is: 60,000/16,420 = 3.65 times. In other words, we are turning over the working capital more than three and a half times each year. There are no hard and fast rules as to what is an acceptable ratio. Clearly the more times working capital is turned over, stock sold for example, the more chance a business has to make a profit on that activity.
Tests of solvency
These measures see how a company is managing its long-term liabilities. There are two principal ratios used here.
Leverage/gearing
This measures as a percentage the proportion of all borrowing, including long-term loans and bank overdrafts, to the total of shareholdersâ funds â share capital and all reserves. The gearing ratio is sometimes also known as the debt/equity ratio. For High Note this is: (4,908 + 10,000) / 18,800 = 14,908/18,800 = 0.79 : 1. In other words, for every $/£/â¬1 the shareholdershave invested in High Note they have borrowed a further 79p. This ratio is usually not expected to exceed 1 : 1 for long periods.
Interest
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