Financial ratios: What do they mean? (Part 1)

A4The purpose of calculating ratios is to get a bird’s eyeview of the financial situation of a business by analysing the relationships between different amounts on the financial statements. The major advantages of using ratio analysis is that it simplifies the information in the financial statements and allows you to compare the ratio results over time in a specific business, or between different businesses.

Some limitations of ratio analysis are the following:

  • There are no specific standards for what ideal ratios should be, so different people may interpret the same ratio in different ways.
  • Single ratios do not necessarily paint an accurate picture. Just like the meaning of a word can differ depending on the context of a sentence, a ratio must be interpreted in the context of the background of the business and the industry in which it operates.

Set out in the tables below are a number of financial ratios with their formulas and a brief explanation of what each ratio measures. 

Liquidity ratios (short term solvency ratios)

The liquidity ratios measure a business’s ability to pay off its current/short term liabilities i.e. the liabilities which will become due in the next 12 months.

Ratio name Ratio formula What it measures
Current ratio Current assets / Current liabilities Can the business pay their debts due in the next 12 months from the assets they expect to turn into cash within those 12 months?Generally a ratio of 1 or higher than 1 is considered acceptable.
Quick ratio (Acid test) (Current assets – Stock) / Current Liabilities Can the business pay their debts due in the next 12 months from the cash and short term investments they have? Stock is excluded from the ratio as it must still be converted to a liquid asset (debtor/cash).Generally a ratio of 1 or higher than 1 is considered acceptable.

Efficiency ratios

Efficiency ratios show how efficient a business is in using its investment in current assets to make a profit.

Ratio name Ratio formula What it measures
Debtor days (A) Average trade debtors* / Sales x 365 Average number of credit days clients take to pay their accounts.If the number of days are high, especially higher than the industry average, it can indicate problems with debt collection.
Stock days (B) Cost of sales / Average stock** Average number of days it took from receiving stock to selling the stock.If the stock days are higher than the average stock days for the industry, it can indicate poor stock management, for example, having too much money tied up in stock.
Creditor days (C) ((Trade creditors + accruals) / (Cost of sales + other purchases)) x 365 Average number of days it takes from purchasing from a supplier until paying their account.If the creditor days are very short, it may indicate that the business is not taking full advantage of trade credit available to it.
Cash conversion cycle (CCC) Debtor days + Stock days – Creditor daysOR

(A) + (B) – (C)

How fast a business turns stock into sales (debtors), then turn those sales (debtors) into cash by collecting what the debtors owe them, and then pay its suppliers for goods and services bought from them.The shorter the CCC, the better. This will mean:

–          Better liquidity,

–          Smaller need to borrow money,

–          Money available to make use of discount terms for cash payments to creditors,

–          Better capacity to fund expansion of the business.

*Average trade debtors = (Debtors’ opening balance + Debtors’ closing balance)/2

**Average stock = (Stock opening balance + Stock closing balance)/2

If you need professional assistance with the above calculations, submission or payment of any of your provisional tax returns, please do not hesitate to contact our office. Our staff are friendly and knowledgeable and are looking forward to the opportunity to assist you. 

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions, nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. 

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