LIQUIDITY RATIOS are used to measure the extent to which a business can meet its
short-term obligations. The short term usually refers to one accounting period or a 12month period. One of the most common liquidity ratios is the CURRENT RATIO. This
ratio indicates how well current liabilities are covered by current assets. It is calculated by
dividing the business’s current assets by current liabilities.
Current Ratio =
Current Assets
Current Liabilities
In the case of Boysweekend.com the current ratio is calculated as follows:
Current Ratio
=
(Current Assets/Current Liabilities)
=
($35,000/$15,000)
=
2.3/1
=
2.3:1
A ratio of 2.3:1 means that for every dollar of short-term debt the business has $2.30 of
short-term assets to meet the debt. A ratio of less than one would indicate that the
business has insufficient current assets to meet current liabilities and it could be in
danger of defaulting on its debt.
It is also worth remembering that not all current assets are quickly converted to cash.
Stock and debtors may not be quickly convertible and thus will be hard to use to meet
immediate demands. Because of this problem, a ratio of 2:1 or higher is preferred.
SOLVENCY is the capacity of the business to pay all liabilities, both short and longterm. Solvency ratios are of particular interest to lenders as they indicate the ability of a
business to repay its debts in the longer term as well as giving a strong indication of the
financial health and viability of a business. The DEBT-TO-EQUITY RATIO is one
of the most common measures of solvency, and is calculated by the formula:
Total Liabilities
Debt-to-Equity Ratio
=
Total Owner’s Equity
100
x
1
In the case of Boysweekend.com the debt-to-equity ratio is calculated as follows:
Debt-to-Equity Ratio =
=
=
=
(Total Liabilities/Total OE) x 100/1
($345,000/$155,000) x 100/1
2.2/1
2.2:1 or 220%
This ratio is traditionally presented as a percentage. The figure is only meaningful when
related to the industry in which the business operates. For this reason, most ratios are
interpreted by comparing them with industry averages. However, as a general rule
anything less than 60% is regarded as ‘satisfactorily geared’. Higher levels of gearing are
regarded as ‘highly geared’. Gearing or leverage, is the relationship between the level of
debt and the level of owner’s equity in a business.
PROFITABILITY is a critical success factor for any business. It is an indicator of the
success or failure of a business’s plans and strategies for achieving its goals. In order to
assess the profitability of a business a series of ratios are used. These are:
i)
Gross Profit Ratio
The gross profit ratio (commonly known as the gross profit margin) expresses gross
profits (revenues less COGS) as a percentage of sales.
Gross Profit
Gross Profit Ratio
=
100
x
Sales
1
In the case of Boysweekend.com the gross profit ratio is calculated as follows:
Gross Profit Ratio =
=
=
(Gross Profit/Sales) x 100/1
($90,000/$150,000)
60%
This means that for every dollar of sales, Boysweekend.com is making 60 cents gross
profit.
ii)
Net Profit Ratio
The net profit ratio (commonly known as the net profit margin) expresses the average
net profit generated by each dollar of sales.
Net Profit Ratio
=
Net Profit
Sales
x
100
1
In the case of Boysweekend.com the net profit ratio is calculated as follows:
Net Profit Ratio
=
=
=
(Net Profit/Sales) x 100/1
($40,000/$150,000)
27%
A net profit margin of 27% means that for each dollar of sales, the business is realising
a net profit of 27 cents. Again, managers will compare the result against the objectives
that are set. If the margin is too far below the objective, they will need to cut the
business’s expenses, such as wages, advertising and interest.
iii)
Return on Owner’s Equity
Return on Owner’s Equity (ROE) is a popular ratio for measuring management
performance. The ROE ratio indicates how much profit is generated by the business
relative to the equity invested in it. It is a measure of how well management can use
its funds to generate wealth for shareholders.
Return on Owner’s Equity
=
Net Profit
x
100
Total Owners’ Equity
1
In the case of Boysweekend.com the return on owners’ equity is calculated as follows:
ROE
=
=
=
(Net Profit/TOE) x 100/1
($40,000/$155,000) x 100/1
26%
A 26% ROE is excellent. For every dollar invested by owners, 26 cents is returned as
profit.
Efficiency refers to the ability of the business to manage its assets in order to generate
profits at minimum cost to the business. Efficient management of working capital,
such as inventory and accounts receivable, is important because the use of these assets
is contributing towards the business achieving its strategic goals. The ratios used to
indicate working capital efficiency are: expense ratio, and accounts receivable
turnover.
Expense ratio
The expense ratio shows us the expenses of a business as a proportion of total sales,
giving an indication of how cost effectively the business is able to generate its sales
revenue. The ratio is expressed as:
Expense Ratio
Expenses
=
Sales
x
100
1
In the case of Boysweekend.com (refer Figure 2.4.1) the expense ratio is calculated as
follows:
Expense Ratio
=
=
=
(Expenses/Sales) x 100/1
($50,000/$150,000)
33%
The calculated figure indicates that for every dollar of sales, 33 cents is absorbed by
expenses.
Accounts receivable turnover
This ratio indicates how often a business turns over its debtors every financial year. It is
calculated as
Accounts Receivable
Turnover Ratio
Credit Sales
=
Average Accounts Receivable
In the case of Boysweekend.com the expense ratio is calculated as follows:
Accounts Receivable Turnover Ratio =
(Credit Sales/Ave AR)
=
($72,000/$5,000)
=
14.4
This means that accounts receivable are turned over 14.4 times per year. Average
accounts receivable can be determined by averaging the level of accounts receivable at
the end of the current year and the year previous. This figure can be used to calculate
how long it takes the average debtor to pay for the products they have bought – if we
know debtors are turned over 14.4 times per year, then:
365 days/14.4 = 25.4 days
Thus, Boysweekend.com debtors pay their accounts after 25½ days (on average) after
purchasing their products. Generally a ratio greater than 12 is good, as it means debtors
are turned over in 20 days or less.