# Calculating performance indicators - liquidity

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1 Calculating performance indicators - liquidity Introduction When a business is deciding whether to grant credit to a potential customer, or whether to continue to grant credit terms to an existing customer, it can analyse the customer s current and past financial statements. This analysis should calculate key performance indicators for three key areas: liquidity profitability financial position and cash flow In this worksheet we will focus on calculating and interpreting liquidity performance indicators. Similar worksheets have also been prepared for profitability indicators and financial position and cash flow indicators. You may also want to try the two worksheets: Calculating profitability indicators and Calculating financial position indicators. Liquidity is a measure of a business s ability to pay its debts as they become due. This is particularly relevant, as a key risk when considering whether to offer credit terms to a customer is that the customer will not be able to pay when the amount falls due. As part of the decision to grant credit to a customer, a business should obtain copies of the customer s recent financial statements; ideally for the past three years; and calculate liquidity indicators from these figures. These performance indicators can then be compared with the same measures for previous years; acceptable industry standards; or used as part of a credit scoring system. On the next screen we will look at the formulae for calculating the key performance indicators used to assess the liquidity of a business. We will then calculate these performance indictors to assess the liquidity of a potential customer. Key liquidity performance indicators The five key performance indicators generally calculated to assess liquidity are as follows. Current ratio Quick ratio (liquid capital ratio or acid test) current assets current liabilities current assets less inventory current liabilities Inventory holding period inventory x 365 cost of sales

3 Quick ratio Typically, current assets include inventory, trade receivables and cash. Of these three categories inventory is the one that can least quickly be turned into cash (that is, the least liquid). Removing inventory from the equation will therefore give a more realistic analysis of liquidity. The quick ratio (acid test) is the ratio of current assets (excluding inventories) to current liabilities. To calculate the quick ratio we divide current assets less inventory by current liabilities. How is the formula stated? Click to display/hide the solution. Quick ratio = current assets less inventory current liabilities The figures that we need for this calculation for Delrex Limited for 2010 are shown in the table below with the quick ratio for 2010 already calculated. You should now complete the figures for 2011 and 2012 and calculate the quick ratio for each of these years. The ratios should be rounded to the nearest one decimal place (for example, 3.1:1). Complete the table and then click to display/hide the solution. Current assets less inventories 1,900 1,500 1,150 Current liabilities 1,800 1,200 1,150 Quick ratio 1.1:1 1.2:1 1.0:1 So what does this tell us about the liquidity of Delrex Limited? Write your answer down and then click to reveal our suggested analysis. A quick ratio of 1:1 or above is considered to indicate good liquidity for a business. Although the quick ratio for Delrex Limited has improved over the three years from 2010 to 2012, indicating that the business does not have too much of its working capital tied up in inventory. This in turn means that it should be able to pay its short-term liabilities as they fall due. Inventory holding period The inventory holding period shows the number of days on average that a business holds inventory. To calculate the inventory holding period we divide inventory by cost of sales and multiply the answer by 365 for the holding period in days, or by 12 for the holding period in months. How would you state the formula to calculate inventory holding period in days? Click to display/hide the solution. Inventory holding period inventory x 365 cost of sales

6 Complete the table and then click to display/hide the solution Trade payables 1,800 1, Cost of sales 6,100 4,200 3,800 Accounts payable payment period 108 days 104 days 86 days What does this tell us about Delrex Limited s liquidity? Write down your answer and then click to reveal our suggested analysis. The accounts payable payment period for Delrex Limited has increased over each of the years that we have analysed and is now 108 days. This could be because Delrex Limited have negotiated better credit terms with their suppliers, which would mean that they are holding on to their cash for a longer period of time. However, if Delrex Limited are paying later than the agreed credit terms this could strain relations with suppliers, and may adversely affect future delivery of goods. The reason for the increase in accounts payable collection period would need to be investigated before agreeing credit terms with Delrex Limited. Assessment of liquidity of Delrex Limited Current ratio 2.2:1 2.7:1 2.1:1 Quick ratio 1.3:1 1.2:1 1.0:1 Inventory holding period Accounts receivable collection period Accounts payable payment period 120 days 148 days 125 days 65 days 63 days 62 days 108 days 104 days 86 days So far we have looked at performance indicators to assess the liquidity of Delrex Limited. The current and quick ratios indicate good liquidity. Delrex seem to be managing their debt collection periods well. However, the reason for the increase in trade payable collection periods will need to be investigated.

7 Working capital cycle One other useful calculation is the working capital cycle. This measures the time between payment for goods received (inventory) and collection of cash from customers. The shorter the time between payment for inventory and collection of cash from customers, the lower the amount of working capital a business needs. The calculation of the working capital cycle is as follows: Working capital cycle = inventory days + accounts receivable collection days - accounts payable payment days Complete the table below to show the working capital cycle for Delrex Limited for the three years and then click to display/hide the solution. Inventory holding period Accounts receivable collection period Accounts payable payment period Working capital cycle 120 days 148 days 125 days 65 days 63 days 62 days 108 days 104 days 86 days 77 days 107 days 101 days What does this tell us about Delrex Limited s liquidity? Write down your answer and then click to reveal our suggested analysis. The working capital cycle for Delrex Limited has reduced by 30 days between 2011 and This means that the time between paying for inventory and collecting the cash from customers has significantly reduced. The reason for this decrease in the working capital cycle is mainly because of the decrease in the time that the business holds inventory. The improvement in this measure of liquidity indicates that the business is using its working capital more efficiently than in previous years. Summary As part of the assessment of creditworthiness for a new or existing customer, performance indicators can be calculated on the financial statements of the business. Part of this analysis should assess the liquidity of the business. Liquidity performance indicators measure the financial stability of a business and its ability to pay its short-term liabilities as they fall due. The key liquidity indicators that can be calculated are: Current ratio

8 Quick ratio Inventory holding period Accounts receivable collection period Accounts payable payment period Working capital cycle These performance indicators should be calculated for the most recent financial information and compared with previous years figures. The performance indicators can also be compared with industry averages. This will help a business to decide whether to grant credit to a customer. In addition to calculating liquidity indicators, performance indicators that assess profitability and financial performance of a potential customer should also be calculated. You may also want to try the two worksheets: Calculating profitability indicators and Calculating financial position indicators.

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