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Working capital ratios / liquidity ratios

In this blog I will introduce five working capital ratios and provide comments on each one. I will then attach a table that will show the results using data taken from the Polly Ester case study and conclude by giving an interpretation of each ratio.

Working capital, or liquidity ratios attempt to give an indication of a company’s ability to pay its way in the short and medium-term. The medium-term is taken to mean up to one year, while short-term is taken to mean up to 13 weeks, i.e. 3 months. All working capital ratios should be compared against trends year-on-year and/or industry averages. Working capital ratios correspond to the working capital cycle of a company and represent the flow of goods/services through a business. The main items comprise inventory, trade receivables, cash and trade payables. Financial controls should certainly exist for the first three items. The current ratio, (current assets divided by current liabilities) considers the whole of the working capital cycle and gives an indication of a company’s ability to pay its way in the medium-term.

The liquid, or acid test, ratio takes current assets, deducts inventories then divides the result by current liabilities. It attempts to give an indication of a company’s ability to pay its way in the short-term. Many academic writers suggest that this is a ‘more stringent’ ratio than the current ratio simply because it deducts stock. This is not the case in practice. The liquid ratio, in its present form, suffers from movements in bank overdraft. For example, if bank overdraft increases and it is used (correctly) to finance a proportion of current assets, then the ratio is unlikely to change. This begs the question "Has there been a change in short-term liquidity?"

The alternative ratio, known as cover for trade payables, takes current assets, deducts inventories and bank overdraft then divides the result by trade payables. Research shows this to be more responsive to changes in short-term liquidity than the liquid ratio.

The final two ratios examine separate components of the working capital cycle. Cost of sales divided by inventory, gives the average inventory turn. Here, the higher the better. Trade receivables divided by average weekly (or daily) revenues, give the average debtor collection period. It would appear that the lower the ratio, the better. However, the simple fact of reducing the amount of credit allowed to its customers might result in a company losing some or many of its customers.

 2009201020112012
Current ratio:
Current assets ÷ current liabilities1.541.151.850.98
Liquid ratio:
Liquid assets ÷ current liabilities0.430.260.460.22
Cover for trade payables:
(LA – BO) ÷ trade payables0.54–0.580.47–1.13
 
Cost of sales ÷ inventory1.41.21.41.3
Trade receivables x 52 ÷ revenues3.74.04.34.8

Working capital or 'liquidity' ratios

The working capital cycle ratios for Polly Ester Holdings plc are heavily influenced by substantial movements in short and long-term borrowings. In this case, the best way to interpret the current ratio is to ignore the movements in the intervening years, simply take the total movement from 2009 to 2012, i.e. 1.54 to 0.98. This is a substantial decline in the company’s ability to pay its way in the medium term. The main cause of of the decline is certainly due to the increase in bank overdraft.

In this example, the liquid, or acid test, ratio seems to follow similar movements to the current ratio. Here the ratio is difficult to interpret.

The 'cover for trade payables' ratio gives a clear interpretation. It takes current assets, deducts inventories and bank overdraft to show the amount trade payables are covered. In this example, in 2009, trade payables are covered 54 pence in the pound, while in 2010 the cover for trade payables is negative 58 pence in the pound. In 2011 another cover for trade payables of 47 pence in the pound, then in 2012 a negative of £1.13 in the pound.

The first of the remaining two ratios is known as stock turn, i.e. cost of sales divided by stock. The ideal value for this ratio – the higher the better. For Polly Ester Holding plc this ratio is fairly stable, between 1.4 and 1.2 times. If we take the 2012 value of 1.3, this means that the company turned its stock over 1.3 times on average per year. Or another way of looking at it is 52 divided by 1.3 gives 40 weeks stockholding (on average). This would be considered very high stockholding, typical stockholding for a retailer might be 10 to 12 weeks. With an inventory holding of £314.4 million in 2006 and a revised inventory turn of 2.6 times this would give 20 weeks inventory holding and release £157.2 million from inventory for alternative use, perhaps in reducing borrowings.

The final ratio, known as the debtor collection period, trade receivables multiplied by 52 then divided by revenues shows an increase. The size of this ratio is influenced by the trading environment the company finds itself in, i.e. it must provide similar levels of credit to its customers compared to its competitors. For Polly Ester Holdings plc the ratio increases from an average 3.7 weeks to 4.8 weeks over the period. This means that the company is allowing its debtors a further 1.1 weeks at average weekly revenues, i.e. £889.8 divided by 52 times 1.1 gives £18.8 million.

Taking the stock and debtor ratios together it should be possible to reduce the working capital by approximately £176 million and in turn reduce bank overdraft which in turn would reduce interest payable and increase profit before taxation.

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