Analysis and Interpretation Liquidity YEAR 12 ACCOUNTING Analysis and Interpretation Liquidity

CLASSIFICATION OF RATIOS/PERCENTAGES We are looking at this today!!!

How to evaluate businesses’ results? Please follow the steps as follows: Calculate Percentages/Ratios Explain the meaning of the Percentage/Ratios Unsatisfactory Trend Look at the financial statements and formula and identify what has been changed? Identify the trend Satisfactory Trend Look at the financial statements and formula and identify what has been changed? Why was there a change in the financial statements? Provide a recommendation/s to overcome the unsatisfactory trend. Why was there a change in the financial statements?

Liquidity Liquidity means the ability of a business to repay short-term debts and to meet unexpected needs of cash. Short-term means within 12 months.

Measures of Liquidity The following ratios are under the area of Liquidity: Current Ratio Liquid Ratio

2:1 Current Ratio BENCHMARK Meaning: It means for every $1 of current liabilities, there are $X current assets available to pay the current liabilities in the next 12 months. It tells users that the business is able/unable to settle its debts in the next accounting period.

Example If the current ratio in 2005 was 2.5:1. Try to write the meaning of the ratio. This means for every $1 of current liabilities, there were $2.5 of current assets available to pay current liabilities within the next 12 months. This tells users that the business is ABLE to pay its debts which are due within the next 12 months.

Calculation 2005 2006 Current Assets Cash on Hand 500 Bank 3,000 N/A A/Receivable 12,000 10,000 Inventory 20,000 18,000 Prepayment 800 36,300 600 29,100 Current Liabilities Accounts Payable 15,000 14,000 Bank (secured $1,000) 4,500 18,500

Calculation 2005 2006 Current Ratio

Satisfactory/Unsatisfactory Ratio The current ratio in 2006 showed a SATISFACTORY or UNSATISFACTORY result. The next step is to describe the reason with using the Balance Sheet.

Identify the trend The Current Ratio showed a SATISFACTORY or UNSATISFACTORY trend.

Reason Remember, we need to include the following when providing reason/s: Information from the financial statements Reasons behind the information (you need to give an example)

Reason for trend (surface level) The reason for the unsatisfactory ratio is there has been a significant decrease in the bank balance (ie from a positive balance to an overdraft).

Reason for trend (deep level) An increase in the bank overdraft can be caused by the following: Excessive Cash Drawings by the owner; Purchase of a piece of property, plant and equipment for cash; Repayment of a Non Current Liabilities This answer is not good enough because we have not yet answered WHY

Recommendations To overcome this unsatisfactory ratio, either INCREASE current assets or DECREASE current liabilities, such as: Purchase PPE by borrowing a long term loan (to reduce the big outflow of cash suddenly) Dispose of any old PPE to obtain cash Owner’s can make an extra cash contribution Reduce the level of cash drawings Borrow a long term loan to ease the shortage of cash

Is an over-high current ratio (like 5:1) a good thing? No, because this tells users that the business cannot use its excess cash efficiently to generate further income. Excess cash means the amount of cash left over after settling all liabilities due within the next 12 months. Businesses should invest their excess cash into investments, such as shares, term deposits etc to earn interest.

Liquid Ratio BENCHMARK 1:1 Liquid Assets Liquid Liabilities Liquid Ratio measures a business’s ability to repay its debts which are due immediately (i.e. within 2 – 3 months).

Meaning This means for every $1 of liquid liabilities, there is $X.XX of liquid assets available to pay liquid liabilities within the next 2 – 3 months, which tells users that the business is able/unable to repay debts which are due in the next 2 – 3 months. For example: Liquid Ratio in 2005 was 1.5:1. It means for every $1 of liquid liabilities, there is $1.50 of liquid assets available to pay liquid liabilities within the next 2 – 3 months, which means the business is ABLE to repay debts which are due in the next 2 – 3 months.

Calculation 2005 2006 Current Assets Cash on Hand 500 Bank 3,000 N/A A/Receivable 12,000 10,000 Inventory 20,000 18,000 Prepayment 800 36,300 600 29,100 Current Liabilities Accounts Payable 15,000 14,000 Bank (secured $1,000) 4,500 18,500

Calculation 2005 2006 Liquid Ratio

Satisfactory/Unsatisfactory Ratio The liquid ratio in 2006 showed a SATISFACTORY or UNSATISFACTORY result. The next step is to describe the reason with using the Balance Sheet.

Identify the trend The Liquid Ratio showed a SATISFACTORY or UNSATISFACTORY trend.

Reason for trend (surface level) The reason of an unsatisfactory ratio is : A high level of inventory on hand despite the level of inventory of hand showing a decreasing trend (inventory could not turn into cash in the next 2 – 3 months) and A significant increase in the bank overdraft. (from a positive balance to overdraft).

Reason for trend (deep level) Possible reasons for having too much inventory on hand: Poor purchase policy, such as buying inventory without double checking the level of stock on hand. Charge products at excessive high price, which means people are less able to afford to buy the products. An increase in bank overdraft can be caused by the following: Excessive Cash Drawings by the owner; Purchase of a property, plant and equipment by cash;

Recommendations To overcome an unsatisfactory ratio, can be achieved by the following: Purchase of PPE by borrowing a long term loan (to reduce the big outflow of cash suddenly) Dispose of any old PPE to obtain cash Owner to contribute extra cash Reduce the level of cash drawings Borrow a long term loan for easing the shortage of cash Sell inventory at a lower price to get rid of inventory Review the purchase policy to ensure no excess inventory is bought Try to ask for a larger amount of secured bank overdraft