How do ratios affect the business?

1. Liquidity

Liquid capital: is current assets excluding stock.
Liquid capital ratio(Acid test ratio): liquid capital/current liabilities

The liquid capital ratio measures: liquid assets in relation to current liabilities the amount of liquid assets available to pay the debts of the business.

If the acid test ratio is increasing, this could imply that the business will find it easier to pay its debts, but that might have too many resources tied up as current assets or liquid capital. If the ratio is decreasing, this could imply that the business will find it more difficult to pay its debts, but that might have reduced the resource tied up current assets or liquid capital to more efficient level.



2.Gearing

It is fixed-return financing in relation to all sources of finance, the ratio is expressed as a percentage.

Formula: Fixed return financing/All sources of finance

The gearing ratio measures:
how a company if financed
finance on which there is a fixed return compared to all of a company's finance

If the percentage is above 50%, this tells that the company is high-geared, which means it has high amounts of fixed-return financing in relation to all financing, and it is able to pay interest/dividends on the fixed-return financing reasonably easier if the company is doing well in terms of profits. However, the business may have difficult to borrow more, because it already has a relatively high amount of fixed-return finance and it's hard to pay interest/dividends if the profits are low.

If the percentage is below 50%, the company is low geared, so it has low amounts of fixed-return financing in relation to all financing and the business may find easier to borrow additional funds.


3. Debtors collection period: Debtors/sales times 365 days,

this is trade creditors in relation to credit purchases.

Debtors collection period measures how many days on average a credit customer takes to pay.

If it's increasing, that means the debtors are taking longer to pay then previously. There will be a weakness because it could imply that credit control is not being as carefully managed as previously and this could lead to an increase in bad debts. However, if previously credit control was too tight, and the change has resulted in a greater volume of credit sales.

If it's decreasing, that means the credit control is being better managed and this could reduce bad debts. But, if previously credit control is too tight, the change may result in a decline in credit sales.


4. Credit collection period: credit/sales times 365 days,

This measures how many days are taken on average to pay for credit purchases.

If the credit collection period is increasing, this tells you hat a business is taking longer to pay its creditors than previously. The business is exceeding the credit period allowed by suppliers and as a result suppliers may discontinue to offer credit facilities. But the cash flow will be improved.

If it is decreasing, that means the credits control is being better managed and that difficulties with supplies over exceeding credit limits will no longer happen. However, the business is now paying suppliers earlier than necessary, resulting in negative impact on cash flow.

( We have to always remember, if the creditor payment period is shorter than the debtor collection period this will have a negative impact on cash flow)