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is borrowed or provided by the owners。
Capital employed is defined as share capital plus reserves plus long…term
borrowings。 Where； say； a bank overdra。。 is included in current liabilities
every year and in effect bees a source of capital； this may be regarded
as part of capital employed。 If the bank overdra。。 varies considerably from
year to year； a more reliable ratio could be calculated by averaging the startand
end…year figures。 There is no one precise definition used by panies
for capital employed。 In this example the sum is： return on capital employed
= 8；700/18；700 ＋ 10；000 × 100 = 30％。
Tests of liquidity
In order to survive； panies must also watch their liquidity position； by
which is meant keeping enough short…term assets to pay short…term debts。
panies go out of business pulsorily when they fail to pay money
due to employees； bankers or suppliers。
The liquid money tied up in day…to…day activities is known as working
capital； the sum of which is arrived at by subtracting the current liabilities
from the current assets。 In the case of High Note we have ￡21；108 in current
assets and ￡4；908 in current liabilities； so the working capital is ￡16；200。
Current ratio
As a figure the working capital doesn’t tell us much。 It is rather as if you
knew your car had used 20 gallons of petrol but had no idea how far you
had travelled。 It would be more helpful to know how much larger the
current assets are than the current liabilities。 That would give us some idea
if the funds would be available to pay bills for stock； the tax liability and
any other short…term liabilities that may arise。 The current ratio； which is
arrived at by dividing the current assets by the current liabilities； is the
measure used。 For High Note this is 21；108/4；908 = 4。30。 The convention is
to express this as 4。30 ： 1 and the aim here is to have a ratio of between 1。5 ： 1
and 2 ： 1。 Any lower and bills can’t be met easily； much higher and money is
being tied up unnecessarily。
44 The Thirty…Day MBA
Quick ratio （acid test）
This is a belt and braces ratio used to ensure that a business has sufficient
ready cash or near cash to meet all its current liabilities。 Items such as stock
are stripped out as although these are assets； the money involved is not
immediately available to pay bills。 In effect the only liquid assets a business
has are cash； debtors and any short…term investment such as bank deposits
or government securities。 For High Note this ratio is： 12；000/4；908 = 2。44 ： 1。
The ratio should be greater than 1 ： 1 for a business to be sufficiently liquid。
Average collection period
We can see that High Note’s current ratio is high； which is an indication that
some elements of working capital are being used inefficiently。 The business
has ￡12；000 owed by customers on sales of ￡60；000 over a six…month period。
The average period it takes High Note to collect money owed is calculated
by dividing the sales made on credit by the money owed （debtors） and
multiplying it by the time period； in days； in this case the sum is as follows：
12；000/60；000 × 182。5 = 36。5 days。
If the credit terms are cash with order or seven days； then something is
going seriously wrong。 If it is net 30 days then it is probably about right。 In
this example it has been assumed that all the sales were made on credit。
Average payment period
This ratio shows how long a pany is taking on average to pay its suppliers。
The calculation is as for average collection period； but substituting
creditors for debtors and purchase for sales。
Days stock held
High Note is carrying ￡9；108 stock of sheet music； CDs etc and over the
period it sold ￡30；000 of stock at cost （the cost of sales is ￡30；000 to support
￡60；000 of invoiced sales as the mark…up in this case is 100 per cent）。 Using
a similar sum as with average collection period we can calculate that the
stock being held is sufficient to support 55。41 days sales （9；108/10；000 ×
182。5）。 If High Note’s suppliers can make weekly deliveries then this is
almost certainly too high a stock figure to hold。 Cu。。ing stock back from
nearly 8 weeks （55。41 days） to 1 week （7 days） would trim 48。41 days or
￡7；957。38 worth of stock out of working capital。 This in turn would bring
the current ratio down to 2。68 ： 1。
Circulation of working capital
This is a measure used to evaluate the overall efficiency with which
working capital is being used。 That is the sales divided by the working
capital （current assets – current liabilities）。 In this example that sum is：
60；000/16；420 = 3。65 times。 In other words； we are turning over the working
Accounting 45
capital more than three and a half times each year。 There are no hard and
fast rules as to what is an acceptable ratio。 Clearly the more times working
capital is turned over； stock sold for example； the more chance a business
has to make a profit on that activity。
Tests of solvency
These measures see how a pany is managing its long…term liabilities。
There are two principal ratios used here。
Gearing
This measures as a percentage the proportion of all borrowing； including
long…term loans and bank overdra。。s； to the total of shareholders’ funds
– share capital and all reserves。 The gearing ratio is sometimes also known
as the debt/equity ratio。 For High Note this is： （4；908 ＋ 10；000） / 18；800 =
14；908/18；800 = 0。79 ： 1。 In other words； for every ￡1 the shareholders have
invested in High Note they have borrowed a further 79p。 This ratio is
usually not expected to exceed 1 ： 1 for long periods。
Interest cover
This is a measure of the proportion of profit taken up by interest payments
and can be found by dividing the annual interest payment into the annual
profit before interest； tax and dividend payments。 The greater the number；
the less vulnerable the pany will be to any setback in profits； or rise in
interest rates on variable loans。 The smaller the number； the more risk that
level of borrowing represents to the pany。 A figure of between 2 and 5
times would be considered acceptable。
Tests of growth
These are arrived at by paring one year with another； usually for elements
of the profit and loss account such as sales and profit。 So； for example；
if next year High Note achieved sales of ￡100；000 and operating profits of
￡16；000 the growth ratios would be 67 per cent； that is； ￡40；000 of extra sales
as a proportion of the first year’s sales of ￡60；000； and 84 per cent； that is；
￡7；300 of extra operating profit as a percentage of the first year’s operating
profit of ￡8；700。
Some additional information can be gleaned from these two ratios。 In
this example we can see that profits are growing faster than sales； which
indicates a healthier trend than if the situation were reversed。
46 The Thirty…Day MBA
Market tests
This is the name given to stock market measures of performance。 Four key
ratios here are：
Earnings per Share = Net Profit
Shares Outstanding
The a。。er…tax profit made by a pany divided by the number of ordinary
shares it has issued。
Price Earnings Ratio = Market Price per Share
Earnings per Share
The market price of an ordinary share divided by the earnings per share。
The PE ratio expresses the market value placed on the expectation of future
earnings； ie the number of years required to earn the price paid for the
shares out of profits at the current rate。
Yield = Dividends per Share
Price per Share
The percentage return a shareholder gets on the ‘opportunity’ or current
value of their investment。
Dividend Cover = Net Ine
Dividend
The number of times the profit exceeds the dividend； the higher the ratio；
the more retained profit to finance future growth。
Other ratios
There are a very large number of other ratios that businesses use for measuring
aspects of their performance such as：
。 sales per ￡ invested in fixed assets – a measure of the use of those fixed
assets；
。 sales per employee – showing if your headcount is exceeding your sales
growth；
。 sales per manager； per support staff etc – showing the effectiveness of
overhead spending。
Accounting 47
bined ratios
No one would use a single ratio to decide whether one vehicle was a be。。er
or worse buy than another。 MPG； MPH； annual depreciation percentage
and residual value proportion are just a handful of the ratios that would
need to be reviewed。 So it is with a business。 A bination of ratios can be
used to form an opinion on the financial state of affairs at any one time。
The best known of these bination ratios is the Altman Z…Score
（creditguru/CalcAltZ。shtml）； which uses a bined set of five
financial ratios derived from eight variables from a pany’s financial
statements linked to some statistical techniques to predict a pany’s
probability of failure。 Entering the figures into the on…screen template at
this website produces a score and an explanatory narrative giving a view
on the business’s financial strengths and weaknesses。
Some problems in using ratios
Finding the information to calculate business ratios is o。。en not the major
problem。 Being sure