Liquidity, Gearing, Solvency and Working Capital Efficiency Ratios

A building materials distributor in Port Harcourt reports a record year: sales up by a fifth and a healthy profit. In December the bank refuses to renew the overdraft, suppliers demand payment on delivery, and by February the company cannot pay its staff. Profit was real; cash was not.

This is the lesson of financial risk: a company can be profitable and still fail, because failing means being unable to pay debts when they fall due. A strategic objective of every company is survival, alongside growth and return, and survival is measured by ratios of liquidity, working capital efficiency, gearing and solvency.

This topic explains what each measures, how to calculate them (the current and quick ratios, receivable, inventory and payable days, the cash operating cycle, debt to equity, interest cover), how they combine to show solvency, the signs of overtrading, and how to analyse and comment on them. It builds on the earlier topic on profitability ratios and financial performance measures. The next topic covers non-financial performance indicators.

Liquidity

Liquidity is having cash or access to cash to meet payments when they fall due: wages, suppliers, tax. A lack of liquidity also restricts flexibility, since a cash-short company cannot take new opportunities. From a strategic view, liquidity is judged by the ratios and, above all, by cash flow: where cash comes from and how it is used.

A company should obtain most of its cash from profitable operations; one that is loss-making and survives on borrowing or new share issues has a long-term liquidity question.

• Current ratio = current assets ÷ current liabilities. A ratio near or above 1.5 to 2 is often thought comfortable. But norms differ by industry: a supermarket sells for cash and pays suppliers on credit and works with a low ratio.
• Quick (acid test) ratio = (current assets − inventory) ÷ current liabilities. It excludes inventory, which is the least liquid current asset; a ratio near 1 is a common guide.

Working capital efficiency, gearing and solvency

Working capital days

• Inventory days = inventory ÷ cost of sales × 365: how long stock is held.
• Receivable days = trade receivables ÷ credit sales × 365: how long customers take to pay.
• Payable days = trade payables ÷ cost of sales (or purchases) × 365: how long the company takes to pay suppliers.
• Cash operating cycle = inventory days + receivable days − payable days: the time between paying for inputs and collecting from customers. A lengthening cycle needs more finance.

Longer inventory or receivable days tie up cash; shorter payable days use cash; taking excessive credit from suppliers to hide a cash shortage harms the relationship and is not good practice.

Gearing and debt

Gearing or debt levels are measured as debt ÷ equity or debt ÷ (debt + equity) (or debt to total assets). Interest cover = PBIT ÷ finance cost shows how comfortably profit covers interest. Highly geared companies are exposed to a large fall in earnings per share whenever operating profit falls, because interest is a fixed charge; and if they borrow at variable rates, a rise in interest rates reduces profit further.

High gearing increases the return to shareholders when times are good and the risk when they are bad. In an environment of low interest rates, many companies borrow heavily and become vulnerable if rates rise.

Solvency

Solvency is the ability to pay debts when they fall due. Short-term problems may be overcome by deferring payments. But strategically solvency is a long-term matter: if a company cannot pay its debts, major creditors may take legal steps to have it declared insolvent. It depends on a combination of:

• Profitability: a company may lose money in some years but cannot remain loss-making for ever.
• Liquidity: cash flow and profit are not the same; a profitable company can run out of cash, and a loss-making one can borrow for a time but not for ever.
• Debt: borrowing too much puts the company at risk if it cannot meet interest and capital repayments, especially if interest rates rise.

Overtrading

Overtrading means expanding sales faster than the finance available for working capital. The signs:

• rapid sales growth
• rising inventory and receivable days
• payable days stretched
• falling current and quick ratios
• a growing overdraft
• falling margins
• operating cash flow that is negative or small compared with profit

The cure is to raise long-term finance, slow growth, or improve control of working capital.

Layouts for liquidity and solvency analysis

1. Liquidity: current ratio; quick ratio.
2. Working capital: inventory, receivable and payable days; cash operating cycle.
3. Gearing: debt ÷ equity; debt ÷ (debt + equity); interest cover.
4. Cash flow: operating cash flow = profit + depreciation ± working capital changes.
5. Comment: trend, cause, risk, recommendation.

Days to one decimal place (365-day year); money in naira millions; each answer is rounded once, at the end.

Worked examples

1. Current ratio.
   Year 1: 2,200 ÷ 1,400 = 1.57.
   Year 2: 2,910 ÷ 2,100 = 1.39.
2. Quick ratio.
   Year 1: 1,300 ÷ 1,400 = 0.93.
   Year 2: 1,610 ÷ 2,100 = 0.77.
3. Inventory days.
   900 ÷ 8,400 × 365 = 39.1
   1,300 ÷ 10,500 × 365 = 45.2.
   Receivable days: 1,100 ÷ 12,000 × 365 = 33.5
   1,550 ÷ 14,500 × 365 = 39.0.
   Payable days: 800 ÷ 8,400 × 365 = 34.8
   1,000 ÷ 10,500 × 365 = 34.8.
4. Cash cycle.
   39.1 + 33.5 − 34.8 = 37.8 days
   45.2 + 39.0 − 34.8 = 49.5 days.
5. Gearing.
   Debt ÷ equity 2,500 ÷ 3,500 = 71.4%
   3,200 ÷ 3,700 = 86.5%.
   Debt ÷ (debt + equity): 41.7% then 46.4%.
   Interest cover 1,500 ÷ 250 = 6.0
   1,400 ÷ 400 = 3.5.
6. Comment. Sales rose by 21%, but PBIT fell. Liquidity worsened (current and quick ratios down, cash almost gone), the cash cycle lengthened by 12 days because stock and receivables grew faster than sales, and the overdraft nearly doubled. Gearing and the interest burden rose, and interest cover almost halved. This is the pattern of overtrading, with the growth financed by borrowing. Management should tighten credit and stock control, raise long-term finance, and watch the bank’s covenants.

1. Calculation.
   400 + 150 − 400 − 450 + 200 = −₦100m.
2. Comment. A profit of ₦400m produced a cash outflow of ₦100m from operations, which must be funded by borrowing. A company that expands this way will run out of finance unless profit turns into cash.

Expect variants: ratios for a service company with no inventory, comparison with the industry, questions on window dressing, and requirements to suggest ways to improve liquidity.

The working capital cycle for a manufacturer, using average balances

First find the cost of goods sold: materials used (opening + purchases − closing) + wages + production expenses, adjusted for opening and closing work in progress, then for opening and closing finished goods. Example (₦000): materials opening 50, purchases 400, closing 70, so used 380; wages 150; expenses 50; total 580. Work in progress opening 30, closing 40: production cost 570. Finished goods opening 40, closing 60: cost of goods sold 550. Sales 800; receivables opening 90, closing 110; payables opening 60, closing 80.

Using average balances and 365 days: raw materials (60 ÷ 400 purchases) × 365 = 54.75 days; work in progress (35 ÷ 550) × 365 = 23.2 days; finished goods (50 ÷ 550) × 365 = 33.2 days; receivables (100 ÷ 800 sales) × 365 = 45.6 days; less payables (70 ÷ 400 purchases) × 365 = 63.9 days. Cycle = 54.75 + 23.2 + 33.2 + 45.6 − 63.9 = about 93 days. To shorten it:

• hold less raw material (JIT)
• speed up production
• produce to order to cut finished stock
• collect faster (credit control, early settlement discount)
• negotiate longer supplier credit
• improve sales forecasting

Common mistakes

• Using revenue for inventory and payable days instead of cost of sales (or purchases).
• Including inventory in the quick ratio.
• Mixing definitions of gearing between years. Say which you use.
• Treating a high current ratio as always good. It may show idle cash or slow stock.
• Calculating without commenting.
• Confusing profit with cash.

Quick revision

• Current ratio; quick ratio; cash cycle = inventory + receivable − payable days.
• Gearing: debt ÷ equity or ÷ total capital; interest cover = PBIT ÷ interest.
• Solvency = profitability + liquidity + debt. Overtrading: growth faster than working capital finance.

How the marks are earned

• Calculation on the right bases.
• Trends and causes.
• Recommendations for liquidity and gearing.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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