Business Capital

Stability/ Measures

Long Term Debt/Owners Equity (ROCE) = Debt/Equity Ratio

This ratio is a measure of the capital structure of the business. For example, It indicates what proportion of the capital is made up of long term loans and what proportion is made up of Reserves/ Issued Share Capita/Retained Earnings.

Using borrowed money, since it has to be repaid, increases the risk to the business. This ratio measures this risk. The higher this ratio, the greater the risk in so far as large interest payments must be paid regularly as will payments of the debt itself. Any figure higher than 1 is suspect.

Profit before Interest and Taxes/ Annual Interest Payments = Times Interest Covered

This measure shows the extent to which profits can decline before a business is unable to meet interest repayments. A figure of 5 is usually considered stable.

Many businesses get into trouble by purchasing goods which may never sell. This ratio examines the relationship between inventory and sales. A falling ratio would indicate that stock is not selling as well as previous periods.

Liquidity measures

Many profitable businesses have gone bankrupt because it lacked cash to pay bills. To avoid having capital tied up in assets which are not readily available to pay liabilities, a series of measures has evolved. These indicate to managers how liquid, ie, readily available or illiquid, hard to realise, their assets are when compared with their bills.

Current Assets/Current Liabilities

This measure is known as the Current or Liquidity ratio. A figure of 2 is regarded as safe. This means, that, even if only half of your current assets might be realised, you can still pay your bills. At this level current assets are around twice current liabilities.

This gives good assurance that the cash will be there to meet current liabilities as they fall due, however, any lower and the business owners run the risk of not being able to pay their debts on time with the consequent loss of goodwill. A high current ratio figure means money is being tied up in stock/accounts receivable/cash or obsolete stock and is an inefficient use of capital.

Current Assets less Inventory/Current Liabilities = Acid Test/ Quick Ratio

This  test ratio (also called the quick ratio) is a stricter test of liquidity as in excludes the effect of inventory from current assets. This is because inventory is the least liquid of current assets. 

An ideal level for this ratio is 1:1 or thereabouts. This level means short term assets are sufficient to meet short term liabilities without needing to sell any more inventory.  

Firms have different requirements for stock holding and compare it with competitors’ levels. The trend is important.

Trade CreditorsOverdraft


Current Assets/Current Liabilities = Current Ratio/ Liquidity Ratio

(15,000 + 20,000 + 40,000)/(40,000 + 25,000)

= 75,000/65,000 = 1.15

  • This would suggest an unacceptable level of liquidity of 1.15 and and there is an inefficient management of working capital. A figure of 2 is regarded as safe.

(Current Assets less Inventory)/Current Liabilities = Acid Test/ Quick Ratio

= 55,000/65,000 = 0.84

  • As the figure is below 1.0, the financial position would need to be addressed immediately, improvements are needed. It will depend on the business.

The following are suggestions to improve the liquidity of a business:

  • Ensure payments from debtors are paid before paying trade creditors.
  • Operate on a cash sales basis only if possible.
  • Maintain bank overdraft at a low level to reduce current liabilities.
  • Reduce stock levels to free up cash flow for the business.
  • Some businesses, such as supermarkets, sell everything for cash and do not pay their trade creditors for weeks.
  • They are known as positive cash flow businesses. Other businesses, i.e. jewellers, may have stock in inventory for months. When these products are sold, a high profit is generated. The original supplier has to be paid – example of negative cash flow business

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