Business Capital

Accounts Receivable /Credit Sales x 365 = Collection Period

This measure examines not only aspects of liquidity but also provides a check on management. It is easy to generate sales by offering long periods of credit. This ratio measures the average length of time taken by debtors to pay their bills. A figure of over 60 days should be investigated. A falling ratio indicates stock is not selling as well as previous time periods.

Cost of Sales/ Average of Opening and Closing Stock/Inventory = Stock Turnover

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

Cash Flow

This simply means the amount of money received by a business in a fixed time period. The stronger the cash flow position, the more liquid the business.

Example

The following are the figures for X Company Ltd. 2020:

X Company	2020 (euros)
Authorized Share Capital	800,000
Issued Share Capital	350,000
Long Term Loans	180,000
Retained Earnings	160,000

1. Explain the term debt /equity?
2. Calculate the debt/equity figure for this company?
3. Discuss the importance of debt/equity when deciding new sources of finance for the X company?
4. What are the limitations of using ratios to analyse the final accounts of a business?

Answer

1. 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.

2. Debt/Equity Ratio = Long Term Loans/Retained Earnings + Issued Share capital

180,000/( 350,000 + 160,000) =180,000/510,000 = 0. 35: 1

3. Using the ratio: Debt/Equity Ratio, a figure of 0.35: 1, shows the the company’s debt is less than their equity and therefore is a lowly geared business.

Raising finance through additional borrowing as it is does not have too many existing loans or selling more shares is an option for the company going forward.

Most of the capital has been provided by the owners in the form of share capital and retained earnings.  The owners can raise further capital by issuing shares.  For example, they can issue 450,000 more shares ( Authorized Share Capital , 800,000 – Issued Share Capital, 350,000).

4. Limitations:

• Assets may not be shown at their true value.  Ratios are based on past figures and do not represent future performance  figures.
• Final Accounts only hold for a certain year.  Balance Sheets are only
  good for the day they are written.
• The external business/economic environment – are not taken into account – competition/recession, product/brand strength. 
• Inflation/deflation make the comparison of ratios from one period to another unreliable. Figures will need to be adjusted accordingly.
• Different accounting policies may be used from one year to the
  next.