BUSF_A01.qxd

Ratio analysis

credit policy will lead to them taking as short a time as possible to pay, without dam-

aging good customer relations.

Settlement period for trade payables (days trade payables) ratio

×365 days

Assuming that all of the purchases are on credit and that the trade payables relate only

to purchases of raw materials inventories, the ratio for Jackson plc for 2008 is:

× 365 =64.4 days

This ratio tells us how long, on average, following a purchase on credit, the busi-

ness takes to meet its obligation to pay for the goods or service bought. A well-man-

aged trade payables policy will lead to as much ‘free’ credit being taken as possible

without damaging the goodwill of suppliers.

The management of inventories, trade receivables and trade payables (and cash) is dis-

cussed in some detail in Chapter 13.

Liquidity ratios

Liquidity ratios are used to try to assess how well the business manages its working

capital.

Current ratio

The ratio for Jackson plc for 2008 is:

=1.96 : 1

Note that this ratio is usually expressed by stating the amount of current assets per £1

of current liabilities.

The current ratio provides some measure of how the balance has been struck

between the two aspects of working capital. Usually, businesses seek to have current

ratios higher than 1 : 1, that is, they try to avoid having current assets financed entirely

from current liabilities. In this way they hope to give the short-term creditors (for

example, trade payables) confidence that there are sufficient liquid assets comfortably

to cover their claims.

Rule-of-thumb figures for this ratio tend to be bandied about in the literature and

in financial management folklore, a popular figure being 2 : 1. In fact, actual figures

tend to vary widely but there seem to be characteristic figures for different industries.

The high street supermarket chains typically seem to have ratios below 1 : 1, whereas

176

90

Current assets

Current liabilities

45

255

Trade payables

Credit purchases