Teachers Network
Balance Sheets
Home
Home
     
 
 

Ratios

The Current Ratio

The current ratio is a measure of liquidity. It helps us to answer the question: 'If a business had to pay off all its current liabilities tomorrow, would it have enough current (liquid) assets to make the payments and avoid insolvency?

All you do is divide current assets by current liabilities, as shown below.

If the current ratio is less than 1, the business has more current liabilities than current assets - it is in danger of failure.

If the ratio is high, perhaps above 2, the business has more than enough current assets. It might be a good idea to use some of the value to buy fixed assets or increase employment and try to improve business efficiency.

The ideal current ratio is between 1 and 2 - just enough to be getting on with.

Looking at the Dagenham Duvets current ratio, we can see that the business is certainly liquid. In fact, with £15,000 in the bank and such few current liabilities, it might want to pay-off some of its loan or run a marketing campaign to boost sales.


The Acid Test Ratio

The current ratio says 'can we pay our current liabilities by liquidating our current assets?'

The acid test ratio asks the more interesting question of 'what if nobody will buy our stock? Can we still pay our short term debts with our other current assets?'

As you can see, we look at current assets without stock. This is a sensible approach - a business with liquidity problems might also be a business that can't sell its product easily.

The same guidelines apply to this ratio as to the current ratio - it's ideally between 1 and 2.

Again, Dagenham Duvets are secure. They could use their current assets, excluding stock, to pay their short term debts 12 times over. Perhaps it's time to use that cash for something better.


Return on Capital Employed

This final ratio is not a measure of liquidity but of profitability and general performance.

Return on capital employed asks how successful the business has been at making profit based on the money put in by the owners. It is a percentage, like the gross and net profit margins, and as with them, the higher it is the better.

The figures you need are net profit, which comes from the profit and loss account, and capital. The figure used for capital is the value of the money invested by the owners plus the retained profit kept by the business.

Assume that Dagenham Duvets had a net profit for the year of £1,300. That would mean that a business that was sitting on £204,000 of owners' money produced a profit of only £1,300. That's 0.6%.

If you were an owner or shareholder, you'd probably be a little upset with that figure - you could have earned more by leaving your money in a bank. 0.6% may not be bad in some situations - perhaps the whole economy had a bad year, perhaps the business is looking to grow in the long term, etc but it's not exactly a world record.

Again, the higher the value the better. It's useful to compare the ROCE ratios of different companies if you are thinking about buying shares - which company has the manager who is most likely to turn your investment into profit (which will be your reward)?


 
Now You Try...
 
 
     
Concepts | Assets | Liabilities | Capital | Ratios | Challenges