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YEAR 12 ACCOUNTING
Analysis and Interpretation
Liquidity
CLASSIFICATION OF
RATIOS/PERCENTAGES
Ratios/Percentages
Profitability
Liquidity
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Financial Stability
How to evaluate businesses’ results?
Please follow the steps as follows:
Calculate Percentages/Ratios
Explain the meaning of the Percentage/Ratios
Identify the trend
Unsatisfactory
Trend
Look at the financial
Satisfactory Trend
Look at the financial
statements and formula and
identify what has been
changed?
Why was there a change in
the financial statements?
statements and formula and
identify what has been
changed?
Why was there a change in
the financial statements?
Provide a recommendation/s to
overcome the unsatisfactory
trend.
Liquidity
Liquidity means the ability of a business
to repay short-term debts and to meet
unexpected needs of cash.
Short-term means within 12 months.
Measures of Liquidity
The following ratios are under the area of
Liquidity:


Current Ratio
Liquid Ratio
Current Ratio
Current Assets
Current Liabilities
Meaning:
BENCHMARK
2:1
It means for every $1 of current liabilities,
there are $X current assets available
to pay
the current liabilities in the next 12
months. It tells users that the
business is
able/unable to settle its debts
in the next
accounting period.
Example
If the current ratio in 2005 was 2.5:1. Try to write the
meaning of the ratio.
This means for every $1 of current liabilities, there
were $2.5 of current assets available to pay current
liabilities within the next 12 months. This tells
users that the business is ABLE to pay its debts
which are due within the next 12 months.
Calculation
2005
Current Assets
Cash on Hand
Bank
A/Receivable
Inventory
Prepayment
Current
Liabilities
Accounts Payable
Bank (secured
$1,000)
2006
500
3,000
12,000
500
N/A
10,000
20,000
800 36,300
18,000
600
15,000
14,000
N/A
15,000
4,500
29,100
18,500
Calculation
2005
Current
Ratio
36,300
 2.42 : 1
15,000
2006
Satisfactory/Unsatisfactory Ratio
The current ratio in 2006 showed a
SATISFACTORY or UNSATISFACTORY result.
The next step is to describe the reason with
using the Balance Sheet.
Identify the trend
The Current Ratio showed a
SATISFACTORY or UNSATISFACTORY trend.
Reason
Remember, we need to include the following
when providing reason/s:


Information from the financial
statements
Reasons behind the information (you need
to give an example)
Reason for trend (surface level)
The reason for the unsatisfactory ratio is there has
been a significant decrease in the bank balance (ie from
a positive balance to an overdraft).
Reason for trend (deep level)
An increase in the bank overdraft can be caused by the
following:



Excessive Cash Drawings by the owner;
Purchase of a piece of property, plant and
equipment for cash;
Repayment of a Non Current Liabilities
This answer is not good enough because
we have not yet answered WHY
Recommendations
To overcome this unsatisfactory ratio, either
INCREASE current assets or DECREASE current
liabilities, such as:





Purchase PPE by borrowing a long term loan (to
reduce the big outflow of cash suddenly)
Dispose of any old PPE to obtain cash
Owner’s can make an extra cash contribution
Reduce the level of cash drawings
Borrow a long term loan to ease the shortage of
cash
Is an over-high current ratio (like 5:1) a
good thing?
No, because this tells users that the business cannot
use its excess cash efficiently to generate further
income.
Excess cash means the amount of cash left over after
settling all liabilities due within the next 12 months.
Businesses should invest their excess cash into
investments, such as shares, term deposits etc to earn
interest.
Liquid Ratio
BENCHMARK
1:1
Liquid Assets
Current Assets - Inventory - Prepayment
Current Liabilitie s - Secured Bank Overdraft
Liquid Liabilities
Liquid Ratio measures a business’s ability to repay its
debts which are due immediately (i.e. within 2 – 3
months).
Meaning
This means for every $1 of liquid liabilities, there is
$X.XX of liquid assets available to pay liquid liabilities
within the next 2 – 3 months, which tells users that the
business is able/unable to repay debts which are due in
the next 2 – 3 months.
For example: Liquid Ratio in 2005 was 1.5:1. It means
for every $1 of liquid liabilities, there is $1.50 of liquid
assets available to pay liquid liabilities within the next
2 – 3 months, which means the business is ABLE to
repay debts which are due in the next 2 – 3 months.
Calculation
2005
Current Assets
Cash on Hand
Bank
A/Receivable
Inventory
Prepayment
Current
Liabilities
Accounts Payable
Bank (secured
$1,000)
2006
500
3,000
12,000
500
N/A
10,000
20,000
800 36,300
18,000
600
15,000
14,000
N/A
15,000
4,500
29,100
18,500
Calculation
2005
Liquid
Ratio
36,300 - 20,000 - 800
15,000
 1.03 : 1
2006
Satisfactory/Unsatisfactory Ratio
The liquid ratio in 2006 showed a
SATISFACTORY or UNSATISFACTORY result.
The next step is to describe the reason with
using the Balance Sheet.
Identify the trend
The Liquid Ratio showed a
SATISFACTORY or UNSATISFACTORY trend.
Reason for trend (surface level)
The reason of an unsatisfactory ratio is :


A high level of inventory on hand despite the level
of inventory of hand showing a decreasing
trend (inventory could not turn into cash in the
next 2 – 3 months) and
A significant increase in the bank overdraft.
(from a positive balance to overdraft).
Reason for trend (deep level)
Possible reasons for having too much inventory on hand:

Poor purchase policy, such as buying inventory
without double checking the level of stock on
hand.

Charge products at excessive high price, which
means people are less able to afford to buy the
products.
An increase in bank overdraft can be caused by the
following:

Excessive Cash Drawings by the owner;

Purchase of a property, plant and equipment by
cash;
Recommendations
To overcome an unsatisfactory ratio, can be achieved by the
following:

Purchase of PPE by borrowing a long term loan (to reduce the big
outflow of cash suddenly)

Dispose of any old PPE to obtain cash

Owner to contribute extra cash

Reduce the level of cash drawings

Borrow a long term loan for easing the shortage of cash

Sell inventory at a lower price to get rid of inventory

Review the purchase policy to ensure no excess inventory is
bought

Try to ask for a larger amount of secured bank overdraft