Module 1 of 1 · 60 minutes
Profitability, liquidity, efficiency and gearing
By the end of this module you will be able to
- Calculate the core ratios in each family
- Interpret a ratio against the right benchmark
- State the limitation of each ratio
- Spot period end window dressing
Amara Give me the one ratio to look at if I only have thirty seconds.
Nadia For survival, interest cover. Operating profit divided by interest payable. It tells you whether the business earns enough to service its debt, and it is the first number a lender turns to.
Amara And everyone tells me the current ratio should be two to one.
Nadia Everyone is repeating a textbook from decades ago. Ask a supermarket. They run far below that and are entirely safe, because they take cash at the till and turn their stock over in days.
Amara So the rule is wrong.
Nadia The rule is contextless, which is worse than wrong because it sounds authoritative. There are only three comparisons worth making: this business last year, this business against its budget, and this business against its sector.
Amara You mentioned that ratios can be dressed up.
Nadia Routinely, and mostly legally. Your year end is the thirty first of March. Hold back supplier payments until the first of April and your cash looks healthier and your current ratio improves. Nothing real changed. You just chose which side of a date things landed.
Amara How do I see through that?
Nadia Look at several periods rather than one, and ask what moved in the fortnight either side of the date. A business with a genuinely strong position looks strong in a trend. A dressed up one looks strong exactly once a year.
Amara Last one. Return on capital employed.
Nadia The most complete profitability measure, because it holds management to what they were given. Operating profit over the capital in the business. Two firms both earning a million tell you nothing until you know one used five million to do it and the other used fifty.
The written material
Why ratios exist
An absolute number carries no meaning without a denominator. Profit of two million pounds is exceptional on ten million of capital employed and dismal on two hundred million. The ratio supplies the denominator.
Ratios fall into four families answering four questions: are we making money, can we pay what falls due, are we using our assets well, and how much of this business is funded by debt.
Reading them honestly
Every ratio needs a comparison to mean anything, and there are only three worth using: the same business in the prior period, the budget it set itself, and its own sector. A ratio compared to a remembered textbook figure is noise.
Sector matters more than people expect. A supermarket runs on liquidity figures that would terrify a manufacturer, because it takes cash at the till and sells its stock in days, while the manufacturer waits months for both.
What a ratio cannot see
Ratios are calculated from a single date or a single period, and both can be arranged. Delaying supplier payments until after the year end improves the cash figure and the current ratio without anything real having changed. Pushing a delivery into the next period reduces stock days.
None of this is necessarily fraudulent, and much of it is ordinary year end housekeeping. It is simply a reason to read a trend across several periods rather than one immaculate snapshot, and to ask what happened in the fortnight either side of the date.
Knowledge check
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The learning itself stays free and open. You are reading all of it right now without an account.