The CIMA F1, F2 and F3 papers ALL consider financial ratios and how to interpret them. It can be a broad subject when looking at all types of ratios, their audience and how to draw meaningful conclusions from them.
Let’s take a look at the interested users and what type of financial ratios they would be concerned with.
I’ve highlighted the Suppliers user group and the working capital ratio as that’s the area I will focus on next. Generally speaking, though, there are TWO main areas for financial ratios:
- Financial Performance: ratios based on the income statement that can be split into profitability ratios and shareholder investment ratios.
- Financial Position: ratios based on the balance sheet (or SOFP), these can split into activity (day-to-day), liquidity (ability to meet current liabilities) and solvency (ability to meet long term debt) ratios.
Up next, I will look at the working capital cycle that a company’s suppliers (and management) would be interested in. This falls under the activity ratios in Financial Position as it’s concerned with current assets and liabilities.
Financial Position – Activity Ratios
The purpose of the working capital cycle is to ensure the business has enough cash to continue operations and produce goods. It involves managing the relationship between inventories and receivables (short term assets) against the payables (short term liabilities).
This ratio tells us how long (on average) a company holds on to their inventory. The higher the number, the more likely we are able to meet customer demands but this also means we are keeping capital tied up in inventory longer and this could cause obsolescence and wastage.
It’s calculated by dividing the inventory over the operating costs and multiplying it by 365 days. In the example below, you can see that the inventory days has improved in 2015 by 5 days, this is mainly due to holding less inventory in stock (43k from 60k).
Accounts Receivable Days
Much like the inventory days, this ratio will tell us (on average) how long a company takes to collect it’s receivables. The lower the number the better in terms of recycling cash back into the working capital cycle.
However, collecting the debt too quickly could cause a strain on the customer relationship so this factor needs to be considered.
It’s calculated by dividing the receivables balances on the SOFP over the total revenue for the year and multiplying it by 365 days.
Below, you can see the receivables balance has increased in 2015, so has the receivable days (up to 79), therefore this is a concern and should be addressed.
Accounts Payable Days
Again, the accounts accounts payable days ratio is calculated in the same manner as above. And the result is interpreted in the same manner too, but this time the higher the number, the more cash we will have on hand as we are paying our suppliers later.
Here the company should make sure they use their sensitising payment terms to the full extent without damaging the relationship with the supplier.
Again, it’s the mirror image of the above ratio and is calculated by dividing the payables balance in current liabilities over the total operating costs and multiplying it by 365 days.
Here you can see our working capital cycle will have improved as they are now taking 61 days to pay their suppliers rather than 45 days – which has a positive affect on cash flow.
Working Capital Cycle
Finally, the working capital cycle can be calculated now we have the above three ratios. To calculate it you need to do the following:
- Inventory Days + Receivable Days – Payable Days = Working Capital Cycle
Using all of the information above, you can see the working capital cycle has improved from 51 days in 2014 to 47 days in 2015.
This is despite taking longer to collect receivables in 2015 (79 days from 62 days), it appears the positive impact of taking longer to pay suppliers (61 days from 45 days) and holding less inventory in stock (29 days from 34 days) has improved the working capital cycle to 47 days.
Which fundamentally means, in 2015, it took 47 days to turn raw materials into cash. Meanwhile, these ratios above highlight the fact that this can be further improved if better credit control procedures are put into place to reduce the accounts receivable days from 79.