Liquid refreshment

In last month’s column I introduced the concept of duality financial record-keeping, and I identified the purpose of the balance sheet and the profit and loss account. I went on to consider how ratio analysis may be used to assess a company’s performance.

There are many ratios, each designed to illustrate a different aspect of a company’s solvency, efficiency, profitability or liquidity. Here, we limit ourselves to those ratios that deal with a firm’s liquidity.

There are three types of liquidity ratio: the current ratio, the quick or ‘acid test’ ratio and the defensive interval ratio.

Current ratio

This provides a measure of the degree of cover available against short-term demands from creditors for repayment.

It is found by dividing the total current assets by the total current liabilities. By current, we mean those items that fall due within the annual trading cycle. By its very nature, current assets would exclude the fixed assets of any buildings, but would include cash, stocks and trade debtors.

Current liabilities is the value of the amounts owing to the suppliers of goods or services, overdrafts and any dividends intended but not yet paid. A ratio of about 1.5 gives an indication of stability and means a firm could cover its liabilities one-and-a-half times over.

Quick ratio

This provides a more searching test of the company’s liquidity and, accordingly, you would expect the figure to be lower.

Most firms would look for unity – a score of 1.0 – but as construction companies usually have a relatively large amount of working capital tied up in work-in-progress and stocks, results nearer 0.8 are more likely.

The quick ratio is calculated by reducing the current assets figure used in the previous ratio by the value of any stocks. Stocks are of three kinds: raw materials, work in progress (WIP) and finished goods.

The way in which WIP is accounted for changed in the spring of 2006 when the Accounting Standards Board stipulated that accrued costs must be shown, as must the ‘attributable value’.

This ruling ignored the fact that it would be impossible to register certain income, and so it would not be possible to incorporate profit and tax. Comparisons, year on year, need to be judged accordingly.

Finally, if a company increases its trading profile, great care must be taken to ensure the quick ratio does not deteriorate, as this is a sure indicator of a company trading itself out of business.

Defensive interval

Normal business contingency planning rules would require every company to consider the effect of the early termination of an on-going project due to client insolvency. While this may be best expressed in financial terms, there is also a need to have in place policies and procedures to cover the physical consequences of having to leave site early and in an unplanned manner.

To determine just how long a business could survive strangulation of its incoming cashflow, it is necessary to divide the liquid assets, which is predominately the available cash, by the costs of the daily operating expenses.

Periods of less than 30 days would indicate that the business is critically weak, and an excess of 90 days would suggest it was poorly managed.

As the current economic downturn sets in, watching for impending signs of insolvency takes on an increasing importance.

Contracts that entitle the payer to rely on Section 113 of the Construction Act should be avoided. Be wary of significant changes made to the scope of the works, and treat any request for delayed payment with extreme caution.

Finally, if all this is too much to contemplate, organisations such as Experian and Dun & Bradstreet can deliver a credit check service. Good trade associations will offer this service to their members at a reduced charge. All that is required is a regular basic financial report.