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Importance of financial stability indices

Common ratios for judging a company’s financial stability are the leverage ratio, the current ratio, and the liquidity ratio. The leverage ratio shows how dependent a company is on debt to finance its activities. As the ratio of debt increases (especially if it exceeds 65 percent of total funds for most businesses), the greater the risk of financial distress. This is the disadvantage of financial leverage: it increases financial risk.

The current ratio measures the number of times a company’s current assets cover its current liabilities. This is a measure of solvency: a company’s ability to pay off its debts through the normal cash cycle, selling inventory on credit, collecting debts, and paying creditors. This ratio should normally exceed 1:1 and should be closer to 2:1. It should also be noted that an excess of current assets will result in poor asset utilization.

The liquid or quick ratio is a more stringent measure of short-term financial stability. It measures the company’s ability to pay its current liabilities from its liquid assets. Liquid assets are cash or quasi-cash resources. In practice, liquid assets include cash, banks, short-term securities, and accounts receivable, assets that can be readily converted to cash to meet immediate payment requests from lenders and vendors.

Accounts receivable are normally included in liquid assets as they can be sold to a finance company at a discount for later collection from debtors. This is called debt factoring. Debt factoring is not common in all countries. Debt factoring is used as a means of managing cash flow from operations, rather than testing the entity’s funds in accounts receivable. Coming to liquid assets, the main exclusion from current assets is inventory. As this can take a few months to sell, and then often to credit customers, it can take many months before the inventory cash is collected. Among the current liabilities there may be some debts that may not be due for many months. These can be excluded in the calculation of the liquidity ratio. Examples include taxes due and a current portion of long-term debt, both of which may not be due for a few months. However, such adjustments should only be made if the repayment dates are known and are more than six months after the balance date.

A common (but risky) adjustment in the calculation of the liquidity rate is to exclude the bank overdraft from current liabilities. This is not recommended. When a liquidity ratio drops to (or below) the 1:1 level (including overdraft), this is the most likely time the bank will require repayment, upon request. Therefore, an overdraft should only be left out of this calculation when the business is perfectly liquid, when it doesn’t matter anyway!

Since these ratios are based on the statement of financial position, they represent only a “snapshot” of the company’s financial stability, taken at a given point in time. These rates can be manipulated by remitting payments or delaying purchases until the next period, or by billing customers before delivery. Known as ‘window decoration’, these techniques show an improved solvency position at the balance sheet date.

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