#10304 - Ratios Justifying A Persons's Concerns

A Question asking you to consider a D’s or S’holder Concerns and whether they are justified ones

Step 1:

Find the Current Ratio

Is a direct comparison of current assets with current liabilities. I measure the assets which can be turned into cash relatively readily in order to meet liabilities which must be paid within 12 months. The result is expressed as a ratio:

__Current assets__ : 1

Current liabilities

So if the current assets are 40,000 and the current liabilities are 20,000, the current ratio will be :

40,000 = 2:1

20,000

A ratio of 1:1 would mean that the business has exactly 1 of current assets with which to meet every 1 of current liabilities. Most business would expect to have a higher ratio, say 1.5:1.

Step 2:

Find the Acid Test

The Current ratio takes into account all of the current assets. Closing stock may not be quickly saleable. The Acid Test is the ratio between current liabilities and current assets excluding stock (or work in progress in a non-trading business). The Acid Test Ratio omits stock from current assets because of the difficulty in converting stock into cash quickly.

Current Assets – Closing Stock : 1

Current Liabilities

Prepayments form the current assets figure are also excluded as these represent amounts already paid by the business, their very nature means that they cannot usually be converted back into cash.

Current Assets
Stock (Work in progress/prepayments)	65,000
Debtors	+50,000
Cash	+5,000
	=	120,000
Current Liabilities
Creditors	40,000
Accruals	+10,000
	=	<50,000>
Net Current Assets		70,000
The Acid Test is: 120,000 – 65,000 = 1.1:1 50,000

An acid test of 1:1 means that the business has 1 of readily liquid assets for every 1 of current liabilities. The lower the ratio, the greater the risk of the business being unable to meet its debts as they fall due. However, even a high ratio needs to be considered critically. The business may not be pursuing its debtors rigorously, or may not have written off sufficient bad debts.

We want a 1:1 minimum, meaning you can meet liabilities
This test removes assets that may not materialise

Step 3:

Difficulty in Paying Debts?

Look at the balance sheet to compare Cash to Short Term Trade Creditors and ask whether it has difficulty in paying its debts. Look mainly at the configuration of the Balance Sheet
Question:
- Bad debts
- Perishable stock
- Work in progress amount could be over-inflated
- Debtors figure could be over-inflated

Step 4:

Impact of the BB on the Net Assets

Profit/Loss Reserve = reduced
Cash = reduced
This would damage the ratios further, meaning that liquidity could be a bigger problem

Step 5:

Are Concerns Justified?

Always apply to the facts (Not getting a potentially Hostile/conflictive 3^rd party might be good)

Ds Must have regard to s.172(1)(act in Best interest of the Co.))(Look at Director’s Duties Notes)

It might be good for the Co. that the leaving Partner is leaving as he is not happy/ is irresponsible and thus the Co. may be more stable as Ds will have more freedom to make decisions/flow
We might be getting a good deal, they asked for 1 million and we actually sold them for 500k
Remember that Balance Sheet is only a snapshot of one day
What are the future prospects?
E.g. concerns are justified because with the low-level of liquidity following a decrease in cash to X, there would be pressure placed if all the money went on a buy-back

Step 6:

Improve Liquidity

Can an asset be sold?
Issue fresh shares?

Justifying Concerns of S’holder, Worked out

Task 1 Issue Two (b): ¿Are Francine’s concerns justified regarding the issue of shares?

Step 1: Find the Current Ratio	2,372,000 = 0,87:1 2,723,000 We wanted a 1.5:1 minimum This mainly means that Hampton Graphics Ltd has exactly 0,87p of current assets with which to meet every 1 of liabilities. This means that the company’s liquidity is low and will not be able to meet its liabilities relatively readily if the become due within the next 12 months.
Step 2: Find the Acid Test	2,122,000 = 0,77:1 2,723,000 We wanted a 1:1 minimum, meaning you can meet liabilities This test removes assets that may not materialise. The lower the ratio, the greater the risk of the business being unable to meet its debts as they fall due. However, even a high ratio needs to be considered critically. The business may not be pursuing its debtors rigorously, or may not have written off sufficient bad debts.
Step 3: Difficulty in Paying Debts?	By look at the balance sheet and comparing the Cash (1,350,000) to Short Term Trade Creditors (2,473,000) shows that it will be difficult to meet short term debts. This is further confirmation of the Acid Test and the Current Ratio Test as above. There is not enough cash available to repay short term debts.
Step 4: Impact of the Buy-back on the Net Assets	The Profit and Loss Reserve will be drastically reduced. A similar thing will happen with Cash which will be reduced. As I noted above there is not enough cash to pay back short term liabilities. This would damage the ratios further, meaning that liquidity could be a bigger problem
Step 5: Are Concerns Justified?	...

Step 1:

Find the Current Ratio

2,372,000 = 0,87:1

2,723,000

We wanted a 1.5:1 minimum

This mainly means that Hampton Graphics Ltd has exactly 0,87p of current assets with which to meet every 1 of liabilities. This means that the company’s liquidity is low and will not be able to meet its liabilities relatively readily if the become due within the next 12 months.

Step 2:

Find the Acid Test

2,122,000 = 0,77:1

2,723,000

We wanted a 1:1 minimum, meaning you can meet liabilities

This test removes assets that may not materialise. The lower the ratio, the greater the risk of the business being unable to meet its debts as they fall due. However, even a high ratio needs to be considered critically. The business may not be pursuing its debtors rigorously, or may not have written off sufficient bad debts.

Step 3:

Difficulty in Paying Debts?

By look at the balance sheet and comparing the Cash (1,350,000) to Short Term Trade Creditors (2,473,000) shows that it will be difficult to meet short term debts. This is further confirmation of the Acid Test and the Current Ratio Test as above. There is not enough cash available to repay short term debts.

Step 4:

Impact of the Buy-back on the Net Assets

The Profit and Loss Reserve will be drastically reduced.
A similar thing will happen with Cash which will be reduced. As I noted above there is not enough cash to pay back short term liabilities.
This would damage the ratios further, meaning that liquidity could be a bigger problem

Step 5:

Are Concerns Justified?

...

#10304 - Ratios Justifying A Persons's Concerns - Finance and Capital Markets

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