Finance Coursework?

Question

Hey, I am currently doing Business finance coursework and need a problem resolving

How does one use ratio analysis to monitor the liquidity of a business and what is the importance of this? Also what are typical creditor and debtor payment periods?

Answer 1

Ratio analysis is a "dashboard" for checking a company's liquidity. For example, the current ratio (i.e. current assets/current liability) indicates whether or not the company owes more things over the next 12 months than it can fund from its short term balance sheet.

No ratio is perfect in monitoring a situation since there are so many variables that go into liquidity. For example, can the company fund itself from its ongoing operations. Are the short-term assets liquid and does the book value represent market value? Do the short-term liabilities represent something that needs to be paid out or can it be funded in perpetuity by rolling it over (e.g. vendor financing)?

Thus, more ratios are needed to get a portfolio of various meters (e.g. cash interest coverage: EBITDA/interest expense is a short-hand to see if the business' ongoing cash flows can fund its debt burden).

The ratios are important because they enable managers to quickly identify if there is a problem, where the problem is and potentially prevent a problem from becoming critical.

Creditor and debtor payments are going to vary from industry to industry. For example, if you are the power company - you give credit to your customers in 30 day increments (i.e. monthly billing) and vendors (e.g. coal, fuel oil, uranium processors) generally want to get paid on delivery. Meanwhile, consumer products generally give 30 day credit and demand 90 days as an industry norm. Others have very long payment cycles. For example, if you're working on a construction project, sometimes credit is extended for more than a year. If you were to average it out it's about 90 days credit on both side (remember, someone's credit is another person's debit).

Answer 2

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