How to calculate liquidity and efficiency ratios

Analysis and Interpretation of Financial Statements for Decision Making

What you need

• A completed Income Statement to obtain cost of sales, credit sales and opening inventory.
• The Statement of Financial Position for the list of current assets and current liabilities.
• Opening and closing inventory values to calculate average inventory.
• The formula for each ratio and a calculator for accurate calculation.

Step by step

1. 1

   Gather data from the financial statements

   List all figures needed from Perniagaan Setia's statements for the year ended 31 December. From the Statement of Financial Position: current assets are closing inventory RM10,000, debtors RM12,000 and cash RM8,000 (total current assets RM30,000); current liabilities are creditors RM10,000 and bank overdraft RM5,000 (total current liabilities RM15,000). From the Income Statement: cost of sales RM120,000, credit sales RM73,000 and opening inventory RM14,000. Set these figures out first so you do not make mistakes when calculating.

2. 2

   Calculate the current ratio

   Use Current Ratio = Current Assets / Current Liabilities. For Perniagaan Setia, current ratio = RM30,000 / RM15,000 = 2. State it as 2:1, meaning every RM1 of current liabilities is backed by RM2 of current assets. This shows a satisfactory liquidity position, as a ratio of about 2:1 is generally considered healthy.

3. 3

   Calculate the acid test ratio

   Use Acid Test Ratio = (Current Assets - Closing Inventory) / Current Liabilities, because inventory is the slowest current asset to turn into cash. For Perniagaan Setia = (RM30,000 - RM10,000) / RM15,000 = RM20,000 / RM15,000 = 1.33. State it as 1.33:1. Since the ratio exceeds 1:1, the business can still settle its short-term debts without relying on selling inventory.

4. 4

   Calculate the rate of inventory turnover

   First find average inventory = (Opening Inventory + Closing Inventory) / 2 = (RM14,000 + RM10,000) / 2 = RM12,000. Then use Rate of Inventory Turnover = Cost of Sales / Average Inventory = RM120,000 / RM12,000 = 10 times. This means Perniagaan Setia's inventory is sold and replaced 10 times a year; the higher this figure, the more efficient the inventory management.

5. 5

   Calculate the debtors' collection period

   Use Debtors' Collection Period = (Debtors / Credit Sales) x 365 days. For Perniagaan Setia = (RM12,000 / RM73,000) x 365 = 60 days. This means the business takes 60 days on average to collect debts from its debtors. Remember to use credit sales, not total sales.

6. 6

   Interpret the result of each ratio

   Compare each ratio with a benchmark or the previous year. A current ratio of 2:1 and acid test of 1.33:1 indicate good liquidity. Inventory turnover of 10 times shows inventory moves quickly. A collection period of 60 days is rather long; if the credit terms granted were 30 days, debtors are paying late and this may strain cash flow.

7. 7

   Draw a conclusion and make recommendations

   Summarise the findings concisely. Perniagaan Setia has a strong liquidity position and efficient inventory management, but debt collection needs improvement. Recommend actions such as offering cash discounts for early payment or tightening credit terms to bring the collection period closer to 30 days and improve cash flow.

Second example

Now compare with Kedai Harmoni. Its current assets are closing inventory RM10,000, debtors RM6,000 and cash RM2,000 (total RM18,000), while its current liabilities are RM20,000. Current ratio = RM18,000 / RM20,000 = 0.9:1, which is below 1:1. Acid test ratio = (RM18,000 - RM10,000) / RM20,000 = RM8,000 / RM20,000 = 0.4:1. Both ratios indicate weak liquidity because current assets (and liquid assets) are not enough to cover current liabilities.

This means Kedai Harmoni may struggle to pay its short-term debts as they fall due. A large part of its current assets is tied up in inventory worth RM10,000, so when inventory is removed for the acid test, the position looks even more worrying. The owner should raise cash, reduce short-term borrowings or speed up debt collection to improve liquidity.

Common mistakes

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