While being only one of many factors that should be considered when assessing a company’s solvency, Ratio Analysis is a quick and simple process that can be applied on a regular, ongoing basis by business owners and their bookkeepers.  Financial ratios can assist with the early identification of issues that, if left unaddressed, may lead to insolvency.  They can also be the wake-up call some business owners need to realise that immediate action needs to be taken.

What is Ratio Analysis?

In simple terms, ratio analysis involves the use of balance sheets and/or profit and loss figures to calculate various aspects of a company’s financial performance. By comparing different financial figures, you can gain insights into a company’s profitability, liquidity, solvency, and overall financial stability. Ratios are typically categorised into profitability ratios, liquidity ratios, leverage ratios, and efficiency ratios.  This web page considers three relatively simple liquidity ratios to allow a quick preliminary look at a company’s financial health.

Three Simple Liquidity Ratios for Assessing Financial Health

1 – Current Ratio:

Current Ratio = Current Assets / Current Liabilities

A ratio above 1 indicates that a company has more current assets than current liabilities.  This suggests likely good short-term financial health, however, all ratios should used with caution.  If the current liabilities are due to be paid in the short term where the current assets are not due to be realised/received until a later point in time a company could find itself unable to pay its debts as they fall due, i.e. insolvent, even with a healthy current ratio.  Worse still, if debtors included in the current assets are long overdue, that is a clear sign that they may not be collectable and should be excluded from the current asset amount.

2 – Quick Ratio:

Quick Ratio = (Cash and Cash Equivalents + Accounts Receivable + Marketable Securities) / Current Liabilities

This is similar to the current ratio however it excludes inventory/stock, providing a more conservative measure of short-term liquidity.  Most small companies will not have readily available marketable securities so only cash, cash equivalents and accounts receivable asset items are available. As for the current ratio, if the accounts receivable items cannot be realised in time to pay the current liabilities as they fall due, or they turn out to not be realisable at all, a healthy quick ratio can hide imminent or current insolvency.

3 – Cash Ratio:

(Cash + Marketable Securities) / Current Liabilities

For many companies, this can be a very difficult ratio to score over one for.  Again, most small companies will not have readily available marketable securities so this is a test of if the company has enough cash in the bank to pay all its current liabilities.  While this test is very harsh and may be impractical in many industries, a score of over one at least indicates that the company is well able to pay its current liabilities as it has the cash readily available to do so.

Identifying Insolvency Risk through Ratio Analysis

Deteriorating Liquidity Ratios

A sudden decline in the above ratios may indicate difficulty in meeting short-term obligations, a potential precursor to insolvency.  In the absence of a sudden and catastrophic financial event, most often it is the gradual deterioration in the ratios over time that will tell of impending difficulties.  This is why a monthly comparison of the month just ended to the past twelve or more months of ratios should be an end-of-month must-do process for every business owner and their bookkeeper.

Are the asset numbers correct?

For the Current and Quick ratios, it is crucial to consider if the accounts receivable and other assets included in the formula are collectable in the same time periods that the current liabilities are payable, and, for overdue accounts receivable whether they are collectable at all.

Conclusion

Ratio analysis is a valuable tool for monitoring a company’s financial health and identifying potential insolvency risk. Regular monitoring of key ratios allows business owners and company directors to make informed decisions and take corrective actions when necessary. By understanding and reviewing the above ratios on a regular basis, business owners will have visibility of the relative solvency of their business over time.

Do remember that while ratios provide valuable insights, they are just one part of a comprehensive financial analysis and the above are just three of many ratios that should be used in conjunction to gain a full picture of a company’s financial performance.  There are many other factors to consider when evaluating a company’s overall financial stability and potential insolvency risk.  Please do not hesitate to contact Rodgers Reidy today should have any concerns about the financial position of your business and would like an expert opinion on the position and the options available to you.  Early action in this regard is likely to provide a greater number of options to choose from and a greater prospect of success of achieving the outcome you desire.