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HMRC internal manual

Enquiry Manual

Examining Accounts: Business Ratios: Liquidity and Loans

You might consider the short-term liquidity position of the business as part of your evaluation. Two ratios are commonly used. Both are a measure of the trader’s ability to pay his or her outstanding business debts:

  • Current Assets / Current Liabilities = Current Ratio
  • Current Assets - Stock / Current Liabilities = Quick Ratio

 Current assets include cash in hand and at the bank, easily realisable investments, debtors and stock. Current liabilities include all creditors where payment is due within one year, bank overdrafts and short-term loans, and any other short-term payments due.

The ratio will depend on the nature of the business and may also vary between traders in a similar line of business. If the trade requires a higher level of stock to be held and the granting of generous credit terms the current ratio would need to be higher. A business which generates a high proportion of cash sales from a large turnover could get by on a lower ratio.

A ratio of less than one indicates that the business is illiquid - unable to meet these liabilities from readily available funds. A ratio only a little above one may give cause for concern as there may be insufficient working capital for the business to function properly. Figures substantially greater than one may also give cause for concern where a large proportion of the current assets are debtors and there is a long debtors collection period EM3083 - some of these debts may become bad. In this situation, the figure for the value of debtors may well overstate the true position and the apparently good liquidity ratio is actually less healthy than it first appears.

If a business seems to have been insufficiently liquid for some years, it may be worth establishing what action has been taken by the proprietors to improve the position. One possible reason for any lack of concern or action is that the proprietors know the profits of the business have been greater that those shown by the accounts from which you have calculated these ratios.

(This content has been withheld because of exemptions in the Freedom of Information Act 2000)

(This content has been withheld because of exemptions in the Freedom of Information Act 2000)

Outstanding loans

It is also worth considering the ratio of loans to assets:

  • Outstanding Loans / Net Assets = Borrowing Ratio

Banks and Finance Houses require security for their loans. If there is no apparent security in the balance sheet it suggests that the directors or proprietors are putting forward personal assets as security. This can give some indication of their personal wealth.

Banks make extensive use of cash flow forecasting. If a business is illiquid then it is likely that the owners have had to convince the manager that it will be generating sufficient cash to repay loans and interest. The figures used in such assumptions may not tally with the figures in the accounts, and this point may repay consideration if a case is taken up for investigation. Certainly it could be something to raise at any meeting - if the explanations are unconvincing, the forecasts may be worth seeing. Of course, it is possible that the manager has seen a healthier set of accounts than has been shown to HMRC!