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Banking Work Shop 2
Justifying Concerns of Concerned Person 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
Step 2: Find the Acid Test
Step 3: Difficulty in Paying Debts?
Step 4: Impact of the BB on the Net Assets
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 PS40,000 and the current liabilities are PS20,000, the current ratio will be : 40,000 = 2:1 20,000A ratio of 1:1 would mean that the business has exactly PS1 of current assets with which to meet every PS1 of current liabilities. Most business would expect to have a higher ratio, say 1.5:1. 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 65,000 progress/prepayments) Debtors
120,000 Current Liabilities Creditors 40,000 Accruals
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 PS1 of readily liquid assets for every
PS1 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 liabilitiesThis test removes assets that may not materialiseLook 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 SheetQuestion: o Bad debts o Perishable stock o Work in progress amount could be over-inflated o Debtors figure could be over-inflatedProfit/Loss Reserve = reducedCash = reducedThis would damage the ratios further, meaning that liquidity could be a bigger problem
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