Ratios of the Cash Elasticity of Current Assets

Ratios of the cash elasticity of current assets

Given that current assets normally consist of cash, debtors and inventories, the firm's ability to meet current liabilities depends upon the rate at which cash flows into the firm from current operations. Since sales is the critical event in this respect, the rate at which inventories are sold is clearly crucial. Where a substantial proportion of sales are on credit terms, the rate at which debtors settle their accounts is also crucial. For these reasons, the following ratios are good indicators of the cash elasticity of current assets:

(i) average inventory turnover

(ii) collection period of trade debts.

(i) The average inventory turnover is calculated by the following formula: Cost of goods sold during the Average inventory held

The average inventory turnover ratio is only a crude measure of the rate at which inventories are sold for the purpose of comparing the cash elasticity of inventories of different enterprises. Different marketing situations face different industries and trades. A butchery will clearly have a much higher inventory turnover rate than a firm selling luxury goods. Methods of inventory valuation will also distort the significance of inter-firm comparisons.

Nevertheless, the average inventory turnover may give a useful indication of trading difficulties facing a particular firm by comparing it with the average inventory turnover for previous periods. A fall in the average inventory turnover may indicate stiffening competition, adverse marketing circumstances or a degree of obsolescence in the firm's products. At the same time, firms operating in similar markets may be expected to have roughly similar average inventory turnover ratios, so that even as a crude ratio of comparability, it may be a useful indicator for investors. In fact, since cost of sales are not disclosed, analysts use sales figures as the numerator in this ratio.

(ii) An important measure of the cash elasticity of debtor balances may be obtained from the average collection period of trade debtors. The first stage is to establish the average amount of credit sales per day, which may be obtained by the following formula:

Average credit sales per day = Total annual credit sales

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Short-term solvency

Although shareholders bear the ultimate risk of losing their capital in the event of insolvency, unsecured creditors likewise run the risk of financial losses. In the face of a deteriorating financial situation, long-term creditors, such as debenture-holders, may either attempt to realize their security by selling specific assets mortgaged under the debenture instrument, or they may be willing to hold their hand if a viable rescue operation is mounted. Short-term creditors such as trade creditors are generally not willing to allow credit to a firm which is running into financial... see: Short-term Solvency