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In our Level 3 qualification, we ensure that aspiring members can produce draft financial statements from a trial balance. This is essential day-to-day work for a bookkeeper and the end result, a balance sheet and a profit and loss account, is – generally – what you have been commissioned to prepare.

However, within that qualification, we also ask you to calculate some ratios from the figures in the account.  

Everyone is probably familiar with such measures as “Profit Margin” or “Return on Capital Employed” but, being a Level 3 syllabus, it doesn’t stretch you further than doing the calculation and, perhaps, comparing ratios from one year to the previous 

This article has been triggered by discussions about the forthcoming introduction of Making Tax Digital and the opportunities that it will present to you as bookkeepers for sole trader businesses that will fall into scope. The same opportunities apply to limited companies.  

We’ll go into the actual introduction of MTD as we get nearer to the time but the main thing to be aware of is that you will have access to your clients’ digital bookkeeping records and, as well as ensuring that they meet their MTD requirements, it allows you to keep your finger on the business pulse and discuss concerns and opportunities that go beyond basic compliance.  

The ratios I’m going to talk about concern “Liquidity”, which is the business’s ability to generate cash. It is different from “Profitability”; a business with a healthy profit margin is not necessarily going to generate cash. The smaller the business, the greater the concern. A sole trader has to think about drumming up sales, buying in the necessary materials and doing what’s necessary to keep business ticking over. It’s easy to take their eye off the ball and let cash flow management slip.  

So, the three ratios that it helps to understand (not simply calculate) are: 

  • Stock Days  

  • Debtor Days 

  • Creditor Days 

The logic of converting a balance sheet item into a “days” measure goes like this: 

  • In a year, you might make total credit sales of £365,000 

  • That is £1,000 per day 

  • Therefore, if you have debtors of £65,000, it’s fair to say that customers from the last 65 days are still to pay. 

Wemust acknowledge that the calculations involve averaging so we’re simplifying. We would get more information about that balance from an aged debtor report. However, the ratio is a quick guide that might ring an alarm bell, triggering further investigation 

Consider next a business that has the following ratios: 

  • Stock days = 45 days 

  • Debtor days = 65 days 

That tells us that there are 110 days between making a purchase of goods and receiving cash for the corresponding sale. We are not helped that stock and debtors are assets and generally thought of as a “good thing”.  

In those 110 days, the business will have expenses, bills and, possibly, wages to pay. If the trading hasn’t delivered the cash for those costs, the business will have to find other ways to raise the money.  

The “good thing” would be to have cash for those costs! 

The first port of call might be to take credit from suppliers. Let’s say we now calculate: 

  • Creditor days = 50 days 

This reduces that gap to 60 days. There are still expenses and bills that need paid and the business will now have to seek other funding – perhaps a loan or overdraft – to ensure those bills get paid.  

Some terminology that you will hear being bandied around is: 

  • The “Operating Cycle”. In my illustration, the period of 60 days is known as the operating cycle. As discussed, although it’sstated in days, it helps to understand it as the need to raise cash.  

  • “Working Capital”. There are two ways in which this phrase is often used.  
    The first is simply the net value in the balance sheet of Debtors, Stock and Creditors.  
    The second is to do with that loan or overdraft. When people borrow, they might refer to the purpose as being to “fund working capital”. What they mean is that they have bills to pay because their business is not generating the cash quickly enough.  

The money raised to fund working capital has a direct cost associated. You would be doing your clients a favour if you could help to minimise this.  

STOCK 

If stock days are rising or appear higher than you see in comparable businesses, ask your client about whether this is on purpose. Is there a valid reason for increasing the level of stock-holding? Is there any evidence of stock items becoming obsolete or is there wastage of stock? Does the business have reliable suppliers who can deliver promptly? It may pay to use a slightly more expensive supplier if it results in significantly lower stock holding.  

DEBTORS 

The debtor days can be compared as a trend over time (you can do this quarterly with the MTD returns); they can be compared to other businesses you might deal with in the same sector and they should be compared to the terms of credit that the business allows to its customers.  

If the debtor days has increased without a good reason, then you should discuss with the client ways in which they might be able to manage their credit control better. Whether that is to diarise a couple of hours a week to make phone calls to late payers or to incur a direct cost of offering settlement discounts or using a third party “debt factor” (a collection agency), there will be some costs to weigh up against the benefits of reducing the operating cycle.  

CREDITORS 

There’s a risk that a business sees trade creditors as an easy way to reduce the operating cycle. They’re not wrong but if the business in my illustration sees its creditor days creeping upwards from 50 days, they need to be on the lookout for disgruntled suppliers.  

Creditor payments need to be handled delicately. Ask how many “red statements” or final demand notices are being received. It could be vey damaging to the business if the supplier were to refuse to sell or insist on cash sales.  

This type of analysis of the content of financial statements forms a part of the Level 4 Business Insight qualification.  

It is worth noting that there is no specific requirement that any business undergoes such analysis; there is not reporting requirement and there is even some discussion on the “correct” way to calculate the ratios (I only ever use closing balances!). My point is that what’s important is not so much the actual numbers but it’s the interpretation and the ability to spot areas of concern.  

This article is a brief companion to a “Lunch and Learn” webinar delivered on 31st January 2025. If the article has piqued your curiosity, please refer to the recording of the webinar for more discussion. Please note you will need to login to access.

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