Liquidity ratios are a set of financial ratios that measure the ability of the company to meet its short term debt obligations using the most liquid current assets, those that can easily be converted into cash. There are basically two fundamental liquidity ratios that are used to provide insight into a company’s short-term liquidity. These are the current ratios, and the quick ratio, commonly known as the liquidity ratios (Walsh,2009).
Current ratio financial world and it’s easy to understand. Its however misleading to some extend in the fact that it’s highly unlikely that a company in its lifetime would want to liquidate all its assets in a bid to settle its liabilities.
This ratio is computed as current ratio/current liabilities. Ideally, a current ratio should be more than 1, and in most cases, it’s usually between 1.5 and 2. A ratio of less than 1 may mean that the company is unable to meet its debts as they fall due and thus it’s insolvent, while too high a ratio could be construed to mean that the company is tying too much money in current assets which is not the best thing for a company with available investment options (Palmer, 2010).
In order to answer this question, we shall calculate the above ratios in excel and then copy and paste the workings in word.
We shall convert the USDS to Pounds using the exchange rate of $1= £0.6241 GBP
£ million £ million
Current ratio Quick ratio
= 0.68745393 =0.50246397
£ million £ million
Current ratio Quick ratio
= 0.702 = 0.4909
ACID TEST RATIO
This ratio is almost similar to the current ratio, only that it uses the most liquid assets. This means that stocks are omitted from the computation as it may take a longer time to be realized. In most cases, the quick ratio lies between 0.7 to 1 although we may still have a few companies attaining a ratio of greater than 1. These ratios have been computed alongside the current ratios as shown above.
In order to compare the liquidity ratios of Diageo with those of Pernod Ricard, and Sabmiller we have had to convert the Euros to pounds as the reporting currency of Diageo is the pound, using the exchange rate 1 British Pound Sterling = 1.24735 Euro. E shall also convert SABMiller’s financials which are in $ at a rate of 1$= £ 0.6241
Looking at the ratios obtained, for the year 2011, Diageo had a current ratio of 1.45697 and a quick ratio of 0.75306 against a current ratio of 1.9468 and quick ratio of 0.6341 for Pernod Ricard. This indicates that Pernod Ricard had a higher current ratio compared to Diageo and a much lower quick assets ratio. This is as a result of a higher stock value for Pernod Ricard at the end of the financial year thus lowering the ratio. SABMiller however the lowest of all the ratios has in the three years as shown in the computation above. This is because SABMiller has a high level of current liabilities as compared to its two peers
The year 2010 also depicts similar results with Diageo having a current ratio of 1.76268 and a quick ratio of 0.93078 against a current ratio of 1.4881 and a quick ratio of 0.48075. This means that in 2010, had higher ratios in both categories as compared to Pernod Ricards.
Limitations of Diageo Financial statements to an investor
Diageo’s financial statements are prepared using the historical basis of accounting, meaning that the information presented may not be very useful for future planning as they are historical records. For instance, the fixed assets values are recorded at cost, which may not be the prevailing value in the market thus, making the financials quite unreliable for future planning.
The Diageo financials are only quantitative in nature and provide only quantitative information about the company. It therefore fails to provide information about the company’s other aspects such as labor relations, customer’s satisfaction, and management skills etc that are equally important to an investor for decision making. In fact, an investor is sometimes more interested in this qualitative information as it has more impact on the decisions made as opposed to the popular belief that only quantitative information is useful to the investor.
Investors are not able to precisely compare financial statements that are prepared using the historical basis of accounting. This is because, the inflation index affects the figures in a way that cannot easily be quantifiable thus comparison of the financial statements over the years may not give an accurate presentation of the reality on the ground (Fridson,2010).
Past financial performance, whether good or bad, may not help the investor in making an accurate prediction of the future. This is because the performance of a company is affected by other factors that may even be beyond the company. One major factor that would seriously affect the company’s future could be the resignation of key management staff. This could have a negative impact on the performance of the company, an issue that cannot be expected to available in the present financial statements.
Diageo’s financials do not inform the investors of the company’s future prospects and or the results of its expenditures on research and development or any introductions of new products, any new marketing strategies and any other important non financial information.
Financial statements for Diageo are prepared using a number of assumptions, policies and estimates; this subjective information does not give an investor a clear guidance on what the true situation of the company is. Different accounting policies adopted by different company’s result to different results thus an investors decision may not be based on the very objective information.
Lastly, an investor can only rely on the audited figures to make investment decisions. In most cases, even audited figures are sometimes adjusted for a number of issues that may be agreed between the auditors and the company. This means that even audited financial statements may not present an accurate financial position of the company thus the investor could be mislead to believe in the financial statements that are easily manipulated (Siegel,2008)
In conclusion, an investor needs to go beyond the financial statements, key ratios and any other qualitative information when making up a decision on whether to invest in a given company or not. The investor needs to interrogate the management skills, the companies operating environment and future prospects, the company’s past dividend history among other issues but above all, the investor could benefit a lot from making use of financial advisors as they are likely to have a better and in depth analysis of a given stock in the market.
Diageo Annual report (2007-2011)
Panod Ricards Annual report (2010- 2011)
SABMiller’s Annual report (2010-2012)
Palmer, J.E (2010) Financial Ratio Analysis: American Institute of Certified Public Accountants. Indiana University
Mott S. (2010) Ratio Analysis workbook. Publications division, National association of credit management. Indiana University
Fridson, S. M (2010) Financial Statement analysis. A practitioner’s guide. University of Michigan
Siegel, J.G (2008) How to analyze businesses, financial statements and the quality of earnings. University of California.
Walsh, Ciara (2009) Key management ratios: The 100+ Ratios every manager needs to Know. Financial times.