I n t e r a c t I v e t e X t foundations in Accountancy/ acca financial accounting (ffa/FA) bpp learning Media is an acca approved Content Provider

PART H: INTERPRETATION OF FINANCIAL STATEMENTS 

 

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4

   Liquidity, gearing/leverage and working capital 

Liquidity and working capital ratios include:  

 Current 

ratio 

 Quick 

ratio 

 

Receivables collection period 

 

Payables payment period 

 

Inventory turnover period 

Debt and gearing/leverage ratios include: 

 Debt 

ratios 

 Gearing 

ratio/leverage 

 Interest 

cover 

4.1 Long-term solvency: debt and gearing ratios 

Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting 

into heavier debt or improving its situation, and whether its debt burden seems heavy or light. 

(a) 

When a company is heavily in debt, banks and other potential lenders may be unwilling to 

advance further funds. 

(b) 

When a company is earning only a modest profit before interest and tax, and has a heavy debt 

burden, there will be very little profit left over for shareholders after the interest charges have been 

paid. And so if interest rates were to go up (on bank overdrafts and so on) or the company were to 

borrow even more, it might soon be incurring interest charges in excess of PBIT. This might 

eventually lead to the liquidation of the company. 

These are two big reasons why companies should keep their debt burden under control. There are three 

ratios that are particularly worth looking at: the debt ratio, gearing ratio and interest cover. 

4.2 Debt ratio 

The