Financial Management and Analysis of Projects - Financial Management of Executing Agencies - Measuring Performance

Table of Contents

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Foreword

1. Introduction to the Guidelines

2. User Instructions

3. Preparing and Appraising Investment Project

4. Financial Management of Executing Agencies

4.1. Financial Management Overview

4.2. Institutions and Systems

4.3. Financial Analysis

4.4. Measuring Performance

4.4.1. Introduction to Measuring Performance

4.4.2. Objectives of Measuring Performance

4.4.3. Performance Indicators

4.4.4. Using Benchmarking Indicators

4.4.5. Selecting Indicators and Covenants

4.4.6. Operating Indicators and Covenants

4.4.7. Capital Structure Indicators

4.4.8. Liquidity Indicators

5. Reporting and Auditing

6. Financial Institutions

7. Knowledge Management

Financial Management and Analysis of Projects : 4. Financial Management of Executing Agencies

4.4.8. Liquidity Indicators

4.4.8.1. Introduction

4.4.8.1.1. Liquidity indicators are intended to measure the adequacy of an enterprise's working capital, i.e., an excess of current assets over current liabilities, to meet its current obligations in a timely manner and conduct its operations effectively without financial constraints. These indicators were generally used only when working capital requirements were significant, as in the case of most industrial and agro-industrial projects. However, the inability of many EAs to collect and manage their cash resources has brought these indicators into increased attention and popularity.

4.4.8.1.2. While these indicators were not normally used for projects where working capital needs were considered to be relatively small, they are increasing being deployed, particularly as noncovenanted reporting requirements.

4.4.8.1.3. The current ratio and quick ratio define a specified minimum liquidity ratio and corrective actions will be necessary when the actual ratio falls below the prescribed level.

4.4.8.1.4. The quick ratio (or acid test) is the preferred indicator because it ignores inventories that are frequently not readily realizable in public utilities (e.g., large water main pipes and electrical transformers that are stored for emergency use).

4.4.8.2. Current / Quick Ratios

4.4.8.2.1. Sections 3.6.4.2 and 3.6.4.3 discuss the application of these indicators in relation to investment projects.

Current Ratio

4.4.8.2.2. The current ratio is the ratio of current assets to current liabilities as of the date of the balance sheet. It is the measure of the adequacy of working capital and short-term liquidity, since it indicates the extent to which short-term obligations are covered by assets that are capable of being converted to cash in a period roughly corresponding to the maturity of the obligations.

4.4.8.2.3. Current assets are cash; cash equivalent; assets held for collection, sale, or consumption within the enterprise's normal operating cycle; or assets held for trading within the next 12 months. [IAS1.57]. Current liabilities are those to be settled within the enterprise's normal operating cycle or due within 12 months, or those held for trading, or those for which the entity does not have an unconditional right to defer payment beyond 12 months. [IAS1.60].

4.4.8.2.4. The acceptability of a current ratio depends on the type of production and selling operations and the characteristics of the market for the output.

4.4.8.2.5. A ratio of less than 1.0 is generally unacceptable and usually a ratio substantially above 1.0 is deemed necessary. For example, an enterprise subject to seasonal or fluctuating demand for its output, or irregular timings of inventory acquisition/build-up, should have a current ratio high enough to carry the necessary inventories of goods in process and finished and saleable output pending actual sales - possibly as high as 4.0.

4.4.8.2.6. An enterprise such as a public utility, with steady inflows of funds from monthly billings and a good record for prompt collection, may operate with a current ratio as low as 1.0, or even marginally lower. An enterprise which has to transport at its own time and expense large quantities of inputs and finished goods for long distances will likewise require a high ratio.

Quick Ratio

4.4.8.2.7. An alternative and better test of liquidity is the quick ratio. The basic difference between this and the current ratio lies in the treatment of inventories, which are the least liquid of current assets and are also those on which losses are most likely to occur if business conditions are adverse.

4.4.8.2.8. The quick ratio is calculated by deducting inventories from current assets and dividing the remainder by current liabilities. In other respects this form of covenant possesses similar advantages and disadvantages as the current ratio.

4.4.8.2.9. A quick ratio of at least 1.0 is usually prescribed. The current and quick ratio indicators have a serious deficiency in that they present the status of an enterprise at a point in time, and not its regular performance.

4.4.8.2.10. Distortions frequently occur, such as the case of enterprises relying on customers' advance payments for large delivery contracts, which if they do not take place, cause major shortfalls in cash, or if they occur as contracted, may make the ratio far higher than the actual consumption of inputs warrant.

4.4.8.2.11. It is feasible using this indicator to "window-dress" the enterprises' financial status for presentational purposes at the reporting date.

4.4.8.2.12. The intention of covenanting this indicator is to require a borrower to not operate below the covenanted level. However, in practice it can be very difficult to determine defaults during a year. Therefore, the most useful application of this indicator is to request an enterprise to provide a graphic presentation of a series of status indicators at, say, monthly or weekly intervals for each year. In this way, the effective liquidity position can be better determined.

4.4.8.3. Dividend Limitation

4.4.8.3.1. Section 3.6.4.4 discusses the application of this indicator in relation to investment projects. The dividend limitation indicator, with a dividend limitation test, establishes the point at which the borrower is prohibited from declaring a dividend, the payment of which would cause the current ratio (or quick ratio, if that is the selected test basis) to fall below a specified minimum.

4.4.8.3.2. The minimum level of current ratio may be higher than the minimum required under a Current Ratio indicator because decisions on whether to pay dividends are often discretionary, and a stricter standard of prudent financial management can thus be applied to this context. Therefore, a borrower should be asked (through a covenant) not to make voluntary payouts of cash to its stockholders until it has taken further measures to establish and maintain the liquidity essential for operations.

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4.4.7. Capital Structure Indicators