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This is based on a simple idea: SLICE OF LIFE If Lotta Doe borrows money at 8% to invest in a business that generates 11%, that means that each dollar of debt produces 8% for the bank (which receives what it asked for) + 3% for Lotta, the shareholder. Thus, those dollars of debt (dollars that were not provided by Lotta) earn an additional return for the shareholder. And the greater the amount of debt, the greater the leverage. Let’s illustrate this idea with Droids Co. First we have to calculate the interest rate.
What does the £325M in 2012 represent? Rosencrantz: That’s money our customers owe us to pay for goods that we delivered to them. So that’s good news! Guildenstern: No, not really, because we have to remember that today’s accounts receivable were yesterday’s inventories. And those receivables are built on past production expenses and cash outlays. Truth be told, a company that delivers a product is a company that plays the role of a bank: it made cash outlays to purchase materials and produce goods.
So in our case the amount of money that will be received in the coming months is twice as much as what has to be paid out. The company is liquid. Hurray! as long as the customers pay on time. Lastly, the current ratio expands the question to include inventories: they are turned into sales that become accounts receivable, which in turn become cash. Once again we compare what we expect to receive (the top part of the ratio) with what we have to pay (the bottom part). These liquidity ratios introduce a crucial notion: payment and production deadlines.