Question

You are the owner of a business and you hire a new accountant to help you manage the business. The new accountant tells you that in order to operate the business properly you have to pay attention to financial ratios. The accountant prepares your financial statements, then produces for you a number of ratios. The ratios that the accountant produced are listed below. Question: For each one, what does the ratio tell you about your business. Current ratio - .75 Inventory to Sales Conversion Period – 180 days Sales to Cash Conversion Period – 75 days Purchases to Payments Conversion Period - 7 days In addition to these ratios, the accountant also shares that the company has a gross profit margin of 15% and a net profit margin of 3%. Based on this additional information and the above ratio information, will this company have a good return on equity or a poor return on equity.

Answer 1

1. When current ratio is 3/4 means current liabilities are more than current assets .

Because current ratio=current assets/current liabilities.

If current liabilities exceed current assets the current ratio will be less than 1. ... A current ratio of less than 1 indicates that the company may have problems meeting its short-term obligations. Some types of businesses can operate with a current ratio of less than one, however.

2.Inventory turnover ratio is useful for checking the efficiency of stock. It is also improvement of current ratio. Sometime current ratio may mislead use when there is slow movement of stock in to sale. But inventory turnover ratio will give more idea about, how should we keep our stock in store.

Interpretation of Inventory Conversion Period

Less inventory conversion period is better because more fastly, we will convert our inventory into sales, there will be less chance of obsolescence and paying of over-stocking cost. In our case 180 days period is quite high for small business.

3.The sales to cash conversiont period measures the time it takes a company to convert its investment in inventory and other resource inputs into cash. When a company – or its management – take an extended period of time to collect outstanding accounts receivable, has too much inventory on hand or pays its expenses too quickly, it lengthens the CCC. A longer CCC means it takes a longer time to generate cash, which can mean insolvency for small companies.

4. Purchase to payment conversion period is 7 Days which is quite lesser period. We will have to pay our suppliers in 7 days for our purchases used for production.. It takes into account the amount of money the company owes its current suppliers for the inventory and goods it purchased, and represents the time span in which the company must pay off those obligations. This figure is calculated by using the Days Payables Outstanding (DPO), which considers accounts payable. Higher DPO is preferred.

5. Gross profit = revenue-cost of goods sold /revenue

Ideally 65% gross profit is considered good for bussiness here we are having gross profit margin 15%. The gross profit margin ratio analysis is an indicator of a company's financial health. It tells investors how much gross profit every dollar of revenue a company is earning. ... A higher gross profit margin indicates that a company can make a reasonable profit on sales, as long as it keeps overhead costs in control.

6.Net profit margin = net profit/revenue

Our net profit margin is 3% . A study suggests:-

Each employee in a small business drives the margins lower. One study found that 90% of all service and manufacturing businesses with more than $700,000 in gross sales are operating at under 10% margins when "15%-20% " is likely ideal.

7 A study suggests that lesser the cash conversion cycle higher the return on equity but our cash conversion cycle is higher so return on equity will not be so good.