Question

Assuming Target’s industry had an average current ratio of 1.0 and an average debt to equity ratio of 2.5, comment on Target’s liquidity and long-term solvency.

Answer 1

Current ratio is a liquidity ratio that measures a company's ability to pay short term obligations that are due within a year. It is calculated by comparing company's current assets to its current liabilities. Current assets comprises cash, receivables, inventory and other assets that are expected to be turned into cash within 1 year. Current liabilities includes accounts payables, tax payables, employee benefits payable within a year and current -portion of long term debts.

Generally a current ratio of 2:1 seems ideal as it represents that company has adequate funds to meet its short term liabilities. It also varies from industry to industry. A current ratio is that in line with industry average or slightly higher is generally consider acceptable.

In the given case, target's industry current ratio is 1 which indicates that current assets are equal to current liabilities and that industry is just able to cover all of its short term obligations. It can also be used to comprehend that credit policy for trade receivables and trade payables is more or less at par. Industry should try to increase the credit period for payables or reduce the credit period for receivables so that it can reach at current ratio of 1.2 atleast.

Debt to Equity ratio measures the relationship between long term debt and total equity of a company or industry. Long term debt comprises long term loans, debenture, bonds, etc. Total Equity comprises preference shares, equity shares, retained earnings. Optimal debt equity ratio varies from industry to industry but generally preferred to not to be above 2.

In the given case, Target's industry had an average debt equity ratio of 2.5 which indicates that that Company drives more than two-third of its capital financing from debt and less than one-third from shareholder equity. Industry seems to be Capital intensive that invests large amount of money in assets and operations. It is highly leveraged and dependent on long term external borrowings to meet its long term sourcing needs.