Question

Jeffery has just concluded a ratio analysis comparing its performance and position at 31 December 2006 with those at 31 December 2005. The directors are concerned to see that the current ratio and quick ratio show a considerable decline. You are required: (a) State and explain three possible causes for the decline in one or both of these ratios. (b) State and explain three ways in which the company could improve these ratios.

Answer 1

Let's understand the meaning these ratios

Current ratio- It is the ratio which checks company's liquidity position in short term. The formula of this ratio is current asset / current liabilities. It analyse that how much extra current asset my business have against the current liabilities of business.

Qucik ratio- This ratio focus more on liquid asset as, it consider only those asset which can be realised in no time. The formula of this ratio is liquid asset / current liabilities , where liquid asset is composed of cash,marketable securities and accounts receivables,this exclede inventory from calculation. This ratio checks company's ability to pay it's liabilities in any emergency situation.

Reason for low-

1. This can be low, due to company's current performance in terms of sales and cost of goods sold. The company's sales might have decreased and there might be increase in cost of goods sold which is increasing current.
2. The company might have heavily making capital expenditure ,which might be reducing it's cash balance and accordingly current asset.
3. Company might have purchasing more on credit as compared to last year,however company's receivables policy is remaining same. In terms of quick ratio, company's inventory holding period would have increased.

Suggestion for improvement-

1. Reduce the credit sales after analysing the effect on total sales. This would increase in cash collections, consequently company would have low liability to pay. Bad debts problem would be shorted out in very much.
2. Company should focus to imrove it's gross profit ratio, which would want increase in sale and reduction in cost of goods sold.
3. A balance capital expenditure must be done in order to ensure a healthy current and quick ratio.

The improvement in company's overall performance in terms of profits will surely short out the problem of low current and quick ratios.

Please comment for any assistance

Thanks,