Question

The table below shows a ratio of 4 companies.
retail jewelry, advertising agency, heavy equipment manufacturer and bank.

(a)

Company
	1	2	3	4
Debt-equity	9.0	2.0	0.7	1.1
Inventory Turnover	-	2.5	4.0	-
Current Ratio	N.A.	1.6	2.0	1.8
Sales/Total Assets	0.1	1.8	5.0	4.5
Sales/Receivable	2.0	12.0	50.0	9.0

i) Interpret the table and briefly discuss why company (1) is a bank?

ii) Interpret the ratios in the table shown in part (a) to identify the remaining (3) company and briefly discuss the reason?

iii) Morgan and Miller Proposition I with taxes suggest that optimal capital structure should be close to 100% debt. Yet the companies (with the exception of Company 1) in the table have debt level very much less than 100% as shown by debt-equity ratio. Briefly explain why?

Answer 1

Answer of i) As we can see that company 1 is a Banking company, the reason behind is that companies like Banks require more capital as there main business is to lend money and earn interest on that so, they borrow more money from people to lend it. We can see that Debt- Equity ratio is too high which can be possible in Capital intensive industry. which requires huge capital to survive. It Debt- Equity ratio indicates 9 times more portion of debt than Equity.

Secondly, companies which are in service sector do not have inventories so, the inventory turnover ratio mostly is not used in this type of companies.

Third, Debtors Turnover ratio is 2 which shows that how much loan has been given by bank against of deposits. Generally, in Banks this ratio is known as LDR that is Loan to Deposit Ratio.

Answer of ii)   Analyses of Company 2

If we talk about Company 2, then company 2 is the Heavy equipment manufacture. This can be understand by analyses of various ratios.;-

• Debt- Equity Ratio:- D/E ratio shows the Debt and Equity component in a capital structure of a company. If we talk about the company 2 then it's Debt- Equity ratio is 2.0 which shows that component of Debt is twice the component of equity.which is mostly in capital intensive industry which requires huge investment to start business.
• Inventory- Turnover Ratio:- Inventory Turnover Ratio tells us the demand of the goods that company generally produce. Higher the Inventory Turnover ratio, the better it is.
• Current Ratio:-  It shows whether the business have enough short- term assets or liquidity so that it can able to pay it's short- term obligations. Ideal ratio is 2:1, but here as it is capital intensive based industry , 1.6:1 is also a good CR.
• Sales/Total Assets:- It shows how much company can able to generate sales by using its assets. Higher it is, the better it is. Here, the ratio is 1.8 times, which is good.
• Sales/Receivables:- it shows how much goods sold on credit. Here, it is 12 which means business can able to collect money from debtors within 12 months.

Answer of ii)   Analyses of Company 3

If we talk about Company 3, then company 3 is the Retail Jewelry. This can be understand by analyses of various ratios.;-

• Debt- Equity Ratio:- D/E ratio shows the Debt and Equity component in a capital structure of a company. If we talk about the company 3 then it's Debt- Equity ratio is 0.7 which shows that component of Debt is less then the component of equity.which is mostly in less capital intensive industry which doesn't requires huge investment to start business.
• Inventory- Turnover Ratio:- Inventory Turnover Ratio tells us the demand of the goods that company generally produce. Higher the Inventory Turnover ratio, the better it is. In this case it is 4 times which sows the good management of inventory.
• Current Ratio:-  It shows whether the business have enough short- term assets or liquidity so that it can able to pay it's short- term obligations. Ideal ratio is 2:1, but here as it is less capital intensive based industry , they can able to maintain ideal ratio.
• Sales/Total Assets:- It shows how much company can able to generate sales by using its assets. Higher it is, the better it is. Here, the ratio is 5 times, which shows they are using there assets effectively and efficiently.
• Sales/Receivables:- it shows how much goods sold on credit. Here, it is 50 which means business can able to collect money from debtors within 50 months, which can not be considered good for an organisation health and later on they can be converted into bad debt also.

Answer of ii)      Analyses of Company 4

If we talk about Company 4, then company 4 is the Advertising agency. This can be understand by analyses of various ratios.;-

• Debt- Equity Ratio:- D/E ratio shows the Debt and Equity component in a capital structure of a company. If we talk about the company 4 then it's Debt- Equity ratio is 1.1 which shows that component of Debt is almost equal to then the component of equity.which is mostly in less capital intensive industry which doesn't requires huge investment to start business and it is service-based company.
• Inventory- Turnover Ratio:- companies which are in service sector do not have inventories so, the inventory turnover ratio mostly is not used in this type of companies.
• Current Ratio:-  It shows whether the business have enough short- term assets or liquidity so that it can able to pay it's short- term obligations. Ideal ratio is 2:1, but here as it is less capital intensive based industry , they can able to maintain ideal ratio.
• Sales/Total Assets:- It shows how much company can able to generate sales by using its assets. Higher it is, the better it is. Here, the ratio is 4.5 times, which shows they are using there assets effectively and efficiently.
• Sales/Receivables:- it shows how much goods sold on credit. Here, it is 9 which means business can able to collect money from debtors within 9 months, which is average period in which company can able to collect its money from debtors.

Answer of iii) Morgan and Miller Proposition says that value of the firm or we can say that market value of the firm is depends on the income which is generated from its operations of the business. In other words, it says that it is irrelevant that the market value of the firm is affected from its capital structure, the capital structure of the firm (whether it has debt or equity) have no effect on valuation of the firm. The valuation of the firm is only affected by the operating profits of the business.