Question

Each of the following would generally be considered a favorable indicator of an enterprises financial condition. There are circumstances where even though on the surface the ratio looks good, it may actually represents an unfavorable development. For each case give an example of where the event may actually be unfavorable.

a. A current ratio is above 4.0 which is substantially higher than other firms in that same companies industry

b. The accounts receivable collection period is significantly lower than for several recent periods

c. A rapidly rising inventory turnover ratio

Answer 1

Hey there. Here are the exmaples with explanations for each of the cases.

a. Current ratio is given by dividing current assets by current liabilities. Current ratio of 4.0 signifies very high holding of current assets by the company, which is also not normal in the industry. So the company in question is not optimally utilising its resources and leading to wastage of the resources by just sitting in the books and not being put to better use.

An example can be when company is holding very high percentage of cash and bank balances as compared to its current liabilities, which signifies that the company is not ploughing back the money in its business by way of investing in the expansion of the business or if it doesn't have any opportunities, then paying the shareholders by way of dividend. In any case, such large amount of surplus cash and bank balances is only held by the company if its management is not very active and forseeing.

b. At first glance, it appears good that the accounts receivable period has become significantly lower than for recent periods, but it may also signal something wrong with the company. For example, if the accounts receivables have reduced from say, 60 days to 10 or 15 days, it may indicate many wrong reasons for the same-

1. The proportion of industrial customers has reduced significantly compared to retail cash customers, indicating fall in long term relationships with big sized customers.

2. The company is facing cash crunch due to which it is collecting receivables at a faster pace than normal.

3. Company is shrinking one line of products and hence not allowing much credit line to the cstomers as it is wraping up the receivables.

c. Inventory turnover ratio determines how many times the company sold its average inventory during the year. A rapidly rising inventory turnover ratio may indicate many negative traits. For example, if the inventory turnover ratio reduces from 10 times to 4 times, it may indicate that:-

1. The average inventory has reduced which may say that the company is not holding as much inventory in the stock as it earlier was, indicating either deteriorating business or cash crunch.

2. It may also indicate reduced sales with same level of inventory, thus also not giving good picture of the comapny.