Question

Since 2017, HPT has reduced the number of retail locations in hope of saving costs and improving its financial health.

	HPT Company
	2019	2018	2017	Industry Ratios 2019
Current ratio	0.80	1.26	1.54	1.45
Inventory turnover	3.85	4.30	4.45	4.57
Average Collection Period	40.45	35.45	22.45	30.00
Capital asset turnover	1.12	1.33	2.46	3.19
Total asset turnover	1.04	1.46	1.71	2.00
Debt to total assets	65.00%	55.53%	51.25%	30.00%
Times interest earned	2.87	3.06	4.08	14.63
Gross margin	40.00%	39.00%	39.00%	42.00%
Profit margin on Revenue	2.90%	3.56%	4.25%	6.71%
Return on Total Assets	3.17%	5.21%	10.27%	13.42%
Return on Equity	6.65%	10.19%	12.09%	19.17%
Days in working capital	32.45	36.58	40.45	N/A
Cash Conversion Efficiency	5.29%	6.18%	N/A	N/A
Cash Conversion Cycle	73.30	64.04	61.44	N/A

Required:

a. Identify 2 ratios for each category:

Liquidity, Solvency, Productivity, and Profitability (2 marks for each category)

b. Provide an overall trend assessment of each category (do not explain each individual ratio but instead, provide an assessment of the category):

Liquidity , Solvency , Productivity , Profitability

c) The following information for HPT is provided:

	HPT Company
	2019	2018	2017
Z-Score	1.53971	1.5562	2.2341
Sustainable Growth	(0.0267)	0.0180	0.0240

What do the Z-score and sustainable growth numbers in the above chart mean? Has the company done better or worse since 2017? Explain.

Answer 1

(a) We will first have a look at what the terms liquidity, solvency, productivity and profitability actually mean.

1. Liquidity: Liquidity of a company means how well a company is able to take care of its day - to -day cash requiremenrts as short-term debts become due. The company which is able to do this more easily and thus is able to liquidate short-term assets without much problem is said to a have a good amount of liquidity in it's system. Higher the liquidity ratios, better is the firm's ability to service it's short-term obligations.

2. Solvency: Solvency tells us whether a firm will be able to meet it's long-term debt obligations. Solvency of a firm is important to get borrowed funds from outside as the lenders will want to know whether the firm can service it's prinicipal and interest payments on time. It is usually of importance to both shareholders and creditors as it helps them to see company's long-term risk.

3. Productivity: Productivity of a company tells us about how efficient and effective a company's production processes are. It tells us how good company is at efficient utilisation of its inputs to produce a certain amount of output. Productivity ratios generally have an output figure in the numerator and corresponding input figure in the denominator.

4. Profitability: Profitability refers to how much profit or returns are generated for the owners of the firm for the investment that they have made in the company. It is a measure of what actual value is added by the company to shareholders' wealth from utilisation of long-term capital i.e. share capital and long-term debt.

Ratios of various categories -

		Value
		HPT company	Industry ratios
Category	Ratio	2019	2018	2017	2019
Liquidity	Current ratio	0.80	1.26	1.54	1.45
	Cash conversion cycle	73.3	64.04	61%	N/A
Solvency	Times interest earned	2.87	3.06	4.08	14.63
	Debt to total assets	65.00%	55.53%	51.25%	30.00%
Productivity	Days in working capital	32.45	36.58	40.45	N/A
	Inventory turnover	3.85	4.3	4.45	4.57
Profitability	Gross margin	40.00%	39.00%	39.00%	42.00%
	Profit margin on revenue	2.90%	3.56%	4.25%	6.71%

(b) Company's liquidity can be seen from current ratio and cash conversion cycle. Cash conversion cycle should reduce over time as it tells us how much time is taken for the cash to be released from the system. Current ratio of 2:1 is generally ideal. So here if we see, current ratio is below 1:1. Given the industry average, it should be atleast greater than 1. Cash conversion cycle is also increasng which means firm's efficiency of converting input materials to cash is falling over the years. Liquidity situation needs to be improved and is not looking good.

Productivity can be seen from inventory turnover, average collection period, cash conversion efficiency and days in working capital. Inventory turnover is decreasing and collecton period is increasing which again seems to be an alarming situation. Cash conversion efficiency is also lower compared to 2018 which means sales to cash conversion is taking more time. But days in working capital have reduced which is actually a good thing for the business. It means company is better able to utilise its's working capital.

Solvency can be seen from ratios like debt to total assets and times intereest earned. Solvency situation is very tight for the firm as interest coverage ratio has decreased and debt to total assets ratio has gone up. The industry averages are hugely different from firm figures. This needs a serious re-assessment on firm's part. The solvency situation looks very risky.

Profitability can be seen from gross margin, ROE, ROA, etc. All the ratios are going down significantly and the firm needs to do something about the falling profitability ratios. The industry figures again are much better compared to that of the firm and it should be seen what other firms are doing to maintain good profitability.

(c) Z-score helps us predict the possibility of company's bankruptcy in 2 years. Both sustainable growth and z score are falling. Company may enter into bankruptcy . IT is risky,.