Question

Black Sparrow Aviation, Inc. is concerned they are not maintaining adequate liquidity. The accounting department has provided you, the newly hired finance manager, with the following ratios:

• Current ratio 4.5 Industry norm 4.0
• Quick ratio 2.0 Industry norm 3.1
• Inventory turnover 6.0 Industry norm 10.4
• Average collection period 73 days Industry norm 52 days
• Average payment period 31 days Industry norm 40 days

Discuss

• In your opinion, what do these ratios indicate about Black Sparrow Aviation, Inc.?
• What recommendations would you make based on these ratios? What results do you think you can achieve if your recommendations are followed? Why might your recommendations not be effective?

Answer 1

Current ratio is higher than the industry average, this means that Black Sparrow has sufficient current assets to support its current liabilities (as per the industry norms)

But a lower value of quick ratio and also of inventory turnover ratio implies that the company is holding too much inventory compared to its peers.

Also, its average collection period is higher whereas its average payment period is lower than industry norms. This makes the company. This effectively decreases accounts receivable & increases accounts payable both of which tend to affect liquidity negatively as the need for more liquid funds increases.

Recommendations:

1. The company should start bringing down its inventory to comparable levels of its industry peers (on proportionate sales basis). It can employ methods like Just in time and lean inventory management to acheive this.
2. It should try to offer trade discounts to its customers and use persuasion to reduce average collection period.
3. It should try to negotiate longer payment durations to its suppliers to increase average payment period. If suppliers are already offering longer windows, than Black Sparrow Aviation should use the full duration of payment cycles.

If these recommendations are followed, the company can easily acheive better liquidity as the above mentioned parameters will release more liquid funds that are currently locked.

These recommendations might not be effective in cases like if the extra inventory that Black Sparrow is holding is of lower quality that is actually hard to clear. Also if the company's customers or suppliers do not agree to its demands of change in payment durations than average collection period and payment period will not become better and those liquid funds will effectively remain blocked.