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

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 4.5,

A CURRENT RATIO IS THE BEST INDICATOR OF THE LIQUIDITY OF ANY COMPANY. IN THE CONCERNED COMPANY THE CURRENT RATIO US 4.5, WHICH IS ABOVE THE INDUSTRY AVERAGE AND ALSO A VERY GOOD INDICATOR OF THE THE COMPANY. A CURRENT RATIO OF ABOVE 2 IS CONSIDERED GOOD. IT MEANS A LARGE AMOUNT OF CURRENT ASSETS ARE AVAILABLE FOR THE PAYMENT OF THE CURRENT LIABILITIES.

QUICK RATIO CONSIDERS ONLY THE MOST LIQUID PART OF THE INVESTMENTS HENCE IT REMOVES INVENTORY , WHICH TAKES TIME TO CONVERT INTO CASH, IT REMOVES THE PREPAID EXPENSES AND JUST TAKES INTO ACCOUNT THE CASH AND CASH EQUIVALENTS,MARKETABLE SECURITIES AND SHORT TERM INVESTMENTS. IT TAKES INTO ACCOUNT HOW WELL THE COMPANY PAYS THE CURRENT LIABILITIES WHEN THEY BECOME DUE BY ONLY UTILIZING ITS QUICK ASSETS. A QUICK RATIO OF 2 MEANS THAT THE COMPANY HAS TWICE THE QUICK ASSETS TO PAY THE CURRENT LIABILITIES.

IT IS BELOW THE INDUSTRY NORM, BUT IT SIGNIFIES THAT QUICK ASSETS ARE AVAILABLE TO PAY THE CURRENT LIABILITIES.

INVENTORY TURNOVER :

COST OF GOODS SOLD/ AVERAGE INVENTORY

DETERMINES HOW LONG IT TAKES FOR THE INVENTORY TO BE CONVERTED INTO CASH. THE LONGER IT TAKES FOR THE INVENTORY TO BE CONVERTED , THE MORE IS THE CASH TIED UP WITH THE COMPANY THE LOWER WOULD BE THE LIQUIDITY OF THE COMPANY.

HERE, THE INVENTORY TURNOVER IS 6 , WHICH IS BELOW THE INDUSTRY NORM . THE COMPANY CAN MAKE EFFORTS THAT THE INVENTORY GETS SOLD UP FAST. IT IS INDICATING WEAK SALES AND A NOT SO FAST SELLING INVENTORY AS IT IS BELOW THE INDUSTRY AVERAGE.

RECOMMENDATION: THE COMPANY SHOULD OFFER DISCOUNTS TO INCREASE SALES. INCREASE AWARENESS ABOUT THE PRODUCT THROUGH ADVERTISING AND LOWER PRICES TO BEAT COMPETITION. THE SALES WILL INCREASE IF THE COMPANY FOLLOWS THESE RECOMMENDATIONS.

AVERAGE COLLECTION PERIOD : NET CREDIT SALES / ACCOUNTS RECEIVABLE IS THE RECEIVABLE TURNOVER .

THE RECEIVABLES TURNOVER * DAYS IN A PERIOD WILL GIVE US THE AVERAGE COLLECTION PERIOD.

THE LOWER THE RATIO THE BETTER FOR THE BUSINESS. THE MORE TIME A COMPANY TAKES TO COLLECT THE ACCOUNTS RECEIVABLE THE MORE THE CASH FLOW OF THE BUSINESS WILL BE AFFECTED. THE BUSINESS SHOULD ADOPT TIGHTER SCHEDULES TO MAKE PAYMENTS BY THE PEOPLE HOLDING UP CASH, PROVIDE REMINDERS TO THEM SO THAT THE CREDITORS MAKE PAYMENT EARLIER. MAKE IT A CONTRACTUAL OBLIGATION TO PAY UP THE RECEIVABLES BEFORE THE PARTICULAR TIME PERIOD.

BY FOLLOWING SUCH RECOMMENDATION THE COMPANY MIGHT BE ABLE TO COLLECT RECEIVABLES FASTER THAN BEFORE, THUS IMPROVE THE CASH FLOWS.

AVERAGE PAYMENT PERIOD = ACCOUNTS PAYABLE/ AVERAGE CREDIT PURCHASES *365

THE LONGER THE AVERAGE PAYMENT PERIOD, THE CASH INCREASES. IT INDICATES THE CREDIT WORTHINESS OF THE BUSINESS. A VERY SHORT PAYMENT PERIOD MEANS THAT THE COMPANY IS NOT UTILIZING THE CREDIT FACILITY PROVIDED BY ITS SUPPLIERS.

HERE, THE AVERAGE COLLECTION PERIOD IS 31 DAYS , LITTLE LESS THAN THE INDUSTRY NORM. THE COMPANY IS QUICK AND EFFICIENT IN PAYING UP THE DUES OF THE CREDITORS.