Question

The following ratios are for the Roval Co., Blue Corp., and their industry averages.

	Roval Co.	Blue Corp.	Industry Average
Current ratio	700%	200%	480%
Quick ratio	180%	100%	230%
A/R turnover	12 times	12 times	6 times
Return on assets	21%	29%	23%
Total asset turnover	7 times	3 times	5 times

Required:

a..  Explain a potential factor for the large difference between current and quick ratios of Roval, compared to differences of Blue and industry average.

b.   Comment on the short-term liquidity and asset utilization ratios of the Roval and Blue, in relation to the industry averages.

c.  Determine the operating profit margins of Roval, Blue, and industry.  

d.   Discuss the attractiveness of investment in Roval v. Blue, considering the respective profitability & turnover ratios, relative to the industry averages.  

Answer 1

a. Current Ratio = ( Cash + Marketable Securities + Accounts Receivable + Inventories ) / Current Liabilities

Most likely cause of the large difference in current ratio of Roval as compared to Blue and the industry average is slow moving inventory and high accumulation thereof on the balance sheet date. A second reason could be lower accounts receivable. A third reason could be much lower current liabilities in the denominator.

Quick Ratio = ( Cash + Marketable Securities + Accounts Receivable) / Current Liabilities.

The quick ratio for Roval is lower than industry average, but higher than Blue. The possible cause could be lower cash equivalents or accounts receivable in the numerator as compared to industry, and higher quick assets as compared to Blue.

b. The quick ratio is a more stringent indicator of short term liquidity as compared to the current ratio. As borne out by the quick ratios of both Roval and Blue, their short term liquidity position is not as strong as their peers in industry.

Having said that, the accounts receivable turnover and the total asset turnover for Roval is much better than the industry, indicating that is able to utilize its assets to generate sales much more efficiently than the other players in the industry.

Accounts Receivable Turnover = Sales / Accounts Receivable

Total Asset Turnover = Sales / Total Assets.

Blue however is lagging the industry average in total asset turnover, possibly because it is a newer company, and the fixed assets have just started undergoing depreciation. Hence the denominator is much larger than either Roval or industry peers.

c. Return on Assets = Net Operating Margin / Total Assets.

Total Asset Turnover = Sales / Total Assets.

Profit Margin = Net Operating Margin / Sales = Return on Assets / Total Asset Turnover.

Operating profit margin for Roval = 21 % / 7 times = 3 %.

Operating profit margin for Blue = 29 % / 3 times = 9.67 %.

Operating profit margin for industry = 23 % / 5 times = 4.6 %

d. Though the current and the quick ratios for Blue are lower than Roval's, it has the highest profit margin of 9.67 %. This indicates that its assets are being used effectively and efficiently to generate healthy profitability, which in turn creates value for the investors. Therefore, Blue is a better investment opportunity than either Roval, or the other firms in the industry, By the way, a current ratio of 2:1 and a quick ratio of 1:1 are ideal.

The current and quick ratios of both Blue and industry competitors are too high, indicative of idle unproductive assets. That is the reason for their unattractive profitability numbers.