Question

Based on the reviews of the Financial Ratios and Trend Analysis, respond to the following questions.

You are encouraged to research outside sources and, of course, cite them. Do not, however, quote sources word-for-word, but rather, respond to the Discussion Forum Question in your own words.

1.     What three factors would influence your evaluation as to whether a company’s current ratio is good or bad, why?

2.     Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company.

3.     Why is working capital given special attention in the process of analyzing balance sheets?

4.     What does the number of days’ sales uncollected indicate and who would be interested in these ration?

5.     What does a relatively high accounts receivable turnover indicate about a company’s short-term liquidity?

6.     Why is a company’s capital structure, as measured by debt and equity ratios, important to financial statement analysts?

7.     How does inventory turnover provide information about a company’s short-term liquidity?

8. Discuss why there may or may not be ratios that would be more important in a service vs manufacturing environment and which rations would those be?

9. mention more than 2 references used in your answer

Answer 1

1. Three factors that would influence my evaluation are: the type of business, past and current performance, and their turnover rate of assets. Current ratio = current assets/current liabilities. The ratio will be different for different industries and so a lot depends on the type of business and the type of industry that the company operates in. Past and current performance of the company will help in determining whether the short term liquidity of the company is improving or deteriorating.

2. A 2:1 current ratio might not be adequate for a particular company if the current assets mostly consist of inventories and less of cash and debtors. This is because inventory is not considered as a quick asset and is fairly less liquid than cash and debtors. So even if a company’s current ratio is 2:1, but current assets mostly comprise of inventories then it will not be regarded adequate.

3. Working capital is given special attention in the process of analyzing balance sheets because for any business it is the bottom line (or profits) that matters the most. Positive working capital means the company will have enough assets converted into cash within the next year to pay its current obligations. It is important to have a positive working capital cycle as it balances incoming and outgoing payments and free cash flow is maximized. Adequate working capital enables a company to carry sufficient inventories, meet current debts, take advantage of cash discounts, and extend favorable terms to customers. Working capital is a major factor in determining the short-term liquidity position of company.

4. Number of day’s sales uncollected is a liquidity ratio that estimates how many days it takes for a company to collect its accounts receivables. The ratio is calculated using the formula: (accounts receivable/net sales)*365. Thus the ratio indicates the number of days that a company takes to collect cash from its credit sales. The people who would be interested in this ratio will be the company’s creditors and investors.

5. A high accounts receivable turnover implies that accounts are collected quickly, thereby providing cash that can be used to meet obligations. A high turnover also means that a given sales volume can be supported with a lower investment in accounts receivable.

6. Users are interested in the capital structure of a company, as measured by debt and equity ratios, for at least two reasons. First, as a company includes more debt in its capital structure, the risk that it will be unable to meet interest and principal payments increases. Second, the existence of debt introduces financial leverage. If the company can earn a rate of return on its investments that exceeds the rate of interest paid to creditors, the debt will increase the rate of return to stockholders.

7. Inventory turnover reflects on the efficiency of inventory management. That is, a high inventory turnover means that a given sales volume can be supported with a smaller investment in inventory. This insight into the speed with which inventory is sold determines the relevance of the available inventory in meeting the current obligations of the business, which is a focus of short-term liquidity.

8. Certain ratios have more applicability in a service sector while certain ratios have more applicability in a manufacturing sector. For instance take the example of fixed assets turnover ratio. This ratio is computed using the formula: (sales/average net fixed assets). A manufacturing entity will have a higher proportion of fixed assets in its balance sheet compared to a service entity. For a service entity total assets turnover will be more relevant than fixed assets turnover ratio.

9. References:

i. Wall Street Mojo - https://www.wallstreetmojo.com/current-ratio/

ii. CCD Consultants - http://www.ccdconsultants.com/calculators/financial-ratios/working-capital-calculator-and-interpretation?tab=interpretation

iii. Investorwords - http://www.investorwords.com/16938/average_days_sales_uncollected.html

iv. Strategic CFO - https://strategiccfo.com/inventory-turnover-ratio-analysis/