Question

in 200 words or more, Why may a firm's current ratio differ from another in the same industry? Provide specific examples. Which measure of profitability is probably of more interest to the investing public? Why? Explain Return on Equity.

Answer 1

Current ratio , also called working capital ratio is used by management accountants to study the short-term liquidity /solvency ,ie. the ability of the company to meet its current/with-in-a year liabilities/obligations as and when they become due.

The higher the current ratio ,the better ,its liquidity /ability to meet its current or trade liabilities

Formula to calcualte current ratio is

Current assets/ Current liabilities

The current assets in a business normally consist of:

Cash

Marketable Securities

Accounts Receivables

Inventory

Prepaid expenses

and

Current liabilities consist of:

Accounts payable

Accrued expenses

Short-term notes & bonds ,payable within a year

A current ratio of 2:1 is normally considered good for all businesses , but industry average for that particular industry also has to be considered ,while evaluating the results of this ratio.

1.Magnitude of the constituents of working capital can give misleading results:

Even firms within the same industry , with very same current ratio, may not mean that both have the same repaying capacity /liquid assets to meet the obligations.

to explain further, a firm with large balance in inventory , which is not as liquid as receivables and marketable securities , will not have the same repaying readiness , as the other firm which has the same current ratio ,but with more of cash and receivables balance and less of inventory .Here, it is to be noted that inventory takes comparatively more time to get converted into cash, than receivables.

2.Current ratios of firms differ from another in the same industry because of valuation methods followed for the various constituents such as:

Inventory --one may follow FIFO valuation of its inventory & the other might have adopted LIFO or weighted average inventory valuation.

Accounts receivables-- one company may carry receivables after providing for doubtful debts on the basis of aging analysis & another as a percentage of sales or receivable balance.

Thus ,different accounting practices prevalent in different companies , within the same industry , sometimes ,render the comparison meaningless or distracting.

3.Similarly, classification of liabilities as current & long-term (within a year or more-than a year),differ among companies , especially with respect to notes payable & bonds payable, depending upon the purpose for which these liabilities were incurred.

2.Return On Equity (ROE )is probably of more interest to the investing public.

It is calculated as ROE=Net Income/Total Equity

Here,net income is the total after tax income that is available both for distribution as dividends and to be retained in the business.

Total equity is total of stock holders' equity along with additional paidin capital and accumulated retained earnings and all other sums belonging to the shareholders under this section.

This is more relevant because the investors get to know in an instant, the exact return that their money /investment has earned , by carrying on this business.

Comparing this ratio with that of peers in the industry & also with previous year's ratios , certainly helps them to gauge the profitability of their investment .