Question

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?

After you’ve completed the questions above, please provide a brief explanation of how this information is important in managerial decision making.

Answer 1

1)

1. The current ratio should be higher than 1. Higher the ratio, higher the capability of the company to pay off its obligations.
2. If the ration is less than 1, it indicates that at one point the company will not be able to pay its debts and will go bankrupt.
3. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are unable to alleviate their obligations.

2)

In theory you can say that this is an ideal ration keeping in mind the going concern nature of the firm.

Net Working Capital(NWC)= Current Asset(CA)- Current Liability(CL)

So when you say the ratio is 2:1 you mean to say that CA are twice the CL, which means that the remaining portion of CA are financed from Non-CL(NCL). And this provides a cushion to the firm because whenever the CL are realised they can be easily paid by the firm routing them via NCL and the smooth operations of the firm are not hampered. This is working on the the principle of Conservatism that CL are sure to arise but CA may not be realised on time.

But while maintaing this ratio one also needs to keep in mind the composition of CA. Because inventory turnover and receivable realistion period also drastically impacts the ability to respond to a CL.

While it may be good for oil companies it might not be good for steel company.

3) Same answer as 2.

4)Days' sales uncollected is a measurement used to estimate the number of days before receivables will be collected. This information is used by creditors and lenders to determine the short-term liquidity of a company. It can also be used by management to estimate the effectiveness of its credit and collection activities.

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)

The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt.

7) The inventory turnover ratio shows how quickly a company is selling its merchandise. It is computed by dividing the cost of goods sold by average inventory. A high turnover ratio indicates the company has a low amount of inventory for sale, which may cause it to lose potential sales.