Question

Ratios are another amazing way to notice variances in assets, liabilities, income, and expenses. There are tons of different ratios we could look at but let’s take a couple and examine them for Simply Yoga. Take a look at their balance sheet.
Current Assets: Cash9550Accounts Receivable900Prepaid Expenses1100Total Current Assets11550  Property and Equipment: Yoga Props (less accum depr)1500Total property and Equip.1500Total Assets13050  Current Liabilities: Accounts Payable710Payroll Taes Payable672Payroll Taxes Payable1382Total Current Liabilities Long Term Liabilities Loan Payable6500  Stockholder’s Equity Common Stock1000Retained Earnings4186Total Equity5168Total Liabilities13050
Let’s talk first about the working capital ratio. The formula is:
Working capital= current assets−current liabilities
$10,168=$11,550−$1382
So, this shows that Simply Yoga has plenty of funds to pay current liabilities, which is a good thing! But, it also shows that they are holding more funds in a very liquid account, which may be better used to pay off any higher interest debt, such as their loan payable. This is an area for review, right?
The current ratio is another way to look at the ability of a company to cover short term debt.
Current Ratio = Current assets/Current Liabilities
8.36=$11,550/$1,382
What this tells us is that Simply Yoga has enough current assets to cover their current liabilities 8.36 times. Again, this is a good thing, unless they are paying a crazy amount of interest somewhere else. Might that cash be better used to pay off that loan they have sitting on the books? What are your personal thoughts and why?
 

Answer 1

If we look at the components of current ratio for Simply Yoga, cash accounts for 9,550 of the total current assets of 11,550 or nearly 83 %. Investment in accounts receivable and prepaid expenses is only 17 %. Cash accounts for 9,550 / 13,050 or 73 % of total assets.

Of course, with a very high current ratio, and such a high percentage of the most liquid asset, the firm is very comfortable in paying off its short term liabilities, but are the assets being utilized very efficiently? Why is the cash not being put to work ?

In a service industry like yoga, cash tends to build up, as capital expenditures are low. Revenues too could be increasing. But the management should look for investment opportunities to deploy the excess cash, so that a return can be generated from such investment, which would go a long way in maximizing shareholder wealth.

Actually, using the cash to pay off all the long term debt might not be such a good idea, as that would cause the Return on Equity ( ROE ) to fall, as financial leverage results in a higher equity multiplier, and consequently a higher ROE. Currently the Debt Equity Ratio is high, [ 7,864 / ( 1,000 + 4,186 ) ] = 1.52 times.

Part of the cash should be used to retire part of the long term debt, and part should be invested in marketable securities, if the management cannot find any other investment opportunity. If no investment opportunities are there, the excess cash should be returned to the stockholders of the company. It does not make financial sense to be sitting on so much idle cash on the balance sheet.