Question

The industry averages for 2019 that the company refers to as its benchmarks are provided as follows:

Industry Average

Gross profit ratio                                                                          50.11%

Net income to revenue ratio (after tax)                                        22.02%

Return on shareholders’ equity (after tax)                                   35.66%

Current ratio 1.85 : 1

Quick ratio 1.08 : 1

Accounts receivable collection period (in days)                          14.83 days

Company A:

Gross profit ratio                                                                          54%

Net income to revenue ratio (after tax)                                        25.76%

Return on shareholders’ equity (after tax)                                   33.73%

Current ratio                                                                                1.54

Quick ratio                                                                                   0.41

Accounts receivable collection period (in days)                          21.90 days

Use the above ratios of company A performance compare to the industry averages and provide relevant comments under the headings of ‘profitability’ and ‘liquidity.

Answer 1

Note on the performance of Company A

Profitability

1. Both the gross profit and the net income after ratios of Company A at 54% and 25.76% respectively are better than the industry average of 50.11% and 22.02% respectively. This means that company A is being run more efficiently than the industry average and is earning higher margins per unit of revenue than the industry.
2. The Return on share holders’ equity for company A at 33.73% is lower than the industry average of 35.66%. This means that company A is making higher level of investment to earn a unit of profit when compared to the industry average.
3. A higher collection period at 21.90 days as compared to industry average of 14.83 days indicates that company A may be earning higher profits by selling products at prices higher than industry by offering longer credit periods to its customers. This may also be the reason of higher investment in owners’ equity in the company

Liquidity

1. The current ratio of company A at 1.54 when compared to industry average of 1.85 indicate lower amount of investment in the working capital of the company.
2. A very low liquidity ratio at 0.41 in comparison to the industry average of 1.08 indicates that most of the current assets of the company are in the form of Inventory which cannot be liquidated in a short time. The higher inventory levels could be one of the reasons for lower current ratio of the company as it would have led to a higher levels of accounts payable balance thus reducing the current ratio due to higher levels of current liabilities.
3. The AR collection period at 21.90 days is approximately 50% higher than the industry average of 14,83 days. This indicates that either the company is offering higher credit periods to its customers or the customers are not paying on time.
4. The liquidity position of the company as evidenced from its current and quick ratios cannot be termed good when compared with the industry average. The low liquidity of the company in spite of higher than average profit levels indicate that the company is not utilizing its resources efficiently and it should take immediate corrective steps because liquidity crunch can lead to increased leverage levels and as a result reduction in the net income of the company or the company may be forced to be shut down due to liquidity issues.