Question

You have been provided with the following information for a small private company, Formosa Pty Ltd, whose competitors are predominately large public companies.

	2017	2018	2019	Industry average 2019
Net profit margin	8.2%	7.5%	6.8%	8.0%
Return on equity	13.1%	12.3%	11.1%	13.5%
Current ratio	1.8	2.1	2.4	2.0
Quick ratio	1.2	1.1	0.9	1.2
Receivables turnover	12.2	12.6	13.0	13.0
Inventory turnover	4.7	4.5	4.2	4.8

REQUIRED:

1. Comment on the trend of each of the six ratios for Formosa Pty Ltd in relation to the company’s profitability and liquidity. For each ratio, describe what the ratio measures. (word limit 500).

2. Explain the difference between liquidity and solvency when analyzing a company’s financial statements. (word limit 150).

Answer 1

a.

Net Profit margin = Net Profit / Sales x 100

The Net profit margin of Farmosa Pty. Ltd. has been gradually decreasing from 2017 to 2019 and in 2019 it is 6.8% which is much lesser than the industry average of 8 %. This is unfavourable for the company as the net profit is one of the key indicators of profitability of a company. The reasons might range from increase in the costs to reduction in the price of sale. The company needs to carry out in depth analysis as to identify the reason behind the decrease in the net profit margin so it can rectify its mistakes and increase the profitability.

Return on Equity = Net Income/ Shareholder's Equity

Similar to the net profit margin, the return on equity has also gradually decreased from 2017 to 2019 and has reached a rate much lesser than the industry average. It is one of the direct effect of decrese net profit. The reduced ROE may upset the shareholders and cause a reduction in the share value of the company.

Current Ratio = Current Asset/ Current Liabilities

The Current Ratio has gradually increased from 2017 to 2019 and as in 2019 is 2.4 that is above the average industry ratio of 2.0. Although this may seem favorable at a glance it is necessary to identify which assets hold higher value among the increasing current assets. The increase in Debtors or Inventories may indicate that the funds of company is stuck in inventories and debtors and may not be collectible in future.

Quick Ratio = (Current Assets - Inventory)/ Current Liabilities

The Quick ratio has been decreasing from 2017 to 2019 and it has become lower than the industry average in 2019. This is an indication that the increase in currrent assets is due to increase in inventory which may be a result of decreased sales. This indicates that the funds of the company are stuck in inventories and thus the company may be facing a liquidity crunch.

Receivables Turnover = Net credit sales / Average receivables

This indicates the speed with which the debtors are being collected by the company. The trend indicates that the receivables turnover has increased from 2017 to 2019 and has become equivalent to the industry average. This means that the company does not have any problem in collecting the amounts due from the receivables. This is favorable for the company especially because it has less liquidity.

Inventory Turnover Ratio = Sales/ Average Inventory

This indicates the speed with which the inventory is being converted into sales. The trend indicates that the Inventory turnover ratio has decreased and in 2019 it is much lesser than the industry average. This means that the company is not able to convert its inventories into sales efficiently. This is unfavorable and should be attended immediately by the company in order to save itself from severe liquidity crisis.

b.

Liquidity refers to the company's ability to meet its short-term liabilities like daily expenses, creditors and other operating expenses. Whereas, Solvency refers to the ability of the company to pay its long term obligations like debt repayments. Both Liquidity and Solvency indicate the company's ability to pay off its obligations but the only difference is that liquidity related to short term obligations and solvency related to long term obligations.

The various ratios that act as a measure of a company's liquidity are Current ratio, quick ratio, Inventory turnover ratio, Debtors turnover ratio and working capital. The company is expected to have liquidity to at least cover up its daily expenses. A higher liquidity is generally considered favorable.

The various ratios that act as a measure of company's solvency are Interest coverage ratio, debt-equity ratio, debt-to-assets ratio. Higher solvency ratios indicate that the company is capable of meeting its debt obligations which is considered favorable by the investors.