Can a Ratio Be Too Good? Tony Christopher is analyzing the financial statements

Question

Can a Ratio Be Too Good? Tony Christopher is analyzing the financial statements of Shaycole Company and has computed the following ratios. Shaycole Industry Comparison 47 48 times 61 times 274 times 87 times 01170864 19 Current ratio Inventory turnover Accounts receivable turnove Debt-to-equity ratio Andy Martinez, Tony's colleague, tells Tony that Shaycole looks great. Andy points out that although Shaycole's ratios deviate significantly from the industry norms, all deviations suggest that Shaycole is doing better than other firms in its industry. Is Andy right?

Explanation / Answer

Although ratios for company is good but Andy is not fully right. Let’s analyse each ratios one by one;

1. Yes it is true that higher current ratio is better sign for the company but very high current ratio or very high ratio in compare to industry’s average also lead to some bigger problems. As per information of the question it is given that current ratio for industry is 19 whereas for Shaycole company it is 47. It shows that this company have higher amount in current assets which may leads to mismanagement of current assets such as; inventory, account receivables, cash etc. If there are very high amount blocked in current assets then there will be higher chances of frauds & theft of cash, inventory etc.

2. Higher inventory turnover ratio is good symbol for the company because it means that company is selling higher amount of goods in compare to average inventory hence it is good for the company. But if sale is made on credit excessively then it may lead to unneceesary accumulations of accounts receivable or may lead to bad debts or doubtful debts.

3. Higher accounts receivable turnover ratio is good for the company because if accounts receivable turnover ratio is high then it means that most of the sales is being made on cash basis of collection policy from receivables is much bettter. In both cases it will be good for company thus higher accounts receivable turnover ratio is very good symbol for Shaycole company.

4. Debt to equity ratio for Shaycole company is lower than industry’s average that shows that company is using less amount of debt funds in compare to shareholders’ equity. Although it will resut into saving of fixed interest expenses and also lead to higher returns for the real owners but lower debt to equity ratio also have some negative impacts. In case of use of low debt funds Shaycole company will not enjoy full benefits of leverage effect because we know that debt funds help in maximizing wealth of the shareholders and also help in maximizing EPS thus this is negative impact of low debt to equity ratio. Apart from this interest on debt funds is tax deductible hence it results into lower tax liability thus Shaycole company will not take advantage of such benefits due to low debt to equity ratio.

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