A compary has the following ratios: Current ratio: 2.1 to 1.0 Debt/ equity ratio

Question

A compary has the following ratios: Current ratio: 2.1 to 1.0 Debt/ equity ratio. 3.0 to 1 Interest coverage ratio 3.0 to 1 Inventory turnover ratio 5.0 to 1 The industry averages are: A company has the following ratios: Current ratio: 4.1 to 1.0 Debt/ equity ratio. 4.0 to1 Interest coverage ratio 9.0 to1 Inventory turnover ratio 8.0 to 1 Based on the above items, please compare and contrast the ratios between the company and the industry. Please analyze reasons why there could be differences and the overall financial position of the company Also, what of the ways the company could finance the company without significant negative changes to the above financial metrics (ratios)?

Explanation / Answer

Answer:

1.a) Current ratio: Current ratio define the current asset over current liability which is converted into cash in one accounting period. The current ratio is one of the liquidity ratios which determine the company ability to repay the short-term debts.

Current ratio= Current asset/ Current liablities.

In this case, the current ratio is ideal but lower than better than the industry average which means the company is managing its working capital requirement in a better way although it's lower than the industry average. since its already at the ideal mark which is 2:1, it will help in having a better loan facility by the lender in the short term owing better financial position.

The reason of high average of the industry current ratio is due to the fact that many companies in this industry have a higher current asset which can be negative in the long term. so, to assess the impact we need to take into account the type of current asset and current liabilities different companies have on their balance sheet.

b)Debt/ equity ratio: Debt/ equity ratio is leverage ratio which determines the total company debts to total equity.The higher debt/ equity ratio means more financing comes from the creditors (debtors) then the investors financing (shareholders fund).The lower the debt/ equity ratio the better it is. It means the company is a better position to raise funds at a lower cost of interest due to better repayment records of the loan.

Debt/ equity ratio: Total debt( short term and long term debts)/ equity( shareholders fund)

In this case, debt/ equity ratio is 3:1 which means the company has three times of debt as compared to equity. However, it better than the industry average which is higher and having a ratio of 4:1.This highlights the fact that company will able to raise more long-term debts in the near future at a lower cost since it is in better shape to repay those funds as compared to industry players.

The higher industry average highlight the fact that industry operates at higher debt financing which means either this is capital intensive industry or its use more of leverage to finance its asset to take tax benefit on the interest cost.

c)Interest coverage ratio: Interest coverage ratio define company ability to repay its interest burden out of operating profits.The various stakeholders use this ratio to determine company's ability to repay its interest cost in the stipulated period of time. If a company is in not in a position to repay its interest cost, the principal repayment looks difficult in the near term. Higher the ratio better it is.

Interest coverage ratio: EBIT/ Interest expenses

The company interest coverage ratio is lower than the industry average which highlights the fact that either company has lower debt exposure as compared to operating profits which seems visible since the company has lower debt/ equity ratio as well vis a vis an industry average.

The industry average is very high it means different players have higher debt exposure vis-a-vis operating profits. However, it seems the tenure of debts is long which might be resulting in the lower interest cost repayments in the long term.This is acting as a benefit for the various leading player but can lead to the risky situation if dynamics of the industry changes which can result in lower sales.

d) Inventory turnover ratio: Inventory turnover ratio means how much inventory being converted into sales over one accounting period. Higher the ratio better it is but there is catch it should not be too high that company cannot sell that much inventory on the market.

Inventory ratio= sales or cogs/ average inventory

In this case, the company having inventory turnover ratio of 5:1 as compared to industry average of 8:1. This means the company is having lower inventory compared to its peer group resulting in higher turnover or sales over one accounting period. On another hand, the company is in the mode to produce the only sales requirement which is available in the market which can be a good sign for the company in the short term. However, in the long term company has to move in tandem with industry so that new demand can be created to increase its profits.

The higher industry average ratio of inventory means that player of this industry churning higher inventory into more sales in one accounting period which highlights two facts. one is there is a huge demand for the product in the market and second can be this industry works on high inventory which can meet any unforeseen demand of the future as well.

2) The way company could finance the company without significant negative changes are as follows:

a) The company has the ideal current ratio of 2:1 as compared to industry ratio of 4.1:1. This highlights the fact that company has lower inventory or higher current asset which are due to better operations or underutilization of its operation. so it better to have higher inventory which can result in better sales and increase in current liabilities also with longer credit cycle can be beneficial for the company.

b)Debt/ equity ratio of the company is lower than the industry which gives the company an option to increase its exposure in debts to meet the growing demand through better sales. However, the company first needs to consider the existing market demand in dept which can provide signals to make an investment in near term is beneficial or not.

c) Interest coverage ratio: Increase in debt will impact this ratio in a negative way if there is a decline in operating profits. so the company should assess that whether the market can hold the newly created sales so that this ratio doesn't get impacted.

d) Inventory turnover ratio: since its lower than the industry it means the company is not tapping the market in full scale. so to tap the market the new either new investment or scale up the operations by utilizing its asset to its full capacity so that new demand can be met and reap better profitability.

(ends)

Ratios company ratio Industry ratio Current ratio 02:01 4.1:1 Debt/ equity ratio 03:01 4.0:1 Interest coverage ratio 03:01 09:01 Inventory turnover ratio 05:01 08:01

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