You are the owner of a business and you hire a new accountant to help you manage

Question

You are the owner of a business and you hire a new accountant to help you manage the business. The new accountant tells you that in order to operate the business properly you have to pay attention to financial ratios. The accountant prepares your financial statements, then produces for you a number of ratios. The ratios that the accountant produced are listed below.

Question: For each one, what does the ratio tell you about your business. (Not an explanation of what the ratio is, but what it means to the operations of the business).  

Current ratio - .85

Inventory to Sales Conversion Period – 180 days

Sales to Cash Conversion Period – 40 days

Purchases to Payments Conversion Period - 7 days

In addition to these ratios, the accountant also shares that the company has a gross profit margin of 15% and a net profit margin of 3%. Based on this additional information and the above ratio information, will this company have a good return on equity or a poor return on equity. (No calculations required. Just think in terms of what the company's balance sheet will look like with these ratios).

Explanation / Answer

1. Current ratio is less than one. That means the company's total curent liabilities are greater than its total current assets. This raises serious concern regarding the company's liquidity. A current ratio of less than 1 means the company will not be able to pay off its short term debts with the current assets that it maintains.

2. An inventory to sales conversion ratio of 180 days indicates that the company has very poor sales performance and that the products of the company are being sold every 6 months. This is an extremely poor performance and the company should strengthen its marketing efforts to market their products and increase their sales.

3. A Sales to Cash Conversion cycle of 40 days indicates that the company has liberal credit policy where the company is collecting cash from its customers in every 40 days. This is an indicator of poor credit performance by the company.

4. A Purchase to payments conversion of 7 days is even worse considering the above collection period of 40 days. It indicates that while the company is paying its suppliers in only 7 days, it is able to collect cash from its customers in 40 days. This will leave the company in negative working capital situation with acute cash shortages.

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