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

ANSWER:

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 repay its current liabilities using its current assets and therefore, would need to arrange for the repayment of current liabilities from other sources.

Inventory to sales conversion period is 180 days. The company is carrying a too high inventory than its requirement. This ratio shows inefficient inventory management. By carrying this high level of inventory the company is bearing unnecessary inventory cost.

Sale to cash conversion period is 40 days. Cash collections on accounts receivable is not very efficiently. A significant amount of working capital is locked in accounts accounts receivable for which the company is bearing interest cost.

Purchase to payments conversion period is 7 days. The company is not able to use interest free finance in the form of accounts payable for its benefit efficiently. Cash is being paid to the supplies very quickly in comparison to the time company takes in realizing cash from its debtors.

A net profit margin of 3% is too low to have good return on equity. Based on the ratios and additional information provided it can be concluded that the company is not able to provide good return on equity. Return on equity for this company is poor.

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