- What three factors would influence your evaluation as to whether a company’s current ratio is good or bad, why?
- Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company.
- Why is working capital given special attention in the process of analyzing balance sheets?
- What does the number of days’ sales uncollected indicate and who would be interested in these ration?
- What does a relatively high accounts receivable turnover indicate about a company’s short-term liquidity?
- Why is a company’s capital structure, as measured by debt and equity ratios, important to financial statement analysts?
- How does inventory turnover provide information about a company’s short-term liquidity?
- Discuss why there may or may not be ratios that would be more important in a service vs manufacturing environment and which rations would those be?
Why is working capital given special attention in the process of analyzing balance sheets?
Working Capital gives us an idea about company’s short term financial health (Investopedia, n.d.).
Working capital = current assets – current liabilities
Working capital is important because it tells us if the company can cover or pay off its current liabilities, which might include rent, loan payment, interest payment, payment to vendor etc. So a positive working capital or a working capital ratio > 1 (current assets / current liabilities) shows that the company will be able to meet short term liabilities.
Ideally the working capital ratio should be between 1.2 to 2.0 (Investopedia, n.d.).
If the working capital is negative or the working capital ratio is less than 1 that means the company has a problem in hand to pay off current liabilities. If it is too high, then the current assets should be investigated further to see if the company has unsold inventory or too much account receivable that means company is behind in collecting money from the customers. So it is important that for the company the inventory is not too high or not going higher year on year or quarter on quarter. And same with the account receivable. But a lower working capital ratio and shrinking account receivable might show declining sales.
What does the number of days’ sales uncollected indicate and who would be interested in these ration?
It is number of days a company needs to get collect the money back after sale has been made. It is usually derived based on month, quarter or year (Investopedia, n.d.).
Number of days sales uncollected = (Accounts receivable / Total credit sales) * number of days
It is in company’s best interest to keep the number of days sales uncollected low, first of all the sooner they get the cash back the less lose on present value of money and secondly they can put back the cash to work wither on investments or paying off debts.
And I think creditors of the company would be interested to know the number, since a lower number would suggest that the company can collect the cash sooner after making sales and that means less chance of cash flow problem. But one important point is this does not capture any sale made in cash.
While number of day’s sales uncollected can give idea about number of sales a company is making or how well the collection system of the company is functioning and if it has any cash flow problem, but it does not capture the part of sale made in cash.
- Suggest several reasons why a 2:1 current ratio might not be adequate for a particular company
Current ratio is a good measure to see if a company has enough assets to pay off current liabilities. And 2:1 current ratio might mean in theory that the company has $2 worth current assets to pay $1 worth current liability. Which should sound pretty good on the surface.
One reason behind higher current assets could be unsold inventory, and that might mean that slowdown in sales, or low demand for the market. Or it might simply mean the company is not being able to better use its cash. But when the company has too much account receivable and unsold inventory causing a higher current assets that might imply that the company does not have enough cash to meet its current liabilities.
Retrieved on 3/23/2018. Retrieved from https://www.investopedia.com/terms/w/workingcapital.asp
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