Financial ratios are accounting tools which are used in the analysis of the business performance. They include liquidity ratios, profitability ratios, debt utilization ratios, asset utilization ratios.
It is a ratio that mainly measures the level or position of working capital in a company. The Alpha company has a current ratio of 1.3 which is greater than 1.It thus shows that the company has short term assets which include market securities, inventory, receivables and cash equivalents to settle the short term liabilities. Therefore, an additional cushion can be provided for uncertainties which might accrue in the short run. Besides, it gives a sense of efficiency of a company on its ability to turn their output into cash or cash equivalents (Anderson, 2012, p. 23)
Since the quick ratio is higher than the current ratio, Alpha Company should work to maintain the current ratio or improve it to higher levels. The company should also work on reducing the effect of cash receivable since any delay of customers from paying debt will cause an increase in debtors value, which also leads to incline in the value of the current assets and eventually the value of the current ratio.
Acid test ratio
The ratio mainly determines the most liquid asset among the current assets available in the company to cover up its liabilities. It excludes the value of inventory in its computations. It shows the ability of the company to pay their liabilities through the use of quick assets. If the company has quick asset ratio which is more than 1, It thus shows that the current assets are equal to the quick assets. In this case, Alpha has a quick ratio of 1.03 which indicates that it can easily pay the liabilities without selling the long-term assets.
Improve quick ratio by paying bills while sales should be boosted.
Debt utilization ratio
Debt to total asset ratio
The assets are used to gauge the amount of debt which the company uses to manage its operations. The low value of this ratio shows that the company does not fund its operations mainly through debt. While when it is higher, it indicates that the company is highly leveraged. In the case of Alpha company, the debt to total ratio of 0.5 which is a very reasonable ratio for the Alpha company. A lower ratio indicates the stability of the company since a company with a lower ratio is financed by a lower debt.
The company, in this case, should put a lot of emphasis on boosting sales while minimizing overhead expenses. The proceeds of sales can be used to pay debts hence reducing the value of debt to a manageable level.
Times interest earned
It is the ratio that measures the ability of the company to meet her debts without any delay or failure. It can also measure how possible a company can pay interests accruing from an outstanding debt. When Alpha Company shows times interest earned of 8.8, It means that the companys income are enough to settle interest expenses on the outstanding debts. It also shows that the revenue of Alphas company is 4 times higher in a given financial year. In a business set up a ratio of 2 times and above is considered adequate for a company. However, a higher ratio can also mean that the company has a very low leverage system due to higher debt repayments.
With a lower debt, the value of the ratio also declines. While the company is borrowing, they should borrow prudently bearing in mind that too much borrowing affects the level of productivity and hence the value of times interest earned ratio (Kaiser & Young, 2013, p. 14-15).
Return on assets
It mainly shows how a company is profitable while considering the current assets. It also shows how companies can efficiently manage their assets. Besides, it can also show how a company can convert the money used to buy the assets into net income. The higher the ratio, the more the company is favorable to the investors since it is effectively and efficiently managing the assets. Since Alpha company has total assets of 0.532, It shows that it is a darling to the investors and at the same time have increasing trends of profits over the years.
If the company has an increasing trend of return on assets, then the profitability of the company also inclines and the reverse is true.
Return on equity
Measures ability of a firm to generate profits from the shareholders investments. Companies with higher returns are considered successful while those with lower returns are considered unsuccessful. Alpha has a return on equity ratio of 0.1071 which shows that they maximize profits from shareholders wealth.
The company should use more leverage, increase profit margin, improve asset turnover and distribute idle cash so as to attain a higher return on equity.
Gross profit margin
It shows how the company sells its stock at a profit. It is the percentage markup on the costs. Higher ratios indicate favorable conditions for the company. The alpha company has a ratio of 0.2911 which shows that the company is selling their inventory at a profit equivalent to 29%.
Alpha should buy the inventory at cheaper costs while considering purchase discounts to achieve a higher ratio. Besides, they should indulge in marking their goods up higher so as to increase the value of the ratio.
Assets utilization ratio
Account receivable turnover ratio
It is an average value of sales and a balance between the account receivables within a given period. In the case of Alpha Company, it had a ratio of 1.4177.To consider whether the company performs or not, the comparison should be done by the previous years' ratios.
Since account receivables' is averages, they should be reviewed to detect the slow paying accounts.
Average age of account receivables
It is a report prepared periodically to show the account receivables as per their age or length of time. It also shows that some of the customers are not credit worthy. Higher average age accounts receivable, the worse debts indication for a company. The alpha company, in this case, had average aging account receivables of 257 days which mean it had a higher number of debtors who is not credit worthy.
Periodic checks should be done to detect the customers who are low to pay their dues.Higher periods sends a warning that the business operations can slow down hence action must be taken.
Inventory turnover ratio
It a ratio showing how efficiently a company can manage and control inventory. The Higher inventory shows that the company does not spend much in purchasing the inventory. It is also a good prospect for the purchase and sales of the stock. Alphas company has a turnover of 2.8357.It shows that the company replenishes its stock almost 3 times within a given financial year.
Turnovers should be maintained higher since they are used by external parties like bank during provision of loans.
Average age of an inventory
It shows the time on average a company takes to sell inventory held in store for a customer. Higher average age inventory shows that the firm does not have better methods of handling inventories. It helps the purchasing agents of the company to make purchasing decisions. Besides, it helps the sales managers to make pricing decisions. In Alpha's case, the company has an inventory turnover ratio of 2.8357 which shows that the management of the inventory is not better in Alpha.
Factors leading to inventory write-off charge, obsolescence risks which can lead to the loss of soft markets should be avoided as much as possible.
Asset turnover ratio
It measures the firms ability to generate sales from the assets it owns. It compares average total assets with the net sales. Higher ratios show that the company has a good performance and uses its assets more prudently. I f the ratio is 1, it means that net sales=total average assets. (Bhat & Rau, 2008, p. 43)The figures got can also be compared with other figures in the industry. In alpha companys case, the ratio is 0.5657 which shows that for every value of assets. Alpha only makes 57 cents.
The ratio should be maintained higher by boosting the rate of sales with the given level of assets.
Considering the market which Gamma Corporation and Alpha are participating, Alpha Company is performing well since its current asset ratio, and acid test ratio is higher than that of Gamma Corporation. Besides, it has favorable profitability ratios that show that they are not making loss but at least some good profits in the market. The company also has a higher debt to asset ratio which shows that Alpha Company has a balanced leverage which reduces their tax expenses. All the ratios help to determine the efficiency of the management of resources and the rate at which they provide returns to the company. Therefore, to improve the performance, the company should reduce the level of cash receivables so as to avoid bad debts which increase the value of current assets and hence quick higher current ratio. The alpha company should also increase sales and pay their bills so as to increase the value of the quick ratio. Besides, to increase financial performance, periodic checks should be done on the inventory so as to detect and eliminate bad debts. Therefore, for effective management, the company should consider using more leverage, increase profit margin, improve asset turnover and distribute idle cash so as to attain a higher return on equity.
Analysis of NPV of proposal A, B, C, and D
According to the Net Present values of these proposals, all of them are viable for implementation since they have positive NPV. However, when a firm faces financial constraint, then the proposal which has a higher positive NPV will be implemented first. So in this case, Proposal C should be implemented first, followed by A, then B and lastly D respectively.
Anderson, P. L. (2012). The economics of business valuation: Towards a value functional approach.
Bhat, M. S., & Rau, A. V. (2008). Managerial economics and financial analysis. Hyderabad: BS Publications.
Helfert, E. A., & Helfert, E. A. (2001). Financial analysis: Tools and techniques : a guide for managers. New York: McGraw-Hill.
Kaiser, K., & Young, S. D. (2013). The blue line imperative: What managing for value really means.
Sclove, S. L. (2013). A course on statistics for finance. Boca Raton, FL: CRC Press.
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