Liquidity Ratios
These are ratios that help accompany to meet its short term maturity obligations. They are arbitrary measures that are used to verify a company’s capability to settle off short-term debts responsibilities. They basically measure the ability of the company to meet its near-term obligations. Current ratio and acid test ratio are example of liquidity ratio measures.
Current ratio
Current ratio is a liquidity measure that shows the rate at which a company is able to meet its short- term liabilities using its current assets. It indicates the capability of a company to meets its short term liabilities with its current assets. Companies with current ratio more than positive one signifies the company’s ability to effectively use its current assets to meet its near term obligations. However, a situation where current ratio is less than positive one shows that the company has liquidity problems and hence not able to meet its short term obligations. The higher the ratio the more liquid the firm is.
Uses of Current ratio
I. It is used to measure a company’s market liquidity and its position to meet the demand of creditors.
II. It is used to show the ability of the firm to meet its current obligations.
III. The ratio has long been used to give an insight of the company's ability to pay back its short-term liabilities with its current assets. The financial institutions like venture capitalists and angel investors find it useful before they make finance advancement.
Generally, a high current ratio signifies that a company does not efficiently use its current assets and thus is faced with working capital problems. On the contrary, a low current ratio--often values less than one--shows that a firm is unable to meet its current obligations.
For this company, the current ratio is 1.92 which is far more than positive one. This shows that the company has a reasonable liquidity. This signifies a sound working capital. Besides, it indicates that the company has a good short-term financial strength and thus more liquid assets.
The value, 1.92 means that for every dollar the company owes in the short term, it has $1.92 available in assets that can be converted to cash in the short term. It shows that the current assets are almost twice current liabilities which portray a good working capital management.
Acid test ratio
An acid test ratio is an indicator determining whether a firm has adequate current assets to cover its immediate liabilities without selling its inventory. It allows inclusion of inventory. This makes it more rigorous than the current ratio. It indicates whether a firm is able to meet its current liabilities in the short run without selling its inventories. Acid test ratio value of more than one shows the ability of the company’s current assets to cover any unexpected liability. A company with acid test ratio less than working capital ratio however shows that the current assets linearly depend on the inventory.
For this company, its acid test ratio is above positive one. This means that liquid assets are good enough to meet any unexpected depletion of the liabilities. Besides, its current assets do not entirely depend on the inventory to meet unexpected liquid liabilities.
Inventory Turnover Period
Inventory turnover is a ratio that shows the rate at which a company’s inventory is sold and replenished over a period. It shows how many days it takes a company to sell out its inventory and replace with new ones. A low inventory turnover means poor sales. This shows that there is a surplus of inventory in store. It shows poor inventory outs. However, a high ratio value signifies strong sales and or unproductive buying.
A high inventory period shows that there is a zero return rate on the investment which is quite dangerous for the company’s operations.
For this company, its inventory turnover period is 76 which is slightly high. This value shows that the value of sales is high, which plunge the company in problems should there be a drastic fall in prices. Besides, this high value signifies that the rate of return on investment is zero or is low to perform.
AVG Days Receivables
The Days Receivables show the period which elapses between a sale and receipt of payment for each and every sale made. This gives an insight of financial structure of a firm, including how the firm manages its receivables. Calculation of days receivables assist in the determination as to whether a change in receivables is due to a change in sales. Besides, its comparison with a company’s credit terms shows the degree of response from customers. A bigger value of day’s receivables shows that there is a poor response from the customers. The customers’ response is not promising hence may derail a firm’s performance should there be a failure to comply. It indicates the firm’s ineffectiveness in managing its current assets like cash. For this company, the AVG Days Receivable is 84 which is a little higher for a success of a company. The time taken before creditors pay is so long that they may be declared as bad debts, an expense which the firm might not be ready to carry along. For successful firms, the days receivables must be as low as possible.
AVG Days Payables
Day’s payables are am working capital ratio that simply shows the duration taken by a business to pay back its creditors. It is determined by taking the accounts payable and dividing by the cost of sales. The value obtained is then multiplied by the total number of days. Besides showing the period taken to pay back, it is also helpful in determining the period a company makes interest out of the money it makes.
Basically, the larger the value of day’s receivable the better. This is due to the fact that a bigger number shows that a firm is able to earn more from investment made on the sales value. However, it is only reasonable in situations where the company is up to a given duration able to settle off its creditors. The AVG Days Payables value of 38 days show that the company takes 38 days to pay back its creditors. This is so low that the company may not be in position to earn interest in case the money it’s invested. Otherwise, it’s good for the company’s credit worthiness image.
Operating Cash Cycle
Operating cash cycle is used to determine the number of days between the payment for inputs and the number of days it takes to receive cash from the inputs after they are produced and offered for sale in the market. Basically, it helps to measure the duration it takes a firm to be dispossessed of cash should it increase its investment level. This shows that it measures a liquidity risk that comes with any investment made. Simply put, it means the time that elapses between a company’s payout and amassing of cash.
A higher value of operating cash cycle translates to a higher period for which the cash of a given company is tied to in profitable undertakings and thus locked out for other functions like investments. However, short cash cycle points out that there is reasonable working capital management. Therefore, operating cash cycle help determine the effectiveness with which a firm manages its working capital.
For the company, the operating cash cycle is 122 days. This value shows that the company is able to amass cash after 122 days from the date inputs were purchased and products made for sale. Besides, 122 days is a higher value thus signifying that the company has a higher period for which cash is engaged in the company’s undertakings. For the case of this company, Operating Cash Cycle of 122 days is not as bad as the company is able to channel the cash to other investments after every three months.
ROCE and ROSF
Rate of capital employed (ROCE) is used to determine the effectiveness and profitability of a company’s capital investments. It shows how best a company uses its capital to breed revenue. The higher the ratio, the better the company is placed. This is because it shows the company is able to obtain more from its capital cost. The company has a 45.2% as return on capital employed. This shows that the company is not even able to obtain a half from the cost of the capital. This investment is not profitable in the long run.
Return on shareholders’ funds on the other hand is used to measure the availability of a company’s profit for to the ordinary shareholders. Besides, it shows the stake ordinary shareholders have in a company. A higher percentage of ROSF signifies that a company is profitable enough and thus able to offer better return available shareholders. The ROSF of the company is 59.7%. This value is above 50% mark and hence shows that the company is more profitable. The available shareholders are guaranteed better returns at the end of a financial period.
Debt-to-Equity position
Debt-to-Equity ratio is used to measure the amount of money a company should borrow in the long run. Generally, any company that has a debt to equity ratio of over 40 to 50% must be analyzed keenly to guarantee zero liquidity problems. A situation where the debt-to-equity ratio is quite low shows that the working capital management is poor hence critical financial weakness.
Debt-t- equity ratio is also used to measure the solvency as well as the capital structure of a company. Simply put, it measures capability of a company to borrow and repay. Its value is quite crucial to the investors and creditors since presents the extent to which a company financed with equity capital or debt capital. A higher ratio of debt-to- equity shows that the company is more of financed with debt rather than the equity capital. It shows that a company may as well not in a position to repay its debts. This company has a 100% debt-to-equity ratio. This shows that it has balanced debts with the equity and hence a good position as the investors and creditors are convinced that the company has a sound liquidity position.
Internal Rate of Return
The internal rate of return employs cash flows and also recognizes the time value of money. It is advantageous due to the fact that it is easy to interpret and to compute as well. Besides, valuing money in the future and then discounting gives it an upper hand as compared to other capital budgeting techniques likes the payback period. In addition, it makes use of cash flows of each and every investment to be undertaken.
However, the main disadvantage of employing the IRR method as capital budgeting technique is that it often gives unrealistic rates of return on investments to be undertaken. Besides, if a discount rate chosen to asses an investment on trial and error basis is unrealistic; the decision of whether to approve or reject an investment may be unreliable. It also not beneficial to newly established companies which have limited financial knowledge.
Payback period
Payback period is a capital budgeting technique referring to the period of time required by an investment to generate a return on its investment which is able to cover the initial cost of the investment. The advantage of using payback period is that its ease of use and anybody who is having limited financial knowledge can apply it. It is also beneficial for those companies who are recently established and want to know the time frame in which they would recover their original investment. However, it ignores an important concept which is time value of money and therefore may not present true picture when it comes to evaluating cash flows of a project. This is its main disadvantage.
Define and analyze the expression "working capital management." Determine what the term "management" means. (10 marks) Working capital is that part of an organization’s capital that is required for the financing of the current (short-term) assets. Working capital is the cash that is needed to pay for the daily operations of the business. Working capital also refers to the circulating capital or the resolving capital. It is also known as the short-term capital. An organization’s current assets continue resolving very fast and are converted into cash. The cash is then used for exchange of other current assets. For the smooth running of an organization’s daily activities, working capital is needed.
Working Capital Management refers to all the measures that are put in place to ensure that the business has enough cash to finance its daily activities. Proper and effective management of working capital is thus vital.
For an effective management of working capital, the two characteristics of current assets must be kept in mind. Every current asset has: short life span; and swift transformation into other form of current asset. Life span of any current asset depends on the time required for the procurement, the production, the sales and collection. The shorter the life span, the greater the swift transformation into other forms of current assets. These characteristics imply that the working capital management decisions must be frequently taken on a repeated basis. The components of the working capital are very closely related and must be properly managed since the mismanagement of any of the components adversely affects the other components.
Working capital exists in the following forms: Value of Debtors, Stock of Finished Goods, Stock of Cash, Raw Materials, and the miscellaneous current assets e.g. short term investment loans and advances. Working capital management is influenced by several factors, some of which are highlighted hereunder.
The nature of the firm
Working capital and the nature of the firm are always related. The amount of the working capital depends on the nature of the enterprise i.e. the production firms require more working capital than the service sector firms.
The production policy
Every firm has its own production policy in the manufacturing sector. Some firms use the uniform production policy even when there is variation in demand, while others apply the “demand based-production” principle. In both cases, the working capital management varies.
Operations
Working capital management depends on the firm’s operations. Working capital fluctuates for seasonal business. During the peak season (busy season), there is rapid increase in the working capital, and a considerable decrease in the slack season.
The condition of the market
During high competition periods, working capital goes up since a lot of activities are carried out to ensure that the firm withstands the competitive market. During such conditions, a business enterprise engages in activities like sops like credit, quick delivery of goods, etc, which necessitates high working capital. If there is less or no competition, then the working capital requirements are low.
Raw Materials Availability
If the raw materials are readily available, then the firm does not need to maintain a huge stock of the raw materials, thus the working capital investment in the raw material stock is reduced. If the raw materials are not readily available, then a huge stock/inventory must be maintained. This calls for a substantial investment in the raw materials.
Growth and Expansion
The growth and expansion of any business requires huge amounts of working capital. If the working capital is increased, then the firm grows and expands.
Price level changes
If the price level rises, then the working capital investment goes up. If the prices of goods or services rise, then the level of current assets must be considerably increased to carter for the price increase.
Manufacturing Cycle
The manufacturing cycle begins with the purchase of raw materials and ends with the finished goods. The working capital rises when the manufacturing cycle involves longer periods. The reverse is also true.
The factors highlighted above directly influence the working capital. Proper and effective capital management must take all the above factors into serious consideration.
Analyze and evaluate how a company can tackle "periods of cash deficits." What should a company take into account when "investing its short term cash surplus?" (10 marks)
Cash deficit is defined as the shortage of available funds in meeting the firm’s current obligations. As defined above, working capital is the money that is needed to finance the day to day operations of a firm. Working capital is given as the current assets less current liabilities. It gives an insight of the business liquidity in future. If the working capital is insufficient (i.e. the current liabilities are greater than the current assets), then the firm is considered to have a cash deficit. In such a situation, a proper cash flow can be used to highlight the liquidity problems in the future.
Firms need to find ways of managing their cash flow especially during the economic downturn. Proper management of the cash flow is the only remedy to cash deficits; however, this is not easy. The business organization or the firm needs to embrace the spirit of hard work and focus on the essential missions. In addition, the firm must evaluate its operations for the purposes of expense-cutting. The firm must also be ready to bring in more revenue in a very timely manner and at the same time develop a simple and clear cash flow forecast.
Review of the sources of cash
For proper handling of the cash deficit periods, the first step is the review of the sources of the funds. If the organization collects fees for services, more attention should be given to the accounts receivable. The clients should be contacted immediately after the expiry of the payment period after the receipt of the services. A payment plan is very necessary for the clients with a poor payment history or those who pay late, before the provision of the services. It is true that, with strong and strict payment terms, the clients are most likely to continue using the services, especially when there are less costly options.
Exploitation of other sources
In case the regular cash avenues have been exhausted, the company should shift to other sources of cash. The company’s cash reserves, or the investments designated for future use, can be used to support the company’s operations during the periods of cash deficit. If the company’s board designate the endowment for certain purposes, such a designation can be changed and the funds released so as to support the current activities.
Watching of the expenses
It is very essential for a company to scrutinize the areas of potential cost cutting without affecting the company’s services and objectives. The cost cutting areas include travel costs, rent expense or lease expense negotiations, supplies, salaries and remunerations negotiations, among others.
Cash management tools
For the short-term decision making, the strong cash management tools help in controlling the budget deficits which makes the company survive the period of cash deficit in order to meet its long term objectives. The investments that the company makes during this process, is paid back in the future.
Developing a simple Model of Cash Flow Forecasting
The forecasting model that monitors the cash flow is very essential, just as the cost-cutting decisions or the negotiations. The simple forecasting model is divided in three steps. The first step involves the viewing of the annual budget by month, followed by the replacement of the month’s budget with the actual figures once the financial results are made available. This changes the company’s future cash demands. The final step involves factoring in all the changes into the budget, according to the company’s current decisions.
When investing the short-term cash surplus, four major factors must be considered. These factors are: return, risk, liquidity, and maturity. When considering the risks, it is generally believed that the higher the risk level, the greater the return. Less return is expected from the most liquid investments, while longer maturity periods generate higher returns. The reverse is also true.
Describe and analyze how a company should analyze the creditworthiness of customer using the "5C methodology". (10 marks)
When a customer applies for credit, the firm (lender) must evaluate the creditworthiness of the customer before the credit is given. One of the creditworthiness evaluation techniques is the 5C methodology. The 5Cs are capacity, collateral, capital, condition
Capacity
This is the most important factor to the lender. Capacity is defined as the ability of the customer to repay the credit (loan). The customer is therefore required to describe in details how he/she intends to repay the credit (loan), and when. The customer must clearly state the revenue sources, the expenses, and the amounts and timing of the cash flows with respect to the repayment. Capacity is also used to refer to the credit history of the client. The lender must also look at the client’s past repayment history.
Collateral
These are the different forms of security that the client can provide to the lending company. Collateral can include the client’s properties i.e. buildings and equipment, and guarantee by a third party.
Capital
This is the money that the client has invested in the business. Shall the business fail; capital is the money at risk. Capital measures the owner’s confidence in the business. The client’s confidence in his/her business makes the lending company to evaluate the client’s willingness to take risks. Capital is the greatest measure of the client’s ability to repay the credit.
Condition
Condition can be defined as the overall economic environment and the external environment of both the lending company and the client. During recessions, it becomes extremely difficult for the repayment of credits. Lending companies also find it difficult to get funds that they can loan. The client must therefore provide an iron-clad loan application to the lending company.
Condition also refers to the purpose of the credit. Before the credit is given, the company should consider whether the client intends to use the loan in expanding the business through the purchase of new equipment, or increasing the working capital. The client must clearly spell out the reasons why he/she needs the money.
Character
This is the lender’s subjective judgment on the prospective client. The lending company must decide whether the customer is trustworthy with respect to loan repayment and return generation on the investment.
