Writing the right business plan is the key to success and we must analyze out financial ratio to figure out the right plan, and in our case the banker refused to give this company a loan because the ratios don't qualify this company to take the loan, Pehr asked Robert about what do the ratios mean and what should the do to improve the ratios and here are the answers.
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The first ratio is the Current Ratio and it is calculated with the formula: "Current Ratio = Total Current Assets/total Current Liabilities". (Auerbach, 2008). The ratio decreased from 2.3:1 in the last year to 1.7:1 this year and still under the industry average which is 2.4:1 and that tells that the strength of the firm is not certain. Auerbach (2008) says that a good ratio is between 1 and 2, so the current ratios were good. And in order to increase that ratio Auerbach (2008) suggests that it is possible "by increasing current assets or by decreasing current liabilities". And to achieve that goal Auerbach (2008) suggest the following solutions: "Paying down debt. Acquiring a long-term loan (payable in more than 1 year's time). Selling a fixed asset. Putting profits back into the business".
Second of all is the Quick Ratio and it is calculated by the formula: "Quick Ratio = (Current Assets - Inventory)/Current Liabilities". (Auerbach, 2008). For this firm the quick ratio decreased from 0.7:1 last year to 0.4:1 this year and still below the industry average which is 0.8:1, and Auerbach (2008) says that generally a good quick ratio lays between 0.5 and 1 which means that the quick ratio moved to under the required range after being in it. So, in this case the company cannot" meet its obligations". (Auerbach, 2008). A good suggestion to increase that ratio is to sell a fixed asset, put profits back into business or buy some stocks and bonds as quick assets include" include cash, stocks and bonds, and accounts receivable". (Auerbach, 2008).
The third ratio is the Debt ratio and it is calculated by the formula: "Debt Ratio= Total debts/Total assets". (Patsuls, 2007). The debt ratio increased from 0.81:1 last year to 0.89:1 this year and still above the industry average which is 0.65:1, but according to Patsuls (2007) a good debt ratio is 0.5:1 and the company's debt ratio is above that level and even the industry average is above that level. In this case decreasing the ratio is the objective, so a good way to decrease the debt ratio to attract investors so the company gets a cash flow which increases total assets, in the end this makes the debt ratio decreases. According do Patsuls (2007) "investors sometimes like a high debt to asset ratio, because then they figure they are leveraging their investment (like buying real estate with 0% down)".
The fourth ratio is the Debt to Net Worth Ratio and is calculated with the formula: "Debt to Net Worth=Total liabilities/Net Worth", Net Worth is calculated by the formula: "Net worth=Total assets-Total liabilities". (Auerbach, 2008). According to Auerbach (2008) this ratio "is a measure of how dependent a company is on debt financing as compared to owner's equity. It shows how much of a business is owned and how much is owed.". This ratio increase from 2.6:1 last year to 2.9:1 this year and still even above the industry average, from that we can conclude that the indecency of capital in that company decreases. Auerbach (2008) says that "If the debt-to-worth ratio is greater than 1, the capital provided by lenders exceeds the capital provided by owners". The objective here is to decrease this ratio, a good suggestion is trying to attract investors so that they will provide capital, in this case capital provided by investors increase in front of capital provided by lenders and then assets increase and liabilities remain the same or even decrease, and this will make the debt to net worth ratio decreases.
The fifth ratio is the Inventory Turnover Ratio and it is calculated by the formula: "Inventory Turnover Ratio= Cost Of Goods Sold/inventory". (Auerbach, 2008). According to Auerbach (2008) this ratio expresses how many time the inventory becomes sales in a certain period of time, and" It is a good indication of purchasing and production efficiency". For this company the inventory turnover ratio decreased from 4.9 times/year last year to 4.3 times/year this year and still below the industry average which is 7.1 times/year, which indicates to the weakness of purchasing and production efficiency, but as Patsula says this ratio must be between 1 and 6 to be in a good shape and that is the bright side. Our objective is to increase that ratio, and as Auerbach (2008) says" A high ratio shows that inventory is turning over quickly and that little unused inventory is being stored". A suggestion to increase that ratio is decrease production level so that the inventory gets converted to sales and as a result the ratio will increase.
The sixth ratio is the Average Collection Period ratio and it is calculated by the formula: "Average Collection Period=Current Account Receivable Balance/Average Daily Sales", "Average Daily Sales=Annual Sales/360". (Period, n.d.). And this ratio shows how much time needed for average sales to become cash. In this company the average collection period increases from 36 days last year to 43 days this year but still yet above the industry average which is 34 days. Our objective is make this ratio smaller and for that purpose this company must control investments on receivable accounts because" A higher investment in accounts receivable means less cash is available to cover cash outflows, such as paying bills". (Ratio, n.d.)
The seventh ratio is the Net Sales to Working Capital ratio and it is calculated by the formula: "Net Sales to Working Capital=Net Sales/net Working Capital". (Auerbach, 2008). According to Auerbach (2008) this ratio measures how the business uses the working capital and how the capital boosts up sales. For this company this ratio decreased from 10.4:1 last year to 9.7:1 this year and still even below the industry average which is 12.6:1 and that means lower level of using the working capital by the business and lower levels of supporting sales by the working capital. To increase this ratio the company must use the capital more efficiently and invest it but as Auerbach (2008) says using more capital will cause serious problems for the company in sales drops because of a cash flow crisis.
The eighth ratio is Net Profit on Sales and it is calculated by the formula: "Net Profit on Sales=Net Profit/Sales". (Patsula, 2008). For this company this ratio dropped from 4.1% last year to 3.8% this year and still even below the industry average which is 9.4% and indicates to the low level of the net profit on sales for that company. A suggestion for that company to increase this ratio is to try to avoid any kind of unnecessary costs, and try to decrease the necessary costs.
The ninth and final ratio is the Net Profit to Equity ratio and it is calculated with the formula: "Net profit to Equity=Net Profit/Stockholders Equity". (Ratios, n.d.). This ratio" measures the return earned on the owners equity in the firm". (Ratios, n.d.). For this company the net profit to equity ratio increased from 17.6% last year to 18.3% this year and still yet above the industry average which is 13.4% and that indicates to the certain profitability for stockholders. Our objective is to increase that ratio but in this case the ratio is excellent is it doesn't need to be improved.
Generally, the banker was right about disagreeing to give that company a loan because the financial ratios indicate that it very risky in general to invest in that company. But improving those ratios doesn't require that much potential but it requires wise decisions to improve and change the ratio, and especially to set the right ratios of different assets because that what improve the financial ratios very well. So, it is not necessary to spend money in order to improve the financial ratios, but simply set the right amount of each an every asset and this is possible by converting a form of assets to another like selling a fixed asset to get cash.
- Auerbach, A. (2008). How To Analyze Your Business Using Financial Ratios. Retrieved
April 2, 2008, from http://bcrc.compassbank.com/SBR_template.cfm?DocNumber=PL121500.htm
- Measuring Average Collection Period. (n.d.). Retrieved April 2, 2008, from http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_4208
- Patsula, P. J. (2007). Understanding Business Ratios. Retrieved April 2, 2008, from http://www.patsula.com/smallbizportal/articles/index.php?artid=20
- Understanding Financial Ratios. (n.d.). Retrieved April 2, 2008, from http://www.activmediaia-guide.com/busedu_finrat.htm
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