The Ability of a Company to Pay Its Short-Term Dues - Essay Example

?Current Ratio The ability of a company to pay its short-term dues using the current assets is determined through the current ratio. A value of to 2 is an acceptable range and, therefore, the company has maintained a healthy position with 1.06 in 2009 and 1.27 in 2010. This means that, in 2009, the company’s current assets surpassed its current liabilities by 1.06 times and 1.27 times. This trend is encouraging as it shows that the company liquidity is getting even better. This also implies that the company’s financial position is formidable and it is very unlikely to be declared bankrupt. Quick ratio Quick ratio, just as current ratio, is a measure of the company’s liquidity level, only that Quick ratio excludes inventory. This ratio is significantly below the current ratio, which could be an indication that the company is maintaining a high level of inventory. In case the company’s inventory is not easily convertible into liquid cash, then its financial position is at crossroads because it may experience difficulties paying its short-term creditors. The management should also consider whether the company is experiencing sales difficulties because that could be the reason why its inventory level is quite high. If this is the case, strategies should be crafted to increase conversion of inventory into cash so the liquidity could get better. Nonetheless, the positive increase from 0.83 to 0.95 is remarkable and if this trend continues, the company will not have liquidity problems. Accounts receivable turnover This ratio also shows the company’s liquidity level. It is a strong indicator of how the management has efficiently employed the accounts receivable. A ratio of 6.63 in 2009 is remarkably big, meaning that collection of accounts receivable and extension of credit to customers was operated efficiently. Alternatively, this may indicate that the company operated, chiefly, on cash basis. The drastic fall of the ratio in 2010 could send alarm signals to the management that something is wrong especially if this sale is not as a result of a shift from cash sales to credit sales. For instance, this could imply that the debtors are servicing their dues very slowly or even defaulting. Average Collection period Average collection period reflects the period that it takes for the company to receive its accounts receivables. The 53.03 days for 2009 is an ideal period because the company will be assured of conversion of its receivables into cash in less time and use the money to pay its bills. However, 214.38 days for 2010 is very high, and this means that the company may be headed for liquidity problems as a result of customers delaying or defaulting on their dues. This, in turn, will cause cash shortage and hence the company may not be able to meet its administrative and operating expenses. The management should revise its debt collection policies to avoid experiencing liquidity problems. Inventory turnover The inventory turnover for 2009 is 6.5 times, but this reduced to 3.96 times in 2010. This implies that the company’s sales have started moving slowly, which is discouraging because this will most likely affect the profits directly. This, however, could be a sign that the company is increasing its inventory. Decline in inventory turnover will result to cash shortage and hence this trend should be averted. Total asset turnover Total asset turnover indicates how the management has invested the assets to generate revenue. The higher the ratio the better because it shows that the assets are applied more efficiently. Reduction of this ratio from 0.93 in 2009 to 0.71 in 2010 is a cause for alarm because it indicates that the company’s assets are used less effectively, to generating income. The management should seek ways of boosting sales to ensure this ratio is restored to an optimum level. Debt to total assets Debt to total assets shows the company’s financial leverage, by revealing the proportion of the total assets that are funded by debt. In 2009, 47.14% of the assets were financed by creditors while the remaining 52.86% were financed by the owners. This metric has increased to 55.80% in 2010, which is very risky because it means that the largest portion of the assets are now financed by the creditors, exposing the company to high interest expenses. If this trend continues, the company may fail to pay interest rates to its creditors, which can lead the company to being declared bankrupt. Debt to Equity Generally, the company’s debt to equity ratio is extremely high indicating high leverage. In other words, it means that the company has used high level of debt to finance its activities. This implies that the company is liable to pay higher interest expenses, which can result to unpredictable income. However, if the company is increasing its debt finance and use it to increase its operations, then this could be noteworthy because more earnings can be generated, which could not have been generated without borrowing. Time interest earned The high ratio of 2009 indicates that the company is free from the risk of not being able to meet its debt obligations, but the risk was restored in 2010 when the ratio fell to 6.02 times. However, the high ratio in 2009 could be a reflection of an undesirably low level of debt because too much earnings could be used to repay debt instead of being invested in profitable projects. Profit margin The profit margin has dropped from 17.78% in 2009 to 14.85% in 2010. This shows that the company is experiencing serious problems, for example, because of increased operating costs. This trend, if it continues, will send a very negative message to the potential investors as well as the current shareholders since it may lead to reduction of their returns. Return on assets Return on assets is an indicator of how well the management has used the company’s assets to generate income. This ratio has dropped from 16.51% in 200 to 10.52% in 2010, meaning that the assets are being applied less efficiently. Return on Equity Return on equity is an indicator of how profitable the capital of the shareholders has been used to generate income. The ratio has dropped from 31.24% in 2009 to 23.80% in 2009, indicating that shareholders' capital is being used less efficiently to generate income. Overall financial position Overall, the company liquidity is not healthy. Also, the large amount of short-term assets is held in the inventory and this could lead the company into liquidity problems if the inventory is not easily convertible into cash. In addition, the company’s credit policy is worsening over time and if this is not addressed, the company is likely to lose its money to defaulters. Regarding its capital structure, the company seems to be highlyleveraged, which is risky because it means more interest expenses. Unfortunately, the profits of the company are declining as revealed from the profitability ratio, and something needs to be done to address this so the company does not lose the confidence of its shareholders. Also notable is that the management is using the company’s assets and capital less efficiently, which if not addressed could lead to very poor performance in terms of returns. In view of this, the company’s financial position is fairing badly. Read More