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Solution - 1 Liquidity Analysis of a Company

   

Added on  2020-03-04

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Solution – 1(a)Liquidity of a company show the ability of the company to pay off its current liabilities or abilityof the company that how quickly the company can convert its assets into cash, so that shortterm obligations can be paid off. Liquidity can be measured through various ratios such ascurrent ratio and quick ratio. However, taking the internal ratios would not show the truepicture of the analysis, comparing the company’s ratios with the industry ratio is alsoequivalent important. Liquidity ratios includea.Current Ratio = The first step in liquidity analysis is to calculate the current ratio. This ratiocompares the current assets and current liabilities of the company and help in determiningthe company’s ability to pay off its current liabilities from its current assets. Current ratio= Current Assets / Current Liabilities Particulars20072006Current assets180,742155,530Current Liabilities105,06475,129Current Ratio1.722.07b.Quick ratio or acid test ratio = The next step is to measure the quick ratio. It compares thequick current assets means current assets excluding inventory and prepayments withcurrent liabilities to determine the company’s ability to pay off its current obligations fromits quick assets.Quick Ratio= Quick Assets / Current Liabilities Particulars20072006Current assets 180,742 155,530 Less: Inventories (159,880) (135,021)Quick Assets 20,862 20,509 Current Liabilities 105,064 75,129 Current Ratio0.200.27AnalysisTo analyze the company’s data, in 2007, the company’s current ratio was 1.72 times whichshows that the company is able to generate $1.72 dollar to pay off its current liabilities of$1 as compared to 2016 where the company’s current ratio was 2.07. So, it shows thatcompany’s current ratio has improved significantly and has reached to the level ofindustry’s average which is 1.76. It is a good sign for the company. The company’s quickasset ratio has decreased from 2006 by 0.07 times, in 2016 it was 0.27 whereas in 2017 itis 0.20. It means that liabilities have increased but assets have not been increased in thesame ratio. The industry average for this ratio is 0.78. It shows that the company needs toincrease its quick assets to maintain a good liquidity position.(b)Taking finance is a very important part for any business. Finance can be taken into 2 typesdepending upon the requirement of the company. It can be short term as well as long term.Short terms are those which are taken for less than one year whereas long term finance istaken for one or more year. To comment on finances, from cash flow statements, we can

observe that the company has taken short term borrowings for an amount of $255,950 forexpansion of its business. Further, it is observed that all the finance is taken in the form ofshort term borrowings as there is no change in the long term borrowings from last year.Further, there is no increase in equity portion as well. Further, the company has earned almost135% of profit as compared to 2006. That’s why has EPS has improved resulting in higherdividend payout to shareholders. So, to summarize during the period from 2006 to 2007, thecompany has not taken any long term borrowings neither any equity finance is used. However,the company has taken some short term borrowings for meeting its requirements.(c)Inventory turnover is reflected by the inventory turnover ratio. This ratio shows the ability ofthe company to turn its inventory into cash. In 2007, the company’s inventory turnover ratio indays is 143 days approx. It means the company’s operating cycle is like this that it takes 143days from procurement of material till its sales. This ratio is quite high and shows that thecompany’s working capital remains blocked for 143 days. The management should try to keepthis ratio as low as possible as low ratio indicates that the company is able to generate cashquickly from its inventory and thus require less working capital.Inventory turnover ratio= Cost of goods sold / average inventory Inventory turnover period= 365 / Inventory turnover ratioParticulars2007Cost of goods sold 376,733 Cost of goods sold 376,733 Opening inventory 135,021 Closing inventory 159,880 Average inventory 147,451 Inventory turnover ratio2.55Inventory turnover (in days)142.86(d)Whether super cheap to borrow more money for expansion or not depends upon variousfactors. Some of them are discussed below:a.Growth rate – First of all, the management needs to check whether there are growthopportunities available in the market or not. It is feasible to expand more or theproduct is having more demand than supply. If the answer is yes, than the companyshould think over it.b.Management internal decisions – The management internal decisions as to expand ornot also matters. If the management needs to expand the business, then the companyshould borrow the money.c.Cost of Finance – Secondly, the management needs to check the cost of finance ofboth equity as well as debt. If the cost of equity is more than the cost of debt, onlythan the company should go for financing through debt option.In the current situation, we observed that since with little borrowings, the company’s profithas increased by almost 35% as compared to last year. It shows that there are growthopportunities available in the market. Now, the company needs to check the cost ofborrowings, if the cost of debt is less than the cos of equity, then company should borrowthe money to expand further.(e)Price earning ratio is the ratio which values company’s earnings with its market price and iscalculated as follows,Price earning ratio=Market Value per share / Earnings per share=4.50/21=0.214 times

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