Introduction
The bankers have considered the financial position and financial performances of Professional Confectioners through ratio analysis. In this write up, a critical analysis of the ratios have been made in order to arrive at real reason for refusal of loan facility. Based on this analysis suggestions have been made to improve ratios in order to qualify for the loan.
Ratio Analysis
Liquidity is prerequisite for the very survival of an enterprise. “Liquidity refers to solvency of the firm’s overall financial position- the ease with which it can pay its bills.”(Lawrence J. Gitman) The Current ratio and Quick ratio analyzed by the banker provide the liquidity status of the entity. These ratios give an insight into the ability of the enterprise to remain solvent in the event of adversities. Current ratio is worked out by dividing current assets with the current liabilities. Although there is no hard and fast rule, conventionally, as a rule of thumb, a current ratio of 2:1 is considered to be a safe margin of solvency and, therefore satisfactory. In the case of Professional Confectioners ( called PC hereinafter), this ratio is quite satisfactory being at 2.3:1 as compared to 1.7:1 for the year. The improvement is more than satisfactory and the ratio is almost that of the industry, which is 2.4:1.
The other ratio used by the banker to test liquidity is Quick ratio. This is part of Current ratio. The only difference is that in its calculation only the current assets which are liquid or capable of being converted into liquidity faster at the time requirements are considered. That means assets like inventories are not part of current assets to be considered for quick ratio. Bankers normally accept 1:1 as satisfactory. Here the PC lacks the banker’s expectation. The ratio is just 0.7: 1, which in fact very well improved from 0.4:1 in previous year. Surprisingly the industry ratio is also 0.8:1 only, and this fact should have been considered by the bankers. Overall the liquidity position is not bad and therefore should not be a cause to refusal of loan facility.
Profitability performance of PC is reflected through Net profit on sales and Net Profit to Equity ratios. PC has Net profit to sales ratio as 4.1 % when the industry’s standard is of 9.4%. Here lies the problem as it appears that PC has less control over its overheads when compared with figures of industry. Even in previous year the ratio was poor 3.8%. Though there is an improvement but the PC has not capitalized its better sales generation reflected by its ‘Net Sales to Working Capital ratio’, which is 10.4:1 as compared to 9.7:1 in the previous year. As this ratio is calculated ‘Net Sales/ Net working capital’, the increase in ratio as compared to previous year shows that Sales of PC would have increased in the current year. But PC has not taken advantage of increased sales. Even though gross profit ratio figures are not provided, it is clear that from Net profit to sales that PC has burden of fixed overheads like interest on existing debts and finding it difficult to control those overheads. Though PC performed better than previous year, it is no where near to industry ratios.
However, profitability performance when calculated with reference to equity is much better than that of industry. Its Net Profit to Equity is 17.6% as compared to industry’s 13.4%. But it is observed that bankers would have considered it falling performance on this count in the current year (17.6%) as compared to previous year (18.3%).
Efficiency in the working of PC has been considered by the bankers through ratios of Inventory Turnover and Average Collection period. Inventory ratio suggests how many times average inventory has been converted into sales during the financial period. PC did this for 4.9 times, a little improvement from 4.3 times in the previous year. But PC lacks far behind average industry ratio of 7.1 times. Low inventory turnover is one of major reasons for refusal of loan by the bank.
Efficiency is also measured by the average collection period of accounts receivables. Accounts receivable were outstanding for 36 days during the current year which in fact is almost similar to that of industry ratio of 34 days. PC also improved a lot from is previous year ratio of 43 days.
The bankers also considered PC’s Debt ratio, “that indicates how much of a company’s assets are provided through debts.”(College- cram. com). It also indicates capital gearing of the entity. PC is a low geared entity as its ratio is 0.81:1 in the current year as well as 0.89:1 in previous year. In fact the PC has paid back some of its debt liability as reflected by reduction in debt ratio from 0.89 to 0.81. This should be good sign from banker’s point of view, but as the industry is better at 0.65:1, bankers would have thought that long term borrowings of the PC are more than as warranted by equity investment. As debt ratio of PC is higher than industry, bankers would have thought there is greater pressure on earnings of PC, leading to default in meeting obligations.
There is another approach to consider the relation of debts and equity and that is through ‘Debt to net worth ratio’. Here also the debts are more than as per industry standard. PC’s current year ratio is 2.6:1 as compared to industry’s 1.91:1. There is an improvement over previous year ratio of 2.9:1, but that is very marginal. In fact when we study net worth ratio alongside Net profit to sale, it becomes clear that profitability of PC would have been affected because of servicing to short and long term debts of the PC.
Overall the PC is heavily indebted as per industry norms, and this is affecting its profitability margins.
Suggestions to improve ratios
PC should improve average collection period further. This would add more of current liquid assets and improve the quick ratio. The inventory turnover requires a serious consideration, as that is very week when compared to industry. Once inventory turnover goes up, sales will increase resulting into more accounts receivables and further better current and quick ratios. This would also increase the Net profit sales ratio provided PC keeps a check on overheads. With increased profitability PC would be able to serve the existing debts leaving a good margin for to be shared with bankers (as interest on fresh loans) and equities. So the key to all problems is improvement in inventory turnover and thereby sales and profitability increase. This will bring all ratios to a level where bankers would gladly provide loan to Professional Confectioners.
References
College- cram., Ratios of debt management: Debt ratio, 2008. Web.
Lawrence J. Gitman, Principles of Managerial Finance, Eleventh Edition, Chapter 2, page 58.