Expository Essay Sample on Liquidity Ratios

2021-05-11 08:40:59
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Introduction

According to Financial Analysis and Accounting Book of Reference, liquidity ratios measure the liquidity rate in the company since a group can be viewed to be profitable but at the same time, it may have serious cash flow problems. From the shareholder's point of view, profitability is considered to be an important aspect of a company's performance because it is from the profits that they receive dividends. This is the same case for managers who receive bonuses based on the profits generated.

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However, addressing the major issue of liquidity, it is important for the company to have liquid assets. Liquid assets are used to help the company to settle its debts when they fall due. Therefore, liquidity is defined as the amount of cash that can be raised quickly to pay the company's obligations. The following are types of liquid funds; cash, trade receivables, short-term investments with the ready market, for instance, the shares, bills of exchange, and fixed-term deposits. In most cases, sales are considered to be the most liquid asset for many trading companies.

Methods of Measuring Liquidity

Current Ratio

The current ratio also is known as the working capital ratio its formula is as follows

Current Ratio=Current asset

Current liabilities

Companies are required to have adequate current assets; therefore, this ratio measures the adequacy of existing assets that will give the promise to meet its commitment to settling the liabilities when they fall due. The recommended threshold for a company's current ratio is 2:1 however, a proportion of 1:5:1 is considered normal.

As in our case, our current assets are 1.3:1 this ratio is below the required threshold, and one can conclude that the company is lacking enough cash to offset its current liabilities. Although, while giving recommendations about the current ratio should be looked at in the light of what is reasonable for the business. Different businesses will differ in ratios, for instance, supermarkets tend to have low current ratios because of very few trade receivables and very high payables.

Current Ratio Current Assets 19352 = 1.338313

Current Liabilities 14460

Quick Ratios

Quick ratios measure liquidity in a company; it is calculated by eliminating inventory from the current assets. This process provides an acid test of whether the company has sufficient liquid resources to settle the liabilities when they arise. It is an indication of short-term liquidity; the required level of quick ratio should range from 1:1 or 0.7:1.

However, some companies might have a higher quick ratio than the recommended one for instance 2:1 this will be okay for a company that has difficulty in borrowing on short-term notes. On the other side, higher quick ratios are an indication that the business has too much cash that is not being utilized which is idle cash of 2 against the threshold of 1. The excess cash should be invested in other profit-generating projects. This matter can view from a different light that the management of the company is incompetent in financial management.

In our case the Quick ratio is as follows:

Quick Ratio Current Assets-Stocks 2856 0.19751

Current Liabilities 14460

This indicates that the Acid test ratio is not sufficient enough to clear the short-term debts. It means that the company is relying so much on the inventory to pay off the short-term liabilities. The company can improve the test ratio by enhancing its turnover on the inventories disposing of some of the unproductive assets and eventually developing on its collection period.

Leverage Ratios

In reference to Adam (2006), leverage ratios measure the ability of the organization in utilizing its assets to generate income, and at the same time, leverage ratios assess how the company is managing its liabilities. Like the ratio of the inventory turnover, it demonstrates how well the company manages inventories. This rate is expressed sometimes thus indicating whether the inventories are being held for a long time, or they are being sold quickly.

Profitability Ratios

Profitability ratios are also tools of financial analysis they are calculated on sales of the company. Profitability ratios are very vital especially when assessing how efficient or inefficient a company is performing thus helping the management to take quick action to correct the situation. Businesses that are profit-oriented their primary objective is profit maximization because profits are the blood of business in such cases and without it, the business cannot be termed as going concerned. Therefore, the main reason behind the calculation of profitability ratios is to determine business efficiency. Profitability ratios are also used by financial institutions when lending money. Managers also pay to the company's profitability because of their annual bonuses.

Profitability ratios are categorized into two; they are those that are based on sales and those based on the investment.

Possible Reasons for Any Differences Between the Company’s Ratios and Those of the Industry Average

Comparing the company's ratios with those of the industry there are slight differences in some of the ratios. Starting with the current ratio whose threshold is required to be 2:1; this means that the rate of current assets should be twice the amount of liabilities. It is only when the company can be termed secure because it can quickly settle its debts when they fall due. Moser's current ratio is very low is at 1.3. The rate of the current asset is lower than its liabilities; this could mean that the company is likely to have difficulties in settling its short-term obligations. The reason for the decline in the current ratio could be an increase in liabilities and a decrease in assets.

The quick ratio is also low in Moserk Company, which stands at 0.19 against the industry ratio of 0.75. Quick ratios measure the ability of the company to settle its debt with the most liquid assets, this is assets that can be quickly be converted into cash. The required threshold is 1:1 or 0.75:1. The reason for the decline could be due to less current assets and a high level of inventories.

Debt to asset ratio this ratio measures the proportion of the property that is being financed by debt financing. The debt to asset ratio is also used to determine the financial risk of the business, a proportion that is greater than 1 indicates that a considerable amount of property is being funded with debt while a low ratio means that the company uses equity to finance its assets. Moser Company prefers debt financing to equity financing this is because only a small proportion of its assets are funded through debt. This is the same for the entire industry because the overall debt to equity ratio is 0.45.

Time interest earned

This is also known as interest cover; this ratio measures the amount of income that can be used to cover interest in the future. Time interest is expressed in a time that is the number of times a company could pay interest before tax. Moser Company can pay off its interest 21 times because of high income before tax while the industry rate is 15 times.

Gross profit margin

Gross profit is the percentage by which gross profits exceed production cost it measures the rate of efficiency during production. This ratio is used by investors to compare companies operating in the same industry. Companies with a high gross profit margin ratio are preferred because they retain more on sales. In our case, Moserk Company's gross profit margin is 21% against the average industry percentage of 25%. This means that the company is retaining less than it should be and the reason for this could be due to the high cost of sales.

Net profit margin

This is a very significant ratio of profitability; it shows the amount of money left after deducting all the expenses. The rate is also used by the investors to make a comparison of companies operating in the same industry. In our analysis Moserk Company, the net profit margin is 24% while the industry one is 10%.

Return on total assets

This ratio measures the rate of efficiency in a company, assets purchased should be efficiently utilized to increase the profits. Higher ratios are a good indication that the firm is more efficient, and thus, they are more favorable to the investors. The return on assets in Moserk Company is 24% which is high than the industrial percentage at 14.5%. Therefore, Moserk Company is performing better compared to the entire industry.

Return on equity

This is the amount that is received by the shareholders as a result of investing; it is the return on equity. ROE is also used to show a company's growth and for high-growth companies, ROE is supposed to be high. Like in our case Moserk Company has a higher growth of 53% which is higher than the industry rate at 28%.

References

Financial Analysis and Accounting Book of Reference: Statement of Financial Position | IFRS Statements | IFRS Reports | ReadyRatios.com. (2016). Readyratios.com. Retrieved 25 March 2016, from http://www.readyratios.com/reference/liquidity/

Adam Hayes, C. (2006). Leverage Ratio Definition | Investopedia. Investopedia. Retrieved 25 March 2016, from http://www.investopedia.com/terms/l/leverageratio.asp

Net Profit Margin. (2016). Readyratios.com. Retrieved 25 March 2016, from http://www.readyratios.com/reference/profitability/net_profit_margin.html

Study.com. (2016). Study.com. Retrieved 25 March 2016, from http://study.com/academy/lesson/activity-ratios-definition-formula-analysis.html

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