Ratio analysis question - making a decision

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swirlywirly
swirlywirly Registered Posts: 26 Regular contributor ⭐
Hi, I'm a bit confused about a question I'm doing, just wanted some input from people. I'm doing a question in a handout we have and the ratios are as follows:

Current ratio
2003 - 2.0:1
2004 - 2.3:1

Quick ratio:
2003 - 0.9:1
2004 - 0.7:1

Gearing:
2003 - 11%
2004 - 13%

Interest cover:
2003 - 10 times
2004 - 12 times

We have to say whether or not the interested party should lend money to the above company, based on the ratios calculated.

We have been taught not to sit on the fence, but I am unsure about this one. I want to say YES to lending money because even though their gearing % has increased, it is still quite low.

Obviously their current & quick ratio calculations show poorer liquidity, and also that they are holding onto stock for too long. Is this of interest to someone loaning money?

Their interest cover has improved - does this suggest better profits??

Thanks.

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  • sdv
    sdv Registered Posts: 585 Epic contributor 🐘
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    We have to say whether or not the interested party should lend money to the above company, based on the ratios calculated.

    The calculations of ratios on their own are meaningless, unless they are compared with the company’s competitor, the company’s industrial sector or against it’s own past performance.

    When ratios are calculated against it’s own past performance, it gives some valuable information but it has its limitations.

    The lenders are more likely to be interested in the interest cover and gearing ratios. However, we need to comment on the above given ratios.

    Current Ratio and Quick Ratio demonstrates the ability of a company to meet its current obligations. That is to say that it will be able to operate and continue to trade without any difficulties. It will be able to pay it’s trade creditors, paye, and other creditors payable within the next 12 months

    The current ratio is calculated by dividing current assets with current liabilities. The above calculations shows that the ability to pay it’s obligations has improved from 2:1 in 2003 to 2.3:1 in 2004. This means that either the currents assets (inventories, Trade R, bank) have increased or the current liabilities have decreased, or both.

    Looking at the interest cover ratio, it suggests that the company has increased its profits, even though the interest expense has gone up (increase in the gearing ratio). This increased profit has been converted into increased current assets.

    The quick ratio demonstrates the company’s ability to meet it’s current obligations immediately.

    The quick ratio is calculated by taking away the Inventories from the current assets and dividing the result by current liabilities. The quick ratio has deteriated from 0.9:1 in 2003 to 0.7:1 in 2004. This can only happen if the current assets, excluding inventories, has reduced or the creditors has increased.

    However, we know that the current assets have increased and the quick ratio has worsened. Therefore the stock has increased and this is confirmed by stock to creditor’s ratio of 1.1:1 in 2003 to 1.6:1 in 2004.

    This can be a problem for the company to trade effectively in the short term until it reduces it’s stock levels and improve the quick ratio. Alternatively the company could raise some money to increase it’s liquidity, to trade comfortably.

    The lenders of money to the company will want to assure themselves that the company has the ability to meet it’s interest payment obligations as well as the borrowed amount. The company need to show that it is making enough profits to meets its obligations.

    The interest cover ratio shows the ability of the company’s profit to cover the interest expense expressed as number of times.

    The interest cover is calculated by dividing profits before interest with interest expense. The higher ratio indicated better ability to meet its interest payable obligations.

    The ratio has increased from 10 times in 2003 to 12 times in 2004 even when the interest expense has gone up. This indicates that the company has made better profits in 2004 then in 2003.

    Interest cover is a favourable indicator for the lender to lend money.

    The gearing ratio indicates what percentage of the company is owned by the lenders (non-equity holders) and by implication what percentage of the company is owned by the equity holders.

    The ratio is calculated by dividing Debt by (debt plus Equity). Ideally the Equity holders should own 67% or more of the company for the lenders to comfortably lend money to the company

    The gearing ratio in 2003 is 11% and in 2004 is 13%. These percentages are well within the comfort margin of 33%.

    Based upon the above two ratio the lenders should be happy to lend the company more funds. It would cement the lending deal if the net profit margin are higher then the borrowing rate of the loan.
  • Lyn32
    Lyn32 Registered Posts: 85 Regular contributor ⭐
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    DfS Unit11!

    Hi Everyone

    I am revising this unit but I have a problem on sticking on my head about "IAS" or IFRS so far.I am able to do all the figures to balance it (Income statement, Balance Sheet and Cash Flow etc. ) but IAS and IFRS it drive me mad?

    Did anyone know hints and tips on how to understand without copying all the definition in the past exams paper which the assesor don't want us to do.

    My problem though when I do revision I scape it to do it later and now I am stock because after working all those figures it doesn't stick into my head at all!

    Thanks in advance.
  • A-Vic
    A-Vic Registered Posts: 6,970 Beyond epic contributor 🧙‍♂️
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    Fab answer STV copied and printed :)
  • swirlywirly
    swirlywirly Registered Posts: 26 Regular contributor ⭐
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    Thanks for the detailed answer sdv!!
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