Practice of Ratio Analysis

Interpretation and Recommendations

Question # 1: Presented below are selected ratios for three years ending December 31 st
for company Alpha Ltd.
Ratios Year1 (in %) Year2 (in %) Year3 (in %)

Current ratio 200 500 150

Acid test ratio 110 320 80

Debt equity ratio 15 40 55

Operating expense ratio 24 25 32

Number of times interest earned 6 6 -1

Stock turnover 12 10 6

Rate of return on total assets 15 10 5

Required: Outline the possible explanations for the drastic changes in some of the ratios
from year1 to 2 and from year 2 to 3.

Solution:

Current ratio has been increased and then sharply decreased in year three which may be due
increase in current assets or decrease in current liabilities. Acid Test ratio has been sharply
increase and sharply deceased in third year. It could be due to increase in short term borrowing
which ultimately increase the current and quick assets. Due to increase in interest and operating
expenses cash was reduced which ultimately reduced the current ratio, quick ration and effect the
times interest earned. Due to less activity stock turnover and rate of return on total assets has
been reduced.
Question # 2: The standard ratios for the industry and the ratios of company X are given.

Industry Standards Company X

Current Ratio 2.4 2.67
Debtors turnover ratio 8.0 10.0
Stock turnover ratio 9.80 3.33
Assets turnover ratio 2.00 1.43
Net profit ratio 3.3% 2.1%
Net profit to total assets ratio 6.6% 3.0%
Net profit to net worth 10.7% 4.8%
Total debts to total assets 63.5% 37.7%
Required: Indicate the strength and weaknesses of company X, also suggest the areas in
which improvements can be made and how?

Solution:
Stock turnover ratio is far below the industry, which means our production activity is very less. It
will impact profitability and current assets as well. Less asset turnover depicts that assets are not
being properly utilized. Due to reduce production activity net profit has been reduced. Net profit
to total assets ratio shows that our revenue is not meeting the assets which company has
employed. Due to increase in debt the interest cost has been increased which has impact on
profitability and net profit to net worth.
Question # 3: Mr. Parks has asked you to advise him on the long-term debt-paying
ability of Arodex Company. He provides you with the following ratios:
2011 2010 2009
Times Interest earned 8.2 6.0 5.5
Debt ratio 40% 39% 40%
Debt to tangible net worth 80% 81% 81%
Required:
1. Give the implications and the limitations of each item separately and then the collective
influence that could be drawn from them about Arodex Company’s long-term debt
position
2. What warning should you offer Mr. Parks about the limitations of ratio analysis for the
purpose stated here?
Solution:

Times interest earned has been increased. That means net profit has been increased which is
good for the long term debt position of the company. Company becoming strong to pay interest
charges

The bebt ratio has been not been change drastically which mean company is maintaining an
appropriate debt to equity ratio. The above point is also supported by the results of debt to
tangible net worth ratio.
Question # 4: Assume that you have several thousand dollars to invest in the stock
market. Given the people will always have to eat. You have decided to explore the possibility of
investing in Wendy’s and McDonald’s your analysis of each company’s financial statements
reveals that both have negative working capital and both have current and quick ratios of less
than 1 to 1.
Required: Based on your findings, should you be concerned about the short term liquidity of
these two companies? Explain

Soultion:

Negative working capital means the current liabilities are more than current assets
Ideal current ratio is 2:1 and quick ratio is 1:1

But in this case both ratio are less than which means both company are not in liquid position
to pay off its current obligation which is not good view for investor so yes I would be
concerned about the short term liquidity as it will raise on the question on the
decision of the investment..

Concerns related to investment

A)Investment in both company will be like blocking of funds which means the liquidation of
funds is difficult
B) totally dependence upon the long tem solvency position this investment if done by
investor only on the basis of long term position
C) chances of irregular or non payment of dividend /interest.. due to short of current asset
there are chance of non payment regular interest or dividend payment.
D)there are chances of both the company that due to poor net working capital,there is
decrease in stock price in future .

These will be the basic concerns of mine as a investor ,if i have many dollars i will rather do
search for better option which provides sustainability ,continues growth and minimal risk.