Financial Ratios
A company’s financial performance can be evaluated using financial ratios. The magnitude, trend, and value relative to close competitors help deduce the firm’s profitability, ability to meet its financial obligations, capital structure, and effectiveness in the utilization of assets. Table 1 below shows the company’s financial ratios for the last two fiscal years.
Table 1. Company’s financial ratios
Equity Ratio
The company’s equity ratio declined from 40.71% in 2019 to 36.88% in 2020. This ratio, which expresses the value of shareholders’ funds to the total assets, illustrates the firm dependence on low-risk equity to finance its assets. The company has a higher proportion of equity compared to the sectorial average. A high proportion of equity reduces the firm’s exposure to agency risks. These risks increase when the firm becomes unable to repay its obligations, thereby promoting creditors to appoint administrators to recover their investment. However, maintaining a low proportion of debt in the capital structure increases the cost of capital, as the required return on equity often exceeds that of long-term debt. Therefore, the company should maintain an optimal balance of debt and equity in its capital structure.
The optimal balance of debt and equity varies based on several factors. These include management preferences for risk, nature of the industry, age of the company, cost of financing, and legal requirements. Other factors include market conditions, stability of sales, and availability of cash flows. In this case, the company’s management prefers a relatively large proportion of debt of at least 63.33% (or 100%-36.88% equity ratio), which ensures a healthy balance of the lowered cost of capital and the potential for higher agency risk.
Non-Current Asset Coverage Ratio
The non-asset coverage ratio indicates the firm’s ability to repay its debt obligation after selling its fixed assets. The company’s non-current asset coverage ratio declined from 67% in 2019 to 61% in 2020, which reflects a deteriorating credit position for the company. Notably, the company’s only non-current asset comprises only premises, which is difficult to liquidate. However, the company has sufficient other current assets to finance any financial obligations falling due in short to medium term. Nevertheless, fixed assets can only pay up to 61% of the firms’ total debt, leaving 39% to be recouped from the liquidation of current assets.
Liquidity Ratio
The liquidity ratio assesses whether a firm has sufficient current assets to repay its short-term financial and operational obligations. The company’s current ratio declined from 1.01 in 2019 to 0.97 in 2020, which indicated a declining capacity to meet financial obligations. The declining liquidity was caused by the sale of marketable securities, an increase in trade payables, and additional borrowings from the bank.
The ratio of current assets relative to current liabilities fell below 1.0. Therefore, the value of current liabilities exceeded that of current assets in the year 2020. While maintaining high levels of liquidity presents a significant opportunity cost of idle assets, reducing this proportion below 1.0 presents significant risks to the company. These risks include delays in paying suppliers, lack of sufficient inventory, and non-payment of maturing debts. Delayed payments erode the goodwill of suppliers, financiers, and employees- the key stakeholders that have the strongest influence on the firm’s competitive advantage. Therefore, the management must devise new methods of boosting the firm’s liquidity to avoid these consequences.
Return on Assets before Tax
The return on assets before tax reflects the firm’s profits relative to its total assets. The return on assets declined from 6% in 2019 to 4% in 2020. In comparison, the average return on assets for the industry was 9%. Therefore, the company lagged behind its competitors in generating a net income from its assets.
Two possible reasons explain the low and declining return on assets for the firm. Firstly, the company’s operating expenses increased at a faster pace compared to the total sales. As a result, the modest growth in sales could not offset the increase in expenses for the period. Secondly, the firm’s total assets increased in 2020 compared to the year before. Such an increase in assets outpaced the firm’s growth in revenue. Therefore, the management should take urgent action to raise the return on assets to match the sector’s average.
Potential measures for increasing the firm’s return on assets include disposing of non-productive assets, reducing the production and operating expenses, and increasing the total revenue. Disposing of the assets will reduce the balance sheet value of assets, which will increase the total return on assets. However, the management should dispose of only non-productive assets. In addition, reducing the production and operating expenses will boost the total profit, which will also increase the return on assets. Lastly, increasing the total revenues will boost the firm’s profitability that, in turn, will boost its return on assets.
Interest Coverage
Interest coverage indicates the sufficiency of the operating profit in repaying the finance cost on debt. The company’s interest coverage ratio declined from 5.0 in 2019 to 1.3 in 2020. Therefore, the company could only pay interest expenses for 1.3 years from its annual profit in 2020. The decline in interest coverage was caused by falling profitability and increased borrowing from the bank in 2020. Nevertheless, the low-interest coverage posed no significant threat to the firm’s ability to finance its loan obligations in the subsequent years, especially if the management manages to increase the operating profit in 2021.
Trade Receivable Days
Trade receivable days increased from 22.86 days in 2019 to 39.29 in 2020. This increase indicated the increased delays in converting receivables into cash. In comparison, the industry takes an average of 25 days to convert receivables into cash. Therefore, the company is offering more flexible repayment terms compared to its competitors.
A flexible repayment period enables customers to buy more goods from the company. As a result, the total revenue increases, and the company faces minimal chances of realizing obsolete inventory. However, the long repayment duration also presents significant liquidity challenges for the company. It also increases the chances of realizing bad debts from customers. Therefore, the company should balance between the adverse outcomes arising from the flexible payment terms and the benefit of higher rates of revenue growth.
Maintaining sufficient liquidity
Maintaining sufficient liquidity enables a firm to operate smoothly. It ensures timely payment of suppliers, loan obligations, and procurement of sufficient inventory. Consequently, firms should boost their liquidity by raising long-term finance, disposal of non-productive assets, and optimizing the working capital.
Raising Long-Term Finance
Raising long-term finance entails the issuance of bonds or floatation of stock in the capital markets. Unlike short-term notes, bonds offer a long-term solution for the company’s liquidity. The company can use the proceeds from long-term bonds to purchase inventory, settle the trade payables, and repay accrued liabilities. In addition, some of the proceeds from the issuance of stocks or bonds can be maintained as cash to finance immediate financial and operational needs.
The option of whether to raise long-term finance from either bonds or the sale of equity depends on several factors. These include the management’s preferences, the firm’s cash flow level, capital structure policy, and the relationship with investors. Small firms often raise additional capital from bank loans due to their lack of a strong relationship with the financial markets and relatively limited demand for large capital. In contrast, large firms often have large capital requirements and have an established relationship with the capital markets. As a result, large firms often raise long-term finance directly from the capital markets. Once the company raises the long-term capital, it should use the proceeds to acquire inventories or repay current liabilities.
Disposal of Assets
Companies should dispose of their unproductive assets to raise working capital for their operations. The management should assess the impact of eliminating these assets from the firm’s value chain before making this decision. Any assets selected for sale should not be critical to the firm’s core operations. For instance, a production company should not sell its only functional machine to raise working capital. Therefore, only non-core assets should be sold to generate working capital.
Companies can also enter into sale and leaseback transactions. These transactions involve the firm selling its core assets and leasing the same assets from the buyer. The initial sale releases the capital tied up in the long-term asset such as premises. In return, the company pays the periodic lease premium, which can be done from the operating profits. Sale and leaseback transactions enable the company to convert the property into capital without losing control of the asset. In addition, periodic lease payments are tax-deductible, which reduces the total taxable profit for the company. Moreover, such a transaction enables the company to avoid floatation expenses when raising debt or equity from the capital markets. Furthermore, the company will experience a boost in the asset turnover ratio as the asset will be removed from the balance sheet. However, such transactions are reserved for high-value assets, including premises, custom vehicles, and machinery.
The company can also sell the account receivables to third parties. This process, which is referred to as factoring, entails exchanging the account receivable balance for a percentage of cash. A factor pays a certain percentage of the total value of receivables (for example, 80% of total receivable balance) and earns the rest as commission. While this process reduces the total cash derivable from debtors, it avails immediate cash for the business. This increases the actual cash available for settling maturing obligations.
Optimizing Working Capital and Reducing Overhead Expenses
Companies can optimize their working capital to increase the cash available for short-term obligations. The elements of working capital that can be optimized include inventory, trade receivables, and payables. Managing the amount of these balances could boost the firm’s level of liquidity.
- Inventory. Firms maintain a significant amount of inventory on their balance sheet. While maintaining a large amount of inventory enables firms to fill customer orders promptly, holding these assets for a long time ties up the firm’s liquidity. As a result, the company should maintain an optimal balance of inventory to prevent stock-outs on the one hand and to minimize the cost of holding stock.
Companies can use economic order quantity models to determine the optimal level of stock to hold in order to achieve a 100% service level. By determining the lowest levels of inventory, the company will convert most of its stock into cash, thereby shortening the cash conversion cycle. In addition, it will reduce the associated costs, including insurance, storage, and demurrage. These recurrent expenses also reduce the company’s liquidity. Therefore, optimizing the inventory level will boost the firm’s liquidity.
- Trade receivables. Trade receivables refer to amounts owed by customers after making credit purchases. Companies offer customers a generous repayment period to facilitate their buying in large quantities. The firms hope that traders can convert the merchandise obtained from the company into cash and use the proceeds to settle the debt. However, the long duration presents a significant opportunity cost for the company.
The money invested in trade receivables could be diverted into other cash-generating activities within the company. In addition, cash payment for goods reduces the risk of bad debts for the company, which poses a significant loss of cash flow. Therefore, the company should balance the need for increasing sales and the firm’s cash flow requirements.
The company can reduce the trade payable days by offering incentives to cash buyers. In addition, it can offer a percentage discount on the amount due from debtors. This discount acts as a deterrent for customers wishing to take advantage of lower prices to pay early. It also serves as a penalty for credit customers that take long to settle their obligations. As a last resort, the company can transfer the outstanding payables to factoring agents to convert the balance into cash at a fee.
- Trade payables. The company should extend its payables period. This extension will preserve the cash available in the business for a longer period, thereby ensuring that liquidity remains available for urgent and priority functions. However, the company should be guarded against eroding suppliers’ goodwill, which could result in a lack of critical supplies. Such a shortage of critical materials would result in production stoppages, disruptions in the supply chain, and eventual loss of customers.
- Reducing Operating Expenses. Companies use most of their cash balances to settle recurrent operating expenses. These expenses include payment of wages, transportation, rent, and utilities. The company can reduce these expenses by improving the workers’ productivity, eliminating unnecessary trips, reducing the rented space, and through efficient use of utilities. The company should invest in efficient production technology and tools that result in higher output per worker, which will reduce the number of workers needed on the factory floor. The company can also give up any unnecessary space to save on the monthly rental expenses. These savings will reduce the accrued expenses and boost the firm’s liquidity.