Question

1.      ElectroStar Corporation is a manufacturer of electronic components with total assets of $20,000,000. Selected financial ratios for ElectroStar and the industry averages for firms of similar size are as follows:

                                                                              ElectroStar                      

                                                                                                                                    Industry

2012                2011                2010                Average

Current ratio . . . . . . . . . . . . . . 2.61                 2.32                 2.09                 2.28

Acid-test ratio . . . . . . . . . . . . .  1.21                 1.12                 1.15                 1.22

Inventory turnover . . . . . . . . .   2.02                 2.18                 2.40                 3.50

Return on equity . . . . . . . . . . .  0.17                 0.15                 0.14                 0.11

Debt-equity ratio . . . . . . . . . . .  1.44                 1.37                 1.41                 0.95

ElectroStar is under review by several entities whose interests vary, and the company’s financial ratios are part of the data being considered. Each of the following parties must recommend an action based on its evaluation of ElectroStar’s financial position. ElectroStar has given the requested informationto each party on a confidential basis.

• MidCoastal Bank. The bank is processing ElectroStar’s application for a new five-year note. MidCoastal has been ElectroStar’s banker for several years, but must evaluate the company’s financial position for each major transaction.

• Ozawa Company. Ozawa is a new supplier to ElectroStar and must decide on the appropriate credit terms to extend to the company.

• Drucker & Denon. A brokerage firm specializing in the stock of electronics firms, Drucker & Denon must decide if it will include ElectroStar in a new mutual fund being established for sale to Drucker & Denon’s clients.

• Working Capital Management Committee. This is a committee of ElectroStar’s management personnel chaired by the chief operating officer. The committee is charged with the responsibility of periodically reviewing the company’s working capital position, comparing actual data against budgets, and recommending changes in strategy as needed.

Required:

1. Describe the analytical use of the given ratios.

2. For each of the four entities described above, identify two financial ratios from those ratios presented that would be most valuable as a basis for its decision regarding ElectroStar.

3. Comment the performance of ElectroStar based on the five ratios given above.

Answer 1

a

Current ratio	It shows the liquidity of the company. Higher ratio means better liquidity. Ideal ratio is 2 : 1.
Acid test ratio	It also measures liquidity. Acid test ratio shows how quickly the assets can be converted to cash.
Inventory turnover	This ratio measures the speed at which the company is able to sell its inventory. Lower turnover ratio means either lower sales or higher level of inventory.
Return on equity	Assets are generally financed through either debt or equity. ROE evaulates the performance of the business taking Equity as the base. ROE measures profitability of the business on investors funds.
Debt equity ratio	It measures the relationship between long term debt and equity. If the debt portion is less, that means, if the ratio is less than 1, it is much ideal. It depicts if the company is dependent more on debt or on equity, less dependence on debt is better.

b

Mid Coastal Bank	-Debt equity ratio - This will show whether the company is overutilising borrowed funds. If the company already has a high debt equity ratio, borrowing more will not be ideal at all. -Acid test ratio - It shows the liquidity of the company. It shows whether the company would be able to repay the installments on time.
Ozawa Company	-Inventory turnover - Inventory turnover will tell the supplier about the requirements of the company. Higher inventory turnover means more requirements from the supplier. -Current ratio - This would show the repaying capability of the company.
Drucker & Denon	-ROE - Return on equity would be very relevant since it'd show the profitability. -Debt equity ratio - debt equity ratio shows dependency of company on debt. If it is high it is risky as there would be high fixed costs. So, investors would not be interested in investing such a company.
WCM Committee	-Current ratio - Working Capital and current ratio are interrelated. High current ratio means high working capital. -Acid test ratio - Acid test ratio is an extension of the current ratio itself.

c

Current ratio	Current ratio of the company is improving over the years. In the current year it is much better than the industry average. It indicates that the company has over 2.6 times more assets to cover its current liabilities.
Acid test ratio	Acid test ratio is very close to the industry average. It shows the liquid assets. The company has a good acid test ratio to cover up the current liabilities.
Inventory turnover	Inventory turnover is quite weak as compared with the industry average. It is also deteriorating over the years. The company is not able to move its stock as fast as it used to.
Return on equity	ROE is better when compared to the industry average. It depicts the profitability. The company is able to use the investors funds judiciously over the years.
Debt equity ratio	The debt equity ratio is weak, it is not ideal at all. It shows that the company is much more dependent on borrowed funds instead of equity.