Question

Question (2.A).

A lending officer is provided with the following Table 1 about the financial ratio of a business borrower XYZ Ltd. XYZ Ltd. is a paper producer and has a policy of giving 30 days’ credit. What do these tell us about the efficiency management of XYZ Ltd?

Table 1. Financial Ratios of XYZ Ltd.
	2018	2019	2020
Current Ratio	1.5	1.4	1.2
Quick Ratio	0.9	0.8	0.8
Inventory Turnover Ratio	2	2.2	1.78
Creditor Turnover(days)	37	39	64
Debtor Turnover(days)	73	74	86
Gross profit	27%	24%	22%
Net Profit	7%	6%	6%
Gearing ratio	8%	7%	7%

Answer 1

Efficiency Management of XYZ Ltd :

1. Current Ratio : Though the current ratio has decreased slightly from 1.5 in 2018 to 1.2 in 2020, it is still over 1.0. That indicates a good working capital management as Current Liabilities can be paid off using the current assets and working capital is positive. No additional working capital loan should be required unless there are huge seasonal fluctuations.

2. Quick Ratio has been quite steady at 0.9 and 0.8 range which is quite comfortable. It indicates that most of the current assets are quite liquid (like Cash & Cash equivalents and AR ) and most of the current liabilities can be easily paid off using the liquid current assets .

3. Inventory Turnover ratio is a matter of concern. The Inventory turnover has decreased from 2 in 2018 to 1.78 in 2020. This is a concern as in 2020 the inventory is held up for 205 days in a year. XYZ needs to pay immediate attention to the matter and reduce the inventory holding , systems like JIT may be adopted to get rid of the problem.

4. Creditor turnover days has increased from 37 days in 2018 to 64 days in 2020. If the enhanced credit period is a result of agreed negotiations with the suppliers , then it is a good sign. However, if the extended credit days are due to delay in payment for shortage of cash , then it may be risky as suppliers may stop the supply and credit rating of XYZ will be lower. XYZ Management needs to take a detailed look into it and prevent any artificially extended credit periods to prevent probable disturbance in supply chain in future.

5. Debtors Turnover days have increased from 73 days in 2018 to 86 days in 2020. However, the credit period offered by XYZ is 30 days. This indicates a bad credit management by XYZ Ltd. The collection process is quite slack . Management needs to tighten the collection process, introduce some discount offer if required and need to bring down the collection time in the short run. This is a serious issue that needs immediate attention.

6. Gross Profit is gradually decreasing ( 27% in 2018 to 22% in 2020). This indicates that COGS cost is increasing much more than increase in revenue. Management needs to pay immediate attention for better rate negotiation for direct materials, better productivity of labor through improved processes and better management of factory overheads for reducing the COGS.

7. Net Profit is steady at 7% to 6% level, which indicates no change in operating expense and interest expenses management efficiency. Management needs to increase sales revenue and better manage the operating expenses so that the net income improves. If the fixed interest coverage is too high , the Management needs to take a re-look at the debt position and try to repay some part of debt to reduce fixed interest exposure.

8. Gearing Ratio : The Debt Equity Ratio is quite stable and on the lower side of 8% to 7% which should be a comfortable level of gearing. XYZ company has apparently no risk from leverage point of view and should be able to service debt charges provided the profit margin is comfortable in future.

On Overall basis , the inventory turnover , the higher collection days , the decreasing Gross Profit margin are some

of the concern areas that the XYZ Management needs to address . The overall performance should improve once the concern areas are fixed and the current resources are utilized in a better way.