Robbins Ltd. is a wholesale distributor of professional equipment and supplies. The company’s sales have averaged about $900,000 annually for the three-year period 2015–2017. The firm’s total assets at the end of 2014 amounted to $850,000. The president of Robbins Ltd. has asked the controller to prepare a report that summarizes the financial aspects of the company’s operations for the past three years. This report will be presented to the board of directors at their next meeting. In addition to comparative financial statements, the controller has decided to present a number of relevant financial ratios that can help with identifying and interpreting trends. At the request of the controller, the accounting staff has calculated the following ratios for the 2015–2017 period:
In preparation of the report, the controller has decided first to examine the financial ratios independent of any other data to determine if the ratios themselves reveal any significant trends over the three-year period.
Instructions
(a) The current ratio is increasing while the acid-test (quick) ratio is decreasing. Using the ratios provided, identify and explain the contributing factor(s) for this apparently divergent trend.
(b) In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s use of financial leverage during the 2015–2017 period?
(c) Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net investment in plant and equipment?
(d) Using the activity ratios provided for inventory and accounts receivable, comment on the effectiveness of working capital management.
SOLUTION
(a) The acid-test ratio is the current ratio with the subtraction of inventory and prepaid expenses (the latter is generally insignificant relative to inventory) from current assets. Any divergence in trend between these two ratios would therefore be dependent upon the inventory account. Inventory turnover has declined sharply in the three-year period, from 4.91 to 3.72. During the same period, sales to fixed assets have increased and total sales have increased 5 percent. The decline in the inventory turnover is therefore not due to a decline in sales. The apparent cause is that investment in inventory has increased at a faster rate than sales, and this has accounted for the divergence between the acid-test and current ratios.
(b) Financial leverage is the use of borrowed funds (debt) to increase the return earned by investors, such as the shareholders of a business, and is measured by looking at the relationship between the amount of debt and the amount of shareholders’ equity. For example, if a company can borrow $1,000 at an interest cost of 6% and put that $1,000 to work and earn 10%, the excess 4% return goes to the shareholders without their having to invest any additional funds of their own. But consider the situation for the shareholders if the $1,000 borrowed and invested earns only3%! Too much debt can be injurious to a company. With increased debt come increased requirements for regular interest and principal payments, and bankruptcy risk increases.
In the Robbins situation, financial leverage has definitely declined during the three-year period. This is shown by the steady drop in the long-term debt-to-total-assets ratio, and the total-debt-to-total-assets ratio. Apparently the decline of debt as a percentage of this firm’s capital structure is accounted for by a reduction in the long-term portion of the firm’s indebtedness. This reduction of leverage accounts for the decrease in the return on equity ratio. This conclusion is reinforced by the fact that net income to sales and return on total assets have both increased.
(c) The company’s investment in plant and equipment has decreased during the three-year period 2015–2017. This conclusion is reached by using the sales to fixed assets (fixed asset turnover) and sales as a percent of 2015 sales ratios.
Because sales have grown each year, (3% in 2016 and 5% by 2017) the sales to fixed assets could be expected to increase unless fixed assets grew at a faster rate. The sales to fixed assets ratio increased at a faster rate than the 3 percent annual growth in sales; therefore, investment in plant and equipment must have declined.
(d) Both the inventory and accounts receivable turnovers have deteriorated substantially during 2016 and 2017. Unless the decline in the receivables turnover can be attributed to a change in the terms of payment negotiated with customers, Robins should not be experiencing this decline in spite of the increase in sales.
Expressed as a number of days these ratios further demonstrate the seriousness of the decline in activity during 2016 and 2017.
2015 2017
| Number of days to collect receivables | Number of days to collect receivables | | Number of days to collect receivables | Number of days to collect receivables |
|---|
| 365 | = 41.7 | | 365 | = 56.9 |
| 8.75 | | | 6.42 | |
| Number of days sales in inventory | Number of days sales in inventory | | Number of days sales in inventory | Number of days sales in inventory |
| 365 | = 74.3 | | 365 | = 98.1 |
| 4.91 | | | 3.72 | |
| total days | 116 | | | 155 |
| Increase in number of days | Increase in number of days | Increase in number of days | Increase in number of days | 39 |
| Increase as a % | Increase as a % | | | 34% |
| Further attention will need to be paid to the management of these two important current assets. | | | |