Ratios Tell Story–2007 Harvard Case Solution & Analysis

1.      Current Ratio:

This ratio is an indicator of the liquidity of the company. It shows the company’s ability to pay its short term debts as they fall due, with its short term assets. This ratio is also an indicator of the performance of the working capital management policy of the business. A ratio of less than 1 indicates that the company does not have sufficient short term assets (cash, stock, receivables) to pay its short term liabilities (payables and debt). The company needs to maintain a good current ratio of more than 1 and match it with the industry average. On the other side this ratio also gives an idea about the performance of the operating cycle of the company. Also the business operations vary greatly within different industries therefore each industry have their own standard current ratio. Company 2 has the highest current ratio of all. As previously identified, this industry belongs to the software developer industry. Its current assets include highly liquid assets such as 35% of cash and 6% of receivables and there is no inventory. The portion of total liabilities is also small, which gives it the highest current ratio of all.

  • 2.      Receivables Collection Period:

This ratio is one of the components of the cash conversion cycle. It is the average number of days it takes to collect the payments back from the customers. Due to the growth of the business and the increasing number of transactions of the business, companies usually grant credit to the customers, but they don’t know when they will receive back their payments. Therefore, a lower collection period means the company receives its receivables before time and the working capital is smoothly managed, and there is less risk of payment default by the customers. Looking at the ratios it is evident that the highest collection period of 4803 days is, of the banking industry, where receivables constitute about 71.5% of total assets. The companies with the collection period of both 23 days are from the internet retailing and electric utility industries. The current ratio of both these companies is also same around 1.25 times.

  • 3.      Inventory turnover:

This ratio is one of the efficiency ratios. It shows the number of times the company’s inventory is sold and is replaced. When the inventory turnover ratio is low it indicates poor sales and excess inventory held. A higher inventory turnover ratio shows that the company has strong sales. Companies need to reduce their inventory levels. Higher levels of inventories are unhealthy for the business because they represent an investment with a zero rate of return. Companies 2, 3, 4 and 11 have no inventories. Companies 1 and 12 have the higher inventory turnover ratio, which means the sales are strong of these companies. Rapid sales are most likely possible in supermarkets and fast food industries, therefore, a company 1 belongs to the supermarket industry with inventory turnover of 10.8 and company 12 belongs to the fast food industry with a ratio of 44 times.

  • 4.      Gross Margin:

The gross margin ratio is that portion of the sales, which remains after the direct costs of producing the good or service are deducted. The higher the gross profit margin the better it is because then the company retains more sales to service its other obligations such as selling and admin expenses and interest expenses. This is the reason that software companies will have a higher gross profit margin than manufacturing firms and that is the reason that in this case the software development industry has a gross margin of 91%, while company 8 has a gross margin of 25%, which belongs to the manufacturing industry.

  • 5.      Dividend Payout:

Dividend payout is that portion of the firm’s net income which is paid out to common shareholders of the company. Investors that prefer higher earnings on their investments and are not interested in capitalizing growths prefer to invest in companies that have higher dividend payout ratios. Analyzing the ratios we can see that company 9 has the highest dividend payout ratio of about 101%, which means the company is paying more than it is earning to its shareholders. Such dividend payout ratio might be possible only in a pharmaceutical industry. The stocks of a pharmaceutical company show low volatility and stable payments of the dividends. The investment in pharmaceutical stocks is riskier than the stocks of other industries such as energy companies, utilities and telecom. To compensate this high level of risk these pharmaceutical companies pay solid dividend payments to its investors.............................

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