Given the following information from ABC and its competitor (XYZ), comment on th

Question

Given the following information from ABC and its competitor (XYZ), comment on the following issues. I. How does ABC’s liquidity compare to XYZ? II. What conclusions can you make regarding how well ABC is managing its operations compared to XYZ? Use all the relevant information presented in the table. III. Compare ABC and XYZ from an investment point of view. Specify how each ratio justifies ABC or XYZ as a better investment.

Ratios XYZ ABC Acid test ratio 0.6 0.8 Inventory turnover 3 2 Accounts receivables in days 131 63 Accounts payables in days 200 110 Return on Assets 9% 7% Equity Ratio 0.6 0.7

Explanation / Answer

I. The acid test ratio which is a measure of liquidity is computed by dividing the quick assets by the current liabilities. It denotes how much of an entity’s current liabilities can be met with its quick or highly liquid assets. The higher the acid test ratio, the better is the entity’s liquidity. It is seen that ABC has a higher acid test ratio of 0.8 as compared to XYZ’s 0.6 which means that ABC enjoys a better liquidity position as compared to XYZ.

II. The inventory turnover, accounts receivables in days and the accounts payables in days shows us how well the operations are being managed. Let us look at each one of these ratios independently.

Inventory turnover: The inventory turnover which is measured by dividing the cost of sales by inventories, denotes how fast the inventory is moving and generating sales revenue. It thus reflects the efficiency of inventory management. The higher the inventory turnover, the more efficient is the management of inventories and vice-versa.

The higher inventory turnover of XYZ of 3 against the 2 of ABC denotes that XYZ is managing its inventory more efficiently.

Accounts receivables in days: The accounts receivables in days is measured by dividing the number of days in a year by the receivables turnover. It denotes the number of days a company will take to collect its receivables and hence the lesser the accounts receivables in days, the better managed are the receivables.

In comparison to XYZ’s accounts receivables in days of 131, it is observed that ABC had a much lower accounts receivable in days of 63 which means that ABC collected its receivables faster than XYZ and hence performed much better than XYZ in managing its receivables.

Accounts payables in days: The accounts payables in days is measured by dividing the number of days in a year by the payables turnover. It measures the number of days a company will take to pay it creditors.

Thus, ABC pays its creditors faster than XYZ.

III. From an investment point of view, XYZ has a better return on assets of 9% as compared to ABC’s 7%. The return on assets denotes the income generated for every $1 invested in the assets of the entity.

Thus, XYZ seems to be a better investment option since it generates a higher return on assets.

The equity ratio shows the percentage of assets of an entity that have been financed by the owners of the entity. The remaining portion is financed through debt. It is seen that in case of ABC, 70% of its assets are financed by investors or owners as against 60% in XYZ. A higher equity ratio shows that the owners have more faith in the entity and are willing to invest more in it. Thus ABC seems a better investment option based on the equity ratio.

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