Black Sparrow Aviation, Inc. is concerned they are not maintaining adequate liqu
ID: 350891 • Letter: B
Question
Black Sparrow Aviation, Inc. is concerned they are not maintaining adequate liquidity. The accounting department has provided you, the newly hired finance manager, with the following ratios: •Current ratio 4.5 Industry norm 4.0 •Quick ratio 2.0 Industry norm 3.1 •Inventory turnover 6.0 Industry norm 10.4 •Average collection period 73 days Industry norm 52 days •Average payment period 31 days Industry norm 40 days
Discuss In your opinion, what do these ratios indicate about Black Sparrow Aviation, Inc.? What recommendations would you make based on these ratios? What results do you think you can achieve if your recommendations are followed? Why might your recommendations not be effective?
Explanation / Answer
Current Ratio = Current Assets / Current Liabilities
Current ratio measures the company's ability to pay its current liabilities with its current assets. The higher the current ratio, the more capable is the company of paying its obligations. However, a high ratio does not necessarily mean that the company's state is financially stable. It may also indicate that the company is not using its current asset efficiently or not managing its working capital well. Hence, I would recommend that the company should bring its current ratio to atleast in line with the industry standards by utilising its current asset more efficiently. This will help in better utilization of its asset and would increase its business.
Quick Ratio = (Cash + Cash equivalents + Marketable securities + Accounts Recievables) / Current Liabilities
Quick ratio is the acid test ratio that measures the firm's ability to meet its current obligations with its most liquid assets. The only assets that can be liquidated immediately are taken into consideration. The main difference between quick and current ratio is the Inventory. The huge difference between this ratio indicates that Black Sparrow has huge inventory. Since, here the quick ratio is well below the industry norms and current ratio is above industry average, it means that the company relies heavily on inventory to pay of its current liabilities. It also indicates the company is not cash rich and has low account recievables as compared to its rivals. I would recommend that the company continue with this ratio as although it is below indusry average but it is well over 1 and hence the company has sufficient quickly liquidating assets to pay of its liabilities.
Inventory Turnover = Sales / Average Inventory
Inventory turnover ratio basically depicts how fast a company is selling its inventory. The low ratio indicates weak sales and high ratio indicates strong sales. Black Sparrow's sales are weak as compared to the industry. I would recommend that Black Sparrow could offer some discounts or schemes to increase its sales and hence increase its inventory turnover ratio.
Average Collection Period = (Days * Accounts Recievables) / Sales
Average collection period is the time taken by the business to recieve the accounts recievables or it is number days between day of credit sale and amount recieved for that sale. A low ACP indicates that the firm collects money at a faster rate however it may also indicate that the company has strict collection policies and the customer might seek services from others with lenient payment terms. In my opinion, Black Sparrow should form a little strict collection policy and bring its ACP close to industry average as the longer collection periods also affects the company's cashflow and working capital. Lowering of ACP would help Black Sparrow to bring its quick ratio at par with industry average.
Average payment period = (360 * Accounts Payable) / Cost of Goods Sold
Average paybles period or days payble outstanding (DPO) measures how long it takes for the company to pay its vendors, creditors and suppliers. A delicate balance must be struck by companies with DPO. The longer they take to pay creditors, the more cash they have, which is good for working capital and free cashflow. Although if a company takes too much time to pay its creditors then it makes them unhappy which would inturn mean refusal to extend credit in future or unfavorable terms. Since Black Sparrows DPO is lower than the industry average, it means that it is not using its cash as long as its competitors in the industry. I would recommend that they should stretch out its payment period to improve cashflow without harming its relationship with vendors.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.