Ratio Comparison
Robert is likely to experience the following problems in comparing the ratios for the portfolio. Companies from different industries cannot be compared given that each industry has unique features that affect the financial statements leading to the variability of the ratios. Similarly, different industries use different accounting policies like FIFO and LIFO. Ratios are computed from historical data and therefore they do not reflect the current or future realities that might be different from the past. The portfolio does not include benchmark companies that might reflect the industry averages and therefore comparing one company with another can be misleading. The business condition might also affect some companies more than others and therefore ratio analysis can give the wrong impression.
The current and quick ratios for the electric utility and fast food stock are lower than the other companies because the two might hold more liabilities or fewer current assets compared to the software and motors company. Similarly, the two companies might hold more fixed assets and fewer current assets leading to a small current and quick ratio.
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An electric utility company might carry more debt than the rest of the companies because it needs more capital for investment purposes. Debt, in this case, offers such companies cheaper and readily available funds to expand their operations that lead to future benefits for the stockholders. Similarly, debt reduces the tax burden of the utility company creating more value to the investors. The company might need more capital for expansion purposes which can only be achieved by borrowing funds from outsiders. Similarly, the company might desire to maintain control over the operations of the company and therefore less likely to issue additional shares that will lead to increased control by the new investors.
Investors are unlikely to invest most of their money in software companies because they lack the fundamentals that make them investor friendly. Despite recording impressive net profit margins software companies can easily be affected by new technologies that make them obsolete. Such a scenario renders the company useless and is likely to close down if it is unable to innovate. The companies also lack tangible assets making them risky investment options for potential investors. Software companies have higher returns but their risks are also high due to the nature of their business. The realized returns in such companies might be less than the expected return. The company is therefore exposed to systemic and unsystematic risk.
Interpreting Liquidity and Activity Ratios
According to the ratio analysis, the company is holding more inventory compared to the industry norm. The company is overspending in inventory and waste some of its resources to store non-saleable inventory. The company is either overstocking or inefficient in its sales. It is, therefore, tying too much of its cash in inventory which can lead to a significant drop in its market price. The best approach is to enhance its efficiency or reduce the inventory held.
The company has a higher average collection period than the industry norm indicating that the company is not efficient in collecting its sales. The company can, therefore, face cash flow issues since it takes longer to collect accounts receivables. Bluegrass should ensure that it collects its accounts receivables on time so that it can meet its cash needs when they fall due. It should ensure that the receivables are collected in less than 52 days.
The average payment period for the company is 31 days compared to the industry norm of 40 days. Bluegrass is, therefore, paying its accounts payables faster than its competitors. Despite the fact that the company is paying on time, its cash outflow is higher than the industry average implying that it is paying quickly which not good for its ability to meet cash obligations. The company should, therefore, extend the average payment period to 41 days or more so that it can maintain adequate funds to meet its operational activities.
The above recommendations will ensure that Bluegrass enhances its efficiency by reducing the volume of stock held or increasing its sales. Similarly, it will enhance its ability to meet its near-term cash needs when they fall due while extending the time those payments are made. The company, in this case, will have more cash at its disposal which will enhance the quick ratio and ensure that there is adequate cash to pay for operational activities. However, the recommendations might be ineffective given that the company might experience irregular demands that require additional inventory to be maintained. Similarly, the policies of the company might limit the applicability of the recommendations.
