Current ratio measures the company ability to meet its short term maturing obligation to its creditors or suppliers; it is a measure of a company’s solvency (Microstrategy.com, 2011). A current ratio of more than one represent a margin of safety for the creditors or suppliers, where the higher the ratio the more liquid the firm is and the more confident the creditors will be with the company (Microstrategy.com, 2011).
- =CA / CL
- =340,902/ 381,000
- = 0.89: 1
Current ratio is not an adequate measure of liquidity as it includes inventory or stock which is not easily converted into cash; on the other hand quick ratio excludes the stock in its calculation (Meir, 2008). A quick ratio of more than one is satisfactory for the firm, since the higher the ratio the more the ability of the firm to meet its short term maturing obligations (Meir, 2008). However, a higher quick ratio may not always reflect high liquidity for the firm, which has a high average collection period; on the other hand, a low quick ratio may not necessary reflect low liquidity if the average collection period is short (Meir, 2008).
If the quick ratio of the firm is less than one, this means that the firm’s liquidity is not satisfactory (Meir, 2008). In such cases the company need to do two things; improve it debt management policy ensuring that debtors pay within a short duration of time and it should also improve the stock management policy to ensure that stock is converted into cash within a short duration (Meir, 2008).
- = (CA – Inventory) / CL
- = (340,902 – 267,000) / 381,000
- = 0.19: 1
Working Capital Ratio
The working capital ratio measures the firm’s ability to meet its short term liability from its assets (GoldmanSachs.com, 2011).
- = Total Assets/ Total Liabilities
- = 1,516,002 / 981,000
- = 1.55: 1
Debt to Equity Ratio
Debt to Equity ratio is a gearing or leverage ratio; leverage ratios measures the extent to which a firm uses the assets which have been financed by non-owners supplied funds (Drake, 2009). That is they measure the financial risk of the company; the higher the ratio, the higher the financial risk of the firm (Drake, 2009). There should be an appropriate mix of debt and equity finance in the company’s assets (Drake, 2009).
Debt to Equity ratio measures the proportion of non-owner supplied funds (Long term debt) to owners’ contribution (Shareholders’ Equity); if it is more than 100% the firm is highly geared (Drake, 2009).
Implication of High Gearing Level
Debt financing is more risky from the point of view of the firm, where the firm has a legal obligation to pay interest to the debt holders irrespective of whether the company makes profit or not. If the company defaults on the payment of interest on time the creditors may sue the firm resulting to liquidation (Drake, 2009). A highly debt burdened firm will find it difficult to raise more funds since it will be viewed as risky by providers of funds, that is if the equity base is thin, the firm is less likely to receive funds from creditors (Drake, 2009).
Debt is advantageous to shareholders in that they maintain control of the firm since debt holders do not have controlling interest in the firm (Drake, 2009).
- = Total Long-term Debt / Total Equity
- = 600,000 / 535,002
- =1.12 x 100
- = 112%
The restaurant net profit margin (net profit as a percentage of sales) is at 8.72% this means that the firm has not been efficient in controlling its production, operating and financing cost. This is because the net profit is only 8.72% of sales and 91.28% represent cost of sales, operating costs, financing cost and taxes.
Rally’s current ratio is not satisfactory, since it is below the margin of safety; the current ratio of 0.89 means that the restaurant current assets can only cover current liabilities 0.89, implying that the firm is facing liquidity risk and it cannot be able to pay its short term obligations. However, quick ratio is more preferred than current ratio to decide whether the firm is liquid or not as it does not include inventory (Drake, 2009). From the ratio calculated the firm’s quick ratio is at 0.19 which is below the required ratio of 1 therefore, the restaurant is facing liquidity risk. The current ratio and quick ratio variance is very wide this implies that the firm has a lot of money tied up in inventory or stock. This indicates that the firm is having idle stock in the warehouse. Therefore the firm should; improve it debt management policy by ensuring that debtors pay within a short duration of time and it should improve the stock management policy to ensure that stock is converted into cash within a short duration (Drake, 2009).
The firm working capital ratio is at 1.55 this means that the firm is efficient in using its assets to meet its obligations to the creditors or suppliers; if sales drop, this will mean that the restaurant will not be utilising its asset efficiently and the working capital ratio will drop below 1.55.
The gearing ratio of 112% (debt to Equity ratio) is more than 100%; this means that Rally’s Restaurant is highly geared. Thus, if the restaurant defaults in paying the interest rate it will be sued and finally be liquidated or it may face difficulty in the future if it wants to raise more funds. This implies that the firm is very risky to the creditors.
In conclusion, Rally’s Restaurant is not a successful restaurant as it is facing liquidity problems or risk, leverage or financial risk and it is holding more of its cash in terms of idle stock this is as a result of poor debt and stock management policy. Rally should concentrate on improving debt and stock management policy and also improving its efficiency on cost control.
Drake, P. (2009). Financial ratio analysis. Web.
GoldmanSachs.com. (2011). BRICs. Web.
Meir, L. (2008). Financial ratio analysis. Web.
Microstrategy.com. (2011). Financial Analysis. Web.