Acid-test ratio is one of the ratios that are used to evaluate the creditworthiness of the company. As per the name ‘acid-test’, it’s a very strict method of analysis. Acid-test ratio measures the company’s liquidity. It indicates how quick a company can convert its assets to cash; hence this is the basis for its other name quick ratio. This ratio is highly important and reliable in measuring the company’s financial strength and it’s capability to honoring its short-term demands. Inventory is difficult to quickly change to cash; hence this is why it’s being subtracted before the current assets are compared with current liabilities (Horne and Wachowicz 215).
When the acid-test ratio is 1 or more, then the company is in a better position to meet its short term obligation. In the case above, the ratio is less than 1 for all the three years under study. This shows that the company is at risk incase it has to meet its own immediate obligations. The amount of assets that can be easily sold to get cash may not give the desired amount of money that is required to meet the amount of its liabilities. Hence the company is really struggle to satisfy the demands of the current liabilities.
This ratio is expected to yield 1:1 so that the company is seen as performing well and can meet its demands in the short run. If it is less, then it is unable to pay its short term obligations. In the above case, the company can be said to be next to collapsing and it’s being mismanaged.
This ratio has its own limitations. It cannot be used to compare the company’s performance with other companies even if they are of the same industry. This is because the company in itself should be deeply known so that the ratio will be meaningful. If a company is experiencing decline in the acid-test ratio, like in our case above, it means that the company has a lot of accumulated inventory as indicated above or that the company has increased its collection system (Bull 165).
Acid-test ratio does not provide any relevant information that relates to cash flows, which is the exact position of the company in paying its current liabilities. It also shows that the accounts receivables can easily be converted to cash which is not the case under normal circumstances. The figures also can easily be manipulated by the management so as to indicate that the company is performing well yet it might not be the case. Finally, there is an assumption that the current assets can be easily converted to cash so as to pay the current liabilities which is not realistic as the working capital is required to maintain the operation.
Gross profit ratio
This measures the efficiency of the company’s production process in utilizing the available labor, materials and other necessary resources by indicating the ratio of net sales left after deducting the total cost of the product or service. This shows the profitability of the company before taking into account the overhead costs. When the gross profit is high, it shows the investor that the company can generate a good profit on sales given that the cost of overheads will not go up.
It is the gross profit which is being used by the investors to determine its efficiency as compared to others in the same industry. The gross profit of the company over a given period of tine can be used to indicate the company’s growth or decline. It’s also a good measure of pricing techniques available in the company. Gross profit is highly influenced by the production costs and the prices of the produced goods and services (Troy 29).
Gross profit margin do not easily change or fluctuate over a period of time but if fluctuates, then it’s a sign of fraud, irregularities in accounting techniques used, and that the company is experiencing a lot of problems.
There are limitations for using this formula. Most companies adjust the figures such as the cost of sales buy reducing it so that a higher margin is reported. This will really mislead the investors or other stakeholders of the company, that it is producing its goods and services efficiently yet its not. This margin do not necessarily indicates the liquidity of the company since a company may alter the content of direct sales by taking them to expenses (Tamari 62).
This margin cannot be effectively be used by the investor to compare the company’s performance with other companies in the same industry since there is use of different contents of coming up with it. The company’s size, location, revenue turnover, the rate of competition is factors which affects the gross profit margin. Accounting formulas varies from company to company hence it does give different gross profit margin. In order for this ratio to be meaningful in its application, there should be ratios that are being checked with over a long period of time so as to tell the trend of company’s performance (Higgins 126).
In the case of the diagram above, the total sales have been increasing over the last tree years just like the cost of sale. The Gross profit also has been increasing as a whole figure which shows the company is doing well, but when the gross profit margin is computed, there is a decline over the three years. This measures the decline in performance, but may not be the case since the sales turnover is increasing. The can mean that the company’s product pricing is not efficient. It’s being understated. On the other hand, the cost of sales could have been overstated.
Net profit ratio
This depends on the net profit calculated and the net sales that the company has generated. Net profits are arrived at after deducting the operating expenses and income tax. This ratio is used to evaluate the profitability of the company. It’s a very important ratio to the investors and other stakeholders as this will determine the return on investment.
It also shows the company’s strength in overcoming the economic crisis such as the price changes, decline in demand, and competition among others. When the ratio is higher, the profitability of the company is high also. It is important also to know that the profits’ performance should be indicated in the context of investments or capital not only using sales.
In the diagram above, the net profit ratio has been declining for the past three years. This indicates that the company’s cost and pricing policies are not efficient. The reason behind this is that the company is experiencing increase in the sale revenue but the profit margin is not increasing.
Net profit ratio has limitations. It is not easy to compare companies in the same industry using the net profit ratio. This is because; the accounting techniques used varies from one company to the other. Net profit ratio also can be misleading as most companies my adjust it so as to meet their expectations. An increase in the ratio may not necessarily mean that the company is making good progress in performances since to calculate the profit; it involves several other factors such as cost of sales that can be changed, pricing policies, and the efficiency in production among others (Brigham and Ehrhardt 549).
Technology used in production is the main factor that hinders the explanation for the profit made. If a company has just adopted a new technology, then it is hard to really know the exact position of the company’s performance. The year end values that are used to calculate the ratios may change in the cause of the financial period because of their seasonal determinants. This will definitely affect or changes the ratio. This ratio is meaningless if viewed alone. There should be other combined with it so as to show the correct position of the company’s performance.
In conclusion, there are other methods that can be used to evaluate the efficiency and liquidity of the company. Current ratio can also be used to measure the company’s performance. Creditors prefer a high current ratio to a small one as it reduces high chances of risk occurrence. On the profitability ratios, return on investment ratio and return on equity can also be used.
Bull, Richard. Financial Ratios: How to use Financial Ratios to Maximize Value and Success for your Business. 3rd ed. Elsevier Science & Technology, 2008.
Brigham, Edmunds and Michael, Ehrhardt. Financial management: theory and practice. 12th ed. Cengage Learning, 2008.
Horne, James and John, Wachowicz. Fundamentals of Financial Management. 13th ed. Prentice Hall, 2008.
Higgins, Robert. Analysis for Financial Management. 6th ed. Irwin/McGraw-Hill, 2001.
Troy, Leonard. Almanac of Business and Industrial Financial Ratios. 14th ed. CCH, 2008.
Tamari, Michael. Financial ratios: analysis and prediction. 2nd ed. P. Elek, 2007.