MBA 5010 - Performance Evaluation for Ace Company (9/9/2024)

Performance Evaluation for Ace Company

 

Executive Summary

Ace Company requests a $3 million, 10-year loan to purchase production equipment and the accompanying software (Capella University Instructions, n.d.). Ace Company provided financial data for 2022 and 2021 to analyze the company's performance. The balance sheets, income statements, and financial ratios (Appendix A, B, & C) provide the necessary data to calculate the company’s liquidity, accounts receivable turnaround ratio, inventory turnaround ratio, times interest earned, and debt-to-equity ratio. The analysis will evaluate the financial health of Ace Company and identify any critical trends and potential risks with the requested loan.

Measures of Liquidity

Liquidity is the company’s ability to satisfy its current obligations. Three ways to measure liquidity are working capital, the current ratio, and the acid-test ratio (Marshall et al., 2023). The company’s current assets and current liabilities are used to calculate these, which are included on Ace Company’s balance sheet (Appendix A). The current assets are the assets the company expects to convert to cash over the following year, and the current liabilities are debts it intends to repay within the following year. Working capital is the amount that remains when a company’s current liabilities are deducted from its current assets. A positive working capital generally indicates good financial health (Marshall et al., 2023). Ace Company’s working capital is $12,000,000. The current ratio provides insight into a company’s ability to pay its current bills. The current ratio formula is current assets divided by the current liabilities. Ace Company’s current ratio is 2.12. A current ratio of over two indicates that Ace Company has adequate liquidity.

The acid-test ratio formula is: (investments+ accounts receivables) divided by current liabilities. The acid-test ratio does not include merchandise, so this value indicates how well a company can cover its liabilities with zero inventory sales (Marshall et al., 2023). One is the minimal acid-test ratio value a company can have for its acid-test ratio to indicate that they have sufficient current assets to cover its debts (Ross, 2024). Ace Company’s acid-test ratio for 2022 is 0.77, and 2021 is 0.95.  The acid-test ratio is less than one, indicating that Ace Company is potentially low on cash or relies heavily on inventory, which may take longer to turn into cash (Ross, 2024).

Accounts Receivable Turnover Ratio

Accounts receivable are the funds owed to a company when it supplies goods or services, which will be paid later (Marshall et al., 2023). The accounts receivable turnover ratio (ARTO) indicates how effective a company is at extending credit and collecting that debt from its clients (Murphy, 2024). The ARTO ratio formula is net sales divided by the average accounts receivable (Appendix C).  A high ratio means the company efficiently collects cash for goods and services rendered (Murphy, 2024). Ace Company's accounts receivable turnover rate for 2022 is 5.06, and for 2021 is 4.58 (Appendix C). The average duration, or days it takes to collect the debt, is days in the period (365) divided by the ARTO ratio (Murphy, 2024). Therefore,  for 2022, the average duration is 72, compared to 80 days for 2021. Ace Company’s ARTO ratio improved by 0.48 from 2021 to 2022.

Inventory Turnover Ratio

Ace Company calculated its inventory turnover ratio (ITR) by dividing its Cost of Goods Sold by the average inventory (Capella University Instructions, n.d.). A low ITR could indicate slow product sales, overstocking, or marketing issues, while a high turnover ratio may indicate strong sales. A decline over time in the ITR may indicate a drop in demand for the offered product (Fernando, 2024, April). Ace Company’s Inventory Turnover Ratio is 1.92 for 2022  and 2.00 for 2021. Ace Company’s ITR is slightly less than the previous year; however, it is significantly lower than the industry’s ratio of 10.00. With the current ratio, the average time for Ace Company to sell its inventory is 304 days (365 days/ITR), whereas the industry averages 37 days. Ace Company’s low inventory turnover rate increases the potential lending risk.

Total Debt-to-Equity

The debt-to-equity (D/E) ratio is a measure of financial leverage that compares a company’s liabilities to the shareholder’s equity (Marshall et al., 2023). The ratio measures how much of a company’s operations are funded by debt or capital or how reliant the company is on its debt (Fernando, 2024, March). Generally, nonfinancial companies limit their debt to less than half of the total capital due to the associated risks with more debt.  Companies with a 50 percent debt ratio would have a D/E ratio of one (Marshall et al., 2023). Ace Company’s total debt-to-equity ratio for 2022 is 3.08, and 2021 is 3.2 (Appendix C). Ace Company has lowered its debt since 2021. However, the company relies heavily on debt, increasing the risk with additional loans.

Times Interest Earned

Times interest earned (TIE) is a solvency ratio that measures a company’s ability to pay its debt and interest on its debt with its current income (Chen, 2024). Generally, lenders consider a company with a TIE ratio of five or higher low-risk (Marshall et al., 2023). Ace Company’s times interest earned for 2022 is 9.97, and 2021 is 7.08 (Appendix C), meaning the company should not have any issues paying its future debts.

Short and Longterm Loan Considerations

To assess the risks associated with a company for a short-term loan, lenders consider the current ratio, the inventory turnover ratio, and accounts receivable turnover ratios. For long-term loans, banks often evaluate the time-interest-earned ratio and debt-to-equity ratio (Capella University Activity, n.d.). Ace Company has positive working capital and a current ratio of 2.1, indicating adequate liquidity to cover its liabilities. The accounts receivable turnover ratio has increased from 4.58 to 5.06, indicating that the company is improving its collections process. The company’s times interest earned increased significantly from 2021, indicating that it continues to improve its ability to pay off its debts. However, the acid-test and inventory turnover ratios indicate that the company does not move inventory as fast as the industry. Considering the company is requesting a loan to purchase production equipment and accompanying software, these improvements may also increase the company’s inventory turnaround ratio. Since the company has a high TIE and is steadily improving its accounts receivable and inventory turnover ratios, it is recommended that Ace Company receives the requested loan.

Appendices

 

Appendix A: Balance Sheet

 

(Ace Company’s Balance Sheet by Capella University Instructions, n.d.).

Appendix B: Income Statement

 

(Ace Company’s Income Statement by Capella University Instructions, n.d.).

Appendix C: Financial Ratios

(Ace Company’s Financial Ratios by Capella University Instructions, n.d.).

 

References

Capella University Activity. (n.d.). Assessment 3 performance evaluation [Activity]. https://courseroom.capella.edu/courses/27380/assignments/494374?module_item_id=1371799

Capella University Instructions. (n.d.). Assessment 3 performance evaluation [Instructions]. https://courseroom.capella.edu/courses/27380/pages/assessment-3-instructions?module_item_id=1371787&content_id=494367

Chen, J. (2024, February 13). Time interest earned ratio: What is it and how to calculate it. Investopedia. https://www.investopedia.com/terms/t/tie.asp

Fernando, J. (2024, March 6). Debt-to-equity(D/E) ratio formula and how to interpret it. Investopedia. https://www.investopedia.com/terms/d/debtequityratio.asp

Fernando, J. (2024, April 29). Inventory turnover ratio: What is it, how it works, and formula. Investopredia. https://www.investopedia.com/terms/i/inventoryturnover.asp

Marshall, D. H., McManus, W. W., & Viele, D. F. (2023). Accounting: What the numbers mean (13th ed.). McGraw-Hill.

Murphy, C. (2024, June 15). Receivables turnover ratio: Formula, importance, examples, and limitations. Investopedia. https://www.investopedia.com/terms/r/receivableturnoverratio.asp

Ross, S. (2024, May 21). How to calculate acid-test ratio: Overview, formula, and example. Investopedia. https://www.investopedia.com/ask/answers/011315/how-do-i-calculate-acid-test-ratio-balance-sheet.asp