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Finance :Working Capital Ratio


a) Write a report (no more than 2 sides of A4) with your view on how LMM has
performed in the two year period. You should show supporting calculations of at
least SIX ratios (for each year) to back up your findings. (60%)

In 2013, the Working Capital Ratio which is ascertained by Current Assets / Current
Liabilities, in was 1.4. This increased to 2.3 in 2014. The working capital ratio is an important
ratio in determining the health of the company under scrutiny (Paradi, Rouatt & Zhi, 2011, 102).
It helps one determine the liquidity of a company. The liquidity represents the ability of a
company to rapidly turn assets into cash in order to meet its short-term obligations as they fall
due. Between 2013 and 2014, the company increased the component of liquid cash it held from
0 in 2013 to 582,000. This arrangement is beneficial to the company as it places it in a stronger
position with regards to competitors, in being able to pay off its debts quicker (Paradi, Rouatt &
Zhi, 2011, 100).
The Quick ratio also called the acid test ratio is an important ratio. When inventories are
removed from the current assets figure, the true position of the company is cleared (Lazaridis &
Tryfonidis, 2006, 28). It should not be lost that inventory is held by the organization for trading
or facilitating the operations of the company. It is thus very important to determine how the
cash and other items that can be easily and rapidly converted into a ready cash value. In 2013
the ratio is 0.7 and improves significantly in 2014 to 1.3. Two issues emerge in the analysis of
this ratio. In 2013, when the ratio stood at 0.7 the company could have been said to have a ratio
lower that the ideal position by all companies. All companies will seek to have at least a ratio of
1:1. The position of 0.7 could not be so dire if the inventory is rapidly turned-over. A high
inventory turn-over makes available ready cash to the company within a short period of time
(Paradi, & Zhu, 2013, 62). In 2014 the ratio improved very significantly to 1.3. This position
places the company at a pedestal when it comes to taking advantage of emerging opportunities in
the industry. Taking the argument that the inventory has a high turn-over, it makes the company
highly liquid (Lazaridis & Tryfonidis, 2006, 30). This highly liquid position may however make

the company a prime target for a takeover by a company that is looking to improve its liquidity

position (Paradi, & Zhu, 2013, 62).

Quick Ratio = (Current assets – Inventory) / Current liability
The debt-to-equity ratio determines the level a company’s financial leverage (Paradi,
Rouatt & Zhi, 2011, 102). This is what is arrived at when the total liabilities and divided by the
shareholders equity. This is an important indicator of what proportion of a company’s assets is
financed by equity and which part is by debt. When a company has a huge debt, it reduces the
margins which it operates under and which allow it to respond to market stimuli by adjusting
fixed charges and manipulating the earnings available for dividends (Uyar, 2009). This latitude
is important as it could allow a company facing challenging stimuli adjust accordingly to ensure
sustainability. The risk of using this data to orchestrate a financial crisis is not remote. In 2013
the ratio was 0.5 improving significantly to 0.9 in 2014. In both years, the company reports very
robust ratios. The improvement from 0.5 to 0.9 further shows the strong position the company
holds. The improvement is on the basis of the loan that grew from 4,000,000 to 11,000,000

Debt-to-equity ratio = Total Liabilities / Shareholders Equity
The return on equity ratio is important as it allows ordinary shareholders determine
individually how profitable their capital is in the business venture they have invested in (Uyar,
2009). The profitability of a company is important as it has a direct effect of its shareholders.
When the return on equity is calculated, it reveals the estimated profitability of the company.
This return on equity reveals the amount of profit generated by the company with the money
invested by the shareholders. In 2013, the return on equity was 15.07%. This fell to 9.13% in

  1. The decline in return could be attributed to the additional costs that were incurred by the
    company in 2014. Distribution costs and administrative costs grew significantly. Despite the

increased operational costs that the company incurred, it was able to smooth this by making
additional income from its operations. However, the finance costs increase with such that the
profitability of the year could not cover it (Scott, & Jacka, 2011). As a result the profits fell by
almost 600,000. This had the overall effect of reducing the shareholders return of equity.

Return on Equity = Net Income / Shareholder’s Equity

The net profit margin is an indication of how efficient the company is in controlling the
cost surrounding its operations. When the net profit margin is high, it exhibits a company that is
efficiently converting its revenues into actual profits (Reiner, Turley & Willekens, 2008). It
shows that the company is able to turn its sales into income. For 2013 the profit margin was
5.8% improving to 9.9% in 2014. The increase in profit margin could be as a result of two
factors. To begin with, the company increased it’s from 19,800,000 to 22,600,000. This growth
is sales ensured the company had a strategy that was able to convert revenue into actual profits.
The second factor could be a reduction in the operational expenses (Scott, & Jacka, 2011). The
company was able to employ the same resources but milk greater profits from the same


Profit margin = Net income / Net sales

Another set of ratios that examine how a company is performing are the solvency ratios.
This ratios are important as they determination point the long-term risk (Reiner, Turley &
Willekens, 2008). Shareholders and long-term creditors find these ratios important in assisting
them make investment decision regarding the company. Given that in business, there are only
two ways to finance the acquisition on an asset; debt (using borrowed funds) and equity (using
funds raised by shareholders or funds retained from the company’s internal operations – retained
earnings). The ratio determined for a company shows the percentage that each asset it financed

by (Eljelly, 2004, 51). Ideally, the level of debt that a company takes on is a subjective issue.
For a company that is has a high debt could be viewed as one that is able to leverage greatly. In
the same face, for a company that relies on heavy investment in fixed plants and equipments, the
level of debt financing will similarly be bigger with aspects such as insurance and advertising
agencies being some of the components that will see this figure grow. Given that total debt of a
company is made up of both long and short term debt. For creditors, emphasis and special
interest will be on the long-term debt, specifically seeking to determine how the company used
this facility (Eljelly, 2004, 51). In 2013, the 46.7% while in 2014, it was 90.0%. By taking on

additional debt, the ratio grew from 46.7 to 90.0.
Debt to total assets ratio = total debt / total assets

b) It has been rumoured that LMM is planning an expansion of their production facilities
which will cost £5.5million. Discuss how this might be financed and any problems

associated with the methods you have chosen. (40%)

Currently, LMM has on its books a debt of 11 million. In 2013 the debt ratio stood at 32
cents. When it raised its loan from 4,000,000 to 11,000,000 the debt ratio rose to 47 cents to the
dollar. By adding an additional 5,500,000 to finance the expansion LMM will further raise its
debt ratio to 68 cents to the dollar. This sudden growth of the debt ratio would be alarming to
someone looking at the figures without knowledge of the industry LMM operates in. Before
changing its debt strategy and adopting one that intentionally set out to manage debt over the
long term as opposed to the short term, was based on a number of reasons. LMM could have
been looking at managing its debt better in the long term resulting in lower costs. Though the
short term would experience a growth in the overall debt, this is only an accounting growth

(Paradi, & Zhu, 2013, 62).

Overall LMM will have gained by lowering its debt cost in the long term. By getting the
additional loan to expand its operations, the anticipated additional capacity will mean higher
economies. The expanded economies of scale will allow LMM to manage the additional debt
with only raises the debt ratio marginally despite raising the debt level by almost 50 percent.
This could thus be interpreted to mean the LMM operations are very efficient. This is an
important factor when considering taking on additional debt to finance growth (Abdul &
Mohamed, 2007, 280). Overall LMM is in a strong position in its industry. For the
shareholders, the additional debt would mean better returns to them since the taxation system is
kinder to debt financing for companies as opposed to refinancing or shareholders having

exclusive rights to purchasing additional shares in the company.
LMM’s debt to equity ratio for 2013 was 47 cents to the dollar. When LMM almost
tripled its loan from 4,000,000 to 11,000,000 the debt to equity ratio rose almost doubled to 90
cents to the dollar. By saddling LMM with the additional debt of 5,500,000 to finance its
expansion then the ratio will raise to 1 dollar to the dollar. This means that debt and equity
equally finance the operation of LMM (Abdul & Mohamed, 2007, 280). For the industry LMM
operates in, the ratios point to a very efficient operation. Despite the upward movement of the
debt to equity ratio to the current 1.0 LMM is still below the industry ratio. From its operations,
LMM is able to generate profits that cover the repayment of the loans interest and principle. As
stated earlier, additional debt is beneficial to LMM shareholders. Given the tax plans, LMM
gains by getting debt to finance its expansion as opposed to floating shares to current
shareholders exclusively (Htay, Arif, Soualhi, Zaharin, & Shaugee, 2013).
There are a few options that LMM could choose from when seeking to finance its
5,500,000 expansion in operations. There are number of loan option and designs that LMM

could adopt in order to strengthen its position in the industry. A bank loan; depending on how it
is designed, how it is paid out and repaid and the terms of the loan will determine the value it

adds to the company.

Line-of-credit loans: This finds great favor with small businesses because all they need
to do is walk into their bank, have a good talk with the credit or bank manager and if they have
operated their accounts well, have a line-of-credit (over draft facility) extended (Narware,
2004,123). This arrangement is best suited for securing a business’s operating costs for working
capital, meeting inventory needs or business cycle needs. Since the business only pays interest
on the advanced money only, the knowledge that a pool exists which the company can access
should the need arise, allows the company more room for maneuver in its operations. A line-of-
credit would not be ideal for financing LMM’s expansion (Narware, 2004,123).
Installment loans: This design of loan will allow LMM to repay equal installments over
the loan period (Chowdhury & Amin, Md, 2007, 77). The equal monthly installments are
designed to meet both the interest and principle equitably. The repayment will determined on
loan uptake and clearly captured in the loan contracts. It also allow for early repayment of loans.

In some cases, it actually rewards early repayment of loans.
Balloon loans: By their nature, the interest is paid over the lifetime of the loan in equal
regular installments with the principle paid as a lump sum on maturity of the loan. The balloon
loans are ideal for businesses that get payments on specific periodic dates (Cascarino, 2007, ).
LMM would find this arrangement most suitable given the nature of its business is such that

incomes are period.

Secured and unsecured loans: LMM has the choice of either a secured or unsecured
loan to finance the planned expansion. For the unsecured loan, LMM will not be required to

pledge any collateral in lieu of defaulting the loan (Abdul & Mohamed, 2007, 288). This is the
option available to those considered by lenders as being low risk. The definition of low risk is
relative and will vary from person to person and situation to another (Raheman, & Mohamed,
2007, 280). However the perception of low risk has the advantage of having to pay very low
interest on loans. On the other hand, for the secured loan, LMM will have to provide some form
of collateral to secure the loan. For the expansion that LMM plans, the collateral will the
equipment to be purchased. This is based on the fact that the collateral is related to the purpose
of the loan (Chowdhury & Amin, Md, 2007, 77). By LMM using the loan to purchase
receivable, the bank will consider this as having being used to finance growth. This
classification will allow LMM access the great pool of resources the financier avails to its
customers. Most banks will lend up to 75 percent of the amount due (Padachi, 2006, 51). This
particular loan will thus not be ideal for LMM. Not being able to access the whole amount will

undermine the planned expansion.

Bankers are looking for interest income from a loan, along with a high likelihood that the
loan will be repaid (Padachi, 2006, 55). They don’t want to control the business other than
making sure it meets loan covenant standards, and they take collateral in lieu of repayment only

as a last resort.



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