(i) Explain to Mr Chugani how ratio analysis can help to evaluate the efficiency of a

business and what the efficiency ratios reveal about Party Perishables (25 marks)

How ratio analysis can help to evaluate the efficiency

The modern business environment is based on wide range performance and not profit as
perceived by many. Ratio analysis is a key tool in the modern business environment hence it is
vital for Party Perishables to take note of ratio analysis. It is important to acknowledge the fact
that the small businesses acknowledged to be doing well by the bank might be operating on
lesser capital but efficiently managed. The first element of how ratio analysis helps in
evaluating efficiency is drawn from the fact that ratio analysis is key in determining the liquidity
of an organization. This describes the ability an organization to meet it short term obligations.
This requires the company to have higher value of assets as compared to the liabilities. In this
case, the current ratio is largely applied. Ratio analysis also helps a company determine the
amount of net income earned in a dollar of sales generated. Many large and small companies
have failed because their profits is not compared to the sales so as to determine return on
sales. Like any other company, Party Perishables has an assets base, ratio analysis stands a
chance of helping the company realize the return assets, which portrays the efficient
management and application of assets. In summary, ratio analysis points out the efficiency of a
company in terms of returns on assets, owner equity, meeting obligations both long and short
term, realizing return on sales and the efficient movement of inventory through the inventory
turnover ratio.
What the efficiency ratios reveal about Party Perishables
Starting with the first ratio which is profit margin, it is a vital ratio because it measures the
amount of profits realized at certain level of sales. It is important to note the ratio also
measures how a company manages its expenses to end with good net income. As a result the
ratio is expected to be higher. In the case of Party Perishables it stands at 2.41%, which low an
indication that the company is not converting most of its sales into profits and the expenses are
not well managed.
Return on total assets is another vital ratio because it measures the how efficiently a company
earns from investment on its assets. In the year 2018, Party Perishables had a ratio of 9.73%.
This implies that every dollar Party Perishables invested on its assets returns $ 9.73. This looks
positive but low considering the fact that the assets incur other expenses like maintenance.
Return on owner’s equity on the other hand measures how efficient a company uses money
from shareholders to realize profit and grow. Party Perishables ROE for the year 2018 stands at
11.08% which a reduction of the 2017 figure of 16.7%. The figure is above 10% but still low an
indication that shareholders money is not realizing or fetching much profit.
The inventory turnover at 12x for the whole year 2018 is low considering the fact inventory is
expected to move so as to avoid cases of dead stock. In this case inventory is less efficient thus
realizing less profit.
The current ratio is vital based on that it measures company’s ability to pay its debts over a
period of 12 months. The higher the current ratio, the more the ability of a company to meets
its debts in a period of 12 months. A current ratio of 2 is considered to be favorable, in 2018,
Party Perishables has a ratio of 2.08. This positive an indication that it can meet its debts in a
period of 12 months. Quick ratio on the hand measures the liquidity of a company (ability to
apply quick assets in meeting short – term obligation). A favorable quick ratio should be 1:1, a
higher quick ratio implies a company is keeping too much cash on hand or a problem in
collecting accounts receivables. In this case the ratio is 4.77 which implies Party Perishables is
keeping too much cash in hand and has problem in collecting account receivables.
Question II: Explain to Mr Chugani why the bank might require a ratio of 2.5 and how the
business could satisfy the bank’s demands and increase its current ratio to 2.5 (25 marks)
The bank like any other financial institution is interested in covering most of its money in
shorted time possible. A current ratio of 2.5 according to the bank implies Party Perishables will
be in a position to pay most of the amounts it takes from the bank within a period of 12
months. According to the bank this highly efficient. The bank is interested in a current ratio of
2.5 because it high and does not include inventory meaning the other assets can easily be
converted into cash to service debts in a period of 12 months. Looking at this, the bank will feel
safe lending at a current ratio of 2.5.
In this case, Party Perishables must increase the current ratio to 2.5 so as to satisfy the bank. In
order to achieve this, Party Perishables must ensure the current liabilities are reduced so as to
increase the ratio. Party Perishables must also work on increasing the current assets. The
company will achieve this through undertaking the following steps;
Reduce bank overdraft to a minimal level if not zero
Work on reducing the account payable
Pay the accrued expenses to help reduce
Party Perishables must raise account receivable by allowing credit sales of good period
Party Perishables should also work on increasing its marketable securities
Conclusion
From the ratios obtained in Appendix C and analysis in the report, Party Perishables is not
efficiently managed as indicated by the bank. However, the ratio analysis enables Party
Perishables to pick out areas needed to improve it efficiency. From the financial statements, the
company is making profits in both periods hence the biggest challenge remains efficiency. To
improve, Party Perishables will consider;

 Improve its current ratio through reduction of current liabilities like accrued expenses.
The current ratio can be increased by increasing current assets such accounts
receivables, however, this is not safe since it implies keeping too much cash in hand and
poor collection of account receivables.
 Deploy good management of expenses, which will entail controlling the rise of selling,
administration and internet expenses which evident considering the two financial
periods. This will help Party Perishables increase it profit margin or return on sales.
 Finally Party Perishables must conduct an audit of its asset investment, determine the
expenses involved, and initiate good management to ensure good return on assets.
The three recommendations will no doubt improve the efficiency of Party Perishables right
from the sales to the asset management, thus building reputation with the bank.