Case Study on Financial Soundness
Students studying finance often baffle when asked to compare two companies in the two different sectors. “Sir, these are incomparable, every industry is a unique”, says one after another. It is true but in many aspects, there are common measures which make them comparable.
Take for example, “Financial Soundness”. All business entities would be assessed with the same yardstick. When we look at possibility of defaults in routine payments like markup, we are taking a short-term view. Any company in any field may be heading towards bankruptcy if it lacks ability to clear its liabilities when due. On the other hand, if we want to know whether the company would survive in the next economic down-turn, we would look far into the future. A company doing well now, may go insolvent anytime because of over-borrowing. Similarly, a company solidifying its asset-base may get into trouble for not meeting its current obligations. Hence both “short & long positions” are considered while gauging the financial stability and same ratios are used for all types of industries.
Let us start with two companies. One is known as Cotton Printer Ltd. It is located near the Lahore City in Pakistan. Lahore is also known as City of Gardens or merely Heart of Pakistan being a historical city as well as commercial and industrial centre. Our second company is “Quality Air-Conditioners Ltd”, based at Karachi which has a seaport, big financial market and in fact it is the largest city of the country. Distance between Karachi and Lahore is about 1,000 km.
Both companies differ in regards to technology, stock requirements and trade practices. If one analyses the accounts of these companies, one must try to understand their normal features. A common sense approach would suffice. But first, the question:
If one disregards background of industries these companies belong to, one would be tempted to rate Cotton Printer much higher than the other. If fact, most of the students commit such a folly by not considering the industrial background and going straight for comments based on ratios as shown in the summarized balance sheet:
Analysis means “breaking-down”. As such, aggregates are not considered in analysis such as total current assets but what these assets consist of. Each item would be evaluated one by one. But first, a bench mark has to be ascertained or simply put a question asked, “What is an ideal situation in case of finished goods stocks”. Obviously, in cotton printing, a print loses its appeal when a new and better print is offered by the market. Firms engaged in printing cotton fabrics employ good designers and commercial artists. They try to excel each other. So an old print does not lost for more than a week. The production cycle is short, say one day. Further, it is a fashion ware for summer season. Who buys cotton print in winter especially in December when temperature falls to zero or below? The ideal situation would be not to have a single meter of processed cloth. If there is any stock, it is already a junk to be thrown off.
Similarly, a cotton printing should have small work-in-process inventory in dull season. Same is the case with Trade Receivables. The normal practice is to sell against hard cash. Even if some credit is extended, it should be in peak season which lasts until August. By December, each and every penny should be collected or written off as bad debt. The company may, however, build up stocks of grey cloth to be used in the ensuing spring season.
In air-conditioning, it is different story. The product is stable; it takes lot of time to manufacture. It comes under durable goods industry and so one can extend credit and, in case of default, may take back the product without losing its value. So all ratios auger well in case of Quality Printers.
Actual and ideal position in both cases is shown below:
We can look at the financial soundness from an other angle. How comfortable is the company in the eyes of financiers. Long term survival of a company depends upon attitude of the banks. If they feel, the company has lost its viability or its status as a "going concern", they use all leverages to get back their funds such as selling stocks in pledge, enforcing mortgages or simply getting the company liquidated through courts.
Cotton Printers fails on all counts as would be seen from the following.
Only short comments are needed here. Normally, a bank extends credit keeping an adequate margin of safety as 60% of stocks. The Cotton Printers have already over borrowed from the banks. Similarly, a Development Finance Institution (DFI) would extend a long term loan considering, inter-alia, security aspect. As such, the fixed assets must be much higher than the loan outstanding. In Cotton Printers, it is the reverse.
Cotton Printers do not have any safeguard by having long term investments to be sold when a bad time comes. Also, the fixed assets of the company have almost been depreciated and have become obsolete. So it would be miracle if the company survives next year.
Answering the original question, Quality Air-Conditioners is a better of the two.