1.

ElectroStar Corporation is a manufacturer of electronic components with total assets of

$20,000,000. Selected financial ratios for ElectroStar and the industry averages for
firms of similar size are as follows:
ElectroStar
Industry
2012 2011 2010 Average
Current ratio . . . . . . . . . . . . . . 2.61 2.32 2.09 2.28
Acid-test ratio . . . . . . . . . . . . . 1.21 1.12 1.15 1.22
Inventory turnover . . . . . . . . . 2.02 2.18 2.40 3.50
Return on equity . . . . . . . . . . . 0.17 0.15 0.14 0.11
Debt-equity ratio . . . . . . . . . . . 1.44 1.37 1.41 0.95

ElectroStar is under review by several entities whose interests vary, and the company’s
financial ratios are part of the data being considered. Each of the following parties must
recommend an action based on its evaluation of ElectroStar’s financial position.
ElectroStar has given the requested informationto each party on a confidential basis.

 MidCoastal Bank. The bank is processing ElectroStar’s application for a new five-
year note. MidCoastal has been ElectroStar’s banker for several years, but must
evaluate the company’s financial position for each major transaction.

 Ozawa Company. Ozawa is a new supplier to ElectroStar and must decide on the
appropriate credit terms to extend to the company.

 Drucker & Denon. A brokerage firm specializing in the stock of electronics firms,
Drucker & Denon must decide if it will include ElectroStar in a new mutual fund
being established for sale to Drucker & Denon’s clients.

 Working Capital Management Committee. This is a committee of ElectroStar’s

management personnel chaired by the chief operating officer. The committee is
charged with the responsibility of periodically reviewing the company’s working
capital position, comparing actual data against budgets, and recommending changes in
strategy as needed.
a) Describe the analytical use of the given ratios.

Current Ratio is crucial to be used to look at a company’s liquidity position. With an

idea of current ratio (a test of liquidity), we can know how well is a company’s ability to
pay for short-term debts. Examples, bills for stocks, tax liabilities, and other short-term
liabilities that may arise. The higher the ratio, the higher the availability of liquid assets of
a company is. The formula is as:
Total Current Assets
Current Ratio=
Total Current Liaibilities

Besides Current Ratio, we may use Acid-test Ratio to test for the liquidity of a company.
It is also known as Quick Ratio. It is similar to Current Ratio but it ensures a company
has readily available cash to meet its current liabilities. Thus, the inventory stocks and
prepaid expenses were excluded. The formula is as:
Total Current Assets−Inventory
Acid−test Ratio=
Total Current Liaibilities

Inventory Turnover ratio is often used to show how effectively inventory is managed
by a company. This ratio is important because we would like to take a balance between
stock purchasing and sales. Overstock will incur storage and holding costs. Sales of a
company should also be supported by sufficient amount of stocks. Inventory Turnover
ratio also shows investors how liquid a company’s inventory is. The formula is as:
Cost of Goods Sold
Inventory Turnover =
Average Inventory

Return on Equity (ROE) is a type of ratio to test for the profitability of a company. It
measures the ability of a company to generate profits from its shareholders’ investments
in the company. It is important for potential investors to observe how efficient a company
is in using common stakeholders’ equity to generate income. The higher, the better.
Return on Equity (ROE)=Earning available ¿ common stakeholders ¿
Total equity∨ Average equity

Debt to Equity Ratio provides the relationships between the company’s total debt and its
total equity. It shows that how much a company financing that comes from loan and/or
investors. The higher the Debt to Equity Ratio of a company, meaning more debts are
used than an investor’s, the riskier the investment is in the company.
Total Liabilities
Debt ¿ Equity Ratio=
Total Equity
b) For each of the four entities described above, identify two financial ratios from those
ratios presented that would be most valuable as a basis for its decision regarding
ElectroStar.

The first ratio I would like to look at is Return on Equity (ROE). I would like to know
how well this company uses investor’s money to generate profits. From a point of view
from as an investor, it is a profitability ratio to see the performance of this company. The
higher the ROE, the better the investment is. I would like to know about the trend of ROE
from year-to-year basis in order to track the company’s progress to maintain or improve
the earning over time. I will make a comparison to the industry average ROE to observe
whether ElectroStar is a company worth the investment, compared to other similar
company.

Secondly, I would like to look at the Inventory Turnover Ratio of this company. This
would direct us to look at the company’s effectiveness in handling their merchandise, as
well as the sales volume over inventory. How effective the company is to turn the
inventory into cash. If the Inventory Turnover Ratio is too high, which means the
company overspend in their inventory, leads to overstocks, in which become worthless
because it is not turning into cash at the moment. In facts, these overstocks will require
higher amount of space for storage, leading to increase storage costs and other holding
costs.

c) Comment the performance of ElectroStar based on the five ratios given above.

ElectroStar Corporation financial position was under reviewed and was evaluated with 5
financial ratios, namely Current Ratio, Acid-test Ratio, Inventory Turnover, Return on
Equity, and Debt-Equity Ratio.

The Current Ratio of ElectroStar is going up steadily from 2010 to 2012, from 2.09 to
2.32 and then 2.61. This means the liquidity of this company is improving. Comparing to
the industry average (2.28), ElectroStar Current Ratio is lower in 2010 (2.09). However, it
shows higher Current Ratio (compared to industry average) in 2011 (2.32) and 2012
(2.61), which was a good sign. It means that ElectroStar is doing better than other similar
company in average, in terms of their company liquidity. We can see that the company is
keeping enough short-term money to pay the debts, to employees, bankers, and suppliers
to name but a few.

The Acid-test ratio of ElectroStar is more than 1.0, which means the company is
sufficiently liquid. However, from 2010 to 2012 (1.15, 1.12 and 1.21 respectively),
ElectroStar’s Acid-test Ratio are lower than that of industry in average (1.22). It might be
due to high level of inventory stored in the company in order to provide sufficient stocks
for selling, thus reduces the Acid-test ratio. It makes the company has less liquidity to pay
debts.
Throughout the year from 2010 to 2012, the Inventory Turnover of ElectroStar are 2.40,
2.18, and 2.02 respectively. All are higher than the industry average of 3.50. It means that
the merchandising department was not doing an effective purchasing. The average
inventory was high and overstocks can be seen. It may affect the company liquidity (as
shown in the acid-test ratio) to have adequate cash to pay bills. We may suggest the
company to look into inventory part of the company seriously to improve the Inventory
Turnover.

Return on Equity (ROE) of ElectroStar is in increasing trend, from 0.14 (year 2010), to
0.15 (year 2011), and lastly 0.17 (year 2012). The ROE of this company is also higher
compared to the industry average ROE (0.11). This shows to investors/potential investors
that ElectroStar is doing great in using their equity to turn into profit efficiently. And the
steadily growing ROE shows that this company is growing.

Debt to Equity Ratio of ElectroStar are higher (1.41, 1.37 and 1.44) compared to the
average of the similar company in this industry (0.95). It shows that this company is less
financially stable. The financing of the company is more from the creditors than
investors. Debts must be paid to the creditors, and it can be more expensive due to regular
interest payments and debt servicing. The relatively high Debt to Equity Ratio of
ElectroStar shows that there are investors who don’t want to fund the company. It may be
due to the level of confidence of investors towards this electronic component
manufacturer, as the company is riskier to invest compared to other companies in this
electronic component manufacturing industry.