#10306 - Memorandum - Finance and Capital Markets

(a) What does the ratio set out at Clause 20.1(a) seek to achieve? Why might this ratio not completely address Danton’s concerns?

20.1(a) The ratio of Current Assets to Current Liabilities will not at any time be less than 1.5 to 1 (1.5:1)

Answer:

This is the Current Ratio. It is a liquidity measure and a direct comparison of current assets with current liabilities. It measures the assets which can be turned into cash relatively readily in order to meet liabilities as they fall due. The result is expressed as a ratio:

__Current assets__ : 1

Current liabilities

A ratio of 1.5:1 would mean that the business has exactly 1.5 of current assets with which to meet every 1 of current liabilities. Most business would expect to have a higher ratio, say 1.5:1.On the other hand low current ratio means that company is at high risk of iliquidity and is unable to fulfil its financial obligation which again is considered to be the negative point of the company.

Weaknesses:

It does not give the most accurate and precise idea of firm’s liquidity or financial position as a firm may be in trouble because of the more stock and operations that cannot be converted in cash in a small period of time. Valuation of the current assets is also an issue in calculating the current ratio as the figure of the current ratio can be easily manipulated by overvaluing the current assets of the firm.

- It does not tell anything about the profitability of the company. It does not indicate whether the production cost is high and it may result in incurring a loss to the company.

- Writing down, Bad debts and depreciation of assetsare not taken into account. An acid ratio may be more accurate as the stock prepaid debts and current work will be removed from the equation.

- The formula of the current ratio is not applicable to the seasonal products and hence does not give a clear idea of the product performance throughout the year. Another limitation of the current ratio is that it is calculated on the figures of current assets and liabilities taken from the balance sheet. There is a continuous threat that these figures may be out dated and will not calculate the current ratio accurately regarding a specific time period.

(b) What does the ratio set out at Clause 20.1(b) seek to achieve? How might Danton obtain a more accurate reflection of the Group’s position? And

20.1(b) the ratio of PBIT to Net Interest Payable for any Relevant Period will not be less than 4 to 1 (4:1)

Answer:

This is an Interest Cover Ratio. This is a ratio. Good indicator of how the company is doing. It is used to assess a company's financial durability by examining whether it is at least profitably enough to pay off its interest expenses. A ratio greater than 1 indicates that the company has more than enough interest coverage to pay off its interest expenses; as a result, the lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default. While this ratio is a very easy way to assess whether a company can cover its interest-related expenses, the applications of this ratio are also limited by the relevance of using EBITDA as a proxy for various financial figures.

PBIT (Profit before interest and taxes) = Interest Cover Ratio

Net Interest Payable

Weaknesses:

One situation in which the interest coverage ratio might suddenly deteriorate is when interest rates are rising quickly. That additional interest expense is going to hit the coverage ratio even though nothing else about the business has changed.Another, situation is when a business has a high degree of operating leverage. This does not refer to debt per se, but rather, the level of fixed expense relative to total sales. If a company has high operating leverage, and sales decline, it can have a dramatically disproportionate effect on the net income of the company. This would result in a sudden, and equally dramatic, decline in the interest coverage ratio, which should send up red flags for any conservative investor.

• Can be manipulated in a way that the company looks wealthier than it is.

• It fails to show the correlation between the cash-flow the borrowings of the company.

(c) What does the test expressed at Clause 20.1(c) seek to achieve? Why are amounts attributable to goodwill not included in the definition of “Tangible Net Worth”?

20.1(c) Tangible Net Worth will not at any time be less than 78,000,000.

Answer:

P.79. This is a Tangible Net Worth clause. This is a test if balance sheet. It measures the value of a company’s tangible assets and aim to ensure the company maintains a minimum value of assets in the business. It is intended to represent the borrower’s assets and the borrower’s liabilities. Thus it is a measure of thephysical worth of a company, which does not include any value derived from intangible assets such as copyrights, patents, goodwill, research and development, payments on accounts, unaudited revaluations, tax provisions and intellectual property. Tangible net worth is calculated by taking a firm's total assets and subtracting the value of all liabilities and intangible assets.

Total Assets – Liabilities – Intangible assets =Tangible Net Worth

Weaknesses:

inaccuracy, it may not reflect an accurate picture of the Co. The assets may be charged and will reduce the chances of recovering if the Lender is second to other charges.

It does not include the Company’s cash, the Company may have lots of cash and it is not reflected in the test.

Some of the assets may be overvalued.

There may be liabilities that are not recorded and for which the Company is accountable.

If the company breaches any of these measures of financial health the Bank is likely to meet the...