1.6 Star Technologies Inc.
Review Star Technologies' financial statements included in Exhibits 2 and 3. What changes in Star's financial status between fiscal year-end 1988 and 1989 should have been of concern to the company's independent auditors? How should these changes have affected key audit planning decisions for the 1989 Star audit?
Star's financial status between fiscal years 1989 and 1988 should have given some clue to the auditors that there should be some concern. After looking at their financial statements, I prepared some ratios based on the information given. The ratios that I have examined are the quick ratio, current ratio, debt to equity ratio, times interest earned ratio, return on assets ratio, and inventory to net working capital ratio. After examining these ratios I noticed that there were some definite signs that the auditors should have picked up on and shown some concern.
Short-term liquidity ratios include the quick ratio. The quick ratio had results of $1.12 in 1989 and $1.65 in 1988. This means that for every dollar of current liabilities there are $1.12 dollars of assets in 1989. The same would go for 1988, but there would be $1.65 dollars of easily convertible assets. Creditors want a ratio of one dollar or more. So for this ratio, it would be considered acceptable. However, the decrease in the dollar amount is rather significant and is now getting closer to that one dollar mark. Creditors want there to be at least one dollar because this shows that the company is able to meet their short term liabilities. Decreasing ratios could also mean that company is struggling with sales or maybe they are collecting receivables too slowly. Therefore, the decrease as well as the dollar amount is a sign that the auditors should have picked up on.
The current ratio is considered to be in the category with the short-term liquidity ratio. The current ratio had results of 2.84 in 1989 and 4.47 in 1988. The current ratio, also called working capital ratio or real ratio, shows whether the company is able to pay the short term obligations. There are a few things that have to be taken into consideration when calculating this ratio. This ratio doesn't always show the correct timing of cash received and paid out. The result of this ratio should be close to 1.5 to be considered acceptable. Most businesses want this result to be 2.0. This means that the company has twice as many assets as they do liabilities. Star Technologies has a rather high number. This would be considered healthy. However, in1989 the number has dropped nearly to half of what it was in 1988. This would be a reason to be concerned. Star technologies are still to be considered healthy, but if they continue the trend to the following year they will be in severe trouble.
The category of long-term debt ratios includes the debt to equity ratio. The results from the debt to equity ratio are 5.20 in 1989 and 1.95 in 1988. With this ratio, the higher the number the riskier it will be. When the results of the ratio are greater than one, this means that the assets are being financed through debt and not equity. This shows that with Star Technologies, in 1988 they were being financed through debt, but the risk was not too high. In 1989 the number jumped to 5.20. Therefore, the company has increased their amount of financing through debt. They are not using equity to finance their assets. Auditors should have picked up on this. This is a sign of concern.
The times interest earned are also part of the long-term debt ratios. Times interest earned ratio had results of 1.64 in 1989 and -2.64 in 1988. Another wards, Star Technologies has earned 1.64 times its interest charges in 1989. With this ratio a larger number is preferred. So with a negative number in 1988 this is a weakness. This means that there are fewer earnings available for the interest payments that need to be paid. Bankruptcy is a common result of those who cannot meet these obligations. This is one of the ratios that show a positive result.
Return on assets was the next ratio that I analyzed. The last ratio within the long-term debt ratios is the return on investments. The results for 1989 are -14% and in 1988 the results are 9%. Another name for return on assets is return on investment. Star Technologies earned 9% in 1988 and -14% in 1989. Anything below 5% shows that the company is asset-heavy meaning they have a lot of assets such as equipment or machinery. Any percentage above 20% shows that the company is asset-light such as office equipment. Therefore, Star Technologies would be considered asset heavy in 1989 and I would assume it would be in-between asset-heavy and asset-light in 1988.
The last ratio that I analyzed was the inventory to net working capital. The inventory to net working capital ratio is also part of the short-term liquidity ratios. The results are 94% in 1989 and 81% in 1988. Companies want this percentage to be lower than 100%. This is because it would indicate high liquidity. Companies that have percentages greater than 100% would mean that the company may have inventory that is too large. By the results of Star Technologies we can see that both the percentages are below the 100% therefore resulting in a strength for the company. This would be one ratio result that should not give auditors a reason to be concerned.
These changes that have happened within Star's financial statements should have affected the way that the auditors have planned the audit. If auditors saw that with the results of the ratios there should be a reason to be concerned, then they should have planned better for the 1989 audit. The decreasing quick ratio shows a sign that the company may be having problems with sales and so on. The auditors should have been able to see this as a reason to plan differently for the audit. The increase of the assets being finances through debt instead of equity should have also been a reason to plan differently. The auditors should take each of these ratios and start to plan out how they can examine where there may be a problem linking to all of these areas of concern.
Ratio Formulas:
Short-Term Liquidity Ratios:
Quick Ratio: ((current assets-Inventory) / current liabilities)
21,383 - 12,962 = 1.11 in 1989
7,528
17,028 - 10,732 = 1.65 in 1988
3,811
Current Ratio: (current assets/current liabilities)
21,383 / 7,528 = 2.84 in 1989
17,028 / 3,811 = 4.47 in 1988
Inventory to Net Working Capital Ratio:
(inventory - (current assets - current liabilities))
12,962 = .94 in 1989
21,383 - 7,528
10,732 = .81 in 1988
17,028 - 3,811
Long-Term Debt Ratios:
Debt to Equity Ratio: (total liability/total equity)
26,234 / 5,043 = 5.20 in 1989
16,554 / 8,471 = 1.95 in 1988
Times Interest Earned Ratio: (operating income/interest expense)
<2,614> / <1,597> = 1.64 in 1989
3,380 / <1,453> = -2.64 in 1988
Profitability Ratios:
Return on Assets Ratio: (income before taxes/average total assets)
<4,393> / 31,277 = -.14 in 1989
2,284 / 25,025 = .09 in 1988
