Financial Ratio Analysis of Sparklin Automotive Company - Research Paper Example

? Memo Supervisor Financial Ratio Analysis of SAC for year 2005 & 2006 ______________________________________________________________________________ Introduction Financial ratio analysis is considered as one of the most effective methods of analyzing the financial performance of any company. By systematically using different ratios, an analyst can actually get an insight into the overall performance of the firm while at the same time highlighting the areas where further improvements are required. Financial ratios can be placed in different categories and an analyst can easily calculate different ratios falling in each category to better understand the performance indicators and also suggest a course of action required to improve the situation. Besides, financial ratio analysis can also be used to assess the performance of different departments and managers and how their overall performance may have an impact on the performance of the whole firm. Sparklin Automotive Company is in business since 1990 and is supplying different automotive related parts across the whole country. In order to better assess its performance for the year 2005 and 2006, a comprehensive ratio analysis is important. This will provide a critical insight into areas such as liquidity management, overall asset management, the nature and extent of firm’s debt as well as assessing the profitability during these two years. Ratio Analysis Explanation Ratio analysis is the process of calculation and comparing the ratios which have been extracted from the different financial statements. By forming the historical trends, ratio analysis can actually provide an insight into the performance as well as charm in the company to perform in the long run based on the historical data. Ratio analysis is also important from the perspective of assessing the performance of the managers and understanding as to how the organization is performing. By computing financial ratios, a firm not only compares its performance with the competitors but also get an insight into its own historical performance. Ratio analysis therefore can be used for two different purposes or in two different manners i.e. making comparisons through trend analysis and comparing the ratios with the competitors. When financial ratio analysis is used for the purpose of trend analysis, a firm or a manager can actually get an insight into how the trends in different ratios are pointing towards the performance of the firm. For example, if a manager wants to assess as to how the overall inventory has been managed through out the year, she can compute the inventory turnover ratio and days in inventory to get an insight into how the inventory of the firm has been maintained and how sales have been generated. Ratio analysis therefore provides an ability to perform objective analysis of the performance of the firm. (Bull, 2007) Ratio analysis can either be used by the firm for its own evaluation purposes so that managers can assess what is required to be done in order to improve different areas lacking in achieving the targets. Secondly, ratio analysis can also be used by the investors to not only assess the historical performance of the firm but based on this assessment make forecasts as to how the firm may perform in future. Ratio Calculation Ratio Formula 2005 2006 Current Ratio Current Assets /Current Liabilities 1.475:1 1.403:1 Debt to Equity Ratio Total Liabilities / Total Equity 0.449:0.551 0.440 : 0.56 Inventory Turnover Sales / Inventory 6.11 times 4.620 Times Receivables Turnover Sales / Receivables 18.24 times 18.16 times Gross Margin Gross Profit / Sales 49.19% 40.70% Evaluation of the Ratios Current Ratio Current ratio is one of the basic indicators for assessing the liquidity position of the firm and indicates as to whether the firm has the required liquid assets to pay off its immediate liabilities. A current ratio of higher than 1 is considered as acceptable because for ever $1 of current liabilities firm has more than $1 of current assets to settle these liabilities. A closer look at the current ratio of the firm would suggest that it has declined in 2006 however it is still on the higher side. In 2005, the current ratio of the firm was 1.475:1 which has declined to 1.403:1 however; this decline may not be higher. This decline in the current ratio of the firm may also be attributed to the fact that firm’s cash resources have substantially declined during the period of one year. Debt to equity ratio Debt to equity ratio of the firm provides information regarding the overall proportion of debt in the capital structure of the firm. It also provides information regarding the overall financing structure of the assets i.e. how asset purchase has been financed. A higher debt to equity ratio may suggest that the firm has utilized higher debt in purchasing assets. (Fridson & Alvarez, 2011) The debt to equity ratio of the firm is almost ideally split into 50:50 wherein the debt to equity ratio of 44.9% and 44% of the debt has been used in comparison with the equity. The reduction in the debt equity ratio is good because firm has paid off its debt and has potentially reduced the risk which debt normally carries. Inventory Turnover Inventory turnover is one of the key performance indicators to assess as to whether the management is efficient enough to manage the inventory of the firm. A higher turnover suggests that the inventory of the firm is fast moving and there is ample demand for the product. Further, it also indicates that the management is efficient in utilizing the inventory of the firm. Inventory turnover in 2005 was more than 6 however it declined in 2006 to 4.62 times suggesting that the firm may not be able to turnover the inventory quickly. It may also be suggested that the managers may not be efficient enough to ensure faster turnover of inventory. Low inventory turnover may increase the cost of storage for the firm and hence reduce the profitability. Receivables Turnover Receivable turnover of the firm indicates about how quickly the firm is efficiently maintaining the receivables of the firm. A higher receivable turnover ratio may be indicating that the firm may be having a relatively strict credit extension policy and is making sales on the cash basis. A lower receivables turnover ratio however, indicates that the firm may be finding it difficult to sell therefore it is extending higher credit extension period of to generate the sales. The receivables turnover of the firm has declined from 18.24 times in 2005 to 18.16 times in 2006 indicating a slight decline. However, this may be considered as a higher ratio because firm has been able to receive back its sales rather quickly. In the absence of any industry data, this ratio may be considered as high. Gross Margin Gross margin measures the gross profitability of the firm and is one of the most important indicators of the profitability of the firm. It measures how much the firm has earned before deducting any operating expenses. It is therefore calculated by dividing the gross profit earned in the year with total sales made during the year. It is critical to note that the gross profit may be higher if the firm is using older plant because cost of depreciation could be low. The gross margin of the firm for the year 2005 was 49.19% which declined to 40.70% during 2006 registering a decline of over 9% in just one year. This decline in profitability may be attributed to higher costs of doing the business as well as decline in the sale of the firm. A low gross margin may suggest that the firm may not be able to sustain itself in the long run if the gross margin keeps on declining every year. Other Financial Analysis Financial analysis can also be analyzed by using techniques such as vertical and horizontal analysis. Both these techniques can be used to assess the different balance sheet items as a percentage of total assets whereas income statement elements are analysed by comparing them with the sales. An analyst can also compute other ratios such as acid test ratio, total asset turnover, net profit margin, and debt to asset ratio. These ratios can further help the firm to better assess the complete performance of the firm and accordingly suggest the steps required to overcome the weaknesses. Recommendations for Improvements In order to improve the performance of the firm, it is important to first adjust the credit extension policy of the firm. Higher receivable turnover ratio suggests that the firm may be too strict in extending credit thus potentially throwing away customers. By implementing better credit analysis capabilities a firm can actually improve its debt collection and facilitate its customers by extending higher credit terms. The debt to equity ratio is relatively low thus affecting the overall profitability and earnings per share of the firm. In order to take advantage of the tax benefits provided by the debt, firm may consider obtaining more debt to finance its operations. Debt will not only provide more liquidity but can help the firm to tap into the future market requirements by rapidly responding to marketing opportunities. Finally, firm need to improve its costs to increase profitability. Bibliography Bull, R. (2007). Financial ratios: how to use financial ratios to maximise value and success for your business. London: Elsevier. Fridson, M. S., & Alvarez, F. (2011). Financial Statement Analysis: A Practitioner's Guide . New York: Wiley. Read More