Ratios/Profit Margin - Assignment Example

Ratios and Profit Margin Insert of the DISCUSSION RATIOS Firm’s performance can be predicted by use of financial ratios. When calculating financial ratios, information is generated from company’s financial statements. Among these statements include balance sheet, income statements and cash flow. Practically, financial ratios are calculated to help in analyzing trends, as well, as to conduct a comparison of the company’s financial performance with other companies in the same industry (Lewellen, 2004).

In special cases, ratio analysis is done to help in predicting possible future bankruptcy of the company. The main financial ratios used in most cases include: Liquidity ratio, financial leverage ratio, asset turnover rations, dividend policy ratios and profitability rations. Generally, these ratios are useful indicators of a firm's performance and the prevailing financial situation. Do ratio tells the whole story? To some extents, financial ratios play an important role by providing an overview of accounting and financial position of the company.

However, ratios do not give the overall picture of the organization. This is because it depends on historical figures which are bound to change due to certain seasonal factors. In the same note, ratios are highly subjected to manipulation and this affects credibility of the outcome. This implies that adjustments can be made on earnings to predict higher returns to the company. Based on this view, it means that ratios may mislead and should be treated with a lot of caution when interpreting financial position of the company.

Liquidity Ratios Liquidity ratios are used to determine the ability of the firm to accomplish short term financial needs. It mainly applies to parties who extend short term credit facilities to the company. Two main liquidity ratios include: Current Ratio and Quick ratios. Current Ratio: This is calculated by dividing current asset by current liabilities. The formula for current ratio is as follows: Current Ratio (C.R.) = Current Asset (C.A.)/ Current Liabilities (C.L.) Quick Ratio: This is calculated by dividing the value of Current Asset (CA) less Inventory by Current Liabilities.

The formula for quick ratio is as follows: Quick Ratio (QR): (Current Asset (CA) - Inventory)/ Current Liabilities (CL) How investors can use Liquidity Ratios for investment decisions Liquidity ratio is an important tool for investment decisions. It measures the speed at which the company’s assets can be converted into cash to support short term financial needs. As such, the ratio provides investors with an idea on the capability of the company to raise cash quickly to repay creditors or purchase more assets during normal business operations, as well as, in emergency situations.

Having such an idea helps investors in deciding whether the company is in good financial health and should put more investments into the business. How debt service ratios can be used by a lender in determining whether or not to lend money to a company. Response 1 (Jamie Moore) Debt service ratio is used by financial lenders as a preliminary assessment method to know whether an individual (borrower) is already suffering from too much debt from the previous borrowings. It specifically gives the proportion of an individual’s gross incomes that is committed in the repayments of other loans.

In case the established ration is 40 percent or less, then it implies that the borrower has a relatively acceptable debt levels. Any value above this percentage is a sign of unhealthy financial performance. Response 2 (Venessa Thompson) Financial stability requires that a person or company should have income adequate to pay off debts. Debt service ratio is a model used in evaluating the relationship between disposable income and debt payments. Examples of such debts include mortgages loans, car loans and students’ loans.

Therefore, debt service ratio is a tool used by banks to examine the likelihood of a borrower to default during loan repayments. People with high debt service ration have greater percentage of their income diverted to service debts. Lower debt service ratio is a sign of good financial health of a firm or individual. DISCUSSION 2: PROFIT MARGIN Profit margin refers to the amount of revenue in percentage form that corporation keep a side after taking into account variable and fixed costs incurred in the business.

Profit margin is obtained by calculating the ratio of net income and company’s total revenue. It is used by organizations for internal decision making purpose (Lewellen, 2004). Alternatively, it is used to compare companies’ performance across the industry. However, it should be noted that different industries exhibit a varied acceptable profit margin levels. A case of narrow profit may represent increased level of volatile earnings in the company. A decline in sales volume is likely to cause loss in the company.

On the other hand, profit margin can be calculated by dividing net income and the company’s total sales. High profit margin means that the company is more profitable and has a better control of costs when compared to other competitors in the market. Calculating Profit Margin for Cecil Inc. Corporation Profit Margin = {Net Income (Net Profit)/ Total Revenue (Sales)} Net Profit Margin   Year 2012 Year 2011 Year 2010 Revenue 40,000 35,000 33,000 Net Income 2,000 2,000 3,000 Net Profit Margin 5.00% 5.71% 9.

09% According to the table above, a declining trend in profit margin was reported between 2010 and 2012. The reported percentage was as follows: 9.09% in 2010, 5.71% in 2011 and 5.0% in the year 2012. Though a slump in profitability was reported, the company recorded a steady increase in sales revenue during the same period. In order to reverse the trend, the company should control sales and administrative expenses, as well as, total operating expenditures. Alternatively, sales revenue should be increased.

By controlling the amount of variable and fixed costs, the company will be in a position to report high profitability. Profit Margin below 5 percent is a sign of poor financial performance. On the other hand, 10 percent profit is adequate to pay off debts and give returns to the owners. However, the recommended profit margin should be in the range of 20 percent and above. In summary, the performance of Cecil Inc. Corporation is not encouraging and the management should put up strategies to increase sales revenues while controlling capital and operational expenses in order to achieve high profitable growth.

Recommended changes to improve net margin for the company Response1: (James Marsh). Net margin is the amount of money set aside for owners and shareholders. Secondly, it is a measure of the company’s efficiency. Inefficiency in selling, production and administration cost can lower the net profit margin. Therefore, I suggest that for net margin to be improved, efficiency in various company costs of operations should be enhanced. Response 2: (Jason Hall) Generally, net profit margin can be improved by reducing costs incurred during revenue generation.

The associated costs include cost of sales, administrative expenses, marketing costs, depreciation costs, interest charges and research & developments. I recommend a proper management of the variable and fixed cost in order to improve net profit margin for the company. Reference Lewellen, J. (2004). Predicting Returns with Financial Ratios. Journal of Financial Economics, 74, 209-235