Financial Ratio Analysis - Case Study Example

(a) Introduction Financial ratio analysis is the calculation and comparison of the various financial indicators ratios from values that are derived from the information given in the various financial statements. The financial statements from which such ratios are calculated must be from the same point in time preferably audited and presented in the same manner. The process of the analysis will involve several calculations and interpretations of various financial ratios in order to be in the position of assessing or judging the performance of a firm with relation to the other firm or with the industry in general, as well as determining the status of the firm in its area of operation. (Troy 2007 pg 158-172). The purpose of conducting such a form of analysis is to assist meet the informational needs of the investors, creditors and management so that they are in the position of making appropriate decisions. The ratios analysis conducted herein is done with the objective of comparing the all the measurements of financial data to aid or facilitate wise investment decision, as well as credit decisions and managerial. A Cross-sectional Analysis will be conducted where- ratios are used and compared between two firms (Goofy’s & Pluto’s) of the same industry(the sporting goods business) in order to draw conclusions about an entitys profitability and financial performance hence the ability to invest in this sector. Inter-firm Analysis will be categorized under Cross-sectional, as the analysis is done by using some basic ratios of the Industry in which the firm under analysis belongs (and specifically, the average of all the firms of the industry) as benchmarks or the basis for our firms overall performance evaluation as compared to the whole industry (Troy 2007 pg 113-17). In the analysis, we will use the return ratios, financial leverage ratios, activity ratios, profitability ratios and liquidity ratios to make our decision on whether to invest in the sporting goods business. The decision to invest the $5,000 will be on the criteria of the company that shows good financial shape and hence able to provide the investor with a return on investment. (b) Ratio analysis Ratio Formula Goofy’s Pluto’s Industry Gross profit margin Gross profit/ Sales 186,000/395,000*100 =47.088% 208,000/469,000*100 =44.35% 46% Net profit margin Net profit/ Sales 53,500/395,000*100 =13.54% 59,000/469,000*100 =12.58% 11% Rate of return on assets Net Income/ Total assets 53500/ 476,000*100 =11.24% 59,000/ 475,000*100 =12.43% 14% Rate of return on common equity ratio Net income/ Shareholders’ equity 53,500/ 271,000*100 = 19.74% 59,000/ 175,000*100 = 33.71% 30% Asset turnover ratio Sales/ Total Assets 395,000/ 397,000 =0.99 times 469,000/ 462, 000 = 1.02 times 1.3 times Receivables turnover ratio Sales on credit/ Accounts receivables 395, 000/ 320, 000 = 1.2 times 469,000/ 274, 000 = 1.7 times 14 times Inventory turnover ratio Cost of goods sold/ Inventory 2.4 times 2.75 times 2.5 times Current ratio Current Assets/ Current Liabilities 320,000/ 205, 000 = 1.56 to 1 274,000/ 252,000 = 1.09 to 1 1.75 to 1 Quick ratio (Current Assets – Inventory}/ Current Liabilities (320,000-88,000)/205,000 = 1.13 to 1 (274,000-95,000)/ 252,000 = 0.71 to 1 1.10 to 1 Debt ratio Total Debt/ Total Assets 205,000/ 476,000*100 = 43.07% 300,000/ 475,000*100 = 63.16% 38% Debt to equity ratio Total Debt/ Total shareholders’ Equity 205,000/ 271,000 = .756 to 1 300,000/ 175,000 = 1.71 to 1 .75 to 1 My analysis and decision will be based on the ratios from the table above which can be grouped into return ratios (rates of return on assets and Rate of return on equity); financial leverage ratios (debt ratio, debt to equity ratio). In addition, Activity ratios (Inventory turnover, receivable turnover and asset turnover ratios); profitability ratios (Gross profit margin, net profit margin ratios); liquidity ratios (Current ratio and quick ratio) will also be considered. i. Liquidity Ratios The term liquidity would mean the ability of a company to meet its current obligations or liabilities. An asset is liquid if it has the ability of being converted into cash immediately. Any good firm should ensure that it does not suffer from lack of liquidity or that it is not liquid since the failure of any given firm to meet it current liabilities will lead to its automatic closure while very high liquidity leads to a situation where a firm has idle assets earning nothing making the assets earn nothing. Therefore, it is appropriate to strike a proper balance between liquidity and non-liquidity so that the firm’s current assets are not locked up in current assets. Therefore, a current ratio of 2:1 is normally considered satisfactory given that the higher the current ratio the greater the margin of safety. On the other hand, a quick ratio of 1:1 is normally considered appropriate since quick ratio is considered superior to current ratio in testing the liquidity position of the firm. Our two companies Goofy’s have a current ratio of 1.56:1 and a quick ratio of 1.13:1; Pluto’s on the other hand has a current ratio of 1.09:1 and a quick ratio of 0.71:1. The decision will therefore be appropriate if Goofy’s with current ratio of 1.56: which is closer to the satisfactory 2:1 and a quick ratio of 1.13:1 which is also closer to the satisfactory 1:1. This shows that Goofy’s will be in the position of average liquidity and therefore able to settle its debts in times. ii. Financial Leverage Ratios It is a fact that the short-term creditors as banks are interested in the short-term solvency of a firm, for this purpose liquidity ratio are normally used. The long-term creditors like the shareholders or the debenture holders are interested in the long-term solvency of the firm of which leverage or solvency ratios like debt ratio or the debt to equity ratio to determine the firm they are likely to extend their funding to. These ratios are also the ones used to analyze the capital structure of the firm. Solvency refers to the ability of a firm to pay interest regularly and finally pay the principle amount of the debt at the due date. While the debt equity ratios shows the relationship between the total debts and the capital owned, the debt ratio will show the amount of debt, visa vis the total assets of the firm. The debt equity ratio is one of the most important measures of long-term solvency. It reflects the relative contributions of creditors and owners of business in its financing. If the ratio is 1:1, it is considered satisfactory therefore our case where Goofy’s shows a ratio of 0.75:1 and Pluto’s shows the ratio of 1.71:1 we would pick Goofy’s as they are significantly closer to the required ratio. In addition, the company shows a lower debt to total assets ratio of just 43% as compared to that of Pluto’s which 63% is. Pluto’ is already highly indebted and is risky to choose. The debt to equity ratio is also closer to that of the industry average which is .75 to 1 and hence the choice of Goofy’s. iii. Profitability Ratios The main aim of any form of business is to maximize on its profits as well as the shareholder’s wealth hence profitability if the engine that drives any form of business given the bare fact that a firm should earn profits in order to survive and grow over a long period of time. The management profitability is a motivation as it shows their measure of efficiency and control while to creditors it is a margin of safety. Furthermore, management, creditors and owners also are interested in the profitability of the co-creditors want to get interest and repayment of principal regularly. Owners want to get a reasonable return on their investment. The profitability ratios measure the ability of the firm to earn an adequate return on sales total assets and invested capital. As the gross profit is found by deducting cost of goods sold from the net sales, higher the gross profit ratio the better are the results. Similarly, a high Net Profit ratio indicates that the profitability of the firm is good. If the Net Profit ratio is not sufficient, the firm may not be able to achieve a satisfactory return on its investment. Our industry average for gross profit margin and net profit margin respectively is 46% and 11% respectively. Therefore based on profitability, we would still pick on Goofy’s as it has higher margins when compared to the industry averages of 47% and 13% of Gross and net profits margins respectively as compared to the Pluto’s figures, which are 43% and 12% respectively. iv. Activity ratios These are ratios used to show the measure by which the company is able to convert its assets into revenues. They asses how effectively a firm is in the position of generating revenue in the form of cash and sales based on its assets and the liabilities plus their capital share accounts. Such ratios include the inventory turnover, receivables turnovers and the assets turnover ratios. Activity ratios are critical in evaluating a companys fundamentals because, in addition to expressing how well a company generates revenue, activity ratios also indicate how well the company is being managed. Asset turnover ratio explains the relationship between a company’s assets and its turnover or sales revenue. It measures the company’s efficiency to use its assets to generate revenue. It indicates the amount of sales generated from each dollar of asset. On the other hand, the inventory turnover ratio measures the rate at which a company purchases and resells products to customers. Receivables turnover on the other hand shows the ability of the firm to receive its debts; it should be higher than the payables turnover. The effectiveness of these ratios is found by a comparison to the industry average, which is 1.3 times for asset turnover, 2.5 times for inventory and 14 times for receivables turnover. Goofy’s rate is 0.9 times for asset turnover, 2.4 times for inventory and 1.2 times for receivables. Pluto’s on the other hand has 1.02 times for assets turnover, 2.7 times for inventory and 1.7 times for receivables turnover. Based on this we would not have any of the firms picked but Pluto’s outperforms Goofy’s when it comes to the rate of generating revenues from the other components of the financial statements. v. Return ratios Return ratios are used to indicate how profitable a firm is in relation to its total assets. It is shown by ratios such as the Return on assets and the Return on Equity ratios. It allows investors to see how effectively the money they invested in the firm is being used. It is essentially a measure of how investors have fared with regard to their investment in the firm. Return on equity is usually seen as the bottom line measure of firm performance. The industry averages for both ROA and ROE are 14% and 30% respectively. Goofy’s has 11% and 19% of the same respectively while Pluto’s have 12% and 33% respectively. Based on this we will Choose Pluto’s as an investment decision as it will show the highest returns. (c) Decision and why I will choose Goofy’s because it shows a going concern given that they are highly active according to their activity ratios. Their liquidity are also satisfactory and they are able to pay their debts. They therefore have a promising return and profitability in the near future as opposed to Pluto’s with current returns but at the verge of collapse soon (Troy 2007 pg 312). Works Cited Troy, Leo. Almanac of business and industrial financial ratios. 2008 ed. Chicago, IL: CCH, 2007. Print. Read More