Assignment 3: Ratio Analysis By Week 1, Day 7 Solve The Prob

Assignment 3: Ratio Analysis By Week 1, Day 7 solve the problem below, calculate the ratios, interpret the results against the industry average, and fill in the table on the worksheet. Then, provide an analysis of how those results can be used by the business to improve its performance.

Calculate the following ratios using the provided financial data from Gary and Company as of December 31, 2010. Interpret each ratio's result in comparison to the industry average, categorizing the performance as Good, Fair, Low, or Poor. Finally, analyze what these ratios reveal about the company's financial health and suggest ways in which the business can leverage this information to improve its performance.

Financial Data Provided

  • Cash: $45 million
  • Receivables: $66 million
  • Inventory: $159 million
  • Marketable securities: $33 million
  • Total current assets: $303 million
  • Net fixed assets: $147 million
  • Total assets: $450 million
  • Accounts payables: $45 million
  • Notes payables: $45 million
  • Other current liabilities: $21 million
  • Total current liabilities: $111 million
  • Long-term debt: $24 million
  • Total liabilities: $135 million
  • Owners' equity (common stock + retained earnings): $315 million
  • Income Statement (Year 2010):
  • Net sales: $795 million
  • Cost of goods sold: $660 million
  • Gross profit: $135 million
  • Selling expenses: $73.5 million
  • Depreciation: $12 million
  • EBIT: $49.5 million
  • Interest expense: $4.5 million
  • EBT: $45 million
  • Taxes (40%): $18 million
  • Net income: $27 million

Ratio Calculations and Interpretations

1. Profit Margin on Sales

Profit Margin = (Net Income / Net Sales) × 100 = ($27 million / $795 million) × 100 ≈ 3.4%

This ratio indicates the company’s ability to convert sales into profit. An approximate profit margin of 3.4% suggests that Gary and Company earns roughly 3.4 cents for every dollar of sales, which is slightly above an industry average of around 3%. The interpretation category would be Good, indicating efficient cost control relative to sales or a competitive pricing strategy.

2. Return on Assets (ROA)

ROA = Net Income / Total Assets = $27 million / $450 million ≈ 6%

This ratio measures how effectively the company utilizes its assets to generate profit. The estimated 6% is below the industry average of 9%, indicating potential inefficiencies in asset utilization. The interpretation is Low.

3. Receivable Turnover

Receivable Turnover = Net Sales / Accounts Receivable = $795 million / $66 million ≈ 12.05X

This ratio assesses how often the company collects its receivables annually. With a turnover of approximately 12X, it is slightly below the industry average of 16X, suggesting that collections might take longer. The category is Fair.

4. Inventory Turnover

Inventory Turnover = Cost of Goods Sold / Inventory = $660 million / $159 million ≈ 4.15X

This indicates how many times inventory is sold and replaced during the period. Compared to an industry average of 10X, this is quite low, pointing to possible overstocking or slow-moving inventory. The interpretation is Low.

5. Fixed Asset Turnover

Fixed Asset Turnover = Net Sales / Net Fixed Assets = $795 million / $147 million ≈ 5.41X

This ratio measures the efficiency of fixed asset usage. Although the industry average is 2X, which is lower, our calculated ratio of approximately 5.4X indicates excellent utilization. The interpretation is Good.

6. Total Asset Turnover

Total Asset Turnover = Net Sales / Total Assets = $795 million / $450 million ≈ 1.77X

This measures overall asset efficiency in generating sales. At about 1.77X, it is slightly below the industry average of 3X, indicating room for improvement. The interpretation is Fair.

7. Current Ratio

Current Ratio = Current Assets / Current Liabilities = $303 million / $111 million ≈ 2.73X

This ratio signals liquidity. With a current ratio of approximately 2.73, it exceeds the industry average of 2X, suggesting good short-term liquidity. The category is Good.

8. Quick Ratio (Acid-Test Ratio)

Quick Ratio = (Current Assets - Inventory) / Current Liabilities = ($303 million - $159 million) / $111 million ≈ 1.33X

This measures immediate liquidity. The ratio of 1.33X surpasses the industry average of 1.5X, indicating adequate liquidity but some potential for improvement. The interpretation is Fair.

9. Times Interest Earned (Interest Coverage)

Times Interest Earned = EBIT / Interest Expense = $49.5 million / $4.5 million ≈ 11X

This assesses the company’s ability to meet interest obligations. With a coverage ratio of about 11X, it exceeds the industry standard of 7X, reflecting strong debt service capacity. The category is Good.

Analysis and Business Improvement Strategies

The ratios collectively depict a company with solid liquidity and debt coverage but identified inefficiencies in asset utilization and inventory management. The profit margin, while decent, is relatively low compared to industry peers, hinting at concerns about cost control and pricing strategies.

The relatively low return on assets suggests that Gary and Company could optimize its asset utilization. This might involve re-evaluating fixed asset investments or improving operational efficiencies, such as streamlining processes or adopting technology to enhance productivity. Improving the turnover rates for receivables and inventory should be prioritized. For example, tightening credit policies can accelerate receivables collection, and adopting just-in-time inventory practices could reduce overstocking and improve inventory turnover.

Liquidity ratios indicate robust short-term financial health; however, maintaining a balanced liquidity position is crucial to prevent excessive idle assets. The company should ensure that liquidity margins do not diminish, especially during economic downturns, while actively managing inventories and receivables to free up cash flow for strategic investments or debt repayment.

The strong interest coverage ratio reflects manageable debt levels, but relentless monitoring is necessary as leverage increases. Strategic debt reduction could further enhance financial stability and flexibility for future growth initiatives.

In conclusion, Gary and Company’s financial ratios highlight strengths in liquidity and asset efficiency, alongside areas below industry benchmarks that require targeted improvements. Focusing on inventory and receivables management, enhancing operational efficiencies, and cost control can significantly uplift profitability and overall performance. Regular ratio analysis can serve as a vital tool for monitoring progress and making informed strategic decisions.

References

  • Brigham, E. F., & Ehrhardt, M. C. (2016). Financial Management: Theory & Practice. Cengage Learning.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2013). Corporate Finance. McGraw-Hill Education.
  • Gibson, C. H. (2012). Financial Reporting & Analysis. Cengage Learning.
  • Higgins, R. C. (2012). Analysis for Financial Management. McGraw-Hill Education.
  • Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley Finance.
  • Higgins, R. (2014). The Basics of Financial Analysis. Routledge.
  • Stickney, C. P., Brown, P., Wahlen, J., & Schipper, K. (2010). Financial Reporting, Financial Statement Analysis, and Valuation. South-Western Cengage Learning.
  • Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2015). Financial Accounting. Wiley.
  • Brigham, E. F., & Houston, J. F. (2015). Fundamentals of Financial Management. Cengage Learning.
  • Penman, S. H. (2012). Financial Statement Analysis and Security Valuation. McGraw-Hill Education.

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