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
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
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
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
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
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.
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