Financial ratios are great tools when it comes to the evaluation of the performance of a business entity. In that regard therefore, ratios are used by various stakeholder groups including but not limited to investors, suppliers, creditors, and even regulatory bodies. This text concerns itself with ratio analysis with my entity of choice being a publicly traded beverage company. For purposes of this discussion, I will concern myself with PepsiCo. PepsiCo regards itself "one of world's leading food and beverage companies…" (PepsiCo, 2013)
Key Financial Ratios
A financial ratio in the words of Moyer, McGuigan, Rao, and Kretlow (2011, p. 70) "is a relationship that indicates something about a company's activities…" Various financial ratios have been developed over time. Some of the key financial ratio categorizations that could come in handy in this context include: profitability ratios, liquidity ratios, and financial leverage ratios. So as to enhance the relevance of this analysis, I will compare some of PepsiCo's key ratio values with those of its main competitor, the Coca-Cola Company. The figures that will be utilized in this analysis will come from the companies' latest financial statements.
Two of the most useful profitability ratios that could come in handy in the determination of how successful PepsiCo has been in profit generation include: return on assets and return on equity. In basic terms, return on assets is of great relevance when it comes the measurement of how effectively the assets a given entity are being used in profit generation. According to Baker and Powell (2009), this ratio is computed by dividing the net income figure with that of average total assets. On the other hand, return on equity is one of the most utilized ratios by both management and shareholders. Essentially, return on equity "measures the accounting return earned on the capital provided by the firm's preferred and common shareholders" (Baker and Powell, 2009, p. 63). According to the author, the ratio is obtained by dividing an entity's net income with the average total equity.
Return on Assets
Return on Equity
The liquidity ratio I will highlight for purposes of this discussion is the current ratio. In basic terms, liquidity ratios are of great relevance when it comes to the determination of how ready/prepared a firm is to meet its obligations in the short-run (Brigham and Houston, 2009). The current ratio could, according to Baker and Powell (2009), be obtained by dividing the current assets figure with that of current liabilities.
Financial Leverage Ratios
The relevance of financial leverage ratios cannot be overstated when it comes to the determination of the long-term solvency of a businesses entity. Key financial ratios under this category include the debt to equity ratio and the debt ratio. The debt ratio, the ratio I will concern myself with in this section, could be obtained "by dividing a firm's total (current and non-current) liabilities by its total assets" (Baker and Powell, 2009, p. 53).
Assessment of PepsiCo's Financial Strengths and Weaknesses
With regard to profitability, it is clear from Table 1 above that PepsiCo. rakes in more profit for every dollar worth of shareholder investment. This is particularly the case given that the company has a higher ROE than Coca-Cola. However, looking at the company's return on assets, one would conclude that in comparison to Coca-Cola, PepsiCo. earns less money for the same level of investment. PepsiCo's assets are therefore not being utilized as effectively as they should.
PepsiCo has a current asset of more than 1. In that regard therefore, there is no doubt that the company has sufficient current assets to pay back its obligations (short-term) should they become due. The company is therefore not likely to experience liquidity challenges. Finally, we have the debt ratio which indicates that PepsiCo is more leveraged than the Coca-Cola Company. This could be an indicator of greater financial risk.
Based on the assessment above, it is clear that PepsiCo is not effectively utilizing its assets in profit generation. This is particularly the case given that the earnings the company rakes in from invested capital seem less than those Coca-Cola, its key rival in the market, rakes in. According to Gallagher and Andrew (2007), ROA is a key indicator of just how effective a business entity is in the employment of its assets. It is important to note that one of the key duties of the top management is to allocate resources wisely. In our case, one would conclude that in comparison to those of PepsiCo, Coca-Cola's executives excel in wise resource allocation -- they make more profit at a given level of investment. Overhauling the management team could therefore prove worthwhile.
Potential Limitations of the Ratio Analysis
From the onset, it important to note that although the relevance of financial ratios cannot be overstated when it comes to the analysis of an entity's performance, ratios are not without their weaknesses. To begin with, in the analysis I have conducted above, I have in some cases compared Pepsi's ratios with those of the Coca-Cola Company. To enhance the relevance of financial ratios, a company should compare ratio values with values from other periods or with those of other similar companies. It should, however, be noted that when the accounting practices of companies differ, this can affect ratio analysis results. This is an issue that could have had an impact on the ratio analysis. Further, the ratio analysis I have conducted above cannot be relied upon entirely for purposes of making informed choices or decisions. Other measures of financial performance or situation should be used as well. This is particularly the case given that in some instances, financial ratios do not offer all the information needed to make informed decisions. For instance, while the current ratio I have computed above could be an indicator of favorable liquidity position, it could also mean that the company has excess cash which may not necessarily be a good thing because cash is a nonearning asset. In the final analysis, ratio analysis is just an indicator of performance, and not a solid reference point of performance.
For purposes of making informed financing decisions, I could make use of ratios such as the debt ratio, debt-to-equity ratio, or even the current ratio. While the first two ratios, commonly referred to as debt management ratios, are concerned with the long-term solvency of a business entity, the last ratio is an important measure of short-term solvency and is referred to as a liquidity ratio. Essentially, debt management ratios according to Baker and Powell (2009, p. 52) "characterize a firm in terms of the relative mix of debt and equity financing and provide measures of the long-term debt paying ability of the firm." While the debt ratio as Baker and Powell (2009, p. 52) further point out is a measure of the "percentage of a firm's total assets financed by debt," the debt-to-equity ratio seeks to identify the equity-debt proportion an entity is making use of to finance its assets. The current ratio is essentially a measure of an entity's ability to settle obligations of a financial nature should they fall due at short notice (Gallagher and Andrew, 2007).
Prediction of Negative Trends: Possible Financial Problems and Suggested Solutions
In this section, I will be making use of the return on assets ratio, the debt ratio, and the current ratio.
- Low ROA compared to that of other companies (in the same industry) or industry averages.