Financial analysis concepts and methods

Financial Analysis

This report will cover the most important aspects of the Colorado Group Annual Report in order to be able to draw relevant conclusions related to the organization's operational and financial performances over the past period of time. We will first of all draw on the most important elements comprised in the Annual Report and will subsequently refer to the main financial indicators and ratios, both as an absolute analysis and related to the previous year. Finally, we aim to draw relevant conclusions and show that this is a profitable company, a company that is likely to grow in the future as well.

Principle areas of judgment in the 2006 Annual Report

Before listing the actual financial - related details, the chairman and CEO of the company, Bill Gibson, and the chief operating officer, Eddie MacDonald, list the main characteristics of the past period of time, in terms of financial and operational results, as well as the main strategic objectives for the company in the subsequent period of time.

According to both, the 2005-2006 period has not been a very good one from a financial point-of-view, with the organization failing to continue its extraordinary growth that had occurred since 1999, when it was listed on the stock exchange. The reasons for this were related to internal needs for adjustments, but, even more important, to the macroeconomic situation in the retail industry that affected the organization's financial figures and its capacity of generating profits.

However, as the officers identified and we will later show in our financial analysis, the company had good and strong fundamentals, including good brands, a good distribution network and an excellent infrastructure for growth and productivity. This could ensure future success.

A short summary of the main figures, including the net sales value, profits and EBIT, as well as earnings and dividends per share showed a decrease in most indicators from the previous year. The value of net sales, for example, decreased from 2005 to 2006 with 0.6%.

The financial statements are listed starting with page 43 of the Annual Report and include the organization's income statement, its balance sheet, the statement of recognized income and expenditure and the statement of cash flows. Each of these cover a specific aspect of the organization's financial, operational or equity - related sectors.

The notes to the financial statements are extremely important in clearing up the accounting and financial policies that were used and in explaining these to the audience. For example, the accounting policies mention the basis of preparation, the financial year and the principles of consolidation, as well as the revenue recognition and income tax principles, issues relating to foreign currency translation, trade and other payables or goods and service tax.

II. Analysis of financial ratios

In order to be able to draw relevant conclusions on the company's financial health, its ability to finance future projects, the efficiency with which it is operating or the overall profitability of the organization, we need to calculate, analyze and interpret several financial rations. The main categories we will be using are liquidity ratios, asset utilization ratios, debt utilization ratios and profitability ratios.

II.1. Liquidity ratios

Liquidity ratios are used to evaluate the company's ability to honor its short-term financial obligations, as well as the way it manages to pay its current liabilities with the assets it is generating in the short-term (current assets). We will be calculating both the current ratio and the quick test.

The current ratio is calculated by dividing the value of the current assets by the value of the current liabilities and it is compared to a 1-1.5 value, showing the company's short-term financial health. In Colorado's case, the current ratio in 2006 was 2.69, compared to 2.38 in 2005 (an increase in current ratio value). This fact shows several things. First of all, the organization is following a very prudent short - term financial approach, an approach where the current assets value is usually 2-2.5 times greater than the current liabilities value. Second of all, this is a policy that has been consolidated over the last two years, hence the increasing value of the current ratio.

The quick test is practically the same as the current ratio, with the exception that the inventory value is decreased from the total current asset value and the result is divided by the current liabilities value. In 2006, this value was 1.22, still a healthy value for a sound short-term financial situation. One thing that could be pointed out is the large proportion of inventory in the current asset value - almost 55% in 2006. Given the fact that the organization is operating in the retail segment, where large inventory values are expected, this can be explained.

II.2. Asset utilization ratios

The inventory turnover, the fixed asset turnover and the total asset turnover are the best ratios to be used in analyzing the organization's asset management and asset utilization efficiency.

The inventory turnover is calculated by dividing the cost of goods sold by the inventory value and shows "the speed with which inventory moves through the company and is turned into sales." In the case of the Colorado Group, the inventory turnover amounted to 3.5 times in 2006, while in 2005, this was 3.4. In general, a higher inventory turnover shows a good sales trend, an increase in sales and a good performance in not keeping stock, but rather selling it. This seems to be the case at the Colorado Group, especially considering the retail sector the company is evolving in. In my opinion, the high inventory values at the Colorado Group are a sign that sales are increasing at the same rate as the efficiency in sales.

The fixed asset turnover is calculated by dividing the sales value by the fixed assets value and shows "extent to which company is utilizing existing property, plant, and equipment to generate sales." In 2006, at Colorado, the fixed asset turnover was 7.57, a very high value that shows that the company's fixed assets are efficiently used in generating net sales for the shareholders. This is corroborated with the value obtained for the total assets turnover (2.69 in 2006), which again shows the company's efficiency in using its overall resources to generate sales.

II.3. Debt utilization ratios

The debt ratios are not too useful in the case of the Colorado Group because, as we can see from the balance sheet, the organization has an overall net assets value of $125 million. However, we will, for the sake of the analysis, evaluate the debt ratio and the debt to equity ratio.

For the debt ratio, we will use the interest-bearing liabilities in our evaluation. In this sense, we will first of all notice that the value of the interest - bearing liabilities decreased from 2005 to 2006 with almost 93%, which means that the debt ratio also decreased to 0.2%. The debt ratio was calculated by dividing the value of the total debt by the value of the total assets in the organization.

The debt to equity ratio shows the "portion of the funds obtained by the companies that came from debt vs. stockholders investments." In other words, this ratio shows the preference of the organizational management to choose either debt and credit or stock emission to cover its expansion. The value obtained here is corroborated with the precedent one and amounts to 0.6% in 2006. There is no doubt that the company has chosen a small financial leverage and a financial structure based primarily on stockholders and stocks for future financing.

II.4.Profitability ratios

The profitability ratios obviously show whether the company is profitable or not for its shareholders. We will be using the net profit margin, the return on equity (ROE), the return on investment (ROI) and the gross profit margin to evaluate the organization's current profitability.

The net profit margin is calculated by dividing the net profit by the net sales value and "measures percentage of each sales dollar remaining after all expenses." In 2006, this ratio amounted to 7.6% for Colorado. We should point out that the net profit has decreased from 2005 to 2006 with 23.6%, despite the fact that the net sales volume remained more or less the same ($470.5 million in 2005 and $468 million in 2006). The explanation for this comes in the gradual increase in all sales-related expenses, as well as in fixed and administrative costs. Indeed, the costs of goods sold, the selling expenses and the administration expenses values all grew from 2005 to 2006.

The return of equity is calculated by dividing the value of earnings by the value of shareholders' equity and shows the "rate of return that owners receive on their investment." In the case of the Colorado Group, the return on equity was 3.77 in 2006, compared to 3.48. This shows that (1) the company is more profitable for its shareholders than in the previous year and (2) that it continues to be very profitable, with net revenues amounting to more than 3.5 times the actual value of equity.

The return on investment is calculated by dividing the total net profits by the total assets value and shows the "overall effectiveness to generate profits from total investment in assets." At the Colorado Group, the return on investment amounted to 20.4% in 2006 and 21.5% in 2005. The small decrease from 2005 to 2006 can be explained by the fact that that the net profits decreased significantly during this period of time and that the decrease of the total assets value was by no means similar in value.

The gross profit margin is calculated by dividing the net sales minus the cost of goods sold by the net sales value and shows the "profitability of a company's sales after the cost of sales has been deducted." In this case, in 2006 this ratio was equal to 54.4%, as compared to 55.9% in 2005. As we can see, the value slightly declined, but this is not necessarily something that would point out towards the fact that the company is less profitable.

III. Overall Analysis

Following the calculation, evaluation and analysis of different financial ratios, we are able to draw conclusions both on the financial situation at the company, including the main characteristics of its sources of finance, and on its profitability and operational characteristics over the 2005-2006 period.

First of all, we should point out towards the fact that the Colorado Group uses almost exclusively stock as the source of finance. We have seen that the debt and debt to equity ratios have very small values and that they practically show the company almost doesn't use credit or interest-based instruments for financing. The financial leverage is very low. A stock - based financing scheme provides several advantages, such as the fact that debt - related costs, including interest, do not exist in this case. On the other hand, all stockholders will probably have a say in the way the company is run and dividends will have to be paid out at the end of each year.