In analyzing a Company, we can also compute its gross profit ratio and return on sales. Gross profit ratio is computed by dividing gross profit with sales and return on sales is computed by dividing net income by sales. Respectively, 2006 and 2005 ratios of ABC Company are as follows: 39% and 38% in gross profit; and 16% and 15% in return on sales.
Other quantitative measurement of its liquidity is going into detailed of each current assets account using working capital activity ratios. This provides information about the time within which ABC Company should realize cash from its receivables and inventories. and, although we cannot tell the time within which the Company must pay its various current liabilities by examining the financial statements, we can use ratio to offer us some insight into the company's bill paying practices or how long customers pay their account.
Working capital ratios are accounts receivables turnover, days' sale in accounts receivables, inventory turnover and days' sale in inventory. The following paragraphs will be discussing these particular ratios.
Accounts receivables (AR) turnover measures how rapidly a company collects its receivables. AR turnover is computed by dividing sales with average accounts receivables. Average receivables is defined as the beginning accounts receivables (in this instance, AR of 2005) plus ending balance (AR of 2006) divided by 2. Because we do not have the beginning balance for 2005, we can only calculate the turnover of average receivables for 2006. We can calculate turnover of 2005 using its end of year value. In this particular ratio, turnover of ABC Company increased by 15% from 33.75 in 2005 to 40.00 in 2006. This is good because ABC is able to collect 6.25 times better than in previous year.
With relation to this, we can also calculate the number of days' sales in AR. Computation of this ratio is ending accounts receivables divided by average daily sales. Average daily sales is Total Sales for the year divided by 365 days. This indicates the average age of ending accounts receivables. On average, accounts receivables of ABC Company are 9 days old in yearend of 2006 and 11 days old in 2005, respectively. Decreased in average days' sales in accounts receivables can be a positive note. It means customers pay their accounts in a shorter length as compared last year.
Next we can compute on the inventory turnover. It is calculated by dividing Cost of Goods Sold with Average Inventory. Average inventory is computed by dividing the sum of beginning and ending of yearend inventory balance by 2. This turnover indicates the efficiency with which a company uses its inventory. Again, we can only compute the average balance for 2006 because there is no available beginning balance for 2005. Thus, ABC's inventory turnovers are 4.70 in year 2006 and 3.99 in year 2005. Increased in inventory turnover can be a good point. Higher inventory turnover is critical for many businesses to generate high sales and earn satisfactory profit.
Additional part of Working Capital Ratio analysis is computation of Days' sales in inventory. Computation is done by dividing ending inventory by average daily cost of goods sold. Average cost of goods sold is simply cost of goods sold for the year divided by 365 days. For ABC Company, this is 71.69 for 2006 and 91.58 for 2005.
These ratio analyses can be a helpful tool in deciding whether the Company you are interested in getting involved with is a going concern or can able to sustain its growth and provide employees, suppliers, debtors and investors with the necessity and other requirements.
Based on the financial analysis made with regards to ABC Company, can we say that it is best to be part of the Company whether as an employee, customer, supplier or investor?
Gross Profit Ratio
Return on Sales
Accounts Receivables Turnover
Days' Sale in Accounts Receivables
Days' sales in Inventory
Based on the summary of financial analyses presented above, we can say that ABC is a profitable and growing Company. Although there is a decreased of 0.17 or 4% in Current ratio, there is a positive and increase working capital of $10,000 and increase if 0.37 or 21%, in Quick Ratio. It means that on current liability of $1, the company has a current asset of $3.50 in 2006 and 3.67 in 2005 whereas $1 of current liability, it has "near cash" availability of $1.70 in 2006 and $1.33 in 2005. In both instances, this is a positive note signifying that it has the ability to pay its obligation in the near future.
Gross profit ratio and return on sales both increased by 1%. This is a good note because despite increase of cost of goods sold and operating expenses, ABC is still able to control expenses and increase sales. It can also be attributed with management of long-term debt, thus maintaining finance cost in a controllable manner.
It is also a good point of an increased AR Turnover by 15% and decrease of days' sale in AR by 27%. It can be interpreted that customers has the capacity and is able to pay their account within credit term or less. It also connotes that sales tie up with AR is lesser than previous year, thus is converted to cash in an earlier phase.
In view of inventory turnover and days' sale in inventory, it is viable to say that increase of turnover by 15% and days' sale in inventory decreased by 28% can be attributable to change in inventory policy or increase demand of products.
Overall, quantitatively saying, we can say that ABC Company is highly liquid and can positively accommodate, pay its short-term obligation.
On the other hand, in making decisions we have to consider other factors. Calculating ratios for is only the starting point in analyzing company's operations and prospects. Ratio analysis must be used with care. They provide information only in the context of companies. Comparisons are critical and many factors besides the magnitudes of the ratios must be considered.
The company may maximize its credit terms or choose to pay beyond date agreed to finance other activities or used it in short-term investments than opt to pay within the credit term despite discounts or encouraging promo offered by creditors.
An increase in accounts receivables turnover may connote a positive feedback however we have to consider other factors such as the company may have change credit terms of its customers to generate more cash. The faster customers pay, the better but there are always trade-offs. If a company loses sales because of tight credit policies, the advantage of faster collection might be more than offset by the loss of profits from lower total sales. The increase in average collection period might well be the result of a management decisions to offer more liberal terms to stimulate sales.
A decline in company's days' sale in inventory may be perceived as generating increase in sales but we also have to take note on internal factors such as a change in inventory policy or perhaps just a temporary reduction of inventory because of heavier than expected sales near the end of the year.
Too much cash on hand is also bad for the business. Idle cash is not a sign of good management. Lost opportunities of increasing ones profitability or income is a bad way of running its resources. Considering that the Company's customers are paying within the term, as evidenced by increase of AR Turnover and decrease in days' sale in AR, ABC Company may opt to invest it to earn a decent interest income, if it is not needed in the near future or analyze whether expansion on the business, field related or not, is feasible.
On the part of the Company, managing of working capital should not only be on the context of controlling cost but strengthening or improving internal policies as well. Cash management can be done by giving customers interesting deals to pay early or within the term or maximizing credit terms of payables to use it in the operations, cutting on unnecessary expenses like saving energy by turning off electricity when not in use, recycling and strict issuance on office supplies. There are numerous ways of improving a Company's working capital and managing them in an efficient manner.
With insights aforementioned, it is essential to learn and understand underlying causes of ratio comparisons and trends. We need to understand the company being analyzed and the industry in which it operates and take into consideration that a Company's ratios differ from those in the past, or are in-line or out-of-line with those of other companies in the industry, is not good or bad in itself. Lastly, those financial statements do not tell analysts all they want to know.
Balance Sheet - a Finance Managing Tool. Retrieved April 28, 2007 from http://trmep.tamu.edu/cg/factsheets/rm5-5.html
Working Capital Cycle. (1996-2007). Retrieved April 24, 2007 from http://www.bized.co.uk/learn/business/accounting/busaccounts/notes/wcap-th.htm…