Arrow Company and Plume Inc. Ratio Analysis

Arrow Company and Plume Inc. Ratio Analysis

Arrow Company and Plume Inc. Financial Ratio Computations

Ratio

Computation

Arrow Company

Computation

Plume Inc.

Rate of Return on Equity (ROE)

$610,000/$2,189,200

$887,000/$2,682,000

Return on Assets

$610,000/$3,855,700

$887,000/$4,477,500

Gross Margin

$1,720,000/$4,175,000

$2,117,000/$4,705,000

Inventory Turnover

$2,550,000/$435,000

$2,800,000/$595,000

The Collection Period

$380,000/($4,175,000/365)

$585,500/($4,705,000/365)

Fixed Asset Turnover

$4,175,000/1,695,000

$4,705,000/$2,512,000

Debt to Assets Ratio

$1,601,500/$3,855,700

$1,790,500/$4,477,500

Debt to Equity Ratio

$1,601,500/$2,189,200

$1,790,500/$2,682,000

Current Ratio

$2,105,700/$845,500

$1,940,500/$1,375,000

Acid Test

($2,105,700 - $435,000)/$845,500

($1,940,500 - $595,000)/$1,375,000

Analysis: Interpretation

From the ratios computed in Table 1 above, it may be possible to tell which company is in better financial health than the other. To begin with, we can use a number of ratios computed in the table above to measure the success of the two entities at profit generation. Looking at the companies' rate of return on equity, it is clear that shareholders of Plume Inc. earn much more than those of Arrow Company for their investment in the entity. Return on equity in the words of Rich et al. (2011) "measures the profit earned by a firm through the use of capital supplied by shareholders." In that regard, the high the ROE (in percentage terms), the better off shareholders are. Plume has a higher ROE than Arrow. Yet another important ratio when it comes to measuring or evaluating the ability of a firm to generate profits is return on assets. This ratio according to Rich et al. (2011) "measures the profit earned by a corporation through use of all its capital, or the total of the investment by both creditors and owners." Plume's ROA ratio is higher than that of Arrow. In that regard, one could say that the company's assets are being utilized more efficiently than those of Arrow in the generation of profits. In basic terms, the gross margin is the "amount by which revenues exceed the cost of goods sold" (Needles and Powers, 2010). This ratio hence enables us to measure or evaluate how much gross profit a given entity earns on sales. Looking at Table 1, it is clear that Plume Inc. earns more gross profit on sales than Arrow. Thus the ability of Plume to pay for additional expenses is much greater than that of Plume. In the final analysis (and based on the profitability ratios discussed above), Plume is more successful than Arrow in the generation of profits.

A brief look at the asset turnover ratios of both Plume and Arrow would help shed some light on the efficiency of the two companies when it comes to asset utilization. To begin with, Arrow's inventory turnover is greater than that of Plume. This ratio in the opinion of Albrecht, Stice and Stice (2010) is essentially a measure of the number of times an entity's inventory is replenished or turned over during a year. Therefore, in our case, this means that Arrow replenishes its inventory more times that Plume. This is an indicator of strong sales on the part of Arrow. The collection period on the other hand is simply the amount of time taken by an entity to receive the payments its clients and customers owe it. Arrow has a lower collection period than Plume. In that regard, the Arrow takes a shorter period than that taken by Plume to turn or convert its receivables into cash. Thus Arrow can be regarded more liquid than Plume. The higher fixed asset turnover ratio in the case of Arrow is an indicator that the company is more efficient than Plume in the generation of revenue using its fixed assets. Looking at the asset turnover ratios above, it is clear that Arrow is more efficient than Plume in the utilization of its assets.

However, apart from the ratios I have already identified above, it would also be prudent to take into consideration both the financial leverage and liquidity ratios to get a more vivid picture of the financial health of the two firms. The debt-to-assets ratio according to Albrecht, Stice and Stice (2010) "represents the proportion of borrowed funds used to acquire the company's assets." The slightly higher debt-to-assets ratio in the case of Arrow Company means that the company is more dependent on debt. Thus in terms of risk, Arrow can be regarded more risky than Plume based on its higher debt-to-assets ratio. Arrow also has a higher debt-to-equity ratio. This ratio in basic terms seeks to establish the relationship between an entity's liabilities (total) and its shareholder funds. This effectively means that in comparison to Plume, Arrow utilizes more debt to finance its growth. This makes the Arrow more risky than Plume especially given that an increasing cost of financing could make the firm's earnings volatile. Given the above analysis, Plume comes across as being more solvent in the long-term than Arrow.