Accounting: Financial Ratio Analysis

Topics: Financial ratios, Inventory, Generally Accepted Accounting Principles Pages: 20 (6926 words) Published: April 10, 2011
Financial ratio analysis is a fundamental task of investors, accountants and corporate managers. Financial ratios fall into four main buckets: profitability ratios (which tell you how effectively a company utilizes its assets); liquidity ratios (which measure the financial health of the company); and leverage ratios (which tell you how much debt the company has relative to its total capital); turnover ratios or activity ratios ( which tell you how many times a company's inventory is replaced during a given time period). Financial ratios give you a snapshot of an entity's financial health and help you make informed investment and management decisions. In this case study, we will examine financial ratio results of two businesses, and give detailed analysis of which company’s share is preferred to invest. In prior to deciding between purchasing ordinary shares of either company, we will search some additional information which is not given. In the last part of the case, important recommendation in relation to solvency is highlighted.

Question 1
a) Gross Profit
Gross profit (Gross margin, gross profit margin or gross profit rate) is the difference between the sales and the production costs excluding overhead, payroll, taxation, and interest payments. Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each dollar of a company's revenue is utilized to cover the costs of goods sold1. It can be expressed in absolute terms:

Gross margin = net sales - cost of goods sold + annual sales return Or as the ratio of gross profit to sales revenue, usually in the form of a percentage: Gross margin percentage = (revenue-cost of goods sold)/revenue Higher gross margins for a manufacturer reflect greater efficiency in turning raw materials into income. For a retailer it will be their markup over wholesale. Larger gross margins are generally considered ideal for most companies, with the exception of discount retailers who instead rely on operational efficiency and strategic financing to remain competitive with lower margins. In our case, company C is much preferred to Company B, but we still do not know what each company’s main function. We keep tracking on ratios and after considering all the ratio results, and then we can make decision. b) Return on assets

The return on assets (ROA) percentage shows how profitable a company's assets are in generating revenue. ROA can be computed as:
This number tells you what the company can do with what it has, i.e. how many dollars of earnings they derive from each dollar of assets they control. It's a useful number for comparing competing companies in the same industry. The number will vary widely across different industries. Return on assets gives an indication of the capital intensity of the company, which will depend on the industry; companies that require large initial investments will generally have lower return on assets. Return on assets is an indicator of how profitable a company is before leverage, and is compared with companies in the same industry. Since the figure for total assets of the company depends on the carrying value of the assets, some caution is required for companies whose carrying value may not correspond to the actual market value. Return on assets is a common figure used for comparing performance of financial institutions (such as banks), because the majority of their assets will have a carrying value that is close to their actual market value. Return on assets is not useful for comparisons between industries because of factors of scale and peculiar capital requirements (such as reserve requirements in the insurance and banking...
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