Ratio Analysis

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Financial Statement Analysis Project – “Guess, Inc.” and “The Gap” FI 504 – Accounting and Finance: Managerial Use and Analysis October 13, 2008

I. Liquidity Ratios
Liquidity shows the degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. Also it the ability to convert an asset to cash quickly, known as "marketability.” For an investor it is safer to invest in liquid asset then illiquid ones because it is easier to get his money out of the investment. Current ratio measures a company’s ability to pay short-term obligations. Both companies are able to pay back their short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. Both companies’ ratios are above one, which means they can pay off their obligations. It shows the companies are financially healthy. Current ratio of Guess, Inc. was lower than Current ratio of The Gap during four years from 2004 to 2007, but is was stable. The Gap’s current ratio decreased slightly, it means its liquidity needs further investigation. Investors and managers use the relationship among sales, accounts receivable, and cash collections to evaluate the companies’ liquidity. The Receivables Turnover ratio is an activity ratio, measuring how efficiently a firm uses its assets. A high ratio implies either that a company operates on a cash basis, or that its extension of credit and collection of accounts receivable is efficient. A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. Average collection period should be consistent with corporate credit policy. The increase in Average Collection Period of Guess, Inc. and The Gap may suggest a decline in financial health of customers. Analysis of inventory is a result of Inventory Turnover ratio and Days in Inventory. Having too much inventory on hand costs the company money in storage costs, interest costs, and costs associated with the shifts in fashion. But having too little inventory on hand results in lost sales. The calculation shows that The Gap turns its inventory more frequently than Guess, Inc. Consequently, the average time an item spends in The Gap stores is shorter. This suggests that The Gap is more efficient than Guess, Inc. in its inventory management. Comparing the two companies’ liquidity results with Industry Average’s, it should be mentioned that both companies were pretty liquid during the year of 2007. Most of the figures are either higher or on the same level as Industry Average.

II. Solvency Ratios.
Long-term creditors and stockholders are interested in a company’s long –run solvency – its ability to pay interest as it comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure the ability of the enterprise to survive over a long period of time. Guess, Inc.’s Debt-to-Total Assets ratio of 50% means that the company’s creditors provided $0.50 of every dollar invested in Guess, Inc.’s assets. This ratio exceeds The Gap’s ratio of 40%. The higher the ratio, the lower the equity “buffer” available to creditors, if the company becomes insolvent. Thus, from creditors’ point of view, a high ratio of debt to total assets is undesirable. Guess, Inc.’s solvency appears lower then that of The Gap. Other measures can also be useful in assessing solvency. One of them is the Times Interest Earned (Interest Coverage) ratio, which provides an indication of a company’s ability to meet interest payments as they come due. Guess, Inc.’s Times Interest Earned ratio declined from 27.1 times in 2006 to 22.2 in 2007. Guess, Inc.’s high Debt-to-Total Assets ratio, combined with its interest coverage ratio of 22.2 times, should be...
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