Financial performance of Sparklin Automotive Company
The firm's financial position can be analyzed using financial ratios. The analysis is very vital for would be creditors and the shareholders of the firm. The analysis of the financial position is done at the end f a financial period and is usually based on the available financial information from the company like balance sheets. This paper analyzes the financial ratios that are used to give the financial standing of the firm.
Analysis of a company's financial statements is very important. They help a company evaluate it financial standing as par given period of time. It shows how a company is improving in making profits or making loses. The analysis of financial statements of a firm also helps one to have a deeper understanding of the company. This is because, one is in a position to know the other small details of the company like the liquidity ratios, asset turnover ratios, financial leverage ratios, profitability ratios and dividend policy ratios. Therefore, looking at the profit margin of the firm is not enough and may not give a clear picture to the company's financial standing per given period of time (Oklahoma, 2010).
This is the most common type analyzing a company's performance. Through the use of ratio analysis, the company directors can highlight the problem areas in the organization a part form areas of strength. Some of the ratios that are used in this analysis are: turnover and efficiency ratios, expense ratios, profitability ratios and debt ratios. These ratios make use of financial information of the company provided by the company on the balance sheet (Oklahoma, 2010). The financial ratios are explained below:
These are the ratios that give information concerning the company's financial obligations in the short run. These ratios indicate the capability of the firm to generate cash as fast as possible. Liquidity ratios are of importance to the creditor to the firm. They always want to know the liquidity position of the firm to determine how much money they can lend to the company. The working capital is the most important ratio here, though there are other ratios like the current ratio and the cash ratio (Financial management resources, 2010).
Working capital: this ratio displays the capability of a firm to deal with unexpected expenses. It is calculated by taking the current assets minus the current liabilities. This ratio can be improved though a reduction of receivable accounts and short term debts while maintaining the savings and avoiding current liabilities.
Current ratio: is also known as working capital ratio. This is the ratio of current assets to current liabilities.
Current ratio = (current assets) / (current liabilities)
From the financial data of sparkling automotive company, the current ratio can be calculated as follows;
2005 - Current ratio = = 1.47
2006 - Current ratio = =1.4
Comparing the two years, we see the current ratio increased. This means that the company increased its level of current liabilities. A high current ratio is more preferred by the creditors while shareholders prefer a lower current ratio. Current ratios vary with different firms. Firms in industries that experience more cyclic like have high current ratios for easier liquidity in times of economic downturns (Financial management resources, 2010).
Though current ratio is good, its inventory may contain many items with uncertain values of liquidation and are therefore hard to liquidate. Due to this, the quick ratio is used instead.
Quick ratio: this ratio is also called the acid test ratio. Cash and accounts receivables and the note are the assets that are used. It is found by:
Quick ratio =
Cash ratio: this is a ratio that is used to show the capability of the firm to pay its debtors. It is calculated by:
Cash ratio =
Asset turnover ratios
These are the ratios that show the efficiency of a firm in utilizing its assets. They are also called efficiency ratios. There are two types of asset turnover ratios that are commonly used:
Receivable turnover: this ratio indicates how fast the firm collects its receivable accounts. It is calculated as below:
Receivable turnover =
Basing on the example of Sparkling Automotive company data the receivables turnover can be calculated as below;
2005 - Receivable turnover = = 0
2006 - Receivable turnover = = 0
From the data provided, the company did not have any credit sale. Therefore, the receivable turnover for the two consecutive years is 0 (zero). This ratio is usually reported in days.
Inventory turnover: this is calculated by the amount of goods sold in a given period divided by the average inventory during the same period (NetMBA, 2010).
Inventory turn over =
From the financial data of Sparkling Automotive Company, the inventory turnover can be calculated as:
2005 - Inventory turnover = = 6.21
2006 - Inventory turnover = = 3.2
From the calculation of the above inventory turnover, comparing the two years we see that inventory turn over in 2006 went down. Although there was no opening stock in 2005, this could be attributed to the expansion nature of the company. This ratio (inventory turn) can also be reported the inventory period. This is the number of days for holding inventory. It is calculated as below:
Inventory period =
2006 - Inventory period = = 113 days
Inventory period =
Financial leverage ratios
These ratios indicate the long term financial solvency of an organization. They measure the extent to which the firm utilizes the long term debt (NetMBA, 2010). These ratios include:
The debt ratio: is calculated as below;
Debt ratio =
Debt-to-equity ratio: this is calculated as below:
Debt-to-equity ratio =
Basing on the data from sparkling automotive Company for the year ending 2006, the equity-to-debt ratio can be calculated as;
2005 - Equity-to-debt ratio = = 0.44
2006 - Equity-to-debt ratio = =0.44
Comparison of the two years, the equity to debt ratio is the same. This is relevant in the sense that the organization didn't increase its equity neither though it reduced debt from 49100 to 48150. Times interest earned ratio: this ratio is used to measure how well the firm's revenue earnings can be used to cover the interest on borrowed funds. It is calculated as bellow:
Times interest ratio =
These are the ratios that show how successful a firm is in generating revenue. These ratios include:
The gross profit margin: These measures the amount of revenue earned in terms of gross profit given the cost of sales. It is calculated as below:
Gross profit margin =
From Sparkling Automotive Company financial databases given, gross profit margin can be calculated as below;
2005 - Gross profit margin percentage = X 100 = 49.2%
2006 - Gross profit margin percentage = X 100 = 40.7%
The profit margin reduced from 49.2% to 40.7%. This explains the reduction in the profits of the firm in the year 2006. This could be due to the organization venturing into new markets and the introduction of new product in the market (Financial management resources, 2010).
Return on assets: this ratio measures the profits generated on the firm's assets. It is calculated as:
Return on asset =
Return on equity: this ratio is mainly used by shareholders to measure the revenue earnings of their investment in the firm. It is calculated as below:
Return on equity =
Dividend policy ratios
These ratios depict the policy of the firm regarding dividends. They also reveal the prospectus of the firm for the future growth. There are two commonly used dividend ratios;
Dividend yield ratio: is calculated as below;
Dividend yield =
Shareholders should not base their share returns on this ratio because a high dividend yield doesn't mean high future return on investment. Instead, they should base the future increase in dividends on the prospectus.
Dividend payout ratio: is defined as;
Dividend payout ratio =
This ratio is used by shareholders to gauge the earnings per share. The higher the dividend payout ratio, the higher the dividend earning per share.
Limitations of financial ratios
Despite their usefulness, financial ratios have their disadvantages.
* Financial ratios should be used in reference to historical data or the forecasts of the same organization or similar organizations.
* Most of these ratios are meaning less unless they are used as indicators of the organization's financial position for a given period.
* These financial ratios are a subject to financial methods. Use of a different financial method may yield a different outcome.
* The representation by year end values may not be realistic. This is because there may be an increase or a decrease in certain account entries at the end of the financial period distorting the ratio value (NetMBA, 2010).
The analysis of a company's financial statements is very vital for the future of the organization. The in formation is useful both to the shareholders and the creditors of the company. The analysis of the firm's financial position is usually dependent on the financial reports at the end of financial period e.g. a balance sheet. Financial ratios are the most common ways of analyzing financial data of organizations. These ratios include the following; liquidity ratios, profitability Ratios, financial leverage ratios and asset turnover ratios. Caution should be taken when doing the analysis because the analysis should be compared to historical data available or comparison with other similar companies.
Oklahoma, (2010). “Financial analysis for directors.” Retrieved on February 23, 2010 from: http://pods.dasnr.okstate.edu/docushare/dsweb/Get/Document-3269/AGEC-997web.pdf
NetMBA, (2010). Financial ratios. Retrieved on February 23, 2010 from: http://www.netmba.com/finance/financial/ratios/
Financial management resources, (2010). Financial ratio analysis. Retrieved on February 23, 2010 from: http://www.bizmove.com/finance/m3b3.htm