Audited financial reports are used by all stakeholders of an organization. Financial statements provide the users with a narrow insight into the financial strengths and weaknesses of a business because reported values do not give an in depth depiction of performance of an entity. This creates the need for financial analysis. Financial analysis breaks down the financial data into various components for better understanding. It helps in giving trends in performance over time. The paper demonstrates the use of ratios to carry out financial analysis. It uses financial data for Goofy’s All Star Sports Store and Pluto’s Sporting Equipment for 2011. Profitability, liquidity, financial gearing and efficiency ratios for the two companies are computed. The ratios computed are compared with industry averages and recommendations made to a potential investor.
Financial analysis entails evaluating the financial records finance-related documents of a company to ascertain the trend of their performance over time. Basically, a comprehensive financial analysis is done on an institution’s financial statements to establish if the institution is stable, solvent, liquid, or profitable enough to invest in. All financial records are used in ratio analysis. Ratio analysis is a key technique for financial analysis. This section calculates various ratios for the two companies.
Profitability is the ability of an entity to earn income after excluding cost of running the business. Various ratios are used to analyze profitability such as, gross profit margin, operating profit margin, net profit margin, the return on assets (ROA) ratio, and the return on equity (ROE) ratio. Table 1.0 summarizes the financial ratios for the two companies.
Table 1.0 – profitability ratios
|Profitability ratios||Goofy’s||Pluto’s||Industry averages|
|Return on Assets||12.26%||12.59%||14%|
|Net Profit Margin||13.54%||12.58%||11%|
|Gross profit margin||47.08%||50.10%||46%|
|Return on Equity||19.74%||33.71%||30%|
From the table above, profitability ratios for Pluto’s are greater than those of Goofy’s apart from net profit margin. Besides, they are more than the industry averages. It is therefore apparent that Pluto is more profitable than Goofy.
Analysis of liquidity is necessary as it establishes the ability of an organization to maintain positive cash flow while satisfying immediate obligations, that is, the availability of cash to pay current debt. The common ratios used to analyze liquidity are current and quick ratio. Table 1.1 summarizes the liquidity ratios for the two companies.
Table 1.1 – Liquidity ratios
|Liquidity ratios||Goofy’s||Pluto’s||Industry average|
From the table above, liquidity ratios for the two companies are below industry averages. However, Goofy has favorable liquidity ratios than Pluto.
Financial gearing shows a company’s vulnerability to risk that is, the degree of protection provided for the business’ debt. Several ratios can be used to measure the safety of a business entity such as debt to equity. Debt to equity ratio shows the relationship between shareholders fund and debt. High debt ratio implies high risk to current and future creditors. Table 1.2 summarizes the gearing ratios for the two companies.
Table 1.2 – Gearing ratios
|Debt to equity ratio||0.76/1||1.71/1||0.75/1|
From the table above, Pluto’s debts are well covered with equity than Goofy’s debts. The debt ratio indicates that Goofy is too conservative and risk averse. Therefore, it cannot realize the full potential. Pluto’s debt ratio is favorable since it is below industry average.
Efficiency ratios provide an indication of how well a company manages. These ratios show the amount of profits generated from assets of the company. Further, it also shows the level of activity of a firm as indicated by the turnover ratios. Commonly used ratios are accounts receivable turnover, accounts payable turnover, days payable among others. Table 1.3 summarizes the efficiency ratios for the two companies.
Table 1.3 – Efficiency ratio
|Efficiency ratios||Goofy’s||Pluto’s||Industry average|
From the table above, all efficiency ratios for the two companies are below industry averages apart from inventory turnover. Efficiency ratios for Pluto are more favorable than those of Goofy.
The Price / earnings ratio is the most commonly used to evaluate investment in an entity. A stock with a high price/earnings ratio guarantees shareholders high returns from their investments. Table 1.4 summarizes the investment ratios for the two companies.
Table 1.4 – Investment ratios
From the table, price/earnings ratio for Pluto is higher than Goofy’s. It implies that investing in Pluto pays more than Goofy
Ratio analysis above indicates that financial performance for Pluto is better than that of Goofy. Therefore, an investor should invest in Pluto’s Sporting Equipment. An investor should also monitor performance for the two companies over a period to ascertain that the companies will maintain the financial performance recorded.