Memorandum
TO: EEC Chief Executive Officer (CEO)
FROM: Lela Keel, EEC Financial Analyst
DATE: January 10, 2011
SUBJECT: Financial Performance Analysis
Introduction
Financial ratios are very significant because they analyze numbers a company maintains on their financial statements. Analyzing financial ratios presents ways for internal and external viewers to establish the monetary position of a company, as well as the performance of a company. Financial ratios can aid in answering decisive questions about Eddison Electronics Company (EEC), such as whether we are excessively carrying liability or stock, if our customers are reimbursing in agreement with terms, whether our operational expenses are excessive, and if the assets of the company are being correctly used to produce income For this memo financial ratios will be explained and calculated for Wal-Mart, and recommendation will also be done for analyzing EEC’s financial performance.
Return on Assets
The return on assets (ROA) is a ratio that determines the profit on net revenue on overall assets for a company after interest and taxes have been paid. The ROA measurement is an indication as to how resourceful a company is in utilizing their assets to produce income. ROA = total net income/total assets is the method for calculating the ROA (Investopedia, 2010). In taking Wal-Mart’s net income for 2010 and dividing it by their total assets the percentage would be 84% (Wal-Mart Stores Inc., 2011). This ROA number is good as it indicates that Wal-Mart is generating more capital on fewer assets (Investopedia, 2010).
Return on Equity
The return on equity (ROE) is a ratio that measures return on the stockholder investments in a company. The ROE will aid in determining a company’s profits by disclosing how much income was produced with shareholder investment money. The usual way shareholders will view the shareholders equity of a company would be as the accounting “book value” of the business. ROE = net income/total stockholder equity is the method for calculating the ROE (Motley Fool Staff, 2011). Again, let’s take Wal-Mart’s net income and divide it by the total shareholder equity the percentage would be 20%. This ROE percentage would indicate that Wal-Mart is generating 20 cents on each dollar initially provided by shareholders (Wal-Mart Stores Inc., 2011).
Gross Profit Margin
The gross profit margin is a ratio that will show the operational profits of a company’s processes after variable expenses are taken away from revenues. This ratio will determine a company’s success in their performance at it relates to prices of products and amount of products sold. It does this by disclosing the total revenue left over after taking out for the cost of selling the products. Gross profit margin = gross margin/sales is the method for calculating the gross profit margin (Investopedia, 2010). Take Wal-Mart’s gross profit margin for the year 2010 and divide it by their net sales and the percentage would be 25% (Wal-Mart Stores Inc, 2011). This would be the average mark-up that Wal-Mart applies to their products in order to assure a profit (Investopedia, 2010).
Debt/Equity Ratio
The debt-to-equity (D/E) ratio measures the economic risk that a company undertakes. This ratio specifies the total equity and debt a company is currently using to pay for its assets. The measurement of this would signify as to how much cash would be safe for a company to borrow for long periods of time. D/E = liabilities/shareholders equity is the method for calculating the D/E (Investing Answers, 2011). Take Wal-Mart’s total liabilities and divide it by their shareholders equity which would make the percentage of 1.4 (Wal-Mart Stores Inc., 2011) or 140%. This means that for every dollar of Wal-Mart owned by shareholders, they owe $1.40 to creditors (Investing Answers, 2011).
Debt Ratio
The debt ratio signifies the total debt a company has comparative to their assets. This calculation will permit a suggestion to be specified on the leverage a company has along with the possible debt-load risks the company has. In this respect, the debt ratio can also aid shareholders in determining a company’s level of financial risk. Debt ratio = total liabilities/total assets is the method for calculating the debt ratio (Investopedia, 2010). Take Wal-Mart’s total liabilities for the year 2010 and divide it by their total assets which would be 58% (Wal-Mart Stores Inc., 2011). Lower percentages mean that a company is dependent less on leverage, while higher percentages mean that a company is thought to have taken on more risk (Investopedia, 2010).
Current Ratio
The current ratio measures a company’s ability to pay back short-range obligations. The measurement of this ratio can signify the effectiveness a company has during its operational cycle and the capability it has in turning its products into cash. It is used by creditors or banks to see if a company can recompense for quick-fix loans with quick-fix assets. Current ratio = current assets/current liabilities is the method for calculating the current ratio (Investopedia, 2010). Take Wal-Mart’s current assets for the year 2010 and divide it by their current liabilities and the total would be 0.9 (Wal-Mart Stores Inc. 2011). A company is more capable of paying their obligations if a high current ratio is calculated (Investopedia, 2010).
Quick Ratio
The quick ratio determines a company’s capability in meeting its short-range obligations with its on hand assets. It does this by comparing a company’s on hand assets to its current liabilities. This ratio is somewhat like the current ratio except it excludes the inventory from a company’s current assets. By doing this a company can be given a better idea of where they stand in meeting their short-range obligations. Quick ratio = current assets – inventory/current liabilities is the method for calculating the quick ratio (Investopedia, 2010). Take Wal-Mart’s current assets, subtract their inventory, and divide it by their current liabilities which would total 0.8 (Wal-Mart Stores Inc., 2011). A company is in better position to meet their obligations if their quick ratio is high (Investopedia, 2010).
Inventory Turnover
The inventory turnover ratio measures a company’s effectiveness in selling or replacing their inventory over a given time, usually a year. Inventory turnover = cost of goods sold/total inventory is the method for calculating the inventory turnover (Investopedia, 2010). Take Wal-Mart’s cost of goods sold and divide it by their total inventory and the calculation would be they average 9 times per year in selling or replacing their inventory (Wal-Mart Stores Inc., 2011). The higher the inventory turnover ratios the better, since a low inventory turnover ratio would indicate products tend to deteriorate in sitting (Investopedia, 2010).
Total Asset Turnover
The total asset turnover is a ratio showing a company’s total sales produced for each dollar’s worth of assets. It determines a company’s effectiveness in using their assets to produce revenue or sales. Also, this ratio will be useful for companies who want to check to see if they are generating revenue in proportion to the sales they are generating. Total asset turnover = sales/total assets is the method for calculating total asset turnover (Investopedia, 2010). Take Wal-Mart’s sales for the year 2010 and divide it by and their total assets which would total 2.39 (Wal-Mart Stores Inc., 2011). A low profit margin would indicate that a company has high asset turnover and a high profit margin would indicate that a company has low asset turnover (Investopedia, 2010).
Price/Earnings Ratio
The price/earnings (P/E) ratio is the connection among a company’s market price of shared stock and the stock’s current earnings per-share. The P/E ratio is a method that is frequently applied for establishing the value of stock. It can be vital to forecasters who want to understand how the market values the stock of a particular company. P/E ratio = market value per share/earnings per share is the method for calculating the P/E ratio. Overall, the higher the P/E the better since this would indicate that investors expect future growth of the related stock (Investopedia, 2010).
Accounts Receivable Turnover
Accounts receivable turnover ratio will establish how successful a company is in giving credit as well as gathering debts owed to them. During an accounting period the accounts receivable turnover will measure the number of times a company convents their credit sales into cash. Accounts receivable turnover = credit sales/accounts receivable is the method for calculating the accounts receivable turnover. A high turnover indicates credit is granted effectively and payment receiving from customers is effective (Investopedia, 2010).
Operating Ratios
The operating ratio is another method for analyzing financial statements. This ratio will compare the operating expenses of a company to their net sales. By comparing the operating expenses to net sales management will be given information that is needed to make better decisions regarding the operations of a company. Operating ratio = operating expense/net sales is the method for calculating the operating ratio. A low operating ratio is thought to be ideal, because with a low operating ratio a company will remain profitable in the event of a decline in revenue (Investopedia, 2010).
Common Size Ratios
Common size ratios are another method for analyzing the performance of a company. Common size ratios evaluate the financial statements of a company over different time periods. Common size ratio = item of interest/reference item is the method for calculating common size ratios (Garrison, Noreen, & Brewer, 2010). For instance, let’s say that the company wanted to compare inventory against total assets, the method for calculating this would be common size ratio = inventory/total assets. Comparing inventory within each department against total assets can reveal trends and provide insight to different operational activities of a company. Common size ratios are generally prepared from the balance sheet and income statement and they are expressed as a percentage (Common Size Financial Statements, 2010).
Conclusion
There are many ways to analyze the financial performance of a company. Once the financial performance of a company is analyzed decisions can then be made by management regarding different areas of a company. Given the journal entries for 2005 for EEC I will attempt to assess the performance of the company using two of the ratios mentioned. Calculating the current ratio of EEC for the year 2005 as being right about 3.22 would tell me that we are in good financial health and are able to maintain financial responsibly to pay back loans if needed. The calculation for the D/E ratio for the year 2005 is .45 which is acceptable in that it tells me we are not having excessiveness in our debt to equity for this period. These are just a couple of the ratios that can be used to assess the financial performance of the company, once the performance is assessed in all areas the road to financial success is near.
References
Common Size Financial Statements. (2010). Retrieved from http://www.netmba.com/finance/statements/common-size/
Garrison, R., Noreen, E., & Brewer, P. (2010). Managerial accounting, (13th ed.). New York, NY: McGraw-Hill Irwin.
Investing Answers. (2011). Debt-to-Equity Ratio. Retrieved from http://www.investinganswers.com/term/debt-equity-ratio-358
Investopedia. (2010). Dictionary. Retrieved from http://www.investopedia.com/dictionary/
Motley Fool Staff. (2011). Return on equity: An introduction. Retrieved from http://www.fool.com/investing/beginning/return-on-equity-an-introduction.aspx
Wal-Mart Stores Inc. (2011). Retrieved from http://finance.yahoo.com/q/bs?s=WMT+Balance+Sheet&annual