Financial Ratios Application in Financial Analysis
Instructions: critically analyze the benefits and limitations of ratio analysis, explaining what factors impact the meaningfulness of such measures and what new practices or theories may be emerging regarding the application of ratio and financial statement analysis. Emphasize practical applications and real-world use of ratios synthesizing your readings in published research or survey articles .
Solution.
Financial Ratios Application in Financial Analysis
Executive Summary
Financial analysis is a common practice among many investors in the business world. Financial analysis is conducted to evaluate the performances of individual organizations in comparison with their competitors’ and industry results. Companies prepare financial statements; balance sheet, income statement, and cash flows statement, to show their financial performance over a given a period. It is difficult to compare different companies using these financial statements directly due to the difference in size and capacity of conducting business between these entities. Financial ratios come in handy to level the playing field since it factors size and the capacity of individual entities in comparison. Using the financial statements directly in financial analysis has proven to be a tussle since the vertical and horizontal comparison of the items in these statements does not pin point the area of concern related to a business success or failure. Conduction of financial ratios breaks done the financial analysis into profitability; liquidity, efficiency, and equity to enable an investor pinpoint the area of concern. For financial analysis to be carried out, not only does one need to calculate the financial ratios but also to interpret them.
Introduction
Financial ratios form one of the leading tools of financial analysis. The financial ratios are broken down into profitability ratios, liquidity ratios, investor ratios, and efficiency ratios. In financial analysis of financial statements, the going through different items and large amount of numbers might be intimidating but with the use of financial ratios, this work is made easier (“Financial analysis”, 2016). This easy shall critically analyze the benefits and limitation of using financial ratios in financial analysis. In the analysis the essay shall incorporate real life examples by using Petco Company and Petsmart Company as case studies.
Benefits of using financial ratios in financial analysis
Financial ratios facilitate easy comparison of companies through the provision of a standard method in which these companies and industries can be measured. The use of ratios makes it easy for financial analysts to compare the performances of entities without the biasness of market share, size, and sales volume. Comparing the raw financial data of two companies such as Petco and Petsmart using an item such as the total revenue might bring a limited insight. The total revenue of Petco is larger than that of Petsmart but it does not necessarily mean that its performance is better than the latter company is. Financial ratios explain the companies’ performances deeper than the numbers do. It compares different items of the financial statements such as sales and profit, sales and inventory, and profit and method of financing to determine how good a company makes profit, how it finances its business operations and efficiently the company’s management is carrying its activities. In the case study, despite the fact Petco has a higher sales revenue than Petsmart, a further analysis through ratio analysis depicts that Petsmart has a higher gross margin than the previous company (Altman, et.al, 2013). This example implies that a company that seems stronger at a first glance may not always be what it purports to be. Financial ratios provide a useful tool for comparison of companies.
Financial ratios help in stock valuation. These ratios facilitate investors with the ability to determine the strengths and weaknesses of companies. The fundamental role of financial ratios is the determination of relative strength of individual companies. Financial ratios help investors determine which companies have the capacity to increase the value of their stock over time. Through stock valuation of the financial ratios makes it possible to point out the weak players in the market. Financial ratios help entrepreneurs and business owners in planning and performance. Using industry averages as a guideline, business owners can use financial areas a measure of performance of their organizations. The use of financial ratios creates a good guideline for planning future activities of specific activities (Fridson & Alvarez, 2011).
Financial ratios have some limitations that affect their use in financial analysis. Inflation may affect the ratio analysis of an organization. Inflation distorts the value of items in the balance sheet affecting the company profits. Due to this effect of inflation, the comparison of financial ratios in different periods should be done with judgment. Seasonal factors limit the effectiveness of ratio analysis (Robinson, 2009). For example, the inventory of Petco and Petsmart might be high in summer as compared to other seasons.
Financial ratios are broken down into four categories; profitability ratios, liquidity ratios, efficiency ratios, and investor ratios. Profitability ratios are used to determine whether an organization makes sufficient profits according to its capabilities. Profitability ratios include; return on assets, return on equity, and profit margins. These ratios compare an organization’s profit to its sales, total assets, and total equity (Paramasivan & Subramanian, 2009). Liquidity ratios are used in a financial analysis to assess the liquidity position of a firm. They include the current ratio, quick ratio, and the working capital. The efficiency ratios are used to determine the efficiency of an organization’s management. They include ratios such as the inventory turnover, sales turnover, and, inventory management days. Investor ratios are used to determine the extent in which the organization use equity or debt to finance its operations (WIRE, 2015).
Appendix:
Petco Company Financial statements
Statement of Activities and Changes in Net assets
Changes in Unrestricted Net Assets: May 3, 2014 May 4, 2015
Support and Revenue:
Contributions from Fundraising Activities 13013551 14136918 111111
Contributions from Individuals & Corporations 6782973 5115684
Petco Animal Supplies Stores, Inc. In-Kind Contributions 1096866 362104
Total contributions 20893390 19614706
Special Events:
Revenue 2209767 1090254
Expense (863378) (273119)
Net Special Events Revenue 1346389 817135
Interest income 4741 9688
Total unrestricted support and revenue 22244520 20441529
Expenditures:
Program Grants 15434841 19145848
Administration and Other 1549667 1093665
Fundraising 595467 634357
Total Expenditures 17579975 20873870
Change in Net Assets 4664545 (432341)
Net Assets, Beginning of year 7548304 7980645
Net Assets, End of Year 12212849 7548304
Statement of financial Position
Assets May 3, 2014 May 4, 2015
Cash and cash equivalents 12273632 7446396
Receivable from Petco Animal Supplies Stores, Inc. 1280279 1100031
Other Receivables 434726 26597
Prepaid Expenses 7350 103605
Total assets 13995987 8676629
Liabilities and Net Assets
Liabilities:
Accounts payable and accrued expenses 1606734 836137
Due to Petco Animal Supplies Stores, Inc. 176404 292188
Total liabilities 1783138 1128325
Net Assets:
Unrestricted 12212849 7548304
Total assets 12212849 758304
Total assets and liabilities 13995987 867629
| PetSmart, Inc. and Subsidiaries | ||||||||||||
| Condensed Consolidated Balance Sheets | ||||||||||||
| (In thousands, except par value) | ||||||||||||
| (Unaudited) | ||||||||||||
| February 1, | February 2, | |||||||||||
| 2015 | 2014 | |||||||||||
| Assets | ||||||||||||
| Cash and cash equivalents | $ | 444,178 | $ | 285,622 | ||||||||
| Restricted cash | 80,408 | 71,226 | ||||||||||
| Receivables, net | 87,937 | 72,685 | ||||||||||
| Merchandise inventories | 777,389 | 740,302 | ||||||||||
| Deferred income taxes | 66,298 | 71,945 | ||||||||||
| Assets held for sale | 22,176 | – | ||||||||||
| Prepaid expenses and other current assets | 85,037 | 76,463 | ||||||||||
| Total current assets | 1,563,423 | 1,318,243 | ||||||||||
| Property and equipment, net | 906,965 | 952,955 | ||||||||||
| Equity investment in Banfield | 35,925 | 33,577 | ||||||||||
| Deferred income taxes | 111,467 | 110,408 | ||||||||||
| Goodwill | 138,147 | 41,140 | ||||||||||
| Intangible assets, net | 25,940 | 251 | ||||||||||
| Other noncurrent assets | 45,068 | 65,394 | ||||||||||
| Total assets | $ | 2,826,935 | $ | 2,521,968 | ||||||||
| Liabilities and Stockholders’ Equity | ||||||||||||
| Accounts payable and bank overdraft | $ | 304,604 | $ | 255,251 | ||||||||
| Accrued payroll, bonus, and employee benefits | 142,747 | 160,008 | ||||||||||
| Accrued occupancy expenses and deferred rents | 80,115 | 81,867 | ||||||||||
| Current maturities of capital lease obligations | 71,989 | 66,887 | ||||||||||
| Other current liabilities | 235,204 | 230,332 | ||||||||||
| Total current liabilities | 834,659 | 794,345 | ||||||||||
| Capital lease obligations | 438,879 | 451,597 | ||||||||||
| Deferred rents | 57,918 | 65,932 | ||||||||||
| Other noncurrent liabilities | 125,492 | 116,312 | ||||||||||
| Total liabilities | 1,456,948 | 1,428,186 | ||||||||||
| Stockholders’ Equity: | ||||||||||||
| Preferred stock; $.0001 par value | – | – | ||||||||||
| Common stock; $.0001 par value | 17 | 17 | ||||||||||
| Additional paid-in capital | 1,562,178 | 1,515,333 | ||||||||||
| Retained earnings | 2,540,720 | 2,173,005 | ||||||||||
| Accumulated other comprehensive (loss) income | (10,514 | ) | (2,159 | ) | ||||||||
| Less: Treasury stock | (2,722,414 | ) | (2,592,414 | ) | ||||||||
| Total stockholders’ equity | 1,369,987 | 1,093,782 | ||||||||||
| Total liabilities and stockholders’ equity | $ | 2,826,935 | $ | 2,521,968 |
| PetSmart, Inc. and Subsidiaries | ||||||||||||||||||||||||||||||||
| Condensed Consolidated Statements of Operations | ||||||||||||||||||||||||||||||||
| (in thousands, except per share and store data) | ||||||||||||||||||||||||||||||||
| (Unaudited) | ||||||||||||||||||||||||||||||||
| Thirteen Weeks Ended | Thirteen Weeks Ended | Fifty-Two Weeks Ended | Fifty-Two Weeks Ended | |||||||||||||||||||||||||||||
| February 1, 2015 | % of Sales | February 2, 2014 | % of Sales | February 1, 2015 | % of Sales | February 2, 2014 | % of Sales | |||||||||||||||||||||||||
| Merchandise sales | $ | 1,705,258 | 89.1 | % | $ | 1,609,430 | 89.2 | % | $ | 6,262,624 | 88.0 | % | $ | 6,111,702 | 88.3 | % | ||||||||||||||||
| Services sales | 198,203 | 10.4 | % | 185,532 | 10.3 | % | 807,919 | 11.4 | % | 766,006 | 11.1 | % | ||||||||||||||||||||
| Other revenue | 10,324 | 0.5 | % | 9,904 | 0.5 | % | 41,430 | 0.6 | % | 38,919 | 0.6 | % | ||||||||||||||||||||
| Net sales | 1,913,785 | 100.0 | % | 1,804,866 | 100.0 | % | 7,111,973 | 100.0 | % | 6,916,627 | 100.0 | % | ||||||||||||||||||||
| Cost of merchandise sales | 1,165,982 | 60.9 | % | 1,098,871 | 60.9 | % | 4,360,713 | 61.3 | % | 4,222,542 | 61.0 | % | ||||||||||||||||||||
| Cost of services sales | 140,854 | 7.4 | % | 130,093 | 7.2 | % | 555,087 | 7.8 | % | 539,229 | 7.8 | % | ||||||||||||||||||||
| Cost of other revenue | 10,324 | 0.5 | % | 9,904 | 0.5 | % | 41,430 | 0.6 | % | 38,919 | 0.6 | % | ||||||||||||||||||||
| Total cost of sales | 1,317,160 | 68.8 | % | 1,238,868 | 68.6 | % | 4,957,230 | 69.7 | % | 4,800,690 | 69.4 | % | ||||||||||||||||||||
| Gross profit | 596,625 | 31.2 | % | 565,998 | 31.4 | % | 2,154,743 | 30.3 | % | 2,115,937 | 30.6 | % | ||||||||||||||||||||
| Operating, general, and administrative expenses | 373,559 | 19.5 | % | 349,417 | 19.4 | % | 1,445,953 | 20.3 | % | 1,422,619 | 20.6 | % | ||||||||||||||||||||
| Operating income | 223,066 | 11.7 | % | 216,581 | 12.0 | % | 708,790 | 10.0 | % | 693,318 | 10.0 | % | ||||||||||||||||||||
| Interest expense, net | (12,771 | ) | -0.7 | % | (12,853 | ) | -0.7 | % | (51,405 | ) | -0.7 | % | (51,779 | ) | -0.7 | % | ||||||||||||||||
| Income before income tax expense and equity income from Banfield | 210,295 | 11.0 | % | 203,728 | 11.3 | % | 657,385 | 9.2 | % | 641,539 | 9.3 | % | ||||||||||||||||||||
| Income tax expense | (83,058 | ) | -4.3 | % | (78,350 | ) | -4.3 | % | (252,222 | ) | -3.5 | % | (239,444 | ) | -3.5 | % | ||||||||||||||||
| Equity income from Banfield | 4,861 | 0.3 | % | 6,138 | 0.3 | % | 20,973 | 0.3 | % | 17,425 | 0.3 | % | ||||||||||||||||||||
| Net income | $ | 132,098 | 6.9 | % | $ | 131,516 | 7.3 | % | $ | 426,136 | 6.0 | % | $ | 419,520 | 6.1 | % | ||||||||||||||||
| Earnings per common share: | ||||||||||||||||||||||||||||||||
| Basic | $ | 1.33 | $ | 1.29 | $ | 4.29 | $ | 4.06 | ||||||||||||||||||||||||
| Diluted | $ | 1.32 | $ | 1.28 | $ | 4.26 | $ | 4.02 | ||||||||||||||||||||||||
| Weighted average shares outstanding: | ||||||||||||||||||||||||||||||||
| Basic | 99,416 | 102,076 | 99,301 | 103,203 | ||||||||||||||||||||||||||||
| Diluted | 100,198 | 102,992 | 100,033 | 104,316 | ||||||||||||||||||||||||||||
| Stores open at beginning of each period | 1,387 | 1,314 | 1,333 | 1,278 | ||||||||||||||||||||||||||||
| Stores opened during each period | 21 | 19 | 77 | 60 | ||||||||||||||||||||||||||||
| Stores acquired during each period | – | – | 1 | – | ||||||||||||||||||||||||||||
| Stores closed during each period | (4 | ) | – | (7 | ) | (5 | ) | |||||||||||||||||||||||||
| Stores open at end of each period | 1,404 | 1,333 | 1,404 | 1,333 | ||||||||||||||||||||||||||||
References
(2016). Retrieved 31 July 2016, from https://www.petcodb.co.za/ag3nt/media/media_items/2015//1433755684.pdf
Altman, E., Nimmo, R., Narayanan, P., & Caouette, J. (2013). Managing credit risk. Hoboken, N.J.: Wiley.
Bull, R. (2008). Financial ratios. Oxford: CIMA.
Financial analysis. (2016). Hbr.org. Retrieved 31 July 2016, from https://hbr.org/topic/financial-analysis
Fridson, M. & Alvarez, F. (2011). Financial statement analysis. Hoboken, N.J.: Wiley.
Paramasivan, C. & Subramanian, T. (2009). Financial management. New Delhi: New Age International (P) Ltd., Publishers.
Robinson, T. (2009). International financial statement analysis. Hoboken, N.J.: John Wiley & Sons.
WIRE, B. (2015). Businesswire.com. Retrieved 31 July 2016, from http://www.businesswire.com/news/home/20150304005081/en/PetSmart-Announces-Fourth-Quarter-Fiscal-Year-2014