Accounting Ratios Essays Examples

The statement that “athletics industry is highly profitable” can be looked upon from several perspectives. First, “athletics industry” is an umbrella term which covers a wide range of this industry segments\sectors. Different sectors, e.g. fitness centre and sports equipment manufacturer, will have different profitability, and as the investment decisions are sector-based, the evaluation should be limited to the specific sector. By Sageworks definition, most profitable industries are those which show net profit margins of 10-20%, and provide rather services than products which allow them keeping overhead costs low and profit margins more predictable. The Bloomsberg industry benchmarks for sports equipment producers demonstrate that on average, this sector does not fit into the definition of highly profitable, with low net margins (below 3%) and high overheads costs (up to 20%). However the comparison of Bloomsberg data with those of Sageworks is not fair enough. Sageworks data are extracted only and exclusively for privately held companies, while the Bloomsberg benchmarks are available from market data for listed companies the consultee is planning to invest in. A possible solution may be analyzing other ratios apart from profitability, e.g. performance where rather attractive returns on equity (up to 20%) demonstrate that industry sector can be profitable for the investors seeking capital gains.

Source: Bloomberg Business, 2014; RMA, 2014.

In 2013, Insane gross profit margin (GPM) was 32.94% or quite in line with (0.64% higher) industry average. However, the significant difference is observed when comparing GPM of 2013 to one of 2012, as it fell 7.08% (32.94% in 2013 vs. 40.02% in 2012). The same decline of 8.56% and 5.3% respectively is observed both in operating (OPM) (16.46% in 2013 vs. 25.02% in 2012) and net profit (NPM) (12.05% in 2013 vs. 17.35% in 2012) margins. This decline can be (and most probably is) connected to 2013 World Championship in Athletics participation in Moscow. The margins from this separate event could have been lower then the company average mainstreams (maybe due to very expensive COS which grew up to the export duties). However compared to the industry average both operating and net profitability of the company remains very high (11.19% and 9.24% higher against the benchmarks of 5.27% and 2.81% respectively) which suggests the company has a very tight administrative expenses control and manages its finance costs well.
Insane liquidity position grew worse in 2013 (current ratio 1.29 vs 2.49 in 2012) which is below industry average of 2.20. The acid test (quick ratio) demonstrates the same trend (current ratio 0.79 vs 1.40 in 2012) however here the company is well above the industry average of 0.25 which indicates that it still has a healthy cashflow. Liquidity changes and 26% increase in year-end inventory compared to 2012 can be possibly explained by a further worldwide expansion of the Company operations and higher stock level needs.
Inventory turnover ratios of Insane improved from 6.33 in 2012 to 7.69 in 2013 and remain stably high compared to the industry average of 2.20. The quick movement and processing of inventory can be indicative of both customers’ satisfaction with the Company’s products (quick turnover, high demand, quick sales) and effective supply chain procedures. The Company is successfully managing its inventory generating it into sales.
Accounts receivable ratio of Insane is 7.27, or 86.63 points lower than the industry average of 93.90. Thiis requires a thorough investigation of such decrease causes. First, it can be a result of increased nationwide presence; second, in the current economic conditions customers may require longer credit terms and pay their debt later. Still, compared to 2012, the accounts receivable ratio has decreased (7.27 vs. 8.69 in 2013) which indicates that Insane has a large potential for improvement of credit control and credit risk management system to reduce the time between sales and cash collection. As the bank overdraft line is close to its sanctioned limit of 600 000$, ignoring the issue of credit policy\receivables control can lead to cash deficit and working capital problems.
Return on assets of Insane remains 19.14% above the industry average (28.90% vs. 9.76%) as the evidence of the higher net margins compared to industry benchmarks. The Company has been demonstrating the tendency of outperforming the industry benchmarks for return on capital, and a favorable rate of return (67.68% vs. industry average of 18.09% is a result of both the impressive growth of total assets and operating profit being 5.27% above industry average). The decrease in ratio from 2012 (67.68% vs. 58.33%) reflects the abovementioned decrease in operating margin. The rate of return on assets demonstrates the Company’s superior position against its competitors and will undoubtedly inspire both investors and lenders when financing decisions are taken. Still, gearing ratio should be accounted for when analyzing the returns. The return on equity is possibly so impressive (112.3% vs. 19.47% industry average) as indirect consequence of the company high leverage: whilst the competitors have a more solid share of equity finance in the portfolio and lower returns, the company has relatively low capitalization rate and relatively high debt. Gearing of Insane raises concerns how safely the company can borrow in future, as it equals 1.27 compared to industry ratios of 0.3. However as the long-term 6% loans are repaid in 2015 only and the company demonstrates a steady improvement in gearing vs. 2.55 in 2012, there is a probability the solvency problems will not arise if the debt\equity funding proportion is closely monitored. So far, the investors will not possibly view Insane as a risky investment – it is not highly geared, but a “red flag” should be set.
Generally, in terms of profitability and returns the company is doing well against the industry benchmarks, even given a slight decrease in profit margins in 2013. Still, both liquidity and leverage require constant control. Currently the company’s ability to generate cash is not affected, but in future, close attention should be paid to working capital management and financing structure.
3. The limitations of ratio analysis are highly illustrated by the scenario. First, the ratios are not always comparable even against the industrial sector benchmarks, as different accounting policies can highly influence the comparison of two companies even in the similar industry. Even being allowed by financial accounting standards (FAS), different accounting treatment of similar items can lead to the comparability of figures being distorted ( e.g. FIFO or weighted average method of accounting for inventory will give differences in COS). Second, the companies can operate different units or divisions in different markets ( e.g. Insane is not a local but globally operating company, probably with some additional divisions in other countries), and thus more detailed analysis(e.g. by segments) is necessary to get a meaningful set of ratios.Third, some ratios can be calculated in a different way ( e.g.ROCE or inventory turnover, which can be derived based both on average and year-end balance sheet figures, which will significantly distort comparability in case of fluctuations in capital employed\inventory during the year). The change in company accounting procedures will also affect ratios, so it is essential to look through the annual reports\notes to the reports to be able to understand year-to-year trends. Such inherent limitations as inflation, seasonality factors, need for analysis of a set rather then single numbers and human factor (risk of a wrong misinterpretation) are also limitations of the ratios.
4. Non-financial issues which should be considred as a part of investment decision are potential resource constraints and threats to the company. Based on both financial and non-financial information from the company annual reports, it is necessary to carefully analyze the available resources to identify possible constraints. Question should be raised e.g. if the company has enough skilled personnel to implement the program for 2014 it announced in the annual statements? External environment threats can be another issue worth thinking. Financial statements can give only an insight into financial risks; however, environmental and market risks should be assessed separately. E.g. the company may know that its competitors are launching an attractive new product but cannot estimate what the impact of the product would be. Kotler and Caslione defined a strategy for investment planning suggesting a careful evaluation of all the possible threats (e.g. competitors, legislation and tax changes, government restrictions etc) and then making estimates.Those can be performed by assigning probabilities to the various outcomes or making sensitivity analysis to ensure the investment decision is based on carefully revised and well-grounded information.
5. The decision on investment depends not only on objective factors such as risks assessment and company performance, but on investor’s risk attitude. If the consultee is risk averse, it is worth choosing another sector with low gearing, higher profit margins and relatively low risks of profitability decrease, e.g. restaurants or financial services industry based on Sageworks or sector data analysis. If the consultee is risk neutral, he can try to invest given the profitability of the company is still well above the industry average, liquidity problems are not anticipated and repayment of bonds in 2015 may subsequently lower gearing. Still, if the decision of investment is taken, he would definitely need to assess such additional information as company full annual reports 2012-2013 which can highlight the potential ratio-distorting isues if any. Also, analyzing the performance apart from 2013 World Championship in Athletics figures (which should be assessed as a separate project as discussed) would be useful to evaluate mainstream profitability. Finally, cash flow statements should be carefully analyzed to derive some free cash flow ratios and to evaluate the company ability to generate cash and thus to pay dividends. Together with the statement of changes in equity, it can provide useful information (e.g. preferred (special) and common dividends) to calculate some investors’ ratios demonstrating the company’s ability to pay dividends from year to year, such as earnings per share (EPS), dividends per share (DPS), dividends payout and profit retention. Finally, the market information such as market value of shares can be searched for to evaluate price\earnings (P\E) ratio, dividends yield and dividends cover. That will give the consultee the possibility to estimate the company value and the trends\fluctuations in it and to make more specific decisions on investment (the quantity of stock units and the best time to buy) to be able to make an effective purchase and to generate gains on the funds invested.

Works Cited

1. Sageworks, 2015. The 15 more profitable industries – a data release. Web. 12 Feb.2015. https://www.sageworks.com/
2. Bloomberg Business, 2014. Specialty Retail Industry Ratios. Web. 12 Feb.2015. http://www.bloomberg.com/research/stocks/financials/ratios.asp?ticker=DKS
3. The Risk Management Association (RMA), 2014. Annual Statement Studies.Financial Retio Benchmarks 2012-2013. Web. 12 Feb.2015. www.rmahq.org.
4.   Kotler, Philip and Caslione, John. Chaotics. Chaotics: The Business of Managing and Marketing in the Age of Turbulence. Amacom, 2009. Print.