Overview
This memo attempts to analyze the financial performance of SAC for the financial year 2005 and 2006. Out of the several different types of financial analysis techniques available, this memo uses the ratio analysis method. It will not provide an exhaustive ratio analysis; rather a limited number of primary liquidity, efficiency and profitability ratios will be analyzed. In addition to calculation of the ratios, this memo also attempts to elaborate upon the proper way to use ratios and ratio analysis. The primary users of ratio analysis are also discussed. Furthermore, this memo goes on to evaluate the calculated ratios, and explain what the calculated figures represent. This analysis has revealed important insights about what the company is doing right, and what it is not doing right.
The memo also discusses some other ratios which are not calculated here, but are widely used to analyze financial data. Moreover, other techniques that can be used to analyze financial statements and financial data are also discussed briefly. Lastly, the memo also mentions certain recommendations, which are likely to improve the company’s performance, based upon the brief ratio analysis conducted.
Ratio Analysis Explanation
Calculating the ratios and interpreting the results are two totally different things. Ratio analysis can never be done in isolation, i.e. It is incorrect to analyze each ratio individually, or the ratios of each year individually. Instead, an overall approach needs to be taken. It is a general practice to compare the company’s ratio with its historical performance and the ratios of other similar firms. It gives a better perspective and context for the analysis (Sulivan, 2011).
Furthermore, there are certain benchmarks that can be used to judge the ratios, but it needs to be realized that each industry and company is unique. For instance, a company in the growth stage has different financial ratios than a company that is well established in the same industry. So, while doing the ratio analysis such things need to be kept in mind (White, Sondhi, & Fried, 2010).
Ratio analysis is of great use to a number of stakeholders of the company. First of all, it provides the management with the information about the performance of the company, whether it has improved, remained constant or rather deteriorated. It is also of great importance for the investors, particularly profitability ratios, because the primary concern of the investors is the returns that they get. Moreover, these ratios are of great concern for the creditors, too; particularly the liquidity and solvency ratios, because the major concern of the creditors is a safe return of their money with some interest. These ratios are also of use to the credit rating agencies, who assign ratings to the various instruments of the companies, such as corporate bonds (Garrison, Noreen, & Brewer, 2010).
Ratio Calculation
The above mentioned ratios have been calculated from the data provided in the SAC annual reports (SAC annual report 2005 and SAC annual report 2006).
Evaluation of the Ratios
The results of the calculated ratios show a sound condition of the company, there is no industry data or past data available to compare these results, but the available ratios represent a good financial condition.
The current ratio has decreased a bit, but it is still over 1.40, which means that for every $1 owed in Current Liabilities, the company has $1.4 worth of Current Assets. This shows that the liquidity of the company is good.
The Debt to Equity ratio is pretty low, in both the years. This shows that the company is less likely to have any solvency issues in the short term future, and the company has financed most of its operations through equity, rather than debt. This is a good thing from the point of view that the company has a lot of room to borrow, if the need arises. However, it can also be concluded that the company is relying too heavily on equity. Given the fact that cost of debt is lower for a company as compared to the cost of equity, the company may also consider financing more of its operations through debt.
The inventory turnover of the company has decreased from 3.11 last year to 2.74 this year, which shows that the efficiency of the company to make sales has decreased, and the company is taking longer to make the sales. Another possible reason in this case can be the fact that the company is purchasing more inventory than it should, keeping in mind the demand conditions. This is a probable source of additional costs.
Account Receivables turnover has remained constant over the two years, and it is at a healthy above 18 level. This means that the company efficiently recovers the money from its customers.
The overall gross profit margin has decreased from 49% to 40%, this is a significant decrease. It shows that the cost of goods sold has increased during the last year. One reason of this can be the increased inventory cost, which could have been incurred due to the decreased inventory turnover. There can also be other reasons, such as a general increase in the prices of the raw material.
Other Financial Analysis
Ratio analysis is a very popular method of analyzing financial data, but it is not the only one. Common size analysis and analysis based upon concerned parties are two other such methods (White, Sondhi, & Fried, 2010). In common size analysis the contribution of different accounts, for instance, COGS etc is measured against a base account, e.g. Total sales. Common size analysis can be vertical or horizontal, as well. Concerned party analysis means taking a management perspective of investor perspective. It can either be internal analysis of external analysis.
Following are some other major ratios, which are not calculated here, but are of vital importance (Sulivan, 2011):
- Cash conversion cycle
- Working capital
- Interest coverage ratio
- Net profit margin
- Free cash flows
Recommendations for Improvements
After analyzing the calculated ratios, I have come up with the following recommendations:
- To increase the gross profit margin, COGS needs to be minimized.
- The probable source of increase in COGS is the increased inventory cost. The company should try and improve its inventory turnover, in order to decrease the inventory cost.
- If a faster sale is not possible, the company should try and implement Just-In-Time inventory system, which would automatically decrease the cost.
- Also the Deb to Equity ratio is too low, which means that the company can take significant amount of loans. And since the cost of debt is lower than the cost of equity, the company can raise more money through debt and bring costs down, as well.
References
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2010). Managerial Accounting. New York: McGraw-Hill.
Sparkling Automative Company. (2005). Annual Report 2005. San Diego: SAC.
Sparkling Automative Company. (2006). Annual Report 2006. San Diego: SAC.
Sulivan, R. (2011). Financial Reporting And Analysis. Kansas: CFA institute.
White, G., Sondhi, A., & Fried, D. (2010). The Analysis And Use of Financial Statements. New York: Wiley.