Financial Ratios Calculation & Interpretation
Looking at the Rate of Return on Equity (ROE), it is clear that the shareholders of Plume Inc. are better off than those of Arrow Company as their earnings for each dollar invested seems to be much higher. When it comes to the Return on Assets (ROA), the higher value of the same in regard to Plume Inc. shows that the entity’s assets are being used more effectively than those of Arrow Company to generate profits. A comparison of the gross margin between the two companies shows that Plume Inc. maintains a higher proportion of revenue (per dollar) as gross profit. That is, for each revenue dollar, $0.44 is retained. This is in comparison to Arrow Company’s retention of $0.40 for each revenue dollar. According to Gill & Chatton (1999), the inventory turnover ratio is essentially a measure of the number of times an entity’s merchandise is replaced on an annual basis. Thus in that respect, it is clear that Arrow Company turns over its inventory more times (annually) in comparison to Plume Inc. It therefore means that Arrow Company is well-off than Plume Inc. when it comes to filling the orders of clients on time.
When it comes to the collection period, Plume Inc. seems to have a higher collection period than Arrow Company. This effectively means that Plume’s credit sales take longer to be collected. In regard to the fixed asset turnover ratio, it seems that Arrow Company is able to generate a higher revenue figure than Plume Inc. using its investments in fixed assets. This is mainly because its fixed assets turnover figure is higher than that of Plume Inc. Next, we have debts to assets ratio. This ratio is basically a measure of the proportion of a given firm’s assets whose financing is being undertaken by way of debt. Hence looking at the debt to asset ratio of the two companies, it is clear that a higher proportion of Arrow’s assets are being financed using debt in comparison to those of Plume Inc.
In regard to the debt to equity ratio, we have Arrow Company having a higher figure of the same than Plume Inc. This means that in comparison to Plume Inc., Arrow Company has been using a higher debt figure to finance its growth. This could be risky if the returns the firm generates become outweighed by the debt accrued. Next is the current ratio which according to Tracy (2009), measures the readiness of an entity to settle its obligations (short-term). Thus in this regard, Plume Inc. which has a higher current ratio is better placed than Arrow Company to settle its short-term obligations when they fall due. Lastly, we have the acid test ratio. This ratio eliminates the stock figure from that of current assets and like the current ratio; it is used to measure the liquidity of a firm. The quick ratio may in some instances be preferred over the current ratio as it is inherently difficult to turn some assets into cash. In regard to the two companies, the quick ratio brings out Plume Inc. As being more risky as it is more likely to default on its short-term obligations. According to Tracy (2009), the quick ratio of a firm should ideally be grater than 1.
Part B: Health and Risk Analysis in Brief
Looking at the debt to asset ratio, Arrow Company comes across as being more risky than Plume Inc. This is basically because its higher debt to assets ratio exposes it to a larger amount of debt which both investors and creditors may be wary of. Further, the higher debt to equity ratio in the case of Arrow Company could put the company in risky position if the level of debt used becomes too high. Using these two financial leverage ratios, one can conclude that the solvency of Arrow Company is not guaranteed in the long-term. The lower current ratio in the case of Arrow Company also means that it is more risky than Plume Inc. In the eyes of creditors. However, looking at the quick ratio, Plume Inc. whose quick ratio is less than 1 comes across as being less appealing particularly to creditors than Arrow Company. When it comes to the profitability ratios, Plume Inc. seems much more successful in profit generation than Arrow Company. Thus using the gross margin ratio as well as ROA and ROE as presented in the text above, one could argue that Plume Inc. is more profitable than Arrow Company. Based on the profitability and risk analysis in this section, Plume Inc. seems to be less risky and in better financial health than Arrow Company.
Part C: Overall Reaction to the Exercise
The relevance of financial ratios cannot be overstated especially when it comes to charting the anticipated performance of a given firm going forward. With that in mind, this exercise enabled me to gain hands-on skills on working with ratios. The real life examples involving the two companies give the exercise a more practical feel. However, for learning purposes, it would also be better to compare several financial statements (for different years) of each company so as to ease the analysis of the company’s performance over time.
Gill, J.O. (1999). Understanding Financial Statements: A Primer of Useful Information.
Tracy, J.A. (2008). How to Read a Financial Report: Wringing Vital Signs Out of the Number. John Wiley and Sons.
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