Introduction
In this financial analysis, we will compute various ratios for ABC Group and 123 Company using the information provided in Chart 1 and Chart 2. The ratios will help us gain insights into the companies’ efficiency, liquidity, and overall financial performance, enabling us to make informed investment decisions. The three ratios we will calculate are:
A. Accounts Receivable Turnover Ratio and Number of Days’ Sales in Receivables Ratio for both companies. B. Inventory Turnover Ratio. C. Number of Days’ Sales in Inventory Ratio.
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Financial Ratios Calculations and Interpretations:
A. Accounts Receivable Turnover Ratio and Number of Days’ Sales in Receivables Ratio
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable Number of Days’ Sales in Receivables Ratio = 365 days / Accounts Receivable Turnover Ratio
ABC Group
Accounts Receivable Turnover Ratio = $324,000 / (($75,000 + $125,000) / 2) = 2.16 Number of Days’ Sales in Receivables Ratio = 365 / 2.16 ≈ 169.0 days
123 Company
Accounts Receivable Turnover Ratio = $401,000 / (($92,000 + $123,000) / 2) = 3.15 Number of Days’ Sales in Receivables Ratio = 365 / 3.15 ≈ 115.9 days
Interpretation
A lower number of days’ sales in receivables indicates that a company is collecting its accounts receivable more efficiently, which is favorable (Investopedia, n.d.). Comparing the two companies, 123 Company has a higher accounts receivable turnover ratio and a lower number of days’ sales in receivables ratio, indicating that it is managing its receivables better than ABC Group. As an investor, I would consider investing in 123 Company due to its more efficient accounts receivable management, suggesting better liquidity and reduced credit risk.
B. Inventory Turnover Ratio
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Year 1: Inventory Turnover Ratio = $28,174 / (($29,000 + $10,826) / 2) ≈ 1.75
Year 2: Inventory Turnover Ratio = $12,281 / (($18,261 + $5,980) / 2) ≈ 1.11
Interpretation
A higher inventory turnover ratio indicates that a company is selling its inventory more quickly, which is generally favorable as it reduces holding costs and the risk of inventory obsolescence (Investopedia, n.d.). Comparing the two years, the inventory turnover ratio has decreased from 1.75 in Year 1 to 1.11 in Year 2. This suggests that the company is selling its inventory less efficiently in Year 2, which may be a cause for concern. As an investor, I would investigate the reasons behind this decline in inventory turnover before making any investment decisions.
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C. Number of Days’ Sales in Inventory Ratio
Number of Days’ Sales in Inventory Ratio = 365 days / Inventory Turnover Ratio
Year 1: Number of Days’ Sales in Inventory Ratio = 365 / 1.75 ≈ 208.6 days
Year 2: Number of Days’ Sales in Inventory Ratio = 365 / 1.11 ≈ 328.8 days
Interpretation
A higher number of days’ sales in inventory indicates that a company takes more time to sell its inventory, which could be a sign of potential issues with demand, inventory management, or sales strategies (Investopedia, n.d.). Comparing the two years, the number of days’ sales in inventory has increased significantly from 208.6 days in Year 1 to 328.8 days in Year 2. This indicates that the company’s inventory turnover has slowed down considerably, which might be a concern for investors. Further investigation is necessary to understand the reasons behind this increase in days’ sales in inventory.
Analysis of Outcomes
Based on the financial ratios calculated for ABC Group and 123 Company:
- 123 Company demonstrates better accounts receivable management with a higher turnover ratio and a lower number of days’ sales in receivables ratio, making it more attractive to investors concerned about liquidity and credit risk.
- The inventory turnover ratio for the company decreased from Year 1 to Year 2, indicating less efficient management of inventory. Additionally, the number of days’ sales in inventory increased significantly in Year 2, raising concerns about inventory management and sales strategies.
Challenges Encountered
Throughout Unit 5 assignments, one notable challenge was the availability of reliable and up-to-date financial data for the companies in question. The accuracy of financial ratios heavily relies on accurate financial statements, and obtaining such data can be challenging, especially for privately-held companies or those that do not regularly disclose their financial information.
Course Thoughts
At the midpoint of this course, I find the material covered thus far to be highly informative and practical. The in-depth understanding of financial ratios, their significance, and how to interpret them for investment decisions has been particularly valuable. The course has provided me with a solid foundation in financial analysis and has enhanced my ability to evaluate companies’ financial health. I look forward to the remaining modules and expanding my knowledge in the field of finance and investment.
Conclusion
In conclusion, financial ratios serve as valuable tools for evaluating a company’s performance and financial health. The analysis of accounts receivable turnover, inventory turnover, and their respective number of days’ sales ratios for ABC Group and 123 Company has provided crucial insights for making informed investment decisions. 123 Company appears to be more efficient in managing its receivables, while inventory management raises concerns. As an investor, I would consider these factors carefully before deciding on the best investment opportunity.
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References
Investopedia. (n.d.). Accounts Receivable Turnover Ratio. Retrieved from https://www.investopedia.com/terms/a/accountsreceivableturnover.asp
Investopedia. (n.d.). Inventory Turnover Ratio. Retrieved from https://www.investopedia.com/terms/i/inventoryturnover.asp