7.2 Comparison of Financial ratios for investment decision

 

Financial ratios are determined relationships from financial information of a company which are used for the purposes of comparison (Editorial, n.d.). In this case of study the compared companies are fashion forward and dream design. Prior to the calculation of the two companies’ financial ratios, some important definitions and articulations are based on the following discussion,    

1. Definition, calculation and articulation of every financial ratios

a.       Profit margin ratio is remaining profit from sales after having been paid the expenses

Profit margin ratio:  ( Total Revenue - Total Expenses ) / Total Revenue  (Team, 2021).

Profit Margin = Net income / Revenue (Segal, 2021)

5% profit margin is considered low, 10 % is average and 20 % is high  (Anonimous,2021)

b.      Return on asset (ROA)

Net income / Total average assets 

In general, ROA > 5% are considered good and > 20% are excellent (Hargrave, 2021).

c.       Current ratio

Current Ratio = Current assets / Current liabilities (Fernando, 2021a). Good current ratio is 1.2 to 2 meaning that the current assets are 1.2 to 2 times the liabilities

d.      Quick ratio 

QR = (CE + MS + AR)/CL

Note :

QR = Quick ratio

CE = cash and equivalence

MS = marketable securities

AR = accounts receivable

CL = Current liabilities

(Seth, 2021)

 

Idealized quick ratio is 1 : 1 meaning that meeting current liabilities is not required in the context of technical solvency purposes. (Vaidya, n.d.).

e.       AR turnover ratio

Account receivable turnover ratio = Net credit sales / Average account receivables (Murphy, 2021)

An average of 10 is considering the company stays behind the peers and the greater the less behind.

(Planergy, n.d.) 

f.       Average collection period

It is the average number of days for clients to pay for their bills (Bdc, n.d.). Division of the average balance of AR by total net credit sales for the period, then multiplication of the result by the number of days in the period or  dividing the number of days in the period by the AR turnover. (Kenton, 2021).

g.      Inventory turnover ratio

COGS / average value of inventory (Fernando, 2021b). COGS = Cost Of Good Sold = cost of sales.

Idealized inventory turnover ratio is between 5 and 10 which means that every one or two months roughly the company will restock, sell and restock the inventory (Jenkins. 2020)          

h.      Average sales period

365 / Inventory turnover ratio (Heisinger, & Hoyle. (n.d.))

i.        Debt to equity ratio

Debt/Equity= Total Liabilities / Total Shareholders’ Equity​​
the less the ratio, the better the financial health of the company meaning that the debt is not more than the equity. (Fernando, 2021b)

2. Results, Comparisons of the two companies, Computational evaluation and explained meanings

No	Financial ratios	Fashion forward	Dream design	Difference	Comparison (Fashion Forward)
1	Profit Margin Ratio	0.0546	0.03935185185	0.01524814815	Higher
2	Return on Assets	0.04917146974	0.04812455768	0.001046912062	Higher
3	Current Ratio	1.165688488	1.386200106	-0.2205116185	less
4	Quick Ratio	1.805643341	1.948496554	-0.142853213	less
5	AR Turnover Ratio	10	24.68571429	-14.68571429	less
6	Average Collection Period	36.5	14.78587963	21.71412037	higher
7	Inventory Turnover Ratio	12.5	16.25	-3.75	less
8	Average Sales period	29.2	22.46153846	6.738461538	less
9	Debt to Equity Ratio	0.7985098801	0.7804939516	0.01801592853	Higher

 

No	Financial ratios	Standardized Evaluation	Meanings
1	Profit Margin Ratio	<10 %(low profit margin)	FF has higher Profit Margin
2	Return on Assets	<5% (Not good ROA)	FF has better return on asset
3	Current Ratio	1.2 to 2 (good Current ratio)	DD has better current ratio
4	Quick Ratio	> 1 (both are not ideal)	FF is near to 1 than DD
5	AR Turnover Ratio	>=10 more and more lagging behind the peers	FF has better ARturnover ratio
6	Average Collection Period	< 30 days is better	DD has better collection period
7	Inventory Turnover Ratio	ideal ratio : between 5 and 10.	FF is nearer to 10
8	Average Sales period	the less period of sales the better	DD has better average sales period
9	Debt to Equity Ratio	the less ratio the better	DD has better DtoE ratio

3. Well rationally supported recommendation

No	Financial ratios	Meanings	FF	DD
1	Profit Margin Ratio	FF has higher Profit Margin	1	0
2	Return on Assets	FF has better return on asset	1	0
3	Current Ratio	DD has better current ratio	0	1
4	Quick Ratio	FF is near to 1 than DD	1	0
5	AR Turnover Ratio	FF has better ARturnover ratio	1	0
6	Average Collection Period	DD has better collection period	0	1
7	Inventory Turnover Ratio	FF is nearer to 10	1	0
8	Average Sales period	DD has better average sales period	0	1
9	Debt to Equity Ratio	DD has better DtoE ratio	0	1
		The winner is FF	5	4

 

Based on the above analysis, the winner for investment is the Fashion forward. The company should invest in fashion forward retail.

 

References

Editorial, I. (n.d). Financial ratios - encyclopedia - business terms. Inc.com. Retrieved October 20, 2021, from https://www.inc.com/encyclopedia/financial-ratios.html.

Segal, T. (2021, October 13). Profit margin. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/p/profitmargin.asp.

Anonimous. (2021, January 2). Profit margin. Corporate Finance Institute. Retrieved October 21, 2021, from https://corporatefinanceinstitute.com/resources/knowledge/accounting/profit-margin/.   

 Team, I. E. (2021, February 23). How to calculate a profit margin ratio. Indeed Career Guide. Retrieved October 20, 2021, from https://www.indeed.com/career-advice/career-development/how-to-calculate-profit-margin-ratio.

 Hargrave, M. (2021, October 18). Return on assets definition. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/r/returnonassets.asp.

Fernando, J. (2021a, October 13). What is the current ratio? Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/c/currentratio.asp.

Liquidity. (2021, October 1). What is a good liquidity ratio? FreshBooks. Retrieved October 21, 2021, from https://www.freshbooks.com/hub/accounting/good-liquidity-ratio. 

Seth, S. (2021, October 20). Quick ratio. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/q/quickratio.asp.

Vaidya, D. (n.d). Quick ratio. Wallstreetmojo. Retrieved October 21, 2021, from https://www.wallstreetmojo.com/quick-ratio/.    

Murphy, C. B. (2021, October 13). Why the receivables turnover Ratio Matters. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/r/receivableturnoverratio.asp.

Planergy. (n.d.). How to calculate AR turnover ratio.. Retrieved October 21, 2021, from https://planergy.com/blog/accounts-receivable-turnover-ratio /

Kenton, W. (2021, October 12). Average collection period definition. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/a/average_collection_period.asp. 

Bdc (n.d.). Average collection period standard. Retrieved October 21, 2021, from https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/financial-tools/accounts-receivable-benchmarking-tool-entrepreneurs 

Fernando, J. (2021b, October 13). Inventory turnover: Formula and calculation. Investopedia. Retrieved October 21, 2021, from https://www.investopedia.com/terms/i/inventoryturnover.asp.

Jankins, A. (2021, November 16). Inventory turnover defined : Formula, tips & examples. Oracle netsuit. Retrieved October 21, 2021, from https://www.netsuite.com/portal/resource/articles/inventory-management/inventory-turnover-ratio.shtml.  

Fernando, J. (2021c, October 13). Debt-to-equity (D/E) ratio. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/d/debtequityratio.asp. 

Heisinger, & Hoyle. (n.d.). Average sale period.Ratio analysis of  financials. Retrieved October 21, 2021, from https://2012books.lardbucket.org/books/accounting-for-managers/s17-03-ratio-analysis-of-financial-in.html