Analysis of Financial Statements for Panorama

When deciding on whether or not to invest in or work with another company, an evaluation of the financial statements is very important. Financial ratios based on the financial statements are used to evaluate the health of an organization. The ratios can be used to compare the performance from one reporting period to the next, or can be used to compare against other companies in the same industry. The steps to analyzing a company involve determining the ratios to use, determining the weighting factors for each of the ratios, and asking the right questions to determine the relative importance of the ratios.

Determining Weighting Factors

In evaluating the financial health of an organization, different financial measures can be used. However, not all these financial measures will have the same importance to the evaluator. Weighting of financial ratios is done to state the relative importance of each of the types of financial ratios (U.S. Department of Education, 1997). In the simulation, there were four different categories of financial measures that were evaluated: (1) turnover, (2) liquidity, (3) capital structure, and (4) profitability. Determining how much weight to provide to each measure requires that the analyst review the company's expectations in order to ask the right questions to determine what information will be most valuable to the company.

Turnover Ratios

Turnover ratios, also known as efficiency or activity ratios, measure how effectively a firm is using resources. In general, for all these ratios, a higher ratio is better for the company (NetMBA, 2005). The simulation covered the inventory turnover ratio, the receivables turnover ratio, and the asset turnover ratio.

Inventory Turnover

This ratio is calculated by dividing cost of goods sold by inventory. The ratio shows the number of times inventory is pushed through the company in a year. High turnover ratios reflect usually indicate that sales are strong; however, this could also occur if the company is storing too little inventory, which may mean lost sales (Wiliax, 2005).

Receivables Turnover

The receivables turnover ratio is calculated by dividing net credit sales by receivables. This ratio shows the number of times receivables turn over in a year. The higher this ratio is, the shorter the time between sale and cash collection. Ratios that are low compared to the industry average indicate that the company needs to review their credit policy (American Express, 2003).

Asset Turnover

The asset turnover ratio indicates how well the firm is using the fixed assets in order to generate revenue. The ratio is calculated by dividing sales by fixed assets. The higher the number, the more efficient the company is at using assets; however, the pricing strategy can affect this number (Investopedia, 2005).

Liquidity Ratios

Liquidity ratios indicate how well the company pays off short-term debt. Most frequently these ratios are used to determine whether or not a lender wants to extend credit to the company (NetMBA, 2005). Two types of liquidity ratios were considered in this simulation: (1) the current ratio and (2) the quick ratio.

Current Ratio

The current ratio is used to determine if the company has enough assets to cover liabilities. This ratio is calculated by dividing current assets by current liabilities. A high ratio is usually a positive indicator, but the composition and quality of the assets must also be considered (Wiliax, 2005).

Quick (Acid Test) Ratio

This ratio is calculated by taking current assets less inventory divided by current liabilities. The acid test eliminates inventory to reflect how much the most liquid current assets can cover the current liabilities. Any value less than 1 indicates that the company does not have enough liquid current assets to cover their current liabilities, and therefore might need to sell off inventory and assets to cover the costs (Wiliax, 2005).

Capital Structure (Leverage Ratios) and Coverage Ratios

Leverage ratios are used to determine how much of the company's assets are financed. The higher these ratios are, the less likely that lenders will be willing to extend credit. The simulation covered the debt to equity ratio and the interest coverage ratio (Virtual Advisor, 2003).

Debt to Equity Ratio

The debt to equity ratio is used to determine how much of the company is financed by debt rather than by owners. A higher than normal debt to equity ratio can indicate that a company is providing a higher than normal return for the stockholder; however, this can also indicate that the company is involved in more risk (Chau, 2003).

Interest Coverage Ratio

The interest coverage ratio determines the number of times a company can make an interest payment based on their net income. The interest coverage is calculated by dividing the earnings before interest and taxes (EBIT) by interest expense. A value under 1 may indicate a company that is unable to cover obligations; however, companies with consistent ratios can keep this number low (Anderson, 2002).

Profitability Ratios

Profitability ratios indicate how well the company is operating based on sales and investments (BizPlanIt, 2003). The simulation covered return on investment, return on equity, and operating profit margin.

Return on Investment

The return on investment (ROI) shows the profit per dollar of assets; ROI also referred to as the return on total assets. The return on investment should always be higher than the rate of return on another risk-free investment (BizPlanIt, 2003).

Return on Equity

The return on equity is calculated by dividing the net income by the average stockholders equity. This ratio is used to determine how well the "company used reinvested earnings to generate additional earnings" (Wikipedia, 2005, ¶2).

Operating Profit Margin

Operating profit margin is the profitability without taxes and interest. Higher operating profits can indicate a good control of operating costs, or that sales are increasing more quickly than the company can increase spending. The ratio is calculated by dividing earnings before interest and taxes (EBIT) by sales (BizPlanIt, 2003).

Growth Ratios

Growth ratios measure the increase (or decrease) in sales, net income, earnings