Help, I am stuck - In analysing the financial statements of an entity, the following ratios were calculated:?

Question

........................................... 2007 ................... 2008

current ratio..................... 2:1 ........................... 1.3:1

Quick ratio...................... 1:1 ............................ 0.7:1

Receivables turnover...... 30 days .................. 45 days

Inventory turnover............ 3 times ................... 4 times

Profit Margin .......................10% ........................ 7%

Discuss any potential weaknesses that these ratios may reveal in the overall performance of the entity, and discuss possible causes for the results.

Answer 1

Ratios by themselves don't mean much, for the following reasons:

- Companies have a choice of accounting methods (for example, inventory LIFO vs FIFO and depreciation methods). These differences impact ratios and make it difficult to compare companies using different methods. Before you compare ratios, you have to see if the companies have adopted similar accounting policies.

- Companies may have different fiscal year ends making comparison difficult if the industry is cyclical. It's important to know what each company trades in. If 1 trades in toys, and if the year-end is November 30, you'll find lots of inventory cos it'll have stocked up for the X'mas sales. Merchandise inventory goes into the calculation of current ratio.

- Diversified companies are difficult to classify for comparison purposes. It's no point comparing a supermarket to a real estate agency or a sports car manufacturer. The inventory turnover in a supermarket is far far higher than that of the Lamborghini maker. And supermarket items have very low profit margins.

All in, you have to know what 2 companies you're comparing, otherwise you can't make head or tail of the ratios.