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BAD 306
INSTRUCTOR:
GROUP MEMBERS:
RITA MALIAN
RAZMIG KAPRIELIAN
DIKRAN OHANESIAN
18.10.2010
Introduction
Financial and operating ratios allow one to focus on various areas of business
of the transformed data from these two financial statements makes it possible to
more solid footing you're on when analyzing its prospects. Understanding the
toward understanding why some businesses simply have better economics than
others do.
This paper analyzes the case of 5 industries (Electric utility, Japanese trading
chain) and their corresponding balance sheets and financial ratios (Appendix A)
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Electric utility companies require a large infrastructure in order to produce or
deliver their product, that is, they require a large asset base to generate sales.
Large asset base means a low asset turnover. Electric utilities usually have low
high fixed costs and low variable costs lead to high profit margins and an
acceptable ROA. Their cost of goods sold, mostly variable costs that fluctuate
with sales, don’t rise incrementally with sales or rises at a much slower rate, so
any sale beyond the FC leads to pure profits. On the other hand, this kind of
expected they cannot cover their fixed costs and get into trouble. Electric utilities
have lots of capital tied up in property, plant and equipment (that is why the
owners’ equity or the capital employed in the firm is high), consequently they
have lots of debt outstanding, and so their interest costs are high.
have steady inflows of receipts and can safely afford to have high debt/equity
low levels of inventory and thus a high inventory turnover rate indicating efficient
management of inventory.
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The balance sheet that satisfies this criteria is B (Low cash (2.7%), high Property
and equipment (66.6 %, High owners’ equity (35.2%), Profit margin (0.14), Long-
term liabilities=52.9 % (30 + 22.9%) of, ITR = 10, average collection period = 48
To further support this conclusion, let us continue by analyzing the two other
Both industries have high fixed assets (lower asset turnover) and total liabilities.
low volume demand) and thus lower inventory turnover. Prepayments made by
customer advances which fall under “Other current liabilities” in the balance
sheet. However, their total assets usually exceed their total liabilities, that is why
they’ve a high owners’ equity (capital employed in the firm). Because these types
can't raise cash as quickly. Since the inventory on their balance sheet is normally
ordered months in advance, it can rarely be sold fast enough to raise money for
short-term financial crises (by the time it is sold, it may be too late). It's easy to
see why companies such as this must keep enough cash on hand to get through
All these trends help us conclude that the balance sheet belonging to the
liabilities(27.4%), low long-term debt (8.1%), low level of inventory turnover (1.1.),
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low receivables (11.5%)). Moreover, the company has a high current ratio
(CA/CL) showing that it is capable of servicing its short-term obligations and that
is due to customer prepayments and has a low Debt to Equity ratio due to the low
The Automobile manufacturer, on the other hand, would have a lower level of
inventory, a higher inventory turnover, higher long-term debt and thus higher
Debt to Equity ratio. Auto industry is also characterized by the Captive Finance
company’s products with the purpose of encouraging the sale of the product.
This is why the receivables and notes payable figures of Auto manufacturers are
The analysis helps us conclude that the balance sheet belonging to the
(17.4%), High D/E (1.6), High A/R (31.7%), High N/P (38.4%), long collection
We are left with two balance sheets and two companies: Supermarket chain and
Supermarket chains like most retailers have high variable costs, meaning that
their costs fluctuate with sales levels and high inventory levels. At the same time
and unlike other retailers, supermarkets have relatively more capital tied up in
fixed assets like plant and equipment. When sales go up, this kind of company’s
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round sales). The cost to add new customers is high, which means that profit
margins are usually low. If successful though, high variable-cost firms have high
asset turnover rates (sales/asset), which are just as powerful as profit margins at
influencing overall profitability (NI/OE). Since everyone needs groceries all year
round, sales volume is high and fairly recession-proof. Balances are usually
and a short collection period. Moreover, such companies that have high inventory
turns and do business on a cash basis need very little working capital (current
assets minus current liabilities). These types of businesses raise money every
time they open their doors, then turn around and plow that money back into
inventory to increase sales (that is why the percentage of cash on their B/S is
low). Since cash is generated so quickly, managements can simply stockpile the
proceeds from their daily sales for a short period of time if a financial crisis
arises. For the same reason, there is no need to have a large amount of working
capital available.
Thus, the risk to these types of businesses is their lack of pricing power. They
don’t have a lot of room to raise prices and if they lower prices without
their sales volume, they won’t cover their variable costs, which will decimate net
income.
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Between the two balance sheets that we are left with, C matches the
supermarket chain the best (Low cash (1.4%), Low working capital (-8.2%), High
inventory (23%), High fixed assets (49.9%), High Inventory Turnover (10), low
receivables (2.9%), short collection period (3 days), low profit margin (0.02), high
asset turnover (3.2), high ROE (0.41)). It has the lowest current ratio among the
Finally, the Japanese trading company is only left with Balance Sheet D to be
matched with. Let us see if the figures in this Balance Sheet are representative of
A trading company is a firm that connects buyers and sellers within the same or
different countries but foes not get involved in the owning or storing of
merchandise; that is why such companies have minimal inventories and high
inventory turnover. They have low levels of fixed assets and owner’s equity.
Trading companies usually have a high level of debt (High debt and debt-to-
equity ratios) balanced by a high level of receivables with long term collection
periods and a high level of investments (loans and securities). The majority of
their debt is current or short-term, reflecting the short maturities of their loans.
Like other high-variable-cost firms, trading companies have high asset turnover
rates that can almost offset their low profit margins and ROE (due to the very
All these meet the figures in Balance Sheet D (High Receivables (60.3%), low
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low OE (4.3%), low profit margin (0.01), low ROE (0.13), high Asset Turnover
(2.1), long collection period (106 days), high inventory turnover (23), high debt
The two companies with the lowest quick ratios (CA-Inv/CL) are the supermarket
chain & the Aerospace manufacturer, which is not surprising since these are the
Conclusion
This paper was intended to show that industries have balance sheet and financial
characteristics that set them apart from others. These characteristics are often
used to compare firms within an industry. Summarized data should be used with
caution, however. Different firms (even in the same industry) classify identical
items differently. Thus the analyst should examine original financial statements to
these differences are often useful starting points for obtaining a better