This is “Wrap-Up of Chapter Example”, section 13.4 from the book Accounting for Managers (v. 1.0).
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Recall the dialogue at Chicken Deluxe between Sandy Masako, the CEO; Dave Roberts, the CFO; and Karen Kraft, the purchasing manager. Chicken Deluxe must choose between Deep Fizz Company and Extreme Fizz, Inc., as the supplier of the company’s beverages. Dave was asked to evaluate the financial condition of each company and report back to the group. The group reconvenes the following month, where Dave presents the financial measures for each company. As you read the dialogue, refer to Table 13.3 "Summary of Financial Ratios for Deep Fizz Company; Extreme Fizz, Inc.; and the Industry Average"; it is the summary of financial measures that Dave provides to the group.
Table 13.3 Summary of Financial Ratios for Deep Fizz Company; Extreme Fizz, Inc.; and the Industry Average
|Deep Fizz||Extreme Fizz||Industry Average|
|1.||Gross margin ratio||63.1 percent||54.1 percent||53.1 percent|
|2.||Profit margin ratio||22.1 percent||23.2 percent||19.2 percent|
|3.||Return on assets||15.1 percent||17.3 percent||14.2 percent|
|4.||Return on common shareholders’ equity||36.5 percent||34.9 percent||34.7 percent|
|5.||Earnings per share||$2.01||$3.76||Not applicable|
|Short-Term Liquidity Measures|
|6.||Current ratio||0.85 to 1||1.25 to 1||1.20 to 1|
|7.||Quick ratio||0.62 to 1||0.87 to 1||1.10 to 1|
|8.||Receivables turnover ratio||9.10 times||10.18 times||9.70 times|
|9.||Average collection period||40.11 days||35.85 days||37.63 days|
|10.||Inventory turnover ratio||5.12 times||7.86 times||7.50 times|
|11.||Average sale period||72.29 days||46.44 days||48.67 days|
|Long-Term Solvency Measures|
|12.||Debt to assets||0.34 to 1||0.38 to 1||0.48 to 1|
|13.||Debt to equity||0.67 to 1||0.86 to 1||0.94 to 1|
|14.||Times interest earned||31.60 times||38.93 times||10.70 times|
|Market Valuation Measures|
|16.||Price-earnings ratio||19.34 times||20.31 times||14.60 times|
|Sandy:||Let’s get started! Dave, what do you have for us?|
|Dave:||I used several different financial ratios to evaluate profitability, short-term liquidity, long-term solvency, and market valuation for Deep Fizz Company and Extreme Fizz, Inc., Here is a summary of the results. Items 1 through 4 show that both companies are doing very well with regard to profitability, and exceed the industry average in all four categories. Earnings per share are not relevant for comparative purposes because different companies have different amounts of shares outstanding.|
|Sandy:||The profitability measures look good for both companies. What about the balance sheet?|
|Dave:||For the most part, Extreme Fizz has the edge on short-term liquidity, with top marks for all short-term liquidity measures. However, Deep Fizz is not far behind. Based on items 6 through 11, I consider both companies to have strong short-term liquidity. The only concern is with Deep Fizz’s slow inventory turnover, which is well below Extreme Fizz and the industry average.|
|Sandy:||What about long-term solvency? Given both companies have strong profitability and excellent short-term liquidity, my biggest concern is whether these companies are able to meet long-term obligations.|
|Dave:||The short answer is both companies will be able to meet long-term obligations as indicated in the debt to assets, debt to equity, and times interest earned ratios. Also notice that both companies have large market capitalizations, and price-earnings ratios are strong across the board!|
|Sandy:||So what do we get from all this information?|
|Dave:||Both companies are solid. We shouldn’t have to worry about either company having financial difficulties in the near future.|
|Karen:||Looks like we’ll have to review other factors in deciding which company to use as our supplier.|
|Sandy:||I agree. Thanks, Dave, for your analysis. If nothing else, this puts my mind at ease about whichever company we ultimately select as our supplier.|
As you can see from the Chicken Deluxe example, analysts use many different financial measures to evaluate financial performance. In the case of Deep Fizz and Extreme Fizz, both companies appear to be strong performers. Armed with this information, management can confidently choose either company knowing the winner will be on solid financial ground for years to come.