Calculate and interpret financial ratios, such as liquidity, profitability, and solvency ratios, for a company's financial analysis.
To perform a financial analysis, we'll calculate and interpret some key financial ratios for a fictional company, XYZ Electronics Inc. We'll use the company's financial statements, including the income statement and balance sheet, to calculate the ratios. Let's assume the following financial data for the analysis:
Income Statement (For the Year Ended December 31, 20XX):
* Total Revenue: $1,500,000
* Cost of Goods Sold (COGS): $900,000
* Gross Profit: $600,000
* Operating Expenses: $350,000
* Operating Income (EBIT): $250,000
* Interest Expense: $50,000
* Net Income: $150,000
Balance Sheet (As of December 31, 20XX):
* Cash and Cash Equivalents: $100,000
* Accounts Receivable: $200,000
* Inventory: $300,000
* Total Current Assets: $600,000
* Total Assets: $1,200,000
* Accounts Payable: $100,000
* Short-Term Debt: $50,000
* Total Current Liabilities: $150,000
* Long-Term Debt: $300,000
* Shareholders' Equity: $750,000
* Total Liabilities & Equity: $1,200,000
Financial Ratios:
1. Liquidity Ratios:
a) Current Ratio:
Current Ratio = Current Assets / Current Liabilities
Current Assets = $600,000
Current Liabilities = $150,000
Current Ratio = $600,000 / $150,000 = 4
Interpretation: The current ratio of 4 indicates that XYZ Electronics Inc. has sufficient current assets to cover its current liabilities. A ratio above 1 is generally considered favorable as it suggests the company has enough short-term assets to meet its short-term obligations.
b) Quick Ratio (Acid-Test Ratio):
Quick Ratio = (Current Assets - Inventory) / Current Liabilities
Quick Assets = $600,000 - $300,000 = $300,000
Quick Ratio = $300,000 / $150,000 = 2
Interpretation: The quick ratio of 2 indicates that XYZ Electronics Inc. has a good ability to meet its short-term liabilities using only its most liquid assets (excluding inventory). A quick ratio above 1 is generally considered favorable.
2. Profitability Ratios:
a) Gross Profit Margin:
Gross Profit Margin = (Gross Profit / Total Revenue) 100
Gross Profit = $600,000
Total Revenue = $1,500,000
Gross Profit Margin = ($600,000 / $1,500,000) 100 ≈ 40%
Interpretation: The gross profit margin of approximately 40% indicates that XYZ Electronics Inc. retains 40% of its revenue as gross profit after deducting the cost of goods sold. Higher gross profit margins are generally preferred as they signify efficient cost management.
b) Net Profit Margin:
Net Profit Margin = (Net Income / Total Revenue) 100
Net Income = $150,000
Net Profit Margin = ($150,000 / $1,500,000) 100 = 10%
Interpretation: The net profit margin of 10% indicates that XYZ Electronics Inc. earns a net profit of 10% of its total revenue. This represents the company's profitability after accounting for all expenses and taxes.
c) Return on Assets (ROA):
ROA = (Net Income / Average Total Assets) 100
Average Total Assets = (Beginning Total Assets + Ending Total Assets) / 2
Average Total Assets = ($1,200,000 + $1,200,000) / 2 = $1,200,000 / 2 = $600,000
ROA = ($150,000 / $600,000) 100 = 25%
Interpretation: The return on assets of 25% indicates that XYZ Electronics Inc. generates a return of 25% on its average total assets. ROA measures how efficiently the company uses its assets to generate profit.
d) Return on Equity (ROE):
ROE = (Net Income / Average Shareholders' Equity) 100
Average Shareholders' Equity = (Beginning Shareholders' Equity + Ending Shareholders' Equity) / 2
Average Shareholders' Equity = ($750,000 + $750,000) / 2 = $750,000 / 2 = $375,000
ROE = ($150,000 / $375,000) 100 = 40%
Interpretation: The return on equity of 40% indicates that XYZ Electronics Inc. generates a return of 40% on its average shareholders' equity. ROE measures the company's profitability from the perspective of its shareholders' investment.
3. Solvency Ratios:
a) Debt-to-Equity Ratio:
Debt-to-Equity Ratio = Total Debt / Shareholders' Equity
Total Debt = Short-Term Debt + Long-Term Debt = $50,000 + $300,000 = $350,000
Debt-to-Equity Ratio = $350,000 / $750,000 ≈ 0.47
Interpretation: The debt-to-equity ratio of approximately 0.47 indicates that XYZ Electronics Inc. has a relatively low level of debt compared to shareholders' equity. A lower debt-to-equity ratio is generally considered favorable as it signifies lower financial risk.
b) Interest Coverage Ratio:
Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense
EBIT = $250,000
Interest Expense = $50,000
Interest Coverage Ratio = $250,000 / $50,000 = 5
Interpretation: The interest coverage ratio of 5 indicates that XYZ Electronics Inc. is generating earnings five times higher than its interest expense. This suggests the company has sufficient earnings to cover its interest payments.
Conclusion:
In conclusion, the financial analysis of XYZ Electronics Inc. reveals a favorable current ratio, indicating