Financial Statements Preparation

A financial ratio is a relative immensity of two selected numerical values from a company’s financial statements mainly used to measure the overall financial condition of a firm. Financial ratios are often divided into three main categories; the liquidity ratios, solvency ratios, and profitability ratios. One, liquidity ratios are used to shows the satisfactory of the short-term financial position of an organization. Two, solvency ratios are used to demonstrate the financial soundness of an organization to meet its long-term and short-term liabilities. And lastly, profitability ratios show the market price of the company as well as its overall profitability (Xu et al. 2014).

The current ratio is both a liquidity ratio and an efficiency ratio that measures a business ability to pay off its short-term liabilities using its short-term assets (Beaver, 1966). This ratio helps investors and lenders to understand the enterprise’s liquidity. Also, the ratio is an important measure of liquidity because short-term liabilities that are due are only payable within a year. This means that the business has a limited amount of time to raise funds that will pay off those current liabilities. Red Soda Companycurrent ratio increased from 1.09 while Blue Soda Company current ratio is 0.7. This shows that Red Soda Company can quickly make its existing debt payments than the Blue Soda Company.

An account receivable turnover is a ratio that measures the number of times an enterprise can turn its receivables into cash in a given period. This ratio is also an indication of the quality of credit sales a firm collects from its debtors. A company having a higher accounts receivable ratio shows that it is frequently collecting its receivables as well as its credit sales in a year as it is the case of Red Soda Company which has an account receivable turnover of 2.67. However, Blue Soda Company ratio of 1.7 shows that it can barely collect its receivables even twice a year thus it is also slow when it comes to paying its short-term bills and obligations as well as receiving its credit sales.

Average Collection Period is a ratio that expresses the days a firm takes to collect its receivables. A short collection period of 137 days like that of Red Soda Company shows its prompt collection and better management of receivables. However, a long collection period of 215 days like that of Blue Soda Company, negatively affects the paying ability of short-term debts and this may discourage prospective investors.

Inventory turnover ratio is a ratio that depends on two main components of performance. One, the amounts of inventory purchased by the firm and two, how the company’s sales match the stock purchases (Beaver, 1966). This liquidity ratio shows how effectively stock is managed by comparing the firm’s cost of goods sold with its average stock for a given period. Red Soda Company having an inventory turnover of 4.88 and Blue Soda Company having a ratio of 7.82 shows that Blue Soda Company can efficiently control its merchandise than the Red Soda Company. This means that Blue Soda Company does not over spend on buying too much inventory and waste resources by storing non-salable inventory.

Days in Inventory ratio measures the number of days it will take an organization to sell off its current inventory. Creditors and investors use it to gauge the value of a firm, its liquidity and its cash flow. Blue Soda Company having days in inventory of 47 days shows that its management is keen on making its inventory moves fast, it minimizes on cost and increases cash flow. However, Red Soda Company having a ratio of 75 days shows that the firm’s inventory is selling a bit slower and this may add to the company’s costs.

Current Cash Debt Coverage is a liquidity ratio that measures the relationship between the net cash provided by an enterprise operation and the average current liabilities of the enterprise. This ratio indicates a firm’s ability to pay its current liabilities with its operating activities. Blue Soda Company has a higher current cash debt coverage ratio of 0.77. This shows that this firm’s liquidity position is better regarding its payment of current liabilities from the cash flow of its operations than the Red Soda Company whose ratio is 0.61.

Debt to asset ratio leverage ratio that shows how much of the total amount of assets in a firm are financed by creditors other than its investors. This ratio illustrates how a company has grown and acquired its total assets. Two, it also indicates how leveraged the company is by looking at the enterprise resources owned by shareholders’ in the form of equity and the firm’s resources held by creditors in the form of debt. Investors use this ratio to see the company’s solvency, its ability to pay the return on investments and its ability to raise cash to meet its current obligations. Creditors, on the other hand, want to see how much debt the enterprise already has because they are concerned with a firm’s collateral and the company’s ability to repay its debts (Xu et al. 2014). Blue Soda Company having a high debt to asset ratio of 0.58 will be considered riskier to invest in and loan to because it is more leveraged. However, Red Soda Company, having a lower ratio of 0.49 shows that it will pay a less percentage of its profits in loan principles and interest payments.

Time interest earned is a solvency ratio that measures the proportionate amount of revenue that can be used to cover interest expenses of the enterprise in the future. This is because the interest payments are usually made on a long-term basis and often treated as an ongoing fixed expense. Red Soda Company having a time interest earned ratio of 25.97 shows that the company can pay its interest expense with its earnings before interest and tax 25 times compared to the Blue Soda Company that can only pay its interest expense with its earnings before interest and tax 21 times.

Cash debt coverage is a ratio that measures the relationship between the net cash provided by operating activities and the average total liabilities. Red Soda Company having a high-level ratio of 0.37 shows that the enterprise is financially stable which is a good indicator to the creditors and the investors. However, Blue Soda Company low-level ratio of 0.29 shows that the firm is facing financial stability problems and will not be able to sustain its debt payments soon.

Free cash flow is a ratio that measures how much money a firm generates after accounting for its capital expenditures such as equipment. This ratio is used to indicate how much money in the company can be used for its expansion, paying out of dividends, and reduction of its debt. Red Soda Company having $ 6, 193 is a sign that the firm is healthy and it’s thriving well in its current environment. This is a good indicator for its investors because the company’s share price will soon rise. However, Blue Soda Company having a lower free cash flow of $ 4, 668 shows that the company has less cash to expand its activities and it may be a negative indicator to its investors.

Profit margin is a ratio that measures the amount of net income earned for each dollar of sales generated. This is done by comparing the net income and the net sales of a firm. Investors and creditors use this ratio to measure how effective an enterprise can convert its sales into net income(Xu et al. 2014). Usually, investors want to make sure that the company’s profits are high enough to distribute dividends while creditors want to ensure that the firm generates enough profits to pay its loans back. The Red Soda Company high-level ratio of 0.22 shows that the company has fewer expenses to cater for compared to the Blue Soda Company that has a low-level ratio of 0.14.

Asset Turnover ratio is a profitability ratio that measures the enterprise ability to generate sales from its assets.This ratio is also known as an efficiency ratio because it measures how efficiently a company uses all its assets. This ratio is mostly used by investors to see how a firm is using specific fixed and current assets. Blue Soda Company ratio of 1.09 shows that it is efficiently using its assets. While Red’s Soda Company ratio of 0.64 indicates that the company assets are not being used effectively. This means that the organization is either facing managerial or production problems.

Return on Asset ratio measures the net income produced by a company’s total assets in a given period. The company’s total assets are produced from the company’s biggest investments which are the capital assets. This ratio helps both the management and the investors to gauge how well it can convert its investments in assets into profits in a given period. Blue Soda Company having a ratio of 0.16 shows that the business can efficiently turn the cash used to purchase assets into net income or net profit as compared to Red Soda Company that has a ratio of 0.15.

Return on common stockholders’ Equity measures a company’s success in generating income for the benefit of the common stockholders’. This ratio indicates the dollars of net income have been earned for each dollar invested by the company’s common stockholders’ (Xu et al. 2014). Common shareholders use this ratio to measure the profitability of the firm they have invested according to their view as the owners. Blue Soda Company high-level ratio of 22.08% shows that the company is highly profitable, has a stronger financial position and can easily convert its potential investors into common stockholders’. However, Red Soda Company low-level ratio of 13.36% shows that the company is less profitable and may negatively affect its prospective investors.

In conclusion, both companies are financial stability depending on the ratios that an investor or a creditor may choose to use. For example, according to the current ratio Red Soda Company is more liquid stable than Blue Soda Company. However, according to the Current Cash Debt Coverage which is also a liquidity ratio, Blue Soda Company is more liquid than Red Soda Company. Also, according to all solvency ratios which include; the Debt to Asset ratio, the free cash flow ratio, Cash Debt Coverage ratio, and the Time Interest earned ratio Red Soda Company is more financially stable than Blue Soda Company. Lastly, according to the profitability ratios, only the profit margin indicate that Red Soda Company is financially stable than Blue Soda Company. However, the Asset Turnover ratio, the Return on Assets Ratio, and the Return on Common Stockholder’s Equity indicate that Blue Soda Company is more stable than Red Soda Company.

References

Beaver, W. H. (1966).Financial ratios as predictors of failure.Journal of accounting research, 71-111.

Xu, W., Xiao, Z., Dang, X., Yang, D., & Yang, X. (2014).Financial ratio selection for business failure prediction using soft set theory. Knowledge-Based Systems, 63, 59-67.