Sample Research Paper on Financial Ratios and Practical Applications

Executive Summary

The report analyses two business options, the Target and J.C. Penny Companies. It uses the latest financial ratios to gauge their stability and suitability for the investors. Based on financial ratios like the return on equity (ROE), return on assets (ROA), profit margins and the total asset turnover, the J.C. Penny Company emerges as the best option for the investors. A detailed description of the financial ratios in comparing the two companies and the recommendations is given in the following texts.

Financial Ratios and Practical Applications

Financial analysis and evaluation provides the rating means for companies and other business ventures. It combines use of definitive ratios and relations that weight the different aspects of the business environment. These ratios/relations provide solid guidelines whenever business decisions have to be made, finding faults and improving the market standards or efficiency. These ratios/relations can also be used as a predictive measure to assess a company/firm’s growth/decline with relation to the shapes of curves and figures. The financial ratios provide the market and company capacity, their correlation and the impact of each on the other. Not only are these critical in marketing and advertising strategies, but also helpful for the investors/stakeholders in their choice of firm for investing their capital into. Typical financial ratios include the quick ratio, asset turnover, profit margin, current ratio, the debt to total interests, and etc. they are each represented as a percentage depending on the parameters used in their relations. The two companies involved in this case are the Target (TGT) and the J.C. Penny. Each company has its own set of ratio values which would be used in comparing the profitability of the two when investing. It would come in handy for investors and private developers.

  1. Profit margin

Profit margin refers to the ratio of the net income of a company to its overall costs (Troy, 2008). Net income will incorporate the company’s profits after removal of the costs involved in production. Profit margin depicts the expected profit of a company for every unit/item sold and is expressed as a percentage (Troy, 2008). Low profits margin depicted in a company sales data depicts insecure profitability of that firm. It may be further translated to truncated sales, small market shares and even reduced popularity among the consumers. From the firm’s perspectives, low profit margins could mean increased production costs, the pricing method, and the price margins employed by the same company. From the Week Five data of the two companies (Target and J.C. Penny), the Target Company has a higher profit margin (-2.25%) compared to that of the J.C. Penny Company (-2.34%)

  1. Return on Asset 

Return on Assets (ROA) depicts the efficacy of the company’s management in generation of new revenue from the existing assets (Robert Leach, 2010). It is a ration of the company’s overall income to the assets of the same company (Robert Leach, 2010). It is a comparative figure and should be judged relative to previous performances in the case of one company. For the case of the two companies (Target and J.C. Penny), J.C. Penny Company has no returns on its assets but is better compared to that of the Target Company (-9%) meaning it makes losses on its assets.

  1. Return on Equity

Return on Equity (ROE) provides a comparison of the revenue generated from the investment by the shareholders and other partners (Rist Michael, 2015). It is described as the ratio of the net income generated to the shareholders’ equity (Troy, 2008). In the case of the two companies (Target and J.C. Penny), the shareholders in J.C. Penny Company get higher returns on their investments considering its higher ROE of 79% compared to 76% of the Target Company.

  1. Receivables Turnover

Receivables Turnover is the ratio of a company’s amount of credit given and the mean accounts receivables within that fiscal year (Rist Michael, 2015). It depicts the company’s efficiency at giving and in collection of debts accrued on the advanced credits. The receivables turnover can be calculated over a defined period, preferably quarterly, half and annual basis; a high receivables turnover provides assurance to the investors of getting their investment back coupled with the efficient debt-collection mechanisms by the company. Conversantly, a low receivables turnover is a negative advert to the company’s growth. Low Receivables Turnover depicts the poor debt policies and collection processes and the high risk involved in losing investment by the shareholders. The Receivables Turnover provides means of risk assessment for the investment especially for companies in the same industry (Troy, 2008). Considering the two companies (Target and J.C. Penny), Target Company has a higher efficiency, 44% though not far off from J.C. Penny’s 43%

  1. Average Collection Period inventory turnover

Average Collection Period inventory turnover depicts the ratio of the amount of time taken for a company to receive payment for every credit advanced (Robert Leach, 2010). Optimization of collection period is recommended as unfruitful debts cost the company more in maintenance of such inventories and the returns lost. Considering that time is money, investors prefer shorter collection period for every credit advanced to get more returns on their investments. Low Average Collection Period inventory turnover is preferred in most cases. With the two companies (Target and J.C. Penny), J.C. Penny Company has a lower average collection period inventory turnover (30%) compared to Target Company’s 45%. Therefore, it would take J.C. Penny Company 30% time for every credit advanced unlike Target Company which would take 45% time for every credit advanced. On this basis and considering short-term financial goals, the J.C. Penny Company would be the most viable option to the investors.

  1. Fixed Asset Turnover

Fixed Asset Turnover refers to the ratio of the firm’s net sales to the existing fixed assets (Baker & Powell, 2005). Fixed assets comprise of those assets not easy to be liquidated. As such, companies should ensure they get more liquid cash from their existing fixed assets. A high Fixed Asset Turnover depicts the company’s effectiveness in exploitation of their existing fixed assets (Troy, 2008). Generally, the recommended profitability levels of the Fixed Asset Turnover varies from one industry to another, for example, manufacturing industries might have a Fixed Asset Turnover considering the heavy equipment involved, but comparing this industry with the service industry would be outrageous in the business context. In the two companies’ case (Target and J.C. Penny), the Target Company has higher returns on its fixed assets, 75% compared to J.C. Penny’s 74%.

  1. Total Asset Turnover

The Total Asset Turnover ratio depicts the company’s ability to generate cash from their total assets (both fixed and non-fixed assets) (Rist Michael, 2015). It would include the returns accrued from the credits advanced, their manpower and even their fixed assets. Total Asset turnover is also dependent on industry being focused. Comparison between similar companies is recommended. A higher Total Asset turnover ratio for such industries would mean a higher profitability as those firms can generate more cash from their assets. It could also depict good management techniques being employed thus a higher stability and a preferable choice for the investors. With the case of the two companies (Target and J.C. Penny), the J.C. Penny Company takes it clearly with a 76% total asset turnover ratio compared to Target Company’s 73%. Thus, J.C. Penny’s returns on all its assets are better.

  1. Current Ratio

The current ratio is ration of the company’s existing assets to the existing liabilities (Robert Leach, 2010). It depicts the company’s ability to clear short-term financial obligations and even the long-term ones. The current ratio does not clearly depict the company’s financial state as it is dependent on factors like the state of the current assets and the condition of the existing liabilities (Robert Leach, 2010). Therefore, a high current ratio does not necessarily mean a stable financial status as the company might only be able to pay off only the short-term goals, but fail in the long run. Probably, the current ratio could depict the level of liquidity of that company. Considering the Target and J.C. Penny companies, Target Company has a higher current ratio (70%) unlike J.C. Penny’s 69%. However, it does not clearly show the feasible option considering the dynamic aspects of the ratio.

  1. Quick Ratio

The Quick ratio depicts the short-term liquidity of a company; the company’s ability to fulfill its short-term responsibilities with respect to its most liquid assets (Troy, 2008). In the case of quick ratios, the inventories are not considered which envisions its conservative nature. Therefore, the quick ratio is a ration of current assets without inventories to the company’s existing liabilities. In the case of the two companies (Target and J.C. Penny), the J.C. Penny Company is more liquid with a higher quick ratio of 77% as compared to 75%, that of the Target Company. When the investor has short-term financial goals, the J.C. Penny Company would be the most viable option.

  1. Debt to Total Assets

The Debt to Total Assets ratio measures the company’s leverage in the given industry. It is the ratio of the company’s debt (both short-term and long-term) to its total assets’ value (Robert Leach, 2010). This ratio is universal and can be customized for a particular industry. A higher ratio of debts to total assets would mean that the company has a higher leverage and higher financial risk which is unattractive to investors (Robert Leach, 2010). To its disadvantage, this ratio does not consider the quality of the assets involved. Therefore, for a reliable evaluation, the debts to total assets ratio should be carried overtime to know the right investment choice to make. Considering the two companies (Target with 67% and J.C. Penny with 53%), the Target Company has a higher leverage (67%) when compared to J.C. Penny Company which has a 53% leverage. Therefore, J.C. Penny has a lower financial risk and may be considered a wise investment choice on this basis.

  1. Times Interest Earned

The times interest earned depicts the company’s ability to fulfill the accrued interest charges before tax (Rist Michael, 2015). It is found by dividing the company’s gross income by the total interest value of its bonds and other debts (Rist Michael, 2015). Failure to meet the set times interest earned by any company might lead to its closure due to bankruptcy. Retention of a company’s time interest earned below the set limits depends on its sustenance of the earnings accrued. Non-bankruptcy is only achievable when the company invests its earned capital in different valuable projects and borrowing funds at lower capital cost comparing its current debt figures or percentage. Assuming that the set limit for times interest earned is 50%, both companies (Target with 63% and J.C. Penny with 57%) are afloat; they are above the bankruptcy limit and are allowable to operate their businesses. However, Target Company is the safest company for investment consideration as it has a higher times interest earned compared to J.C. Penny Company.

  1. Fixed Charge Coverage

The Fixed Charge Coverage of a company denotes to its ability to comfortable handle existing fixed financial leases. The Fixed Charge Coverage ratio shows us the number of times a company can fulfill its fixed financial obligations. It also depicts the stability of the company in terms of the wage responsibilities and other necessary acquisition business costs. It gives the investors an image of the company’s financial and debt obligations and thus the security of their investment. The Fixed Charge Coverage rations that fast approach 1 or are way off below 1 would mean a the high likelihood of this company to fail to meet its current debts. Considering the fixed charge coverage ratios of both companies (Target with 0.7 and J.C. Penny with 0.2), the Target Company can handle comfortably its fixed financial obligations as compared to J.C. Penny Company though the risks vary between each.

The data of the financial analysis of the two companies (Target and J.C. Penny) are as depicted in the table below.

  Target (TGT) J.C. Penny
Profit margin -2.25% -2.34%
Return on Asset -9% 0%
Return on Equity 76% 79%
Receivables Turnover 44% 43%
Average Collection Period inventory turnover 45% 30%
Fixed Asset Turnover 75% 74%
Total Asset Turnover 73% 76%
Current Ratio 70% 69%
Quick Ratio 75% 77%
Debt to Total Assets 67% 53%
Times Interest Earned 63% 57%
Fixed Charge Coverage 70% 20%

 

Final Recommendations

For the most viable investment option, the J.C. Penny Company would be the most suitable. Considering the profit margins of both companies, Target Company takes it clearly but by an insignificant margin (0.09%). J. C. Penny’s low profit margins might have been inflated by the high running costs or may be upgrading of equipment or techniques employed by the same company. Its low profit margin is balanced off by its high returns on assets and returns on equity. It means that J.C. Penny Company has better returns that can pay off the shareholders’ investment and even produce some profit. Comparing fixed assets and total assets, total assets are more important as it encompasses the fixed assets (Baker & Powell, 2005). In view of the total asset turnover, J. C. Penny Company is complemented with a ratio of 76%. This means that the overall assets of J.C. Penny Company are better managed which ensures better productivity and thus a recommended investment option. For short term investment goals, J.C. Penny Company might be appropriate, but for long-term investment goals or objectives, the Target Company would be the most viable choice. In addition, J.C. Penny has a lower financial risk as it can comfortably pay off its debts as depicted by the low debt to total assets ratio.

To improve the profit margins of the J.C. Penny Company, the company should consider reviewing the pricing strategy in case the running costs cannot change significantly. Pricing strategy would involve the J.C. Penny Company profiling its subsidiaries as some are not that sensitive to price margins. This would make it maximize on its product sales and increase the earnings accrued. Offering their clients discounts would also improve returns instead of payment delays by the same customers. J.C. Penny Company will have more cash at disposal and even invest in other projects that would generate better returns. The collective returns will increase with the addition of these side projects.

The J.C. Penny Company has deteriorated fixed charge coverage (of 0.2) meaning it cannot handle its financial obligations for a given period. This can be attributed to fluctuating return levels coupled with its high financial risk and instability. To improve the fixed charge coverage, the J.C. Penny Company should strive to increase funds for operations and seek to gain investors’ trust. This would mean its shares and bonds’ prices at the Stocks Exchange would increase translating to greater returns to the shareholders and the company’s stability.

The times interest earned of the J.C. Penny Company (57%) is safe considering the 50% set limit, but this margin should be increased. In addition, this margin determines the stability level of the company as the limit declares bankruptcy margin. The margin determines the confidence and trust levels by the investors. It would determine its viability as the better business option compared to the Target Company. To improve the times interest earned, J.C. Penny Company should apply techniques that would grow its profit margins; it would restore investors’ trust in the company.

 

 

 

References

Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management : a Practical Guide. Oxford.: Blackwell Pub.

Rist Michael, P. A. (2015). Financial Ratios for Executives : How to Assess Company Strength, Fix Problems, and Make Better Decisions. Berkeley, CA: Apress.

Robert Leach, (. (2010). Ratios made simple : a beginner’s guide to the key financial ratios. Petersfield, Hampshire: Harriman House.

Troy, L. (2008). Almanac of business and industrial financial ratios. Chicago, IL: CCH.