Understanding Financial Ratios

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The system of financial ratios that has been developed over the last few decades has become indispensable to analyzing companies’ likelihood of success or failure. Whereas once credit score alone had to suffice for such endeavors, financial ratios now enable a more in-depth and evidence-based approach to determining the company’s state of affairs at the moment. Conveniently, the process of calculating financial ratios and investigating their meaning at length can be applied to businesses of all sorts, regardless of the type of product or services involved and no matter how large or small that company’s business dealings may be. Thus, it becomes instructive to choose a single company, perhaps hypothetical, and analyze that company in detail according to financial ratio theories. In this case, the business in question shall be Eden’s Garden, which falls under the category of nursery, lawn, and garden supplies, and is a rather small business. Upon examination of the financial ratios for Eden’s Garden, it seems apparent that there are multiple issues with the company, and that swift action must be taken to avoid bankruptcy such as seen in the case of Blockbuster Video.

Suspicious Ratios

First of all, there are many ratios that look suspicious even before a more detailed analysis begins. There is no discounting the importance of using models like financial ratios to alert one to these potential problem areas. Indeed, as one study put it, “Dynamic models incorporate the conditional probability of a firm’s financial status changing from financially distressed to stable or bankrupt and enable us to simultaneously examine stable, financially distressed and bankrupt firms” (Hill, Perry, & Andes, 2011, p. 60). This shows that financial ratios can indeed point to a possibility of bankruptcy, and identifying these potential troubles begins with mentally noting troublesome or suspicious areas. For Eden’s Garden, the extremely high debt ratio, the sluggish payable period, and the quite low profit on sales all jump out at once as requiring a deeper level of analysis. However, no analysis is complete without comparison to other companies that may serve as controls against which to check the data, and so now it is important to turn to outside information.

Comparison to Dun and Bradstreet

For a useful comparison on the suspicious ratios in Eden’s Garden’s financial information, Dun and Bradstreet Corporation is an invaluable resource that warrants a significant discussion of the details on a point-by-point basis. Though not all ratios are available to make a neat one-to-one correspondence with the Eden’s Garden data, there is still enough available to proceed. Noted before is Eden’s Garden’s low profit on its sales, with the relevant ratio calculated at 4%. By contrast, the Dun and Bradstreet information puts this number at 15.8%—very nearly four times higher than that of Eden’s Garden (Key ratios, 2014). This means that Eden’s Garden’s profit ratio is indeed far, far, too low as compared to that of other businesses. Unfortunately, the suspiciously high debt ratio did not find its match in the Dun and Bradstreet data, and so one is left to one’s own conclusions in this area. The same is true of the payable period data. However, even simply having learned that Eden’s Garden’s profit ratio needs to improve will become instrumental in constructing a series of recommendations for the company later on in this work. For the time being, it is more helpful to attend to the “red flags” thrown up by these stray pieces of data.

“Red Flags”

The outstanding “red flags” still unexplained in relation to the Dun and Bradstreet information must be analyzed on their own using simple common sense. To begin with, the payable period is not terrible, but it is rather long at 49 days. It would be preferable for Eden’s Garden to be able to pay off its invoices within a month, if not every two weeks. That the calculated financial ratios put this number instead at 49 days seems to indicate the company is falling behind in being able to pay off its expenses. This, along with the unquestionably unreasonable 74:1 debt ratio, is a poor sign for the company indeed. Still, it will do no harm to at least explore giving the company the benefit of the doubt.

Possible Explanations for Deviations

There are many possible explanations for the deviations discussed above, for first and foremost, it is important to note that the data available are only for the most recent of time periods. It could be that historically, the company enjoyed greater success and ratios that were less alarming. In fact, it is possible to raise too much outcry over a few ratios. As some have put it, “While financial ratios have proved to be meaningful discriminators in prior studies . . . these results suggest that they are not so useful in . . . distinguish[ing] between failing firms that effect a turnaround and those that are unsuccessful in their remedial efforts” (Poston, Harmon, & Gramlich, 2011, p. 41). This implies that financial ratios are not the be-all and end-all of determining how to proceed. Indeed, since Eden’s Garden could easily be characterized as a “failing firm” at the moment, it is important to remember that financial ratios can be misleading as one begins to suggest recommendations.

Recommendations and Conclusion

The recommendations for Eden’s Garden are simple. Eden’s Garden must charge more for its products, so that the profit rises. This will also help the company begin to pay off its debt, the debt that is so unfortunately massive whether compared to income or to net worth. The small business should be careful in regards to ethical behavior when increasing prices so as to not be flagged for price gouging.  In addition, tighter record-keeping must begin, for though the most likely reason for the slow payable period is lack of funds, the second most likely reason is simply sloppy records. Eden’s Garden should work at getting the payable period down to no longer than a month. Overall, if the company takes into account all the information about its financial ratios, it can quickly perform a turnaround and start to thrive.

References

Hill, N. T., Perry, S. E., & Andes, S. (2011). Evaluating firms in financial distress: An event history analysis. Journal of Applied Business Research (JABR), 12(3), 60-71.

Key ratios. (2014). Dun & Bradstreet Co. Retrieved from http://investor.dnb.com/financials-keyRatios.cfm

Poston, K. M., Harmon, K., & Gramlich, J. D. (2011). A test of financial ratios as predictors of turnaround versus failure among financially distressed firms. Journal of Applied Business Research (JABR), 10(1), 41-56.