Acc 700 - Ratio Analysis

Milestone one: Financial Statements and Analysis

Prof: Karen Boulay

ACC 700

Ismail Amar

Southern New Hampshire University

November 13, 2016

Ratio Analysis:

Liquidity ratios

One common liquidity ratio is the current ratio. Current ratio is defined as current assets divided by current liabilities. The term current here means items are expected to be converted to cash within 1 year. A ratio above 1 indicates that the company has more than enough current assets to pay off upcoming current liabilities. A ratio below one might suggest liquidity troubles for a given company. For Chester, 2013 had the highest current ratio at 1.81, with it declining in 2014 to 1.22 and remaining in that range at 1.19 for 2015. Considering the company’s use of short term debt as a primary financing strategy, this ratio hovering close to one should cause some concerns for investors. Their competitor Under Armour in comparison has current ratios exceeding 3 in years 2013-2015. This suggests Chester is far behind Under Armour in terms of capital management.  

In addition to current ratio, quick ratio is another commonly used liquidity ratio. Quick ratio is considered more stringent than the current ratio in that it excludes from the numerator inventory and prepaid assets as they are considered to be far less liquid than their counter parts cash and accounts receivable. For 2013, the quick ratio hovered close to 1, indicating that Chester would be able to pay off upcoming current liabilities without relying too heavily on its inventories and prepaid assets, while declining to .59 and .56 in 2014 and 2015, respectively. This would suggest that if inventory sales slowed down significantly, Chester would experience difficultly paying off upcoming debt. Under Armour in years 2013- 2015 had a quick ratio of 1.3, 2.07, and 1.18 respectively, indicating little reliance on sales of inventory to pay off upcoming liabilities.

A third commonly utilized liquidity measure is working capital. Working capital is simply current assets- current liabilities. This gives us an idea of how much our current assets exceeds current liabilities in absolute dollar terms. In the year 2013-2015 Chester’s working capital has hovered in the 19 million range on average, suggesting a healthy amount of available resources to pay off upcoming liabilities. Under Armour in comparison has working capital averaging 949 million in years 2013-2014. Under Armour is of course a larger company, making comparisons on the basis of working capital more difficult.

Overall for Chester, liquidity seems to be poorly managed, with the company relying heavily on inventory sales to pay off upcoming liabilities. One change Chester could implement would be to obtain some long term debt financing in lieu of lines of credit, which should significantly decrease the current liabilities section of the balance sheet (see balance sheet).

Profitability Ratios:

Profitability ratios measure the return generated on either assets, equity or on sales. They give an idea for how well an organization is managing costs and how effectively they are utilizing their asset base. The first liquidity ratio used to analyze Chester was the return on assets. Return on assets takes net income and divides by the total assets on a company’s balance sheet. In 2013, Chester generated an 11.88% return on its assets, peaking in 2014 at 16.54% then declining in 2015 to 7.55%. This return on assets is in line with Under Armour’s ROA of 11.87, 11.33, and 9.37% respectively. On average Chester had a higher return on assets at 11.99% compared to Under Armour’s 10.86%. This would indicate that in terms of net income per unit of assets Chester has a slight advantage to Under Armour. In order to break this relationship down further one would have to look at the asset turnover and the profit margin.

Profit Margin is defined as net income/ sales and is used to give an indication of how much money a company makes on a given dollar of sales. For Chester, the company made 1.78%, 8.17%, and 3% in 2013 thru 2015 respectively. Comparatively Under Armour made 6.96%, 6.75%, and 5.87%. This suggests that Under Armour is profiting more on each unit of clothing sold than Chester, but Chester is selling more clothing (leading to a higher return on assets).

Return on Equity is yet another profitability ratio that helps us determine how much equity holders are making as a % of their investment. It is similar to Return on Assets yet differs significantly depending on how leveraged a company is. In theory the more debt a company has, the higher the return on equity will be, but also the riskier a company is. Return on equity for Chester has been 25.24, 77.63 and 38.94 in years 2013- 2015. Under Armour’s return on equity was 17.36, 17.31 and 15.41% in years 2013-2015. Considering Chester and Under Armour’s return on assets are very similar, this large discrepancy in return on equity can largely be equated to their debt to equity ratios, which will be discussed in the upcoming section on Solvency.

As far as profitability, Chester seems to have a slight advantage over Under Armour, likely due to selling at lower prices and in higher volumes when compared to Under Armour. The use of leverage further compounds the difference in return on assets, while making the firm riskier from a debtholders perspective.

Solvency ratios

Last but not least, solvency ratios give us an idea as to how leveraged a company is, typically being expressed as a ratio of debt/equity, debt/assets, or even times interest earned. When looking at Chester, the debt/equity ratio for the 3 most recent years are 1.12, 3.69, and 4.15 respectively. This suggests that in recent years the company has been increasing its debt used rapidly. This could be due to a belief that the company stock is currently undervalued for the growth they are expecting. Compared to Under Armour’s debt ratios of .49, .55, and .72 in years 2013-2015, Chester has significant amounts of debt on their balance sheet relative to equity.

 To get an idea for how much income they are generating to service the interest expense on this debt, one can look to the times interest earned ratio. Times interest earned is defined as earnings before interest and taxes divided by interest expense. A ratio over 1 indicates a sufficient ability to service the interest expense on a company’s upcoming debt. In Chester’s case times interest earned has been at 9.189, 12.52, and 7.05 in years 2013- 2015 respectively. Under Armour’s 2014 times interest earned figure far exceeded those generated by Chester at 27.27. In lieu of Chester’s large debt compared to Under Armour’s this is not a surprising result.

In addition to debt/equity, one can get an idea for how leveraged the company is with respect to interest bearing debt (long term + line of credit) by taking interest bearing debt divided by total assets. In Chester’s case the ratio hovers close to .48 in the two most recent years, significantly higher than Under Armour’s .136 and .23 in 2014 and 2015 respectively. This is not surprising considering the debt/equity we calculated above and the return on equity values given in the profitability section.

Based on these three solvency ratios, Chester appears to be highly leveraged compared to one of its industry peers, suggesting the management of Chester company believes the equity to be undervalued and that they are better served issuing debt. Given their high growth, one would wonder why they are not retaining more of their earned income in lieu of borrowing from their line of credit.

Overall given the three groups of ratios discussed there are some troubling areas with Chester, the first being their low liquidity when looking at their acid test ratios. The second being their reliance on a line of credit for financing their operations. Overall the company is seeing tremendous growth and as far as profitability goes they are on par with Under Armour, suggesting that if they can successfully manage their working capital, perhaps by issuing long term debt and retaining more dividends, they look to have a bright future.