Evaluating Financial Performance

Evaluating Financial Performance



Evaluating Financial Performance

Question One

Profitability Ratios

Gross profit margin. Formula: Gross Profit/ Net Sales

= 350,000/ 500,000

= 0.7 or 70%

Operating expenses to sales ratio. Formula: Operating Expenses/ Net Sales

= 120,000/ 500,000

= 0.24 or 24%

Profit margin on sales ratio. Formula: Net Income/ Net Sales

= 230,000/ 500,000

= 0.46 or 46%

Return on investment/ Return on assets. Formula: Net Income/ Average Total Assets

= 230,000/ ((84,000 + 355,500)/ 2)

= 1.05 or 105%

The return on investment for Corner Café in 2012 was very impressive. This means that the assets were effectively managed to produce revenue.

Return on equity. Formula: Net Income/ Average Owners Equity

= 230,000/ ((57,500 + 216,000)/ 2)

= 1.68 or 168%

Return on owner’s equity for the year 2012 was 1.68. This shows success by the management to maximize return on stockholder equity.

Working Capital and Liquidity Measures

Net working capital. Formula: Current Assets – Current Liabilities

In 2011            34,000 – 6,500 = 27,500

In 2012            70,500 – 9,500 = 61,000

The increase in net working capital from 27,500 in 2011 to 61,000 in 2012 is a favorable sign. This means that the business is in a better position to service its short-term obligations such as creditors.

Current ratio. Formula: Current assets/ current liabilities

In 2011            34,000/ 6,500 = 5.2

            In 2012           70,500/9,500 = 7.4

In 2012, the current ratio was 7.4. This means that there is $7.4 of short-term assets for each dollar of short-term liabilities. This is an improvement from 5.2 ratio recorded in 2011. The 7.4:1 ratio recorded by the business surpasses the 2:1 ratio recommended by the rule of thumb. Even though its is advisable for businesses to have a positive current ratio, the amount recorded by Corner Café in 2012 is too high meaning that it is not managing its current assets properly.

Quick ratio/ acid-test ratio. Formula: (Current assets – Inventory – Prepaid Expenses)/ Current Liabilities

In 2011            (34,000 – 1,000 – 1,000)/ 6,500 = 4.9

In 2012            (70,500 – 3,000 – 5,000)/ 9,500 = 6.6

The quick ratio recorded in 2012 means that the business has $6.6 of quick assets, such as Cash and accounts receivables, for every dollar of current liabilities. This reflects an increase over the 4.9 ratio recorded in 2011. Since the thumb rule recommends a 1:1 quick ratio, the 6.6:1 recorded in 2012 means that Corner Café quick assets are being under utilized. According to Merrill Lynch (2000), inventory and prepaid expenses are to be excluded while calculating quick ratio since they can not be easily converted into cash.

Activity Ratios

Accounts receivable turnover. Formula: Sales/ Average Accounts Receivables

= 500,000/ ((2,000 + 5,000)/ 2)

= 142.9 times

The high turnover ratio recorded indicates that the business is managing its receivables effectively. The business is investing fewer resources in receivables and has an effective credit and collection policy.

Days’ sales in account receivables. Formula: Days/ Accounts Receivable Turnover

= 365/142.9

= 2.6 days

This means that it takes almost 3 days for sales to be converted into cash. The short collection period is very impressive.

Accounts receivables to working capital. Formula: Average Accounts Receivables/ (Net Working Capital)

= ((2,000 + 5,000)/ 2)/ (70,500 – 9,500)

= 0.06

This means that 6 cents collected from accounts receivables is spent on working capital. The low ratio is admirable since it signifies that the business is not dependent on collection from receivables to finance its operating capital.

Inventory turnover. Formula: Cost of Sales/ Average Inventory

= 150,000/ ((1,000 + 3,000)/2)

= 75 times

The high inventory turnover signifies that the business is effectively operating its inventory. This means that Corner Café is quickly converting its inventory into cash. However, the high turnover might also mean that the business is experiencing stock-outs because it is not keeping adequate inventories in its stores (Carton, 2004).

Days’ sales in inventory. Formula: Days/ Inventory Turnover

= 365/75

= 4.9 days

The business takes almost four days to clear its inventory. The short conversion period is beneficial to the business since it spend less money on stock keeping and also reduces the chances of its stock becoming obsolete.

Inventory to working capital. Formula: Average Inventory/ (Net Working Capital)

= ((1,000 + 3,000)/2)/ (70,500 – 9,500)

= 0.03

This means that 3 cents from inventory is spent on working capital. The low ratio is admirable since it signifies that the business is not dependent on inventory to finance its operating capital.

Accounts payable turnover. Formula: Cost of sales/ Average Accounts Payable

= 150,000/ ((500 + 2,000)/ 2)

= 120

This indicates that the business has $120 from sales for every dollar spent on accounts payable. This means that Corner Café is in a very strong position to pay its short-term creditors.

Days’ purchase in Payables. Formula: Days/ Accounts Payable Turnover

= 365/ 120

= 3 days

The business takes 3 days to pay its short-term creditors.

Operating cycle days. Formula: Days’ Sales in Inventory + Days Sales in Receivables

= 2.6 + 4.9

= 7.5 days

The business takes almost 8 days to convert its purchases into cash through sales.

Total Assets Turnover. Formula: Sales/ Average Total Assets

= 500,000/ ((84,000 + 355,500)/ 2)

= 2.3

The high asset turnover shows that the business is efficiently generating revenue using its assets.

Solvency and Capital Structure/ Financial Leverage

Debt ratio. Formula: Average Total Liabilities/ Average Total Assets

= ((26,500 + 139,500)/ 2)/ ((84,000 + 355,500)/ 2)

= 0.4

            The debt ratio is 0.4 or 40%. This is a favorable dependency ratio since the rule of thumb recommends this ratio to be less than 0.5. The company is in a good position to use its assets to service all liabilities.

Debt-equity ratio. Formula: Total Liabilities/ Owner’s Equity

In 2011            26,500/ 57,500 = 0.46 or 46%

In 2012            135,500/ 216,000 = 0.63 or 63%

Number of times interest is earned ratio. Formula: Income/ Average Interest payable

= 500,000/ ((6,000 + 9,500)/ 2)

= 64.5

The business has sufficient income to service the interest expenses incurred in 2012.

Question Two

Corner Café’s financial performance appears to be impressive. However, some of these figures exceed the benchmarks set for the restaurant industry. This means that certain changes have to be made to improve the restaurants financial performance.  

First Recommendation

            The recommended inventory turnover for the restaurant industry is 17.5 times. Corner Café’s inventory turnover was much higher at 75 times. This could be attributed to ineffective inventory management system. Having insufficient inventory might contribute to customers’ dissatisfaction. Corner Café should therefore increase their inventory levels to eliminate the occurrence of stock-outs.

Second Recommendation

Interest payable resulting from financing leverage activities undertaken during the fiscal year 2012 was unnecessary. To avoid needless borrowing through loans and sale of shares, managers should fully utilize their current assets and equity before venturing into external creditors (Denis & McKeon, 2010). Judging from its financial performance, the business had adequate cash and owner’s equity to finance its activities. The business should therefore desist from taking up debts and consider financing its activities from internal revenues.

Third Recommendation

It is advisable for accounts payable period to be lower than accounts receivable period. From the analysis, Corner Café’s 2.6 day collection period for receivables is lower than the 3 day period for accounts payable. This means that the business is more efficient in collecting its debts and less efficient in paying its suppliers. This may positively impact the operating capital of the business but will discourage potential creditors as it increases Corner Café’s lead-time.


Corner Café. (2012). 2012 Financial Statements. Corner Café.

Carton, R. B. (2004). Measuring Organizational Performance: An Exploratory Study. New York, NY: Wiley.

Denis, D. J., & McKeon, S. B. (2010). Debt Financing and Financial Flexibility Evidence from Pro-Active Leverage Increases. West Lafayette, IN: Krannert School of Management

Merrill Lynch. (2000). How to read a financial report. New Brunswick, NJ: Merrill Lynch

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