BUS FPX 4070 Assessment 1 Investment Analysis and Forecasting

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Capella University

BUS-FPX4070 Foundations in Finance

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Part 1: Ratio Analysis

XYZ Inc. vs Industry Averages

The following table compares XYZ Inc.’s key financial ratios to the industry averages.

Ratio	XYZ Inc.	Industry Average
Current Ratio	1.43	2.0x
Quick Ratio	1.07	1.3x
Days Sales Outstanding	68 days	35 days
Inventory Turnover	12.86	6.7x
Total Assets Turnover	1.61	3.0x
Profit Margin	1.7%	1.2%
Return on Assets (ROA)	2.7%	3.6%
Return on Equity (ROE)	6.8%	9.0%

1) Current and Quick Ratios

Current Ratio: This is calculated by dividing current assets by current liabilities. For XYZ Inc., the current ratio is 1.43 ($500,000 / $350,000), which is below the industry average of 2.0x, suggesting a moderate liquidity concern.
Quick Ratio: The quick ratio accounts for more liquid assets by excluding inventory from current assets. XYZ Inc.’s quick ratio is 1.07 ($500,000 – $125,000) / $350,000), lower than the industry average of 1.3x, indicating some weakness in the company’s ability to meet short-term obligations without selling inventory.

2) Other Ratios

Days Sales Outstanding (DSO): This ratio shows the average number of days it takes for a company to collect receivables. XYZ Inc. has a DSO of 68 days, which is significantly higher than the industry average of 35 days, signaling a potential issue in receivables management.
Inventory Turnover: This metric measures how efficiently inventory is sold and replaced. XYZ Inc. has an impressive inventory turnover of 12.86, far exceeding the industry average of 6.7x, indicating strong inventory management.
Total Assets Turnover: This ratio indicates the efficiency of asset utilization. XYZ Inc.’s total assets turnover is 1.61, lower than the industry average of 3.0x, suggesting inefficiencies in utilizing assets to generate sales.
Profit Margin: XYZ Inc. has a profit margin of 1.7%, which surpasses the industry average of 1.2%, indicating a stronger ability to convert revenue into profit.
Return on Assets (ROA): ROA is 2.7% for XYZ Inc., below the industry average of 3.6%, suggesting weaker asset efficiency in generating profits.
Return on Equity (ROE): ROE is 6.8%, which is below the industry average of 9.0%, pointing to a lower return for shareholders relative to the industry.

3) DuPont Analysis

DuPont analysis breaks down return on equity (ROE) into components: net profit margin, asset turnover, and equity multiplier. The formula is:

[ \text{ROE} = \text{Net Profit Margin} \times \text{Asset Turnover} \times \text{Equity Multiplier} ]

For XYZ Inc., the DuPont formula gives:

[ \text{ROE} = 0.017 \times 1.61 \times 2.5 = 0.068 ]

For the industry, the calculation is:

[ \text{ROE} = 0.012 \times 3 \times 2.5 = 0.09 ]

This shows that while XYZ Inc. is relatively strong in terms of profit margin and asset turnover, its overall return on equity is still lower than the industry standard due to the lower equity multiplier.

4) Strengths and Weaknesses

XYZ Inc.’s strengths include its impressive inventory turnover ratio, which exceeds the industry average, and a superior profit margin, indicating efficient operations and profitability. However, the company faces weaknesses in its current and quick ratios, which are below industry standards, reflecting concerns about liquidity. Additionally, its total asset turnover is relatively low, signaling inefficiencies in utilizing its assets, while its ROA and ROE both trail behind industry averages, highlighting areas for improvement in asset utilization and shareholder returns.

5) Validity of Ratio Analysis

Changes such as doubling sales, inventories, or equity may alter the ratios in unpredictable ways. Some ratios may move closer to the industry averages, while others could worsen. This scenario underscores the importance of context when analyzing financial ratios, as they may not always provide a complete or accurate reflection of the company’s financial health under rapid growth conditions.

Part 2: Investment Analysis

Before making investment decisions, qualitative factors such as the core business, corporate governance, management quality, and competitive advantage are essential to consider (Mukhopadhyay, 2022). Financial ratios, including the price-to-earnings (P/E) ratio, asset turnover, and profit margin, are critical tools for assessing a company’s financial health (Kennon, 2022). However, non-financial factors, such as climate-related risks, employee motivation, and market trends, also play significant roles in evaluating investment opportunities (Hybrid Accountant, 2022).

Part 3: Forecast

Forecasting future performance requires analyzing a company’s annual reports, balance sheets, and inventory levels (Zucchi, 2022). Profitability is assessed by reviewing net turnover and expenses (IONOS, 2019). Given the unpredictable nature of the market, qualitative forecasting methods, focusing on factors such as company reputation, employee motivation, and industry trends, are often preferred over quantitative methods (Boyles, 2022).

References

Hargrave, M. (2022, August 29). Dupont Analysis: The Dupont Formula Plus how to calculate and use it. Investopedia. Retrieved September 1, 2022, from https://www.investopedia.com/terms/d/dupontanalysis.asp

Mukhopadhyay, S. (2022, June 20). Qualitative factors in valuation. WallStreetMojo. Retrieved September 1, 2022, from https://www.wallstreetmojo.com/qualitative-factors-valuation/

Kennon, J. (2022, January 13). Understanding the most important financial ratios for new investors. The Balance. Retrieved September 2, 2022, from https://www.thebalance.com/financial-ratio-guide-357501

Hybrid Accountant. (2022). Investment appraisal-8 non-financial factors that every accountants and managers should consider. Retrieved September 2, 2022, from https://accountantnextdoor.com/investment-appraisal-8-non-financial-factors-that-everyaccountants-and-managers-should-consider/