Accrual Accounting

What Have the Ratios Told Us?

So, what have we learned about the performance of The College Shop? What do we foresee for the company in the future? To answer this question, let's identify some of the basic things that every businessperson needs to do in order to achieve success:

• Make a good profit on each item you sell.
• Move inventory: the faster you sell inventory, the more money you make.
• Provide yourself and others with a good return on investment: make investing in your business worthwhile.
• Watch your cash: if you run out of cash and can't pay your bills, you're out of business.
  

The ratios that we've computed in this section allow us to evaluate The College Shop on each of these dimensions, and here's what we found:

• Profit margin ratios (gross profit margin and net profit margin) indicate that the company makes a reasonable profit on its sales, though profitability is declining.
• One management efficiency ratio (inventory turnover) suggests that inventory is moving quickly, though the rate of turnover is slowing.
• One management effectiveness ratio (return on assets) tells us that the company generated an excellent return on its assets in its first year and a good return in its second year. But again, the trend is downward.
• Financial condition ratios (current ratio, total debt-to-equity, and interest coverage) paint a picture of a company heading for financial trouble. While meeting current bills is not presently a problem, the company has too much debt and isn't earning enough money to make its interest payments comfortably. Moreover, repayment of a big loan in a few years will put a cash strain on the company.
  

What, then, does the future hold for The College Shop? It depends. If the company returns to year-1 levels of gross margin (when it made $0.45 on each $1.00 of sales), and if it can increase its sales volume, it might generate enough cash to reduce its long-term debt. But if the second-year decline in profitability continues, it will run into financial difficulty in the next few years. It could even be forced out of business when the bank demands payment on its long-term loan.