How to Use Financial Ratios to Maximize Value and Success for Business - Case Study Example

? CVS Caremark ratio analysis Task Introduction The CVS Caremark is a US based health service providing company that offers a wide array of pharmaceutical services. The company is considered as the largest in the health care industry, in the United States. CVS Caremark enjoys a great deal of financial stability owing to the uniquely diversified assets. The company’s strong base of assets and financial position provides enough resources to facilitate extensive research work on health care and pharmaceutical issues. The company is therefore focused in the reinvention of pharmacy and the provision of highly innovated solutions that improve the well-being of the customers. The company also has a strategic plan to offer high quality health care service at an affordable cost, to cater for the needs of people with different financial background. The company has also implemented a health care program for the members of staff. The program involves free health care services to the employees. The program also constitutes the employee motivation strategy for the company. The company has more than 7,300 pharmacy stores spread across the United States. The accounting standards The International accounting standards and the general accounting principles have established rules and regulations governing the accounting practices in organizations. These rules and regulations are intended to guide the organization’s management team into practicing the generally accepted accounting methods. The company’s financial statements reflect a commitment by the company to following the standards set by the international accounting standards. Such standards include the guide to revenue recognition, the concept of consistency, the concept of materiality and earnings management. The accounting standards state that revenue is “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants.” According to IAS 18, revenue is supposed to be recognized exclusively under the following criteria: when a business unit has completed the transfer of ownership of goods; when a business has ceased exercising applicable managerial authorities and has given up any form of control over the goods; when the amount of the expected revenue can be determined with consistency; when it is certain that financial inflows resulting from a certain business transaction will be directed to an entity; and when expenditures and costs related to a business transaction can be measured with consistency (Oppermann, 2009). On the other hand, revenues obtained through the provision of services should be recognized “where the outcome of a transaction involving the rendering of services can be estimated reliably, associated revenue should be recognized by reference to the stage of completion of the transaction at the end of the reporting period. The importance of distinguishing between the terms in financial reporting is to facilitate the provision of reliable material information to the users of financial statement. After a keen evaluation of the company’s financial statements, it has been proven that the accounting standards have been given first priority. The company has strictly followed the rules guiding the revenue recognition when preparing the income statement. The concept of consistency is an accounting term that states, similar items in a financial statement should receive similar treatment. For instance, item X in the current financial period should be treated the same as item X in the subsequent financial periods (Oppermann, 2009). CVS Company has considered this concept during the financial statement preparation. To illustrate further, for the two financial periods under consideration, the account receivables have been given a similar treatment. That is, they have been recognized as assets. The concept of materiality states that a financial statement item is considered material if its omission or misstatement has a potential effect on the figures in a financial statement. Therefore, in preparation of financial statements, all material items should be included to facilitate reliability of the final financial report. The CVS financial reports contain all the necessary information for various users (Oppermann, 2009). The ratio analysis The ratios to be analyzed are current, the inventory turnover, the collection period for account receivables, the payment period for account payables, and the leverage ratio. Current ratio (1.52 in 2011, 1.55 in 2010). The current ratios show the ability of a company to pay its short-term liabilities. From the analysis, CVS Company’s current ratio for both 2011 and 2010 are above one. This means that the company was able to pay its short-term liabilities without any default. Current ratios below one reflect a poor financial health of a company. Therefore, the analysis indicates that the company’s financial health for both years was good. The inventory turnover (43 times in 2011, 52 times in 2010). It indicates the period it takes a company to exhaust its stock in a financial year. The higher the inventory turnover, the higher the revenue levels. The inventory turnover for the company decreased in 2011 as compared to 2010. The decrease could have been caused by a reduction in the number of customers who sought for health care services. The collection period for account receivables (21 in 2011, 19 in 2010). It indicates the number of times a company’s debts are turned into cash within a financial period. CVS Company received more cash from their debtors in 2011 than they did in the year 2010 (Bull, 2008). The increase in the debtor’s payments could have been due to more strict debt policies implemented by the company. A more strict debt policy would involve setting limits for debtor’s payment. In addition, the policy would involve fines for late payments. Payment period for account payables (14 times in 2011, 15 times in 2010). This ratio indicates the period that should lapse before a company pays back its obligations. In the year 2011, CVS company was allowed a shorter period as compared to the year 2010. A short account payable period indicates an efficient response to short-term obligation. Therefore, in the year 2011, the CVS company efficiently responded to it debts. The leverage analysis (15.5% in 2011, 15.6% in 2010). This type of analysis shows the debt and the equity proportion of a company’s capital. The higher the percentage, the riskier it is for a company. A high degree of leverage is accompanied with high levels of interest. Interest on debts must be paid irrespective of a company’s financial situation. Defaults on interest payments send a negative picture of a company. In addition, defaults would send a company into receivership (Creditors voluntary winding up). It is therefore, risky for a company to have a financial structure that is dominated by debt. It is in order to say that CVS Company has a lower degree of leverage. The company’s analysis shows a decrease in the level of leverage, in the year 2011 (Bull, 2008). References Bull, R. (2008). Financial ratios: How to use financial ratios to maximize value and success for your business. Amsterdam: Elsevier/CIMA Pub. Oppermann, H. R. B. (2009). Accounting standards. Lansdowne: Juta. Appendices Appendix 1: CVS income statement for 2011 and 2010 2011 (Canadian $ 000) 2010 (Canadian $ 000) Net Sales 113,936 101,891 Less: Cost of goods sold 92,063 80,382 Gross Profit 21,873 21,509 Less: Selling, General and Administrative expenses 15,139 14,980 Earnings before interest and tax (EBIT) 6,734 6,529 Add: Other Income 0 0 Less: Financing expenses 621 570 Earnings before tax (EBT) 6,113 5,959 Less: Income tax expense (39%) 2,384 2,324 NET INCOME 3,729 3,635 Appendix 2: CVS Balance sheet for the years 2011 and 2010 2011 (Canadian $ 000) 2010 (Canadian $ 000) Current Assets Cash 1,503 1,518 Accounts receivable 6,433 5,239 Inventory 10,687 11,378 Prepaid expenses 0 0 Other current assets 617 153 Total current assets 19,240 18,288 Property, land, buildings Property and equipment 9,007 8,853 Goodwill 28,147 27,307 Other assets 1,229 732 TOTAL ASSETS 57,623 55,180 2011 2010 Current Liabilities Bank loans 0 0 Accounts payable 4,649 4,283 Accrued liabilities and unearned 3,505 3,266 Other current liabilities 4,567 4,228 Total current liabilities 12,721 11,777 Long-term debt 9,796 9,204 Other long-term liabilities 1,537 1,125 TOTAL LIABILITIES 24,054 22,106 Shareholders’ Equity Common shares 17 17 Contributed surplus 29,921 29,372 Retained earnings 23,500 20,535 Other equity 0 0 TOTAL SHAREHOLDERS’ EQUITY 53,438 49,924 TOTAL LIABILITIES AND SHARE-HOLDERS’ EQUITY 77,492 72,030 Appendix 3: The financial ratios Ratio Formula 2011 2010 ROE = Net income 3,729 *100 = 6.9 % 3,635 * 100 = 7.3 % Shareholder equity 53,438 49,924 OPM = EBIT 6,734 * 100 = 5.0% 6,529 * 100 = 6.4 % Net sales 113,936 101,891 GPM = Gross profit 21,873 * 100 = 19.2% 21,509 21% Net sales 113,936 101,891 CR = Current assets 19,240 1.51 18,288 1.55 Current liabilities 12,721 11,777 ITP = Inventory *365 10,687 * 365 = 42.4 11,378 * 365 = 51.7 CoGs 92,063 80,382 Collection period for A/R 6,433 * 365 = 20.6 5,239 * 365 = 18.8 113,936 101,891 A/R*365 Net sales Payment period for A/P 4,649 * 365 = 14 4,283 * 365 = 15.3 92,063 80,382 A/P*365 CoGs 9,796 * 100 = 15.5% 9,204 * 100 = 15.6% Leverage ratio 63,234 59,128 Long-term debt Shares+LT debt Read More