ACC 345 Module 2 Ratio Analysis Assignment Example

Faster Growth, Slower Collections: A Three-Year Ratio Analysis of a Composite Fire Sprinkler Contractor

[Student Name]

Southern New Hampshire University

ACC 345: Financial Statement Analysis and Business Valuation

Module Two Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Faster Growth, Slower Collections: A Three-Year Ratio Analysis of a Composite Fire Sprinkler Contractor

Introduction

A family-owned fire sprinkler contractor in metro Atlanta designs and installs sprinkler systems for commercial buildings and provides annual inspection and service under recurring contracts. Its revenue grew 23 percent over two years, and a private equity firm is considering an offer. This assignment computes liquidity, solvency, activity and profitability ratios for three years and interprets the trends. Because the company recognizes installation revenue over time as projects progress, its balance sheet carries contract assets and contract liabilities alongside receivables, which affects how its liquidity and collections should be read (Penman, 2013).

Condensed Financial Data

Table 2. Condensed Balance Sheets (thousands of dollars)

Ratios

Table 3. Selected Ratios

Average balances use Year 2 and Year 3 figures, so return and turnover ratios are shown for Year 3 only.

Interpretation

Profitability improved for a clear reason. Gross margin rose a full point, and operating margin rose from 7 to 8 percent while SG&A held at 18 percent of revenue. The company's service segment, which carries higher margins than installation, grew from about a third to almost 38 percent of revenue. Fairfield and Yohn (2001) found that changes in profit margins are less persistent than changes in asset turnover, so an analyst should ask whether the mix shift is durable before extrapolating it; in this case, recurring service contracts suggest it is.

Liquidity and solvency also improved. The current and quick ratios rose, interest coverage reached 9 times and debt fell relative to equity as retained earnings grew faster than borrowing. A lender would read these as comfortable.

The weak point is collections. Days sales outstanding rose by nine days in one year, and receivables grew 27 percent against 11 percent revenue growth. Contract assets, revenue recognized but not yet billable, also rose 45 percent. Together, these explain why cash fell by $400,000 in a year of record profit. The likely cause is concentration: two large general contractors on a hospital and a distribution center pay on 75-day terms and hold retainage until project completion. Lev and Thiagarajan (1993) identified receivables growing faster than sales as one of the fundamental signals that predict weaker future earnings, which makes this trend more than a technicality.

Efficiency and the Cash Cycle

The activity ratios add detail to the collection story. Asset turnover of 2.54 is high for a contractor, because the company leases its office and fabrication shop rather than owning them, so its asset base is mostly receivables and equipment. Inventory, mostly pipe, fittings and sprinkler heads, turned over about 25 times on cost of goods sold, a level that suggests materials are bought for specific jobs rather than stockpiled. Payables were about 43 days of cost of goods sold, close to the 30- to 45-day terms of its main suppliers. Put together, the company pays suppliers in roughly six weeks and collects from customers in about ten, and the gap between the two must be financed. As installation work grows, that gap grows with it, which explains why a profitable contractor can still need its credit line. Shortening collections by even five days would free about $500,000 of cash at current revenue.

Limits of the Analysis

Ratios are only as good as the statements behind them. The company's statements are reviewed, not audited, so the receivables and contract asset balances have not been tested by confirmation or detailed estimate review. Three years is also a short window for a business tied to commercial construction, which moves in longer cycles; a downturn would hit installation revenue and receivables first. And because the company is private, no market-based benchmark exists for its returns. These limits do not invalidate the trends, but they explain why the next step should be questions rather than conclusions.

Questions for Management

Four questions follow. What share of receivables is retainage, and when is it due? How much of the receivables increase comes from the two large customers, and are their payments current under the contracts? How are percent-of-completion estimates on open projects reviewed, given the rise in contract assets? And is the service segment's margin advantage stable as it grows, or does it depend on a few large inspection contracts?

Conclusion

Over three years the contractor grew steadily, improved margins through a richer service mix and reduced its debt relative to equity. Each of those trends rests on identifiable causes rather than one-time items, which makes them more credible than a single good year. The ratio that deserves attention is days sales outstanding, which rose from 64 to 73 days and, with contract assets, absorbed most of the year's profit. The company looks financially sound, but an analyst should resolve the collection questions before relying on the latest year's earnings.

References

Fairfield, P. M., & Yohn, T. L. (2001). Using asset turnover and profit margin to forecast changes in profitability. Review of Accounting Studies, 6(4), 371-385. https://doi.org/10.1023/A:1012430513430

Lev, B., & Thiagarajan, S. R. (1993). Fundamental information analysis. Journal of Accounting Research, 31(2), 190-215. https://doi.org/10.2307/2491270

Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.). McGraw-Hill Education.