Poorer Profitability and Declined Risk Position of the Company - Essay Example

RUNNING HEAD: Interpretation of financial ments (report) Interpretation of financial ments (report) of of Professor Date 1. Introduction This paper seeks to prepare a report for Devi Patel as senior manager of WBS Ltd, which includes the computations for 2009 and 2010 by providing relevant explanations of and comments on the financial performance of the company. The paper will use financial ratios of profitability, efficiency, liquidity and solvency to see whether the company performs in comparison with industry averages. The need to compare with the industry is dictated by the assumption that if similar players would most at least be showing a certain level of performance as WBS is doing or they could be doing better to challenge how the company is doing. 2. Financial Analysis To keep an investment with a company or its shares is a decision that should be viewed by an owner or investor in terms of cost-benefit analysis just like any purchase transaction. The expected benefits must have to be quantified or measured in order to guide decision making better. A company is generally assumed to growth over time in certain finance models. (Brigham and Houston, 2002). It needs to have profitability, efficiency, liquidity and solvency to survive, grow and stay in business. It competitors would always be there to match every strategy that it unleashes; thus, the strategies to be used must consider its external and internal environment in order to compete well in an industry that is affected by many hard to control factors. External factors need not be avoided however, since companies have employ strategies that would help the to develop strategies that would help them cope with the changing external environment. 2.1 Profitability and Efficiency The return on capital employed (ROCE) of WBS Ltd. at for the last two years 2009 and averaged at about 17% as against the industry average of 20.3%. WBS Ltd. is obviously less profitable than ordinary competitors in the industry in both years. ROCE also declined to 12% in 2010from 22% in 2009. Such declined performance could not be an indication of some problem as it is still very high. Profitability was lower also compared with 2007 and 2008 ratios. See Appendix B. A more than 15% return on capital employed (ROCE) would definitely attract investors as it would mean that for every $100 the investors expect returns of about $15. This could be viewed as something high during normal times or when there is no recession. The present situation of the economy may be described as recovering. The fact the company is slight not doing better than the rest of the industry must convince owners to keep watch their profitability if not their investment with the company may go down in value (Johnson, et al, 2003). See Table A below. Table A – Comparative Financial Ratios; Sources (Case Study, n.d.) It may be noted that ROCE uses the formula where operating profit is divided by the difference of total assets and current liabilities per year. When compared to an average rate of 0.50% if money was invested in a bank using its ROCE of 17 % makes it to more than a least thirtyfold and the rate is something very noteworthy to find for investors. The 0.50 % is the Bank of England base rate could denote the risk free rate investment in the UK (Housepricecrash. 2011). Aside from profitability, it is also engaging to know whether the company management is efficient. To measure the latter, this paper uses ROA. The company’s average ROA of 15% for the last two years. The absence of industry average does not prevent comparison as the rate could be compared with ROCE average as well at 20.3%. This would also therefore indicate lower efficiency than industry average. WBS Ltd. appeared to have higher average for ROCE than ROA but ROCE is more controlling from the point of view of investors (Van Horne, 1992). By comparing the two ratios with the industry, WBS Ltd. is both less profitable and less efficient than industry. The understandable less profitability and less efficiency of the company is further validated by the company’s net operating margin and gross margin. The resulting average operating margin and average gross margins for the past 2 years are 7.5% and 32% respectively as against the industry averages of 10.2% and 35.5% respectively. Operating margin results after deducting cost of sales or services and operating expenses from gross margin (Helfert, 2001). WBS Ltd.’s Operating profit margin for the in 2010 period was posted at 9.% as against the previous year of 6%. See Table A. If the rate is compared the gross profit margin, it could be found that operating profit margin is also lower. This means that WBS Ltd. needed to spend operating expenses to finance its business. This is generally normal for every business to spend operating expenses as having gross margin would limit the expenses to the cost of goods sold like cost of materials, direct labour and overhead (Kieso, et al, 2007). The very net operating margin is also proof of its efficiency, although lower than the industry since it was able to generate that level of profit in relation to revenues generation activities. The company however has higher inventory turnover period of 72 days in 2010 and 64 days in 2009, which are both higher than industry average of 30 days. There is a slight disadvantage in efficiency which aggravated with higher collection period of more than 50 days as compared with just 50 days industry average. However, the company has higher payment period which would better relationship with suppliers. Having faster collection than payment period is working well for the company as it would mean efficiency. However, the industry average for payment period was 60 days and for the company to have too liberal terms with them may be become questionable and doubtful of good business that may rather indicate liquidity problem of the company. After combining the ratio, the fact that is collects faster than it pays should still generally indicate efficiency since it would support its good liquidity position as would be discussed shortly. 2.2 Liquidity WBS Ltd.’s liquidity is its ability to meet a company is currently maturing obligations. The current ratio and the acid test ratio or quick asset ratio, measures said liquidity To compute current ratio, current assets should be related or divided to current liabilities while acid test ratio is almost the same except that the inventory and prepaid expenses are being removed from the current assets to have a new numerator but the denominator is the same. Quick assets are stricter current assets and normally include only cash, marketable securities, and accounts receivable. This makes acid test ratio a finer measure than that of the current ratio. As applied now to WBS Ltd., its computed two-year average current ratio registered at 1.29 as against the industry average of 1.8. The said ratio registered at 1.3 in 2009 and declined to 1.27 in 2010. Quick ratio of the company on the other was reflected at 0.7 in 2009 and 0.68 in 2008 as against its competitor average of 1.1. The current ratio of the company not improving in 2010 compared with 2009. May be due to lower profitability in 2010. Since it is generally accepted to have a current ratio of at least 1.0, the two year average of more than 1.0 current ratio still signals that the company can undoubtedly meet its current obligations on time. This is because its total current liability is matched by current assets of the company. Thus the company may be asserted to have also an excess working capital. This puts in the company safe from danger of become bankrupt (Kieso, et al, 2009). 2.3 Financial Leverage Solvency, on the other hand, measures WBS Ltd.’s long-term capacity to keep up its stability over the long term. Normally measured by the debt to equity ratio, by having the total debt of the company divided by its total equity, a companys solvency should assure investors that the company will not just survive the short term. It needed to have a long life to recover long term investments which takes years to produce the needed returns as well. The gearing ratio or debt to equity ratio of WBS Ltd. is 92% in 2009 and this deteriorated to 197% in 2008 as against the industry average at 60.20%. The two-year-average gearing ratio of the company makes it almost two times less superior than the competitors average. This means the value the company investments from stockholders is less strong as against its competitors. This condition is not favourable to company since it faces a lower risk in comparison. It present highly leverage ratio provides evidence of a weakened structure (Helfert, 2001) for WBS Ltd. In one sense, the company would be considered uncertain to make further expansions in the future without falling to be further riskier than present competitors were. It means also that the company may have some difficulty to manage its long terms risk that its profitability may have not providing enough funds to strengthen its leverage. Sometimes, a choice of higher leverage is done to support possibly liquidity problem to have higher profitability. Although it may choose to weaken its leverage to strengthen its liquidity, the same may not just easily happen. The company must be consider the better aim or better profitability for improving both the financial position of the company as measured using debt to equity and liquidity ratios. Such deteriorated leverage structure could also mean of its possible inability to provide good amount of dividends annually to investors may be in danger, as well as plans to make future expansion. Companies are therefore bound to see and manage their risk level. They could not disregard the risks that come with business. 3.3 Conclusion The company is operating profitably within the industry in 2008 and 2007 as far as its gross margin is concerned. However, this was not the case of 2009 and 2009 anymore. But actually it was performing better with the higher ROCE, better collection period and stronger financial leverage in 2008 and 2007. What happened in 2009 and 2010 with poorer profitability and declined risk position of the company compared with more favourable position in previous years should serve as wake up call for the company to really make good is strategies. It still acceptable liquidity should be encouraging for the company to improve its profitability, efficiency and solvency position. The industry averages are good reflection of what the company can do on the premise that others can do, WBS may also do if given the correct strategies to what the environment may bring to the decision makers. . Appendix A: (Source: Case Study, nod) Appendix B - Comparative ratios of prior years: Source: (Case Study,n.d.) References: Brigham, E. and Houston (2002) J. Fundamentals of Financial Management, London: Thomson South-Western Case Study - WBS Ltd. Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Housepricecrash, 2011, UK base rate. Retrieved 27 November 2011 from < http://www.housepricecrash.co.uk/base-rates.php > Johnson, et al (2003). Financial Accounting. Tata McGraw-Hill Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Van Horne, J. (1992). Financial Management and Policy. London: Prentice-Hall International. Read More