Financial Management Analysis of PQ - Admission/Application Essay Example

Financial Management analysis of PQ Table of Contents Table of Contents 2 Introduction 3 Financial background 3 Financial ment analysis 4 Balance sheet analysis 4 Income Statement analysis 6 Key factors to consider for future 7 Ratio analysis 7 ROCE 7 Gross profit 8 EBIT ratio 8 Inventory turnover ratio 9 Debtors turnover ratio 9 Current ratio 9 Capital gearing ratio 9 Conclusion 10 Reference List 11 Introduction PQ is a new brand of cosmetics. The business was started in the year 2010 and is located in New York. The company has a significant number of shops in the city. The brands cosmetic items are sold by retailers across New York. New York has a significant market in respect of cosmetics. The consumers normally prefer to purchase from high end brands and retail stores. PQ will cater to all types of customers ranging from high to middle end. The products are largely herbal based. Over the last few years of operation, PQ has been able to generate adequate revenue. The company has been successful at establishing a good market base as a result of which sales figures have been going up. Financial background PQ has significantly been able to increase its market share since the time it has entered the London markets. The revenue of the firm has remained high. The firm had extended its credit in the year 2010 by obtaining a convertible loan from Mr Banks, a private investor to gain more finance for developing brand awareness and for promotional activities. This had significantly helped the company to widen its market base and increase sales. But with the increase of sales came the increase in market demand. The firm needed to expand its production widely so as to be able to cater to the needs of the consumers. Hence the cost of production has expanded immensely. The firm has also been facing some significant problems to manage the working capital of the company as a lot of the revenue remains trapped with the retail customers for they maintain the firm’s stock and cannot make payments till the stock has been sold up to a certain level. Hence a major portion of the firm’s revenues remains trapped in the form of receivables. Since the level of delayed receivables are high, as a result the firm also faces the problem of not being able to make payments on time as the firm faces a crunch in the proper management of its working capital (Berk and DeMarzo, 2013). In the light of such financial conditions of the firm, a detailed financial analysis of the company’s profits has been undertaken to understand its financial strength and position. Financial statement analysis Balance sheet analysis The summarised balance sheet of PQ for the period ended 31st December is shown as follows: Figure 1: Comprehensive balance sheet of PQ 2013 2012 ASSETS $000 $000 Non-current assets Property, plant and equipment 85 70 Current assets Inventories 1,580 1,556 Trade and other receivables 750 800 Cash and cash equivalents 45 60 Total current assets 2,375 2,416 Total assets 2,460 2,486 EQUITY AND LIABILITIES $000 $000 Share capital ($1 shares) 1,500 1,500 Other elements of equity 10 10 Retained earnings 40 (210) Total equity 1,550 1,300 Non-current liabilities 5% Convertible debt 2014 360 336 Current liabilities Trade and other payables 550 850 Total liabilities 910 1186 Total equity and liabilities 2,460 2,486 Current Asset position- From the above balance sheet it can be analysed that the firm has a large portion of current assets trapped in inventories and receivables. This can significantly lower the firm’s liquidity. As a result the firm may not be able to make payments of dues on time. Hence the proportion of payables will also significantly rise. Therefore in order t o manage the flow of working capital it is advisable that the company increases the level of liquidity by converting a subsequent amount of the receivables and inventories to cash and cash equivalent. Also the inventory conversion cycle needs to be shortened by converting the raw materials to finished goods faster. Similarly finished goods conversion to cash can become faster by reducing the time period allotted to debtors. However from the ultimate point conversion of stock into cash on a faster level is only possible if the firm adopts better marketing policies to increase the demand of products so as to make the revenue cycle faster (B. Elliot and J. Elliot, 2013). Fixed asset position- The fixed asset position of the firm needs to be made stronger by investing more upon fixed assets. The higher the level of fixed assets, the greater will be the production capacity. However considering the current level of demand, the existing capacity serves to be enough. However in order to generate greater revenues, it is important that the firm increases its asset base. This involves increasing plant and equipment facilities. Hence if the firm can obtain a higher level of finance, this aspect can be fulfilled. Also if the debt proportion gets converted into equity, a large portion of the earnings gets saved as the firm need not pay interest. The profits get retained in the business. Although the firm will have to pay dividends, but if the proportions of dividends are lower than the total interest, the firm will be at a benefit if it adopts this policy (Joehnk, 2012). Current liability position- current liabilities represent the total payments of the firm. The company has been able to reduce the level of current liabilities as compared to the year 2012. This indicates that the purchase dealing, such as of raw materials and so on has considerably reduced. It also indicates that the firm has adopted the policy of settling payments in cash. Early and prompt payments provide the advantages of cash discounts. However it also results in the drainage of liquid cash. Therefore PQ needs to suitably distribute the payment structure by deciding what payments it should make on time to redeem discount facilities and the payments it needs to maintain in the books in the form of creditors (Baker and English, 2011). Capital structure- The balance sheet reveals that the firm’s major portion of capital is sourced by equity. Hence the risk position of the firm is quite advantageous as the firm has lower debts and higher equity. However a low level of debt leads to lower leverage. Therefore the firm should maintain a certain level of debt proportion to attain leverage (Bierman and Smidt, 2007). Income Statement analysis The comprehensive statement of income for the period ended 31st December is prepared as follows: Figure 2: Comprehensive income statement 2013 $000 2012 $000 Revenue 2,600 2,300 Cost of sales (1,800) (1700) Gross profit 800 600 Distribution costs (310) (210) Administrative expenses (114) (137) Finance costs (24) (20) Profit before tax 352 233 Income tax expense (102) (68) Profit for the year 250 165 Sales- the firm has been able to increase its sales in comparison with the previous year. This is a favourable trend as PQ is highly in need of generating higher revenues so that it can suitably meet the requirements of liquidity. The higher the demand for goods, the greater is the revenue generation and the faster will be the turnover period. Therefore the firm needs to continuously adapt measures that help to increase the revenues. Cost of sales- The level of cost of production has been a major concern for PQ due to the expansion of production so as to cater to the needs of higher demand. Therefore the firm needs to achieve economies of scale of production so as to suitably be able to decrease the level of expenses. Since the firm is considering expanding more, it needs to achieve the economies of scale. Gross profit- The level of gross profits of the firm has increased considerably in comparison with previous years. The major reason for this is the increased level of sales. However the level of gross profit can be increased by decreasing cost of production. Operating expenses- the operating expenses of the company have increased considerably. The reason for this is the expansion of production. However it must be taken care that the increase of expenses does not result in the fall of revenues. This however been taken care of as the firm has been able to significantly increase the revenue along with the increase of sales. Operating profit- the operating profits of the firm have significantly gone up. This has resulted in the generation of a satisfactory level of EBIT. High level of EBIT helps in the generation of positive ratios while conducting the ratio analysis (Bragg, 2011). Key factors to consider for future On the basis of the above discussion of balance sheet and the income statement, the following factors can be deduced for the future performance of the firm. Increasing the total revenue- A higher level of revenue will influence other aspects such as increased level of gross profit and net profit, ability to cover expenses and manufacturing costs, increase shareholders wealth and retained earnings. The company needs to concentrate on the increase of the total sales through greater production. However sufficient means of promotion and product popularity also needs to significantly achieved so that higher production is supported by increased demand (Drury, 2008). Achieving economies of scale- Economies of scale is an advantage that a firm obtains by increasing its production overtime. It helps to reduce the costs associated with production due to mass scale production. This is an important factor that must be analysed when the firm is focusing on trying to expand. Since costs of production are a concern for the firm, it needs to concentrate on the achievement of economies of scale or production (Chandra, 2005). Working capital concern- PQ is facing a crunch with respect to the working capital needs as the costs of production have been going up highly. Therefore the firm needs to concentrate on maintain adequate liquidity so as to meet its day to day expenses on a timely basis. The problem faced by the firm is that a large portion of cash is trapped in the form of inventory and receivables. The sooner the cash gets realized from inventory and receivables, the higher is the liquidity achieved. This aspect can be fulfilled by reducing the number of days granted to debtors for making payments and retaining cash in the business as long as possible by making payment at the end of the granted time by the creditors. Hence in this manner liquid cash gets retained faster and stays for longer. The liquid cash that is idle can be used for investment in extremely short term instruments such as money market instruments and so on (Dayananda, et. al., 2002). Ratio analysis ROCE Return on capital employed (ROCE) is a measure by which it is possible to ascertain the returns earned on the capital that has been employed by the firm. It is ascertained as follows: ROCE= EBIT/Capital employed. From the above income statement it can be seen that the earnings before interest and tax (EBIT) amounts to $ 352 for the year 2013. Capital employed can be calculated as: Capital employed= Total assets- Current Liabilities. Therefore the total capital employed will be $1910 (2460-550). Hence the ROCE can be calculated as follows: ROCE= EBIT/ Capital employed = 352/1910= 0.18. Hence 18% is the ROCE. The ROCE analysis reveals that the firm is having positive returns on capital. However the level of ROCE is low. It is generally advisable that a firm should have a higher level of ROCE as compared to the level of borrowed capital. It is seen from the above balance sheet that the level of debt capital is $ 360 which is a little higher than the level of EBIT. ROCE is considered to be a useful way of analysing capital as it takes into account the long term finances as well. Since operating profit is expressed as a percentage of the total capital employed, it helps to analyse the level of operating profit a firm is able to generate on the basis of the capital used by it. It can be said that the ROCE position of the company is positive. However the firm is considering reducing the level of debt so that the ROCE level is higher than the debt proportion (Drury, 2008). Gross profit Gross profit is calculated as follows: Gross profit= Gross profit/sales. From the above income statement of the firm it is observed that the gross profit of the firm is $ 800 for the year 2013. Similarly the sale of the firm is $2600. Hence the gross profit can be calculated as follows: Gross profit= 800/2600*100= 30.76%. It is important to generate an adequate level of gross profit in order to be able to pay off the firms expenses and to pay taxes, interests and other dues to shareholders and investors. Hence higher the proportion of gross profit better is the profitability (Pancholi, 2010). PQ is therefore able to generate adequate profits. EBIT ratio Operating profit is calculated as follows: Operating profit ratio= operating profit/sales. The operating profit for the year amounts to $352. The revenue is $2600. So, the operating profit amounts to 352/2600*100= 13.53%. Just like gross profit, a higher level of EBIT is also favourable for the firm. The more the EBIT the higher are the retained earning and the ability to pay taxes, dividends and interests (Shapiro, 2008). Inventory turnover ratio The inventory turnover ratio can be calculated as: Cost of goods sold/ average stock or closing stock. Hence the inventory turnover ratio= 1800/1,580= 1.14 times. From the above calculation it can be seen that the inventory turnover is low. This may have adverse effects on the working capital. Hence it is important that the firm considers developing a better plan of working capital chain (Shapiro, 2008). Debtors turnover ratio The debtor’s turnover ratio can be calculated as: Net credit sales/ average accounts receivables. Hence the debtors turnover ratio = 2600/750= 3.46 So the debtor’s turnover period is calculated as: 365/3.46= 105.49 days. The debtor’s turnover over ratio is observed to be high as per the above calculation. The lower the number of days, the more rapidly stock is turned into cash (Shapiro, 2008). Current ratio The current ratio is calculated as current assets/ current liabilities. The current assets as per the above balance sheet are a total of $2,375. The totals of current liabilities are $550. Hence the current ratio can be calculated as: 2375/550=4.31 The current ratio is a tool that helps to analyse whether the firm is able to generate enough liquidity to pay off its current dues. From the calculation it is seen that the current ratio is quite high for PQ. This means that the firm is able to generate adequate levels of profits to meet its current expenses. The higher the current ratio, the better is the liquidity position (Small Business Development Corporation, 2013). However the current ratio does not adequately take into account the time period or lag for receivables and payments. This is an important factor. The lag in receipts must be lower than the lag in payments. Capital gearing ratio The capital gearing ratio can be calculated as: Equity share capital/ fixed interest bearing capital. As per the above balance sheet, it is seen the total value of equity is $1,550. Also the total value of debt or fixed interest bearing capital is $360. Hence the capital bearing ratio amounts to 1550/360= 4.30. The capital gearing tool is an important method to analyse the capital structure of the company. It analyzes the relation between the variable returns bearing capital and the fixed interest or dividend bearing capital. Variable returns bearing capital refers to the equity stock of the firm. Similarly variable interest bearing capital is the debt capital of the firm. The more the proportion of the equity, the lower is the capital gearing ratio. Similarly a high level of debt in the capital structure leads to greater gearing ratio. It is preferred that a firm stays low geared as a high level of debt brings in greater risk. When the proportion of debt is high, a large portion of the income is lost by paying interests at fixed rates. Hence very less revenue is left behind for equity shareholder’s dividends (Small Business Development Corporation, 2013). Therefore in this respect PQ’s capital structure is quite favourable, as the company is not highly geared. Conclusion The above financial analysis of PQ reveals that the company is financially quite stable. It has been able to generate sufficient returns in the year 2013. Also it is worth noting that the revenue of the firm has significantly gone up in comparison with the previous year. However the main shortcomings of the firm lie in the lack of proper working capital management and high costs of production. In order to counter these issues, the firm must adapt to a more profitable working capital cycle and achieve greater economies of scale. By significantly increasing the liquidity and adopting to cost reduction measures, it is expected that the firm can do even better financially in coming years. Reference List Baker, K. H. and English, P., 2011. Capital Budgeting Valuation. New Jersey: John Wiley & Sons. Berk, J. and DeMarzo, P., 2013. Corporate Finance. New Jersey: Pearson Education. Bierman, H. and Smidt, S., 2007. The Capital Budgeting Decision. New York: Routledge. Bragg, M. S., 2011. Obtaining debt financing. New Jersey: John Wiley & Sons. Chandra, P., 2005. Fundamentals of Financial Management. New Delhi: Tata McGraw-Hill. Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and Rowland, P., 2002. Capital Budgeting. Cambridge: Cambridge University Press. Drury, C., 2008. Management and Cost Accounting. London: Cengage Learning. Elliot, B. and Elliot, J., 2013. Financial Accounting and Reporting. New Jersey: Pearson Education. Joehnk, G., 2012. Fundamentals of Investing. New Jersey: Pearson Education. Pancholi, J., 2010. Financial Statement Analysis (2). Available at: [Accessed 1 April 2014]. Shapiro, C. A., 2008. Capital Budgeting and Investment Analysis. New Delhi: Pearson Education India. Small Business Development Corporation, 2013. Understand and analyse your accounts. Available at: [Accessed 1 April 2014]. Read More