Financial Analysis by Using Ratios: Bloodstone Ltd - Case Study Example

Financial Analysis by using Ratios - Bloodstone Ltd By: Ewa Szczepaniak Year 3 Financial Management BA Business Word count: 2142 Introduction 3 2. Ratio Analysis 3 2.1 Total Owing over Total Assets 3 2.2. Sales Growth on last year 3 2.3. PBIT (Profit Before Interest and Tax) 4 2.4. Interest Cover 4 2.5. EPS (Earning Per Share) 5 2.6. ROCE (Return on Capital Employed) 5 2.7. Current ratio 6 2.8. Acid Test 6 2.9. Gearing (long term debt to long term debts plus equity) 7 2.10. Capital turnover 7 2.11. Debtor Days 8 2.12. Average Stockholding days 8 3. Reliability of Ratio Analysis 8 4. References: 9 5. Appendix I: Ratio calculations of Bloodstone Ltd. 10 6.Appendix 2 : Bloodstone Ltd. Profit and Loss Account for the year ended 31st December 12 7.Appendix 3: Bloodstone Ltd. Balance Sheet as at 31st December 12 8. Appendix 4: Ratios based on the annual accounts for 2006 for Garnet Plc 13 1.Introduction An effort is made in this study to calculate ratios from the statements of Bloodstone Ltd. and analyse those by comparing the available ratios of Garnet Plc. The ratios used in this study cover various aspects and issues of financial statements like liquidity, capital structure, risk coverage, activities, capital gearing, profitability, and performances of assets. Efforts have been made to make a constructive analysis subject to the limitations of ratio analysis, so that appropriate predictions are made and additional information is made available to a potential investor. 2. Ratio Analysis 2.1 Total Owing over Total Assets This ratio indicates the financial structure of the enterprise. In other words the ratio is a barometer to reveal how the assets of the enterprise have been financed. Total Owings (Debts) include long-term debts and current liabilities, whereas Total Assets consists of both fixed and current assets. The ratio measures the total assets financed by outside debts. In 2006 47.54% of total assets of Bloodstone Ltd. Were financed through total owings, both long term as well current liabilities; where as in 2007 dependency on owings for assets financing has marginally gone up to 48.38%. The situation of Blooodstone Ltd.is little better than Garnet Plc., half of whose assets are financed through owings 2.2. Sales Growth on last year The ratio measures the incremental sales over previous year sales. The formula is to divide the absolute increased value of sales by total sales of the previous year and express the increment as percentage over previous year’s sales. Blood Stone Ltd. has attained a 15% growth in sales in the year 2006 over the sales of 2005. On the other hand such growth is only 8% for Garnet Plc. Even assuming both the companies in the same industry there may be a variety of reasons for such increased growth for Blood Stone Ltd., like: a) Increased value of fixed assets in the year 2006 as compared to 2005 suggests the new fixed assets have been manage effectively in the contribution of growth in sales. There may have been increase in sale outlets and in areas where there is no or negligible competition. b) Debtors have gone down to ₤1050 in 2006 as compared to ₤1,100 in 2005. This implies that the emphasis was on cash sales either by reducing the sales prices per unit or by providing cash discounts. There is also a possibility that certain incentive plans might have been introduced or there was better credit control. 2.3. PBIT (Profit Before Interest and Tax) This ratio measures the overall efficiency of production, administration, selling, financing, pricing and tax management of an enterprise. Bloodstone Ltd.’s PBIT ratio has remained more or less constant during 2005 and 2006. In 2006 it was 4.67% as compared to 4.5% in 2005. Marginal changes in operating profits are due to routine effects of a normal business. However, Garnet Plc.’s PBIT ratio of 7% in 2006 is much higher than Bloodstone Ltd. PBIT of Bloodstone Ltd. is certainly a cause for concern. May be operating systems or the marketing of the products is not as efficient as that of Garnet Plc. However, such differences are normally found within firms the same industry, where operating system, capital efficiency, and other factors contribute to different PBIT of different firms in the same industry. High PBIT ensures adequate return to the organization; and a low ratio may be the result of excessive costs being incurred due to lower/ slow inventory turnover. In other words, PBIT has to be studied with reference to other ratios and different financial aspects 2.4. Interest Cover Interest Cover ratio indicates earning capacity of the entity to meet interest charges. The higher the ratio, the more secure is the lender with regard to receiving of interest on the loans extended to the entity. It is calculated by dividing earnings before interest and taxes (EBIT) by the fixed interest charge on loan Interest cover in case of Garnet Plc. is 5 times, whereas Bloodstone Ltd. has been able to find its earning before interest and taxes only 3.87 times the interest payable by it in the year 2006. From the point of view of lenders, larger the ratio the greater is the ability of the entity to pay fixed interest charge. But too high ratio may imply unused debt capacity. That means Garnet Plc. might have unutilised debt funds in the year 2006. 2.5. EPS (Earning Per Share) Earnings per share for Bloodstone Ltd. is constant for the years 2005 & 2006..( 0.03P per share). year 2006) In fact EPS indicates the quantum of profits that would be ranking for dividend for each share of the company. On this count Garnet Plc. is better placed. Each share of Garnet Plc. has earned 23p in 2006 that would be ranking for dividend. EPS is a measure of profitability from the point of view of shareholders. The increasing trend of EPS enhances the possibility of more cash dividend or bonus shares. 2.6. ROCE (Return on Capital Employed) ROCE relates profits to the capital employed. Capital employed here means long term funds provided by all concerned (owners, bankers, creditors, lenders and others). The ratio gives an insight into how efficiently the long terms funds of owners and others are being used by the enterprise. Considering this ratio for the year 2005, Bloodstone Ltd. has 13.72% of return on capital employed. In 2006 Bloodstone Ltd. has progressed o this count and ROCE has increased to 16.11%. But the capital for Garnet Plc. Is earning 21% on capital employed for the year 2006. That means Garnet Plc. is comparatively efficient in exploiting the funds at its disposal because the higher the ratio, the more efficient is the use of capital employed. ROCE can be improved by improving the profitability or by increasing the turnover of capital or by a combination of both. Though ROCE of Bloodstone Ltd.is increasing, it has make more efficient and effective use of capital in order to reach the standard set by Garnet Plc. 2.7. Current ratio Current ratio reflects the ability of an enterprise to meet its short term or current obligations. In 2006, Bloodstone Ltd. achieved a current ratio of 1.49: 1 as compared to a little better ratio of 1.6: 1 of Garnet Plc. The higher the current ratio, the larger would be the amount of pound available per pound of current liability. In other words, the ability of the enterprise is more to meet its current obligations, which indicates the safety of funds of short-term creditors is greater. In a way, current ratio is a measure of margin of safety to the creditors. There is no hard and fast rule, but conventionally a current ratio of 2:1 is considered to be a safe margin of solvency and, therefore, satisfactory. The logic for such a rule of thumb is that even if the value of current assets is reduced to half, the creditors would be able to get their payments in full and the enterprise can retain some amount as working capital in the business. In the case of Bloodstone Ltd. ratio of 1.49: 1 is not very satisfactory to meet its current obligations as available current assets are a little less than one and half times the current liabilities. A slight decline in the value of current assets would adversely affect the ability of the company to meet current obligations. Current ratio needs to be interpreted in the context of quality and reliability of relative assets. 2.8. Acid Test Also known as the Quick Asset ratio, the Acid test is a refinement of the current ratio. Although Current ratio measures the adequacy of working capital of an entity, it fails to distinguish between more liquid and other assets comprised as current assets. The Acid test ratio is designed to take into account the quick (and more liquid) current assets to determine the quick or instant liquidity position of the entity. Content of liquidity in current assets in the case of Bloodstone Ltd. has declined from 1.38:1 in 2005 to 0.78:1 in the year 2006. That means in case of very emergent situations to meet current obligations the company may face liquidity crunch. On the other hand Garnet Plc. is placed in a little better position. 2.9. Gearing (long term debt to long term debts plus equity) The relation of equity capital to preference capital and other types of fixed- interest bearing loans is known as Gearing. In other words the technique of raising finances for an entity by resorting to fixed- interest or dividend- carrying securities is called ‘gearing’ the capital. High gearing implies capital carrying fixed rate of interest or dividend is more than equity capital. Not more than, but a high proportion High gearing may allow the company to ‘trade on equity’, but sometimes the implication of high gearing could be serious for both creditors and the owners as the likely pressure on earnings of the entity could lead to a default on meeting its debt obligations. A low-geared financial structure indicates the higher stakes of the owners and a sufficient safety margin for creditors. In such a case the servicing of debts, fixed rate of interest and dividend does not cause any strain on the entity in meeting such financial obligations. Bloodstone Ltd. is highly geared in 2006, and thus can enjoy the benefits and risks of trading on equity. Also it may face the risk of facing all sorts of difficulties of high-geared capital structure. In case of big trouble, the creditors (debenture holders or other lenders) may interfere in the management monitoring day-to day transactions. The company at that stage may find it difficult to borrow more funds. Garnet Plc. is safely placed with gearing only 27%; and thus can play the game of finances in a well-controlled style. 2.10. Capital turnover This ratio establishes a relation between the cost of sales and the average capital employed by the entity. The purpose of the ratio is to find out whether capital investment is judicious and contributed towards the achievement of desired sales targets. High ratio indicates effective utilization of the capital investment, while a low ratio is indicative of under- utilization of the capital good Capital investments in the case of Bloodstone Ltd. have been much better utilized than what Garnet Plc. has achieved on this front. With a mere 3 times capital turnover, the Garnet Plc. has not taken benefit of capital investment to its full potential. 2.11. Debtor Days Quality of debtors determines, to a great extent, the liquidity of an enterprise; and to determine such quality Debtors days ratio is an important barometer. ‘Debtors Days is a measure of average time payment takes. Increases in debtors’ days may be a sign that the quality of a company’s debtors is decreasing. This could mean greater risk of default. It could also be an indicator that cash flow is likely to be weaken or that more working capital is required’ (Money Terms). Bloodstone Ltd. has shown efficiency on this account. Debtors’ days has gone down from 50 in 2005 to 42 days. It speaks of a lot of good things like qualitative products, increasing demands, efficient collection process, catering to high-end areas, and many others. Garnet Plc. has 40 days as Debtors’ days ratio in 2006. If the industry standard is say 40 days, then Bloodstone Ltd. has performed remarkable well in 2006. 2.12. Average Stockholding days Also known as Inventory turnover ratio, this ratio is calculated by dividing the cost of goods sold by the average inventory (stockholding) and indicates the number of times the inventory is turned over or rotated during the year. Bloodstone Ltd. has rotation period of 37 days as compared to 20 days of Garnet Plc. in the year 2006. That means Bloodstone Ltd. rotate stock approximately 10 times during the year, whereas Garnet Plc. rotate this for about 18 times. Excessive stockholding days causes low turnover; and thus increases overheads like bank interest. Slow turnover of stock may be due to stocks becoming obsolete or change in style or fashion. For correct analysis, the average of stockholding days of two periods needs to be considered and analysed, and this will remove seasonality of the operations, if any, of the enterprise. 3. Reliability of Ratio Analysis Ratio analysis is a device by which the relative size, importance of and relationship between strategic items or group of items in the Balance Sheet and the Income Statement are examined and compared. Though ratio standards have been set up industry wise based on past experiences, comparison to those standards may be made keeping in mind the under- mentioned limitations of ratio analyses. a) Ratios are only tools and the ultimate judgement depends on the personal judgement of the analyst. b) Ratio analysis communicates only a relative picture. c) Window dressing of the accounts could provide an altogether biased d) Inflationary effects normally affect ratios. e) Ratios only help in spotting the symptoms. 4. References: http://moneyterms.co.uk/debtor_days/ (Money Terms) http://www.tutor2u.net/newsmanager/templates/?a=1389&z=82 (Tutor2u, Accounting Glossary, Ratio analysis,) Atrill P., (2003), Financial Management for Non-Specialists (3rd edition), Financial Times/Prentice Hall, London CIMA Dictionary of Finance and Accounting: Over 5,000 Jargon-free Definitions of Key Financial Terms and Ratios, (2003) Bloomsbury Publishing PLC, London Thomas A, (2005) Introduction to financial accounting, (5th edition) Mc Graw Hill Education, Maidenhead Temple P., (2002), Magic numbers; the 33 key ratios that every investor should know, John Wiley & Sons (Asia) Pte Ltd, Singapore 5. Appendix I: Ratio calculations of Bloodstone Ltd. 6.Appendix 2 : Bloodstone Ltd. Profit and Loss Account for the year ended 31st December 2005 2006 ₤000 ₤000 Turnover 8000 9200 Costs and Expenses 7500 8620 Net Trading Profit 500 580 Net Interest Paid 140 150 Profit after Interest 360 430 Corporation Tax 100 125 Profit available for distribution 260 305 Proposed Dividend 100 150 Profit for the year Retained 160 155 Profit brought forward from last year 1885 2045 Profit carried forward 2045 2200 7.Appendix 3: Bloodstone Ltd. Balance Sheet as at 31st December 2005 2006 ₤000 ₤000 Fixed assets, as cost 3600 4600 Less: Aggregate Depreciation to date 1080 1660 2520 2940 Current Assets Stock 800 950 Debtors 1100 1050 Bank 50 0 1950 2000 Current liabilities Dividends Due 100 150 Corpotarion Tax Due 75 125 Trade Creditors 650 1000 Bank Overdraft 0 65 825 1340 Total Assets less Current Liabilities 3645 3600 10% Debenture Stock 1400 1200 2245 2400 Shareholders Funds 200 200 Ordinary Shares of 25p each 2045 2200 Profit and Loss Account balance 2245 2400 8. Appendix 4: Ratios based on the annual accounts for 2006 for Garnet Plc Total Owing over Total Assets 50% Sales Growth on last year 8% PBIT 7% Interest Cover 5 times EPS 23p ROCE 21% Current Ratio 1.6 : 1 Acid Test 1.1 : 1 Gearing (long term debt to long term debts plus equity) 27% Capital turnover 3 times Debtor Days 40 Average Stockholding Days 20 Read More