Capital and Liquididty Ratio Analysis - Essay Example

Cash flow, gearing and working capital & liquidity ratio analysis Cash Flow Analysis Cash flow ment is one of the financial statements that must be prepared by a company to show their financial performance. From the cash flow statement, the company’s ability to meet its debt obligations can be determined. An analysis of the cash flow statement will also reveal whether a company has recorded growth or decline in the cash from the various activities. The cash flow statement is composed of three broad category i.e. cash from operating activities, investing activities and financing activities. An analysis of Zytronic cash flow statement reveals an increase in the net cash flows from operating activities. In the year, 2011 the company net cash flows from operating activities was £3658000 compared in to £3147000 in 2010. This is 16.42% increase in the cash inflows meaning that the company realized improved cash from its day-to-day operations. From the cash flow statement, the positive improvement can be attributed to the increase in profits from continuing operations from £2924000 in 2010 to £3557000 in 2011 (Zytronic, 2011). The increase in depreciation cost on property, plant, and equipment increased the not cash inflows because in determining the net cash inflows the values are added back since the does not account for any actual cash flows. In 2011 for instance, the depreciation value was £802000 meaning that the company incurred more depreciation cost because of the increase in the assets. The improvement in the cash inflows could be much more if the company could have reduced the values of inventory and receivables in 2011. The increase in inventory from 85 in 2010 to 166 in 2011 and of receivables from £356000 in 2010 to £647000 in 2011 is significant and adversely reduced the cash inflow figures in 2011 (Zytronic, 2011). At the same time, the increase in trade and other payables made the net cash flow from operating activities to improve. Finally, tax paid is also a component of the operating cash flows. In 2010, Zytronic paid a tax of £65000 compared to £821000 in 2011. The increase in the tax obligation between the two years is attributed to the increase in the profit recorded by the company. Tax is charged as a percentage of profits and therefore an increase in the profits would automatically translate in increased tax expense which as an outflow. The second component of the cash flow statement is the cash flows from the investing activities. Investing activities are those activities that a company puts its resources in order to earn profits, increase its capital assets in order to improve its performance or proceeds resulting from the disposal of its assets. In 2011, the company had a net cash outflow from investing activity of £810000 compared to the net cash outflow of £315000 in 2010 (Zytronic, 2011). The company therefore realized an increase in the net cash outflow resulting from the investing activities. The 157.1% decline in the cash outflow from invested activities can be explained from the various increases in cash spent in investing. First, Zytronic did not receive a government grant in the year 2011 as oppose to the year 2010 in which the government extended a grant of £540000. The company’s expenditure in acquisition of intangible assets increased from £228000 in 2010 to £297000 in 2011. This also led to the increase in the net cash outflows. At the same time, Zytronic realized a reduction in the interest’s that was earned from the investments in bonds and bills from 13 in 2010 to 1 in 2011. Moreover, the company reduced the amount used in the acquisition of new plant property by £115000. The net increase in the cash flows from the investing activities thus had a negative impact on the cash inflows of the company. The last part of the cash flow statement is the cash from financing activities. Financing activities are those that are pursued by the business in acquiring capital for their activities. A company can finance it operations from either debt or equity. In the year 2011, Zytronic had a net cash outflow of £1484000 compared to the net cash outflow of £1727000 in 2010. This is a positive increase in the net cash flows from the two years by £243000. Zytronic therefore improved the cash from the financing activities in 2011. The improvement in the cash flows from the financing activities can be attributed to several factors. First, the company reduced the amount of interest paid for their debt from £128000 in 2010 to £110000 in 2011. Additionally, the amount used in repaying capital element of hire purchase contracts reduced from £476000 in 2010 to £45000 in 2011 while the amount used in repaying the borrowings reduced by £19000 from £342000 in 2010 to £323000 in 2011. On the other hand, Zytronic increased the amounts of dividend paid from £852000 in 2010 to £1044000 in 201. This means that the amount of cash used in paying dividends increased resulting into increased cash out flow. The company did also not receive any refund for overpayment of VAT in 2011(Zytronic, 2011). In general, Zytronic total net cash flows were £1364000 in 2011 compared to the total net cash inflow of £1105000 in 2010. This means that the general cash flows improved in this year and the resulting cash balance at the end of 2011 financial year was £2578000 compared to that of £1214000 in 2010. Gearing ratios Gearing rations also known as capital structure ratios indicates the extent to which a company has used fixed charge capital in financing its activities. A firm that has used more borrowings to finance its activities is said to be highly geared and might have the risk of repaying their debt hence experience bankruptcy proceedings. A high gearing ratio implies that a larger proportion of the company’s operation will be financed from debt. There are instances in which the security and exchange commission sets the limit that must be followed by firms in the financing their activities. From the calculations shown at the appendix, the debt/ equity ratio was 17.86% in 2010 while that of 2011 was 13.14%. The debt increase ratio shows the proportion of the assets that are financed by debt i.e. a gearing ratio of 17.86% means that 17.86% of the amount used in acquiring an asset is from debt. This improvement was positive as the business reduced the level of debt and therefore reduced the chances of it facing gearing risks. The improvement in the debt/ ratio is attributed to the increase in the value of the net assets and a reduction in the amounts of the debt. The long-term debt declined from £2045000 in 2010 to £1722000 in 2011 whereas the assets increased from £11452000 in 2010 to £13107000 in 2011 (Zytronic, 2011). The company therefore financed the assets from equity than from debt. The interest cover ratio indicates the number of times that the interest expense can be paid from the operating profits. The higher the value, the better the company is positioned to pay its interest obligation. In 2010, the interest cover was 23.21 while the interest cover was 31.76 in 2011. This implies that the company could pay its interest obligations 23.21 times from the operating profits in 2010 and 31.76 times in 2011. This can be explained from the reduction in the interest expense from £126000 in 2010 to £112000 in 2011 whereas the operating profits increased from £2924000 in 2010 to £3557000 in 2011(Zytronic, 2011). The interest expense reduced over the years because interest was pad on the bank loan, which was amortized upon making repayment. The amount of interest paid would therefore decline with the reduction in the value of the bank loan. The company thus increased the operating profit and ensured that the profits were kept as low as possible. At the same time, earning per share increased from 14.9p in 2010 to 18.3p in 2011 from the year 2010 to the year 2011. This is in line with the increase in the operating profits and the increase in earnings available for ordinary shareholders from £2188000 to £2692000 in 2010 and 2011 respectively. It should be noted that the weighted number of shares did not change during the two years. The return on the shareholders investment thus improved. This could be due to the better utilization of the company’s assets. However, the debt ratio increased from 0.36 in 2010 to 0.39 in 2011 because of the increase in the current liabilities. The net current liabilities increased from £3400000 in 2010 to £5856000 in 2011. This shows that the company’s short-term obligations increased significantly and therefore contributed to the increase in the debt ratio. For example, the financial liabilities increased from £ 669000 to £2266000 in 2011 while accruals increased by £518000 to £ 1118000 in 2011(Zytronic, 2011). Contrary to the increase in the current liabilities, the company’s long-term debt reduced significantly. This therefore means that the shareholders stake increased with a reduction in the amount of long-term liabilities and reduced the gearing level. The company reduced the amount of financial liabilities from £ 2045000 in 2010 to £ 1722000 in 2011. Moreover, the business reduced the amounts of net deferred tax liabilities from £ 827000 in 2010 to £ 726000 in 2011. This is in addition to the reduction in the government grant from £ 289000 in 2010 to £ 97000 in 2011 (Zytronic, 2011). Because of the reduction in the long-term liabilities, the company will reduce the amount of interest expense in the long-run. Finally, Zytronic reduction in the balance sheet values of the noncurrent assets should be of worry to the company. A company that invests in the short-term assets at the expense of the noncurrent assets risks from realizing declining future performance. This is one of the strategies that managers use to hide the risks in the repayment of the short-term obligation and should be discouraged by all manner. For example, balance sheet value of the property, plant and equipment reduced from £8387000 in 2010 to £8113000 in 2011. Intangible assets might have also declined from £1869000 in 2010 to £ 1811000 in 2011 due to amortization of the intangibles. Gearing ratios determines the financing of the firm’s activities and should be well determined to ensure no violation of repayment periods. Working Capital and Liquidity Ratios The working capital and liquidity ratios are used to indicate the firm’s ability to meet the firm’s short term obligation as they fall due. Companies have the obligation to pay their creditors and in return demand to be paid by their debtors in order to remain liquid. Despite a good financial performance, a firm might lack the ability to repay their debts in time and hence face charges from the suppliers or those who provide the short-term debts. The working capital ratio is the difference between the current assets and the current liabilities. It is not really a ration but an amount that shows the difference between the current assets and current liabilities which constitutes the company’s working capital. A look at the working capital ration of the company shows an improvement in the value of the ratio from £4159000 in 2010 to £5432000 in 2011 (Zytronic, 2011). It is important to note that the ratio gives the absolute value and does not show the proportion of the current assets to current liabilities. Though important, it can give misleading information and may not be important in making decisions. Current ratio on the other had is a liquidity ratio that shows current assets as proportion of the current liabilities. Through the ratio, we get to determine the number of times that the current assets can be used to repay the short-term financial obligation. In 2011, the current ratio was 1.93, which is a negative performance from the 2.22 in 2010. The company ability to discharge the short-term debts from the current assets was thus lowered. This is because the company increased the acquisition of long-term assets from the short-term borrowings. For example, the total current liabilities increased from £3400000 in 2010 to £5856000 in 2011. The quick ratio is also a form of liquidity ratio that measures the ability of a firm to repay the short term financial obligation from the current assets less the inventory. In this case, the inventory is deducted because it might require a long period to be converted into cash. It therefore means that quick ratio is used to measure the capability of a firm to discharge its financial obligation using the most liquid current assets. A calculation of the quick ratio shows improvement or decline in the ability of the firm to discharge its debt. In both 2010 and 2011, the company had a quick ratio of 1.46 which can be interpreted that the most liquid assets could be used to repay the short term debts 1.46 times. This ratio shows that Zytronic is financially liquid and can meet its financial obligation without being faced by other legal challenges. The receivables turnover is one of the efficiency ratios that are calculated by the business. This ration will reveal how long the firm takes to collect the amount owned by its debtors. In the case of Zytronic, the business set a debt collection period of between 30 and 60 days. However, from the calculation of the debtors’ period, we realize that the debtors took a longer period than the required duration to repay their obligation. To improve the financial position of the business, Zytronic, the company need to increase its creditors payment periods while reduce the period undertaken to recover their balances from the company’s debtors. In 2010, the debtors’ collection period was 68.45 days while in 2011 it took the debtors 66.7 day to completely make their payments (Zytronic, 2011). Though an improvement in the debtors collection period, the number of days were below the company’s required limit hence is affected the liquidity position of the business. Working capital management is important for the firm’s day-to-day operation and must be well managed by the company. Investing many resources on the current assets could mean lower returns to the company in the long term at the expense of the current performance. At the same time, failing to manage the creditors could adversely affect the company’s obligation from the multiple of legal suits filed by the creditors in a bid to have their debts repaid. Managing working capital is thus important in the success of a firm and if not well managed, the business might record underperformance. Appendix Table showing calculation of gearing ratios Ratio formula 2010 2011 Debt/ equity ratio= *100% =*100%=17.86% =*100%=13.14% Interest cover= ==23.21 ==31.76 EPS= =14.9p =18.3p Debt ratio= ==0.36 ==0.39 Table showing working capital and liquidity ratios Ratio formula 2010 2011 Working capital ratio= current assets- current liabilities =7559-3400 =4159 =11288-5856 =5432 Current ratio= ==2.22 ==1.93 Quick ratio= = =1.46 = =1.46 Receivables turnover= = =68.45 = =66.70 Reference Zytronic 2011, Zytronic Plc Annual Report and Financial Statements 2011 Retrieved from http://www.academia research.com/filecache/instr/z/y/675156_zytronic_plc_annual_report_and_financial_statements_2011_-_web_1_.pdf Read More