Ratio Analysis of Financial Statements - Case Study Example

Ratio Analysis of Financial ments Introduction Maclnray’s Mints Limited has approached the bank for a loan. Accordingly an assessment of the financial statements is required to be made in order to analyze the status of Maclnray’s with regard its profitability, liquidity, efficiency, and gearing of capital. The system of ratio analysis has been adopted for purposes of such analysis. Ratios have been calculated on basis of extract of information from the final accounts of Maclnray’s Mint Limited. An effort has been made in this write up to analyze an overall financial performance of Maclnray’s in order to ascertain bank’s possible report with regard to sanctioning of the loan. In the second part of the write up a comparison between trading sole proprietor and company’s year end accounting has been described. Part I Task 1 Profitability The profitability of an entity can be assess by use of its Gross Profit Ratio, Operating Profit Margin, Return on Total Assets, and Return on Equity. Gross Profit Ratio “measures the percentage of each sales dollar remaining after the firm has paid for its goods. The higher the gross profit margin, the better, and the lower the relative cost of merchandise sold.” (Lawrence. J. Gitman, 2000). Operating profit margin is “measurement of management’s efficiency. It compares the quality of a company’s operations to its competitors. A business that has higher operating margin than its industry’s average tends to have lower fixed costs and a better gross margin, which gives management more flexibility in determining prices. This pricing facility provides an added measure of safety during tough economic times.” (Investing for beginners) In fact operating margin reflects the management cost efficiency with regard to overhead expenditure. Return on Total Assets is designed to effectiveness with which total assets of the company are utilized for its operational activities. Return on Total assets. Its calculations involve use of profits before interest and taxes in order to match total assets performance only operational results. This is because interest and taxes are decisions that are taken by the management keeping the overall long run perspective of the company in view. Return on Equity (ROE) can be used to judge profitability, asset management, and financial leverage of the company. From the profitability point of view ROE explains how efficiently the capital of the company has been employed to earn its profits. “This ratio indicates how profitable a company is by comparing its net income to its average shareholders equity. The ROE measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and better returns to its investors.” (Richard Loath) All these Profitability Ratios in case of Maclnray are calculated hereunder: Gross Profit margin is 17.14% and the operating profit margin is merely 0.86%. These two figures indicate the following analysis: a) The company is efficiently manufacturing and trading and its control over direct manufacturing expenses and other cost of goods sold is appreciable; and that is the result is 17.4%. b) The company has failed in making policy and controlling its overhead expenses or ‘below the line’ expenditure. Return on assets is not at all encouraging as the ratio is mere 0.014. Two analyses can be made out of this situation. First, assets are not fully and effectively utilsed. Secondly, the assets of the company might be not completely for purposes of its manufacturing. However, return on equity of 0.115 is comparatively better. The company’s ways of utilizing capital resources are quite effective, and that must provide bankers with the some comfort, when they will distribute the loan to the company. Liquidity “Liquidity in business refers to availability of cash in times of uncertainty or in times of unwanted cash outlay. It is the capacity of any business to be prepared for any cash disbursement without any burden on where to get some money. This aspect is very important in any kind of business.” (Clive Green 7 May 2006). Liquidity ratios determine the relationship between company’s current assets and the current liabilities. The idea to establish whether company is capable of meeting its current liabilities from its available resources from current assets. The best available and most widely used tool to judge liquidity in a business is its current ratio. The current ratio of Maclnray is calculated as under: From bankers point of current ratio of 2 is considered as the best, but mostly depends upon the industry in which the company operates. The ratio here is merely 1.04 and that is not a good sign. That indicates that Maclnray may find it difficult to meet its current liabilities when those become due. “Generally the current ratio shows the ability of the business to generate cash to meet its short term obligations. A decline in this ratio can be attributable to an increase in short term debts, a decrease in current assets, or a combination of both. Regardless of the reason, a decline in this ratio means a reduced ability to generate cash.” (Small business guide). Though the position of Maclnray is not comfortable liquidity wise, but slight change in its credit policy towards accounts receivable and accounts payable may show some to improve upon its current ratio and the overall liquidity of the company. Efficiency The efficiency is an all-round performance of an entity that may be judged by a review of its Inventory turnover and Assets Turnover. Both these ratios in case of Maclnray are calculated as under: Inventory turnover is an indication of over stocking or under stocking of inventory. The more turnover of stock involves helps also in keeping current ratio healthy. In absence of information about cost of goods sold, this ratio has been calculated replacing cost of goods sold with cost of sales. Similarly inventory as at 30 June 2007 is taken as average inventory held during the year ending 30 June, 2007 for the entity. The inventory turnover for Maclnray is 2.07, which is quit healthy ratio looking at the total turnover of the company. Assets turnover conveys the extent of exploitation of assets for the business; and whether the assets were under utilized or over burdened. Generally the higher a firm’s total assets turnover, the better it is. The ratio of 1.67 is further a good ratio when we view the company’s turnover and the dwindling current ratio. Capital Gearing Capital Gearing describes the mix of internal financing and external financing of the assets of the company. Capital gearing planning is an integral part of overall financial planning of a company.” Capital Gearing or leverage describes the mix of long term corporate funding provided internally (by shareholders) to that contributed externally (by lenders) i.e., the relationship between the debt base of a business and the gross assets.” (Finance Southeast). Capital gearing is the process whereby the proportion of the contributions of equities and debt capital is decided in capital financing of a company. A company is said to be highly geared when debt capital is proportionately more than the equity capital in total capital of the company. It is called low geared, when equity is proportionately higher than debts in total capital of the company. In fact the more debt a firm has, the greater is its risk of being unable to meet its contractual debt payments and becoming bankrupt. The reason for this is that the claims of creditors have to be satisfied first before the earnings are distributed among the shareholders. Lenders or contributors to the loan funds of a company are also concerned about existing debts, or in financial terminology about financial gearing of the entity. Simply speaking the more debts are used in financing of the assets of the company; the greater is its financial leverage or gearing. It can also be stated in other way round. The more fixed cost debt a company uses, the more will be the company’s expectations of risk and returns. The gearing for Maclnray’s Mint Ltd. is calculated as under: The Maclnray is a highly geared organization. It loan financing is 7.08 time more than the contribution from the equity contributors. Highly geared companies may provided tremendous earning opportunity per share to equity shareholders in good times of the company, as the interests payments on loans payments are fixed, and here the gearing actually its role. Task 2 Analysis of company’s performance and likely response from the bank Ratio analysis point out that there are two basic weaknesses of the company so far its financial position is concerned. The first weakness is its low Operating Profit Margin despite an impressive gross profit ratio; and The second weakness of the company is its very low current ratio. Low operating profit ratio indicates concentration of certain fixed overheads that are greatly reducing the gross profit ratio from 17.14% to a mere 0.86% of operating margin. This possible reason for such fallout may be as under: 1. Concentration of fixed nature of overheads like rent of office premises, salaries of administrative staff and others. 2. The company might be paying heavy interest on its long term loan liability of $15000. 3. There might be heavy sales promotional expenses. 4. The company might be claiming deprecation on double declining method on certain newly attained fixed assets. Current ratio is also playing truant with the financial position of the company. Current ratio of the company is very low. It is only 1.04 against the established standard of 2: 1. That means bank people will be concerned how the company would be meeting its short term liabilities, particularly when the company is already heavily indebted on long term as well under current bank overdraft. Long term loan liabilities are to the tune of ₤ 15000, and bank overdrafts are to the tune of ₤ 12000. Yearly payments of interest on fixed interest bearing long term loan might be creating the situation so bad for the company. This is very much clear from the very low operating profit ratio despite impressive gross profits. That means profits are being eaten away by such fixed current portion liabilities of long term loans. Entire good work done by the company on trading front is getting lost due to unplanned financial arrangements already made by the company. Besides these two major weaknesses appearing in the overall financial analysis of the company bank will also be concerned with heavy capital gearing structure adopted by the company. Heavy capital gearing might be good for equity stakeholders during hay days; but when thing go wrong the same equity holders would be the great sufferers. Liabilities arising from fixed interest bearing loan liabilities have to be met even if the company is not earning profits. Current assets will have to suffer the brunt of such liabilities for their current portion. The result would be cash crunch, and the company may get entangled into a vicious circle of low cash liquidity seeking more loan funds, and that in return further worsening the already dwindling cash position. The company is working efficiently as is indicated by good inventory turnover ratio and assets turnover ratio. But such efficiency is not yielding final good result for the company. Under such conditions any bank would hesitate to extent further loan to the company. This will certainly worsen already critical position of the company. Under such situations bank would advise the company to seek more equity capital say on basis of private placement. This will at least not put pressure on already dwindling operating profit margins. Any further loan is not good for financial health of the company. Part II Major differences between component parts of the year end accounts for sole trader and a limited liability company Year end accounting is generally understood to mean the preparation of financial statements. In case of companies those statements are of particular interests to following groups: Shareholders: They are investors of equity and other capital and are keen to know their share of profits, i.e., dividends, Banks and other financial institutions, who have loaned the funds, are keen to know the health of company with regard to security of repayment of loaned amount. Income Tax authorities as they are keenly interested in assessing results of the tax policies of the state; and Dealers in Stocks, stock exchanges, statistical institutions, and various other govt. and non- govt. institutions keenly observe the final prints of company’s financial statements for their interests and purposes. In case of proprietorship mainly the owner is interested in knowing the progress of the business, particularly the performances of funds investment in terms of generation of profits. Banks and other institution seek information the proprietor about financial statements, as proprietorship’s financial statements are published public documents. In the case of sole proprietor who is a trader, the following financial statements are prepared: 1. Balance Sheet as on the last date of financial period. 2. Income statement or profit and loss account showing totals of revenue transactions occurred during the financial period and the calculations of resultant profit or loss from such transactions. In case of trader, profit and loss account is further divided into two parts, namely trading account and the profit and loss account. Trading accounts shows the trading results called gross profit or gross loss, and the profit and loss portion calculates operating profits or net profits after deducting the overhead costs, administrative, finance and sales expenses from the gross profits. 3. Some time traders also prepare a cash flow statement as part of the financial statements, but that is not the usual presentation. A limited liability company usually prepare the under noted statements as part of year end accounting in accordance with IAS 1.8: “1. Balance Sheet 2. Income Statement 3. A statement of changes in equity showing either: all changes in equity, or changes in equity other than those arising from transactions with equity holders acting in their capacity as equity holders; 4. Cash flow statements, and 5. Notes, comprising a summary of accounting policies and other explanatory notes. (IAS Plus International) Sole Proprietors follow conventionally laid down accounting principles unless very specific provisions of any statue, say tax laws, are required to be followed. Companies strictly observe GAAP as applicable to particular country, tax laws, and other statutory requirements while framing the final accounting. . References: Clive Green, Liquidity in business, Article Alley, 7 May, 2006, http://www.articlealley.com/article_51116_19.html Finance Southeast, definition of Capital Gearing, viewed on March 28, 2008, http://www.financesoutheast.com/guidetofinance/index.aspx?id=432#Capital_Gearing IAS Plus International, Summary of IAS 1, Components of Financial Statements, http://www.iasplus.com/standard/ias01.htm Lawrence J. Gitman, Principal of Managerial Finance, ninth edition, page 143, published by Pearson Education Inc.2000 Investing for Beginners, Operating Income and Operating profit MarginAbout.com, Viewed on March 28, 2008, http://beginnersinvest.about.com/cs/investinglessons/l/bloperincmarg.htm Richard Loath, Profitability Indicator ratio: Return on Equity, Investopedia, http://www.investopedia.com/university/ratios/profitability-indicator/ratio4.asp Small Business Guide, Current Ratio, viewed on March 28, 2008, http://www.toolkit.com/small_business_guide/sbg.aspx?nid=P06_7135 Read More