Analysis of Accounts of Wild Life Holidays Ltd - Example

RUNNING HEAD: Finance and Accounting Analysis of Wild Life of Problems Introduction This paper seeks to analyse the accounts of Wild Life Holidays Ltd (or "Wild Life") and prepare a report providing recommendation on the purchase of its shares by Annie Max Ltd. The report aims to provide and overall impression on the companys position and performance as well as a fully detailed numerical analysis. 2. Financial Analysis To acquire a company or its shares is a decision that should be viewed in terms of cost-benefit analysis just like any purchase transaction. An investment decision however may be partly different since the expected benefits must have to be quantified or measured in order to guide decision making better. A company is assumed to growth over time; hence it is required to have profitability, efficiency, liquidity and solvency or financial leverage. The following subsection will analyse each aspect extracting financial ratios from the historical financial statements of Wild Life for the last two years 2004 and 2005. For purposes of this paper and to afford a better way understanding the company in relation to other companies that could be assumed to be possible investment options of Annie Max Ltd, this paper assumes that Wild Life is part of the retailing industry since its business is trading of animals. Thus averages from the retail industry would be used as benchmark in understanding Wild Life. Industry averages signify average competitors of Wild Life. 2.1 Profitability and Efficiency The return on equity (ROE) of Wild Life at for the last two years 2004 and 2005 averaged at 8% as against the industry average of 9%. Wild Life is also obviously more profitable than ordinary competitors in the industry in 2004 but not in 2005 because of the decline in ROE from 11% to 5%. Such a show of declined superiority about its prior performance could indeed some problem when a company is expected to grow overtime. In the absence of recession, it could indicate a problem given the 7% decline in revenues. Is Wild Life being sold because of expected decline in the profitability? An 8% return on equity however may still definitely attract investors as it would mean that for every £100 the investors expect returns of about £8. This could be viewed as something acceptable if there is a recession. However as the rest of the industry may be doing better, such lower profitability may be a problem for investors See Table A below in relation to Appendices A and B. Table A – Comparative Financial Ratios; Sources (Case Study, n.d. ; Reuters, 2011) It may be noted that return on equity uses the formula where net profit is divided by the total stockholders’ equity. When compared to an average rate of 0.50% if money was invested in a bank using its average ROE of 8% makes it to more than a ten times 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 appealing to know whether the company management is efficient. To measure the latter, this paper uses return on assets (ROA). The company’s average ROA of 7% for the last two years was higher than industry average of 5%. Wild Life appeared to have higher average but in term of ROA but ROE is more controlling from the point of view of investors (Van Horne, 1992). By comparing the two ratios, it appears that Wild LIFE is both profitable and efficient than industry. The understandable profitability and efficiency of the company is further proved by the company’s net operating margin and net profit margin. The resulting average operating margin and average net profit margins for the past 2years are 13% and 9% respectively as against the industry averages of 4% and13% respectively. Operating margin results after deducting cost of sales or services and operating expenses from gross margin (Helfert, 2001). Wild Life’s net margin for the in 2005 period was posted at 7% as against the previous year of 11%. See Table A. If the rate is compared the operating profit margin, it could be found that net profit margin is lower. This means that Wild Life needed to spend other expenses to finance some of its borrowing. It further means that WILD LIFE is using other creditors money while improving profitability for stockholders. No wonder Wild Life had very high return on equity as earlier analysed against its ROA. 2.2 Liquidity Wild Life’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 Wild Life, its computed average current ratio registered at 0.83 as against the industry average of 0.97. Quick ratio of the company on the other was reflected at 0.81 as against its competitor average of 0.8. The current ratio of the company therefore in 2005 deteriorated compared with 2004. This may be due to decline revenues and profitability in 2005. Although it is generally accepted to have a current ratio of at least 1.0 if two year average of 0.83 current ratio is used, it most recent or 2005 current ratio is controlling and the company will be still considered as not liquid. This is because its total current liability is not matched by current assets of the company at 0.28 current ratios. Thus the company may be asserted to have negative working capital. This puts in dangers is financial condition as it could become bankrupt if profitability will not improve (Kieso, et al, 2007). 2.3 Financial Leverage Solvency, on the other hand, measures Wild Life’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 debt to equity ratio of Wild Life is 0.27 as against the industry average at 0.45. The solvency ratio makes it almost two times better than the competitors average and this means the value the company investments from stockholder is stronger for the company as against its competitors. This condition is favourable to company since it faces a lower risk in comparison. It present leverage ratio provides evidence of a higher a good capital structure (Helfert, 2001) for Wild Life. In one sense, the company would be considered certainly able to make further expansions in the future without falling to be further riskier than present competitors were. It means also that the company could have not much difficulty to manage its long terms risk that its profitability may have to provide funds to strengthen its leverage. This could be good support to its ailing liquidity as explained earlier. Although it may choose to lessen it leverage to strengthen its liquidity, the same may not just easily happen since much will depend on the companys capacity to generate funds. Such good leverage structure could also mean of its ability to provide good amount of dividends annually to investors, to make future expansion. However, spending funds cannot be done freely if liquidity will completely fail. In other words, a company may be solvent yet it is not liquid, in which case a company can still cease from operation. 3. Limitation of the ratios The ratio analyses applied and used in analysing Wild Life tell things about the past that may be used to predict the future of the company. It is just like taking a psychometric exam for an employee to see his or her personality and human behaviour and attitudes towards work and the resulting efficiency or inefficiency. However, there are various factors that could cause the changing of happened in the past to what occur in the future. For investment purposes, determining the profitability, efficiency, liquidity and gearing ratios and their implications may not be sufficient in assisting the decision maker. The thing that must be determines is whether Wild Life is worth the price that Annie Max Ltd is willing to pay. However, the case study does provide the £4m as price to acquire Wild Life for 100% equity and the issue is whether there is basis to continue with acquisition. Based on financial analysis made, the said buying price was not determined. The ratios can however tell that company may happen to certain level of revenues and profits with that may happen in the years to come. Hence the actually buying price is yet to be determined by making an assumption of cash flows, the projected cash flows from acquiring Wild Life which should be forecasted to several years in the future and the same must be discounted as an estimated cost of capital. If net present value (NPV) is positive after considering the proposed acquisition cost using the correct cost of capital (Shim & Siegel, 2008; Brigham, and Houston, 2002), then there is reason to decide whether Wild Life should be acquired or not with the certain price. If the computed net present value of cash flows is lower, Annie should not acquire Wild Life, but is it is higher it should acquire the same. 4. Cash is not same as profit using Wild Life to illustrate points Cash is different from profit. This can be seen in the case of Wild Life plc. It may have a profit of this £180,000 for the year of 2005 but in that same year it has net cash of £105 million. Assuming that 180,000 would be realized for the next five years total amount would be £900,000 which is still less than the offer price of £4 million. For the company to consider the net income the net benefit for the period would not be correct since not net income are cash flows or collections for the year and vice versa. They may represent proceeds from sale of investments that may have been done with loss on sale or they may come from sale of stocks to raise capital. On the other hand having a big profit does not necessarily mean higher cash or vice versa. 5. Conclusion Based on the companys financial ratios, there is a certain good basis to purchase the shares of Wild Life because some evidence of profitability and its better financial leverage compared with competitors. However, a clear problems is seen it its liquidity which declined in 2005 from 2004 because of declined revenues and profitability. It can be concluded that Wild Life may profitable, efficient, than its average competitors in the industry. However, the company poor liquidity may pose a problem. As revealed in the analysis, Wild Life’ very good solvency can help in its liquidity problem but the profitability must be established. In making an investment for the future, a decision maker should answer the question on whether the decision which is about to be made will made the investor richer or wealthier after some time given the opportunity cost of the investor (Brigham & Ehrhardt, 2010). The case just presented financial information of the Wild Life for two years and to estimate the value of the company compared to its selling price by it owner and purchase offer to Annie, there is need to know the real value of company. The financial ratios used and presented earlier can only talk of what happen but they cannot tell how much wealthier Annie after a number of years. To value Wild Life there is therefore need to know the initial net cash inflows that would come in every year over the life of Wild Life and discount the same using cost of capital which is not given in the case. By so discounting the cash flows, the net present value generated is below the £4 million price of Wildlife. To purchase therefore Wildlife at L4 million is not advantageous to Annie since its actual value by discounting 2005 profit of $180,000 into perpetuity is just £2 million assuming a 9% cost capital based average ROE computer earlier. This is done by dividing $180,000 by 9%. 6. Recommendation This paper therefore recommends the use of capital budgeting techniques to help the client decide on acquisition as the financial ratio analysis used in this paper is limited to use the past information and which can partly be used to predict the future (Needles, et al., 2007; Rajasekaran, 2011) with no clear indication on how much is the net advantage of acquisition. A difference of cash and profit was also demonstrated in this paper. The managers of Annie Max are advised to use of capital budgeting techniques like the NPV method in order to help them decide on the proposed acquisition of Wild Life. This has assumed certain rate but it turned that the computed value of Wild Life it most £2 million. £4 million offer is too high a price for Wild Life. 7. Appendices Appendix A; Souces (Case Study , n.d., Reuters, 2011) Appendix B; Source (Helfert, 2001) 8. References: Brigham & Ehrhardt (2010). Financial Management Theory and Practice. Cengage Learning Brigham, E. and Houston (2002) J. Fundamentals of Financial Management, London: Thomson South-Western Case Study - Annie Max Ltd on Wild Life Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Housepricecrash, 2011, US base rate Retrieved 25 November 2011 from < http://www.housepricecrash.co.uk/base-rates.php > Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Needles, B. et al.(2007). Principles of Accounting. Connecticut: Cengage Learning Rajasekaran (2011). Financial Accounting. Pearson Education India Reuters (2011). Industry Ratios. Retrieved 25 November 2011 from < http://www.reuters.com/finance/stocks/financialHighlights?symbol=TSCDF.PK> Shim, J. &J. Siegel (2008). Financial Management. Barrons Educational Series Read More