Financial Analysis - Profitability Ratios, Liquidity and Efficiency Ratios - Example

Contents 2 Financial Analysis 3 Profitability Ratios 3 Liquidity and efficiency Ratios 4 Gearing Ratios 6 Conclusion 7 References 8 Ratio analysis is a very accurate and reliable tool when it comes to analyzing the financial outlook of an entity. (Investopedia, 2012) The primary reason to conduct a ratio analysis is to quantify the results of the operations of a company and compare them with that of the prior year(s) in order to assess different aspects of the financial feasibility. The ratios can be divided into various categories such as profitability, gearing and liquidity, each focusing on a different area of the financial outlook of the organization and highlighting the company’s performance. These analysis form an integral part of the financial statement analysis, especially from the investors point of view, who always strive to invest in countries having strengthen and stabilizing financial ratios and representing an upward trend. It is of great significance that the ratios must be benchmarked against a standard in order for them to possess a meaning. Keeping that into account, the comparison is usually conducted between companies portraying same business and financial risks, between industries and between different time periods of the same company. The company under consideration is JB Hi Fi Limited and in this report analysis of the financial performance of the company for the financial year 2009 with the financial year 2010 has been conducted in order to draw attention to various financial trends and significant changes over the period. The analysis is divided into three main categorize namely Profitability, Liquidity and Gearing. Profitability ratios identify how efficiently and effectively a company is utilizing its resources and how successful it has been in generating a desired rate of return for its shareholders and investors. Liquidity ratios measure the ability of the company to quickly convert its asset into liquid cash to settle its short term liabilities. Whereas, the Gearing ratios identifies the extent to which the company is financed through debt and to what degree the operations are being conducted from the finance raised through raising equity capital or otherwise. Financial Analysis JB Hi Fi Limited is regarded as one of the prominent when it comes to selling home appliances. The company is involved in selling plazmas, computer and tablets and several other digital home entertainment appliances. It holds a considerable market share and manages its operations through a well established supply chain. The company represents sound financial outcome as its turnover has increased by 27% during the financial year 2009 as compared to the prior financial year, boosting the net profit by a massive 39%. The company’s reserves have also increased during the current financial year which shows that its investors are considering the company lucrative and are planning to have a long term association with it. Profitability Ratios   2009 2008   Profitability Ratios Gross profit margin 21.51% 21.86% Net profit margin 6.17% 5.65% ROCE 41.19% 39.71% Gross profit margin is an analyzing tool which assists in identifying how effectively and efficiently the company is utilizing its raw materials, variable cost related to labor and fixed costs such as rent and depreciation of property plant and equipment. The ratio is calculated by dividing the sales revenue by the gross profit. Analyzing the trend of gross profit margin, in the financial year 2009 the gross profit margin has marginally decreased as compared to the financial year 2008. Although the sales in the year 2009 increased by $498.702 million, but this was offset by an increase of $ 397.802 million in the cost of sales. Net profit margin, on the other hand analyzes the profitability of the company before deducting the taxation and finance charges from the earnings. The ratio is calculated by dividing the profit before interest and tax with the sales revenue of the current financial period. The ratio highlights how well the company is managing its selling and administrative expenses it also highlights the other income generated by the company during the course of its operations. The net profit margin has represented an inclining trend in the financial year 2009 as compared to the financial year 2008. In the financial year 2008, the margin was at 5.65% and although due to the increase in the operating expenses by 20.4% the net profit margin for the financial year 2009 still increase to 6.17% which was due to the fact that the company was able to post a higher gross profit figure in the financial year 2009 as compared to 2008. This shows that the company did not let its operating expenses go out of the control and curtailed it to the maximum. This could be due to the prudent allocation of the resources by the company during the year. Return on capital employed (ROCE) is, according to the analyst, is considered to be the most significant ratio in order to evaluate a company’s performance from an investor’s point of view. ROCE measures a company’s ability to earn a return on all of the capital that is being employed by the company. The ratio is calculated as net income upon total capital employed, which is the sum of debt and equity financings. The ROCE has increased during the financial year 2009 which could be due to the increase in the net and gross profit of the company. The equity share capital of the company remained constant throughout the period thus variation among the ROCE of different periods is due to the change in retained profits and revaluation reserve. Liquidity and efficiency Ratios 2009 2008 Liquidity Current ratio 1.32 1.38 Acid test ratio 0.31 0.24 Debtors turnover period 38.61 34.5 Inventory turnover 6.13 10.51 The liquidity ratio measures the company’s ability to pay its short term liabilities. The ratio illustrates that how quickly a company can convert its assets into cash and cash equivalent in order to pay off its short term liabilities. (investopedia, 2012) The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The strengthened the current ratio the more ability the company has to pay its debts and short term obligations over the next 12 months. An overall analysis of the ratio would portray that in all the years the company had enough assets to pay off its obligations and debts. The current ratio decreased in the financial year 2009 due to the fact that although the value of the current assets increased by 29% during the current financial, the increase in the current liabilities was greater at around 35% which offset the increase in the current assets. An analysis of the current liabilities reveals the fact that the major increase in the liabilities was on account of the trade payables which increased by around 32% from the prior financial year. In addition to that, the other liabilities have also shown an increase. Keeping that in mind, the company’s current ratio is greater than 1 which shows that the company will be able to pay off its debts in the near future. High current ratio can also indicate that the company has additional inventory and the assets are not generating enough cash. The acid test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance. . Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. The acid test ratio has shown an inclining trend which is in contrast to that of the current ratio. This could be due to the fact that inventory form as the most major and significant portion of the current assets of JB HI FI limited and it is not included in the calculation of acid test ratio. Receivable turnover represents how quickly the cash is received from the debtors. The ratio is calculated by dividing the revenue generated from the sales by the receivable balance as mentioned in the balance sheet of the company. The formula calculates the number of times the debtors are turned over during a year. The higher the value the more efficient the management is or it could also mean that the debts are more liquid. This particular ratio has represented inclining trend over the period. This fact can also be corroborated due to the fact that the sales have gradually inclined from the financial year 2008. One reason behind such trend would be the fact that the company is allowing excessive relaxation to its customer in order to enhance their sales level Inventory turnover represents how quickly a company’s inventory is sold, which can be calculated by dividing the sales revenue by the average inventory balance as at the year end. High inventory level is not beneficial for the company as it represents that the company’s investment is tied in inventory and currently it is not generating any income. A lower inventory turnover period represents that the sales are poor and there is excess inventory in the storage. Whereas a higher turnover period might represents that sales are comparatively higher. An inventory turnover period can also decreased due to the shift in the operation policy of the management e.g. if the management decides to increase the level of ‘safety stock’ then the balance of closing inventory would be greater and thus inventory turnover period would decrease, although the sales would have increased during the period. The inventory turnover of the company has been decreasing over the past year which is in line with the increasing cost of sales of the company mainly on account of the purchases. The company needs to evaluate the situation by making sure that its cash is not tied up in inventory for long and should devise strategies to sell them as soon as possible. Gearing Ratios 2009 2008 Gearing Ratios Equity ratio 0.35 0.31 Debt ratio 0.65 0.69 Debt : equity ratio 0.35:0.65 0.31:0.69 Borrowing ratio 0.47 0.82 The gearing ratios and indicate the level of risk taken by a company as a result of its capital structure. These ratios are a great source of determining the level of financial risk to which the company is exposed and thus helps in reducing it to the optimum. (Qfinance, 2012) The equity ratio indicates how much of the entity’s assets are financed through the finances generated through the revenue generated from the operations of the entity and raising financing through equity issue rather than acquiring debts or other financial institution. (investopedia, 2012) If we analyze the ratio over the period, it represents a stabilized trend over the period. The ratio has increased during the current financial year which shows that the company is trying to finance major of its operations through equity rather than through debt. The debt ratio represents characteristics which is the opposite to that of the equity ratio. Debt ratio, which calculated by comparing the total liabilities to total assets, is a primary tool in determining the influence the company is under as a result of obtaining finances from sources other than equity. A lower ratio represents that the company is utilizing its equity in order to finance its operations and thus curtailing the financial risk. (Peavler, 2012) The debt ratio represents trend which is the total opposite of the one represented by equity ratio. Thus the analysis of the debt: equity ratio presents that the company aggressively started financing its operations after the financial year end 2008, through equity. This could be due to the fact that company was able to manage its resources prudently and thus it is generating the required funds on time. Another ratio to assess the financial leverage of the company is by calculating the borrowing ratio of the company. The ratio is calculated by dividing all the short term and long term borrowing of the company in the form of overdraft, long term loan and finances etc., with the shareholder’s equity. The borrowing ratio presents similar trends as the debt ratio, and also due to the fact that the ratio uses the same dependents. The borrowing ratio of the company has decreased in comparison with the prior year which shows that the company utilized significant of its resources for repayment of its debt. Conclusion Based on the above analysis, it would be sensible and prudent to invest in Marks and Spencer as it displays a more stable financial outlook. , it appears that although the company is currently facing certain liquidity problems, it is likely that the company will be able to further enhance its profitability and liquidity, based on stable financial history. References Investopedia.com (2012) Financial Ratio Tutorial | Investopedia. [online] Available at: http://www.investopedia.com/university/ratios/ [Accessed: 18 Sep 2012]. Investopedia.com (2011) Understanding Financial Liquidity. [online] Available at: http://www.investopedia.com/articles/basics/07/liquidity.asp [Accessed: 18 Sep 2012]. Investopedia.com (2012) Equity Financing Definition | Investopedia. [online] Available at: http://www.investopedia.com/terms/e/equityfinancing.asp [Accessed: 18 Sep 2012]. Peavler, R. (2012) Profitability Ratios - Financial Ratio Analysis - Profit Margin - Return on Equity - Return on Investment. [online] Available at: http://bizfinance.about.com/od/financialratios/a/Profitability_Ratios.htm [Accessed: 18 Sep 2012]. Peavler, R. (2012) Debt and Equity Financing - Advantages and Disadvantages. [online] Available at: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm [Accessed: 18 Sep 2012]. Qfinance.com (2010) Gearing Ratios - Definition of Gearing Ratios - QFINANCE. [online] Available at: http://www.qfinance.com/dictionary/gearing-ratios [Accessed: 18 Sep 2012]. VERNIMMEN, P., & VERNIMMEN, P. (2009). Corporate finance theory and practice. Chichester, U.K., John Wiley & Sons. Read More