Financial Ratio of Warratah Bank - Case Study Example

Save this file under a name unique to you. Preferably start the file name with your family name and first name and the relevant year and study period. Highlight and delete this message. [ENTER THE TITLE OF THE REPORT INCLUDING THE NAME OF THE BUSINESS BEING INVESTIGATED] for [Enter the name of the client] [Enter the date of submission] prepared by [Enter your name] Executive Summary In this report, financial ratios are used to determine the credit worthiness of the firm. As a credit officer of Warratah bank, I have analyzed the financial ratios to determine whether the bank should get the loan. The profitability, liquidity and stability ratios of Balloons limited have improved over the three years. It is most efficient in its third year and based on the prospects of the firm, its revenue is expected to improve in the subsequent years. However, the decision as to whether to advance the loan to the firm should however not be entirely based on financial ratios as they are associated with some weaknesses. Other factors such as prospect of a greater market share, technological advancement, managerial skill and size of the firm will also be considered when coming up with the financing decision. When all these factors are put into consideration, an optimum interest rate should be set for the firm. This would result to the firm making the right decision regarding lending Contents Introduction A financial ratio is a relative magnitude of two financial numerical values from an accounting entity in their financial statements. These ratios are used to indicate the performance of a firm, compare such firms with others in the industry and help poor performing firms to take corrective action. This report enables Warratah bank to come up with an informed decision as whether to finance Balloons limited or not. In this report, the profitability, liquidity and the stability of the firm is scrutinized using the financial ratios. These ratios are available for the three year period that it has been in operation. The bank also uses other relevant data provided by the firm. The recommendation of the report however has been mostly based on the ratio analyses. Financial ratios are subject to a number of limitations which have been discussed in the report. This therefore implies that the weaknesses in the financial ratios have also been reflected in the decision of the bank regarding advancing the loan to Balloon limited. Profitability The return on assets has increased significantly over the three years. This is attributed by the steady growth in the operating profit as well as the decrease in the interest expense over the years. The increase in the number of average total assets should reduce the return on assets but this is overwhelmed by the significant growth in the profit over the three years. However, the relative increase in the return has reduced over the three years. During the second year it grows by 43.1% while during the third year, it only increases by 13.3%. The return on ordinary shareholders has grown over the three years. This signifies a growth in shareholders wealth. This is greatly attributed by the growth in profit after tax. The ordinary shareholder’s Equity has also increased over the 3 years (Clyde and Stickney, 2008). This may be attributed to issuance of more shares or due to share splits. Although there is an increase in the ordinary shareholders growth, the increase is retrogressive, in the year 2010 it grows by 47.7% while in the year 2011, it grows by 16.1% This trend is also the same in the earnings per share which have increased over the three years. Just like the ratios discussed above, there is a retrogressive rate in growth. The dividends as well as the dividend payout have increased slightly over the two years where information is provided. The profitability of the firm is generally increasing over the years. However, the profitability of the firm is increasing at a decreasing rate (Donald, 2009). However, more information will need to be provided on the dividend yield as well as earning yield details over the three years in order to make more informed decision. Liquidity The current and quick ratios have decreased over the 3 years. This may be attributed to a significant increase in current assets and a relatively small increase in current liabilities. Most of the firm’s current assets are held in stocks. The firm is too liquid especially in the first and second year. The ideal current ratio should be 2 and therefore they should invest more so as to increase their turnover. During the second year, current assets grow by 19% while the current liabilities grow by 70%. In the third year, the growth rate in the current 13% while that of current liabilities is 31.8%. This implies growth in the firm but in a decreasing rate (James and Philip, 2010). The firms seem to be moving towards an efficient equilibrium between the current assets and liabilities. There is a significant growth in the accounts receivable in the firm. There is a 9.8% growth of debtors in the second year a 19.8% growth in the third year. This signifies is an increase of credit sales over the three years in a progressive rate. Although this implies an increase in the turnover as well as the reported profits, the firm should take into consideration the risk of bad debt. The value of inventory has increased by 22% in the second year and by 27.7% in the second year. However, the firm is taking a shorter period to convert their inventory into sales which is beneficial to the firm as it reduces costs associated with storage of stocks such as theft, obsolescence and storage costs. The liquidity position of the firm is above average. However, its liquidity is poorer in the third year as compared to the second year and first year (Carl, 2005). It is beneficial for a firm to be liquid in order to run its day to day activities and avoid insolvency risks. However, the firm should be prudent not to be so liquid and under invest as such funds would be utilized in higher interest yielding activities. The firm however is moving towards an efficient equilibrium in the liquidity as too much liquidity in the third year as the ideal ratio should be around 2:1. Financial Stability The debt ratio of the firm has decreased over the three years while the equity ratio has increased over the three years. This indicates a decrease in liabilities and also shows that more of the firms operations are covered by internal funds rather than external financing. The capitalization ratio is constant over the three years which indicates constant growth in total assets as well as total shareholders’ equity. The percentage growths in liabilities have reduced from 8.7% in the second year to 6% in the third year. The capitalization ratio has increased from 9% in the second year to 10.3% in the third year. This implies that the firm’s assets are growing with increase in shareholders’ equity. The times interest earned ratio improved by 38.7% in the second year and by 9.3% in the third year. This shows that the firm is able is able to honor its debt payment. This signifies more earnings are available to meet interest payment and thus the business is less vulnerable to increase in interest rates. Based on the industry, this ratio is slightly higher because the industry ratio is about 10:1. Interest liability may be brought about by non current liabilities such as bank loans or bank drafts (Stephen, 2008). However, this has remained the same over the three years. This therefore implies a strong financial base and therefore the company is stable. The asset turnover ratio has improved by 7.7% in the second year and remains constant in the third year. This implies that each unit of dollar used produces 1.4 units of revenue. This is attributed by the steady growth in the average fixed assets over the three years which is not reciprocated by a significant growth in the income (James, 2008). This may also be dictated by the pricing strategy of the firm. The firm is therefore not efficient in generation of income as an ideal ratio for the industry is 3:1. Conclusion From the above analysis, it has been observed that the firm is performing well in general. This is despite the fact that the firms performance (as far as ratio analysis is concerned) has been noted to improve at a decreasing rate. However, it is worth noting that this observation is single sided owing to the fact that it has only been based on ratio analysis only. It would therefore be prudent if more factors are considered in order to make a more informed decision on whether to advance the loan or not. However, as far as the financial analysis is concerned, the bank should not find it difficult to advance the loan since the firm’s performance is alright. Recommendation Based on the financial ratios provided, Warratah bank should advance the loan to Balloons limited. The profitability of the firm has been improving over the three years. Although the growth in profitability is retrogressive, the firm has maintained profitably. The liquidity position of the firm is also above average. The firm would therefore be able to meet its financial obligation (repayment of principal and interest) if the trend persists. However, the gradual decrease in the current ratio of the firm should be discussed in order to establish the performance of the firm while incorporating the loan repayment to be made in future (Daniel, 2010). The loan repayment period should also be established in order to reduce the risk of defaulting the repayment of the loan. The financial stability of the firm is above average. However, the bank will need to discuss with the firm that no other loan may be taken before prompt payment of their loan. Future prospects of the firm need to be discussed, any change in their market share due to more competitors must be taken care off as will directly affect gross profit as well as the net profit. If Warratah bank incorporates all this factors they should determine their interest rate as this will be affected by their level of risk (Esther, 2010). Since their risk is average, an average interest rate should be applied to Balloons limited. Appendix – Part C Limitations of entirely relying on financial analysis to make financing decisions The decision of advancing the loan to the firm has been entirely based on financial ratio analysis. However, there are certain disadvantages associated with basing a financing decision entirely on financial ratios. These include: A) Inadequate information Ratios provide clues about a company’s performance as well as its financial position. However, they cannot provide enough and analytical information regarding its entire performance. Quantitative data is required on the ratio in order to come up with sound conclusions. Secondly, ratios are calculated based on historical data and therefore they may not explain a firms’ current position. When historical costs are used, assets valuation in the balance sheet will be inaccurate and thus will be misleading to decision makers. Ratios are based on summarized information as at the end of a particular accounting period. This may not be an indication of what has been happening in the firm all year long and there could be misleading especially where there are significant financial changes during the year end. B) Comparison of performance over long periods. Inflation and price changes over the years will result to misleading information as they are not captured in the calculations of ratios. Technological changes over the firm and the industry should be taken into consideration since they greatly affect the efficiency of a firm (Esther, 2010). Firms within the same technological reach should be compared in order to come up with more logical conclusions. Changes in accounting policy and standards affect the way firms report during different accounting periods and it would therefore be misleading to compare such periods. Organizations such as those dealing with tourism and ticketing may have large variances within their financial year, if such firms choose to report their financial reports during peak periods in order to attract investments or for other reasons, this results would be exaggerated and therefore misleading to the users. C) Accounting information. Different firms in an industry apply different accounting policies. IAS 16 for instance allows valuation of assets to be based on either depreciated historical cost or valuation of assets (Linda, 2011). Firms that may have similar results but use different policies in order to manipulate the profit will report different ratios to the users of financial information. Firms may also adopt creative accounting. This is mainly applied by firms to improve their reported profitability which will improve their investors, partners or access to higher value bank loans. This may be interpreted wrongly by the users of the financial information. D) Hard inter firm comparison. Each firm is unique. Two competing firms in the same industry have different financial and business risk profile. It would therefore be misleading to use ratios to compare the performance of such firms. Funding abilities to firms may affect their gearing levels. Subsequently, a firm with a low gearing ratio may be preferred yet the low gearing may be brought about by the firm’s inability to access loans which is required for growth and expansion. It would also be misleading to compare firms with different capital structures. For instance, an equity financed firm should not be compared with a geared company. Other indicators of good performing firms which would influence the money lending decision would include: a) Availability of collateral Availability of collateral would enable a firm get access to loan facilities as compared to those with little or none. This may be in the form of assets. b) Size of the firm. The size of the firm will influence its ability to access loans. Large firms tend to have a wider access to credit facilities. This is because they enjoy economies of scale and are more technologically advanced, moreover, they have a larger market share and are able to diversity their investments as well as their risk. C) Borrowing history of a firm. Firms with a good borrowing as well as repayment history are able to access loans as compared to those listed as defaulters or those that have not borrowed before. D) Legal requirements. The legal requirement in a certain state or industry will determine a firm’s ability to get access to loan facilities (Linda, 2011). High interest rates set by the government through their fiscal agents will discourage firms from borrowing and the vice versa is true. Reference List: Clyde, P and Stickney, R2008, Financial accounting: An introduction to concepts, methods and uses, London, South western college. Donald, E2009, Financial accounting: Tools for business decision making, New York, Willey. James, R and Philip, E2010, Financial and managerial accounting, London, Prentice Hall Carl, S2005, Corporate financial accounting, London, South Western college. Stephen, A2008. Investment decisions, Australian management journal, Vol. 1, no. 3pp 50- 56. James, K2008, Financial accounting with case problems, Macmillan, Melbourne. Daniel, G2010, financial accounting principles and basics, London, Rutledge. Esther, C, 2010, Role of financial ratios in making financial decisions. Australian accounting review journal, Vol. 1, no. 10 pp 110- 116. David, A and Christopher, N2010, Key management ratios, Oxford, Oxford University press. Linda, M.2011, IFRS 13: Making wise investment decisions, Australian accounting review journal Vol. 2, no. 4 pp 78- 96. Read More