Using Accounting Information for Decision-Making - Otter Enterprises Pty Ltd - Assignment Example

Name: College: Course: Instructor: Date: Executive Summary In arriving at an informed decision, it is imperative for Simon Wright to be informed about a financial analysis of Otter Enterprises Pty Ltd that he is considering to acquire. He also needs to be informed of interest rates paid on short-term bank deposits. Information on the above investment options is imperative in choosing the best investment option since Simon is considering investing in either of the two options. Financial statement analysis entails analyzing the profitability, liquidity and financial stability. Profitability is the sole target of any business operation. Business entities survive on profitability. Profitability is measured by the amounts of incomes generated by the business and expenses incurred in the process of generating income. A critical analysis of past and present profitability as well as future projections offers a clear picture of the businesses position. Liquidity is the ability to respect debts payments when they become due for payment. Financial stability is represented by a stable financial system. A business is financially stable when it is able to honor its contractual duties without relying on outside assistance (Gotthilf 1980; Alawode and Sadek 2008). Financial statement analysis is based on two very important financial statements; the income statement and the balance sheet. The analysis is done by the use of ratios. They simplify the information portrayed by financial statements. They are easy to understand and interpret. They save effort and time in making a decision. Contents Accounting for business major assignment study period 5 2012 using accounting information for decision-making 13 1 Executive Summary 2 Introduction 4 Overview 4 Profitability 5 Ratio analysis 5 Conclusion 6 Liquidity 6 Ratio analysis 6 Conclusion 7 Financial stability 7 Ratio analysis 7 Conclusion 8 Conclusion and Recommendation 8 References 9 Appendix 1 11 Definition of terms 11 Appendix 2 12 Introduction Business analysis is all about problem solving. The analysis opens out strengths and weaknesses of a business. This offers guidance about areas that need changes and improvements for future prosperity. It is essential to conduct this analysis when faced with a myriad of investment opportunities to identify the most feasible and lucrative option. Business analysis enhances decision making (Gotthilf 1980). The objective of this report is to conduct a financial analysis Otter Enterprises Pty Ltd taking into account the past three years. The report shall also touch on interest rates on bank deposits. This is to provide in depth information to Simon Wright to arrive at an informed decision on the best investment strategy between taking over the bookshop enterprises and investing his $850, 000 in a 3 – 5 year bank term deposit. The report shall cover three basic areas of financial statement analysis. These are profitability, liquidity and financial stability as regards to Otter Enterprises Pty Ltd. Further, the report shall cover interest payments on short-term bank deposits. Overview There are numerous ratios that can be used in financial statement analysis. To analyze profitability, liquidity and financial stability separately, however, the analysis focuses on two most important ratios to analyze each of these items. It is may be reckless to consider all ratios. There is no criterion used to arrive at the ratios considered. The ratios chosen are based on common practice. Vertical analysis, horizontal analysis as well as trend analysis of the financial statements is conducted. Profitability Ratio analysis The main ratios analyzed are return on assets (ROA) and return on equity (ROE). The ROA for 2012, 2011 and 2010 is 53.83, 61.47 and 65.89 respectively. The ROA for 2012 declined by 12.4% from that of 2011 while the ROA for 2011 declined by 6.7% from that of 2010. The ratios are declining at an increasing rate. The ratios are high indicating high returns on the assets. Despite an annual increase in total assets the ROA is declining perhaps owing to declining profit levels (Sakolski 1923). ROE is regarded as the most important ratio as it directs potential investors in deciding whether to invest or not to invest in a company. The 2012, 2011 and 2010 ROE is 47.89%, 57.51% and 63.39% respectively. The ROE for 2012 declined by 16.7% from 2011 whereas that of 2011 declined by 9.3%. Although the ROE is high, just like the ROA, the ROE is also declining at an increasing rate. The decline is preeminent despite a significant annual increase in the shareholder’s equity (Sakolski 1923). The 2012 P/E ratio for Otter Enterprises Pty Ltd is 4.55 times. This represents a 22.00% earnings yield. The ratio is high an indication of good returns. The previous accounting periods, 2011 and 2010, had a 0 P/E ratio. This reflects prospective better returns in future (Beranek 1963). The 2012, 2011 and 2010 dividend yield for Otter Enterprises Pty Ltd is $153, $179 and $175 respectively. The dividend payout for the 3 years is 86.93%, 89.95% and 82.16% respectively. Considering that Otter Enterprises Pty Ltd has a high return on equity, however the dividend payout is high. This indicates that the funds cannot be reinvested at a higher rate of return than the shareholder’s equity (Beranek 1963). Conclusion The profitability ratios for Otter Enterprises Pty Ltd are impressively high indicating that the business is performing well. However, the ratios indicate an increasing decline in profitability despite increase in total assets and shareholder’s equity. This can be attributed to a decline in sales or a negative impact from the external forces such as the 2010 world economic crisis. Liquidity Ratio analysis The major ratios used to measure liquidity are the current ratio and the quick (acid test) ratio. The current ratio indicates whether the business can sustain payments of its expenses. The ratio measures short-term financial position of a business. The current ratio for 2012, 2011, and 2010 is 6.11:1, 5.31:1 and 4.51:1 respectively. The ratio increased by 15.1% from 2011 and by 17.7% from 2010. This can be explained by an increase in the current assets as current liabilities reduce over the 3 years from 2010 to 2012. The industry average current ratio in 2012 is 4.58:1. This indicates that Otter Enterprises Pty Ltd is able to honor its short-term obligations effectively. However, the annual increase observed may be attributed to increases in accounts receivables. The accounts receivables increased by 8.333% from 2010 to 2011 whereas there was a decline from 2011 to 2012 by 19.23%. The same is reflected by almost similar changes in the current ratio. It may suggest there are challenges in collecting debts (Dale 1962; Gotthilf 1980). The quick ratio is a more effective measure of liquidity than the current ratio; it does not include inventory that is considered less liquid. The ratio for 2012, 2011 and 2010 is 2.17:1, 1.88:1 and 1.65:1 respectively. The industry average for 2012 is 2.26:1. The ratio went up by 0.29 (15.4%) in 2012 from 2011 and 0.23 (13.9%) in 2011 from 2010. The increase indicates that Otter Enterprises Pty Ltd is able to honor short-term obligations without relying on selling its stock. The inventory turnover may be declining. There is an increase in closing inventory across the 3 year period; 2011 inventory increased by 5.83% and 2012 inventory went up by 0.79% (Dale 1962). Conclusion The ratios indicate that Otter Enterprises Pty Ltd is in a solid liquid position. The business’s current assets can suitably cover its short-term debts. The quick ratio overcomes the limitations attributed to a high current ratio. The ratio indicates that the Enterprise has a high cash translation cycle (Dale 1962). Financial stability Ratio analysis The main ratios considered are the debt ratio and the capitalization ratio. The debt ratio for 2012, 2011 and 2010 respectively is 22.34%, 25.52% and 28.81%. The ratio is declining from 2010 to 2012. The decline may be attributed to a decrease in total liabilities and increase in total assets. Total liabilities reduced by 10.29% from 2010 to 2011 and by 8.33% from 2011 to 2012. The total assets increased by 1.27% and 2.09% in 2011 and 2012 respectively (Gotthilf 1980). The capitalization ratio for 2012, 2011 and 2010 respectively is 1.29:1, 1.34:1 and 1.40:1 respectively. The ratio is declining. This may be as a result of increase in shareholder’s equity. The equity increased by 5.35% and 6.46% in 2011 and 2012 respectively (Dale 1962). The 2012, 2011 and 2010 times interest earned ratio is 32.5 times, 36.5 times and 44.4 times respectively. The industry average is 15.5 times. The ratio is too high indicating that the business has enough earnings to meet interest payments (Dale 1962). Conclusion The ratios indicate that the business is financially stable. The debt levels are decreasing so the business can sustain itself without relying on outside assistance. It is also has enough earnings to pay up interest obligations. Conclusion and Recommendation The financial statement analysis reveals that is profitable, liquid and financially stable. Although profitability is declining, the profitability level is high and well above the industry average. This indicates that the business is performing well. The enterprise is in a solid liquid position. It is able to honor short-term obligations without entirely relying on selling inventory. It has high cash convergence ability. The business is also financially stable. The debt levels are declining. The earnings are sufficient to pay for interests when they become due. Most ratios are above the industry average. Otter Enterprises Pty Ltd is in a sound financial position. The report has covered its intended purpose of analyzing the financial position of Otter Enterprises Pty Ltd. Simon Wrought can rely on the information herein to make a decision. Simon should also consider his other investment option. Banks in Australia are paying interests of between 4.50% and 5.00% on term deposits of more than $50, 000 over the 3 – 4 year period. Simon should look into the future projections of Otter Enterprises Pty Ltd and interest payments on bank deposits before arriving at a final decision. Also, Simon Wrought should look beyond the financial statement analysis. Simon should consider the macroeconomic and microeconomic environment of both options. References Abayomi A.A and Mohammed Al Sadek, 2008, What is Financial Stability. Financial Stability Papers Series, Central Bank of Bahrain. Available from: http://www.cbb.gov.bh/assets/FSP/What%20is%20Financial%20Stability.pdfhttp://www.cbb.gov.bh/assets/FSP/What%20is%20Financial%20Stability.pdf Beranek W, 1963, Analysis for financial decisions. Homewood, Ill, R. D. Irwin Blecke C. J, Gotthilf, D. L, 1980, Financial analysis for decision making. 2nd ed. Englewood Cliffs, N.J, Prentice-Hall Edmonds C, Edmonds T, Olds P, & Schneider N, 2006, Fundamental Managerial Accounting Concepts. New York, McGraw-Hill Irwin Howard Podeswa, 2008, The Business Analysts Handbook. Course Technology PTR, 1st ed. Kennedy R. Dale, 1962, Financial statements: form, analysis, and interpretation. 4th ed Homewood, Ill.: R.D. Irwin. Sakolski A M, 1923, The analysis of financial statements. New York: G.P. Putnam's Sons. Appendix 1 Definition of terms Profitability is the ability to achieve a positive gain from a business activity. Liquidity is the ease at which a business entity can convert its assets to cash. Financial stability is the ability of a business to endure disruptions in the market. A ratio is a measure of relative size expressed in form of a proportion. The return on assets (ROA) ratio indicates the efficiency with which a company utilizes its assets to generate income. The return on equity (ROE) ratio is a measure of returns generated from the capital invested in the business. The price earning (P/E) ratio is measured by a stock market price and the earnings per share. The dividend yield ratio compares the dividends earned to the market value of a stock. The current ratio is measured by the current assets versus current liabilities. The quick ratio is measured by the current assets less inventory versus current liabilities. The debt ratio shows how much a business is indebted. The capitalization ratio indicates the debt component of the amount of capital invested in a business. The times interest earned ratio indicates the ability of a company to honor its interest payments. Appendix 2 Financial statement analysis is useful in evaluating a company’s financial performance. This offers both quantitative and qualitative analysis. Apart from the use of ratios, personal judgment is considered in decision making. On the other hand, financial statement analysis is handicapped. Financial statements rely on past statistics and figures. The statements do not present a clear picture about the future. They are not effective when planning for the future. The current world is so dynamic. The statements do not capture current realities in the markets. The information depicted is therefore not up-to-date. Making comparisons across different accounting periods may not present a true picture owing to market forces such as inflation. The information obtained may thus be inaccurate and unreliable. Making comparisons between the business and the industry may not also be depended upon. Different business entities use different accounting methods. There is no uniform comparison. Also the statements may be misleading if they are not correctly prepared. Technical expertise is required to prepare and analyze financial statements. Financial statements fail to present sufficient qualitative information. They are mainly quantitative. They do not capture political, technological and economic impacts (Sakolski 1923). Effective business analysis should include other forms of analysis. This includes both the internal and external environments analysis. The business should have proper operational systems and processes. Business systems and processes also need to be analyzed. Economic or logical analysis is also important. The business should analyze issues of cost structure – minimizing costs. Cost benefit and cost effective analysis should be conducted. The analyses points out project feasibility and effectiveness against the cost. Macroeconomic variables such as trends in overall price level, economic growth rates and interest rates should be considered in business analysis. A business, customer, competitor and product SWOT analysis in the market place is also important. Analysis of the strengths and weaknesses is significant to identify where changes and improvements can be made as well as offer a reflection of future opportunities (Podeswa 2008). A general analysis should include technological and economic changes. The analysis should include changes in consumer behavior - tastes and preferences - as well as changes within the entity such as new employees. A change in key management positions is a potential area to analyze due to the impact of the senior management business operations. Analysis of the political environment cannot be ignored. Government policies and regulations on the particular business sectors have to be looked at. They dictate how a business is to be operated. The regulations discourage or encourage investment in the sector. All this analysis is important since business analysis is about solving problems (Podeswa 2008). Read More