Financial Analysis of AC Pty Limited Based on Its Three Years Performance - Example

Running header: AC Pty Limited Student’s name: Instructor’s name: Subject: Date of submission: AC PTY LIMITED FINANCIAL ANALYSIS The following is the financial analysis of AC Pty limited based on its three years performance i.e. 2010, 2011 and 2012. Profitability Analysis: Having been established in 2010, the company shows an improving performance since its inception as far as profitability is concerned. This shows that the company’s ability to generate profits for the owner has improved over the years. For instance, the company’s gross profit margin improved from 54% in 2010 to 57% in 2012. The net profit margins have improved from 10.7% in 2010 to 21.4% in 2012. The company’s return on assets ratio has improved from 13.4% in 2010 to 29.6% in 2012. Although this is still very low performance, the improving trend is encouraging given that the company is only three years old and with the trend continuing, the company should register better return on asset ratio in future. Similarly, the company shows an improving trend in performance as far as Return on shareholders equity is concerned. This has improved from 13.7% in 2010 to 31.7% in 2012. Similarly, there is an improvement in the company’s earnings per share from $1.02 in 2010 to $2.54 in 2012. In other words, all the company’s profitability indicators have shown an improving trend over the three years the company has been in operation. This means that the company is becoming more able to generate profits which can be used to pay dividends to the owner as well as meet the financial obligations that the business might have. It should however be noted that the company’s dividend payout ratio for the year 2012 was very high at 90%. Being a new company which has an ambitious development plan, the amount of retained earnings should be more than 10% so that cash may be available for development and for meeting future financial operations (Marcus, 2004). Having been in operation for three years only, the improving performance is encouraging despite the fact that some of the profitability aspects may be below the industry average. This is because if the trend was to continue, the company’s performance will in no doubt be above the company average. Liquidity analysis: This shows the company’s ability to meet it s current obligations using its current assets. Unfortunately, all the liquidity indicators for AC Pty limited have been on a decreasing trend depicting a decreasing ability to meet current obligations using current assets. For instance, the current ratio has gradually declined from 5.05 in 2010 to 3.35 times in 2012. The quick ratio on the other hand has declined from 2.85 in 2010 to 1.88 times in 2012. Although this is a new company, the decline is understandable, there is need to ensure that the company does not acquire a lot of current liabilities to a level that would affect its operations when they fall due. The company’s debtor’s turnover has however declined from 9.9 times in 2011 to 8.2 times in 2013. Contrary to this, the debtors’ collection period has increased from 40 days in 2010 to 44 days in 2012. This calls for the company to come up with measures that will reduce the collection period to an acceptable level. The company’s inventory turnover has also declined from 5.1 times in 2011 to 4.3 times in 2012. Measures should be undertaken to improve this as this would result in more sales revenue and hence profitability. Similarly, the company should put in measures to reduce its inventory turnover (days) which have been increasing from 79 days in 2010 to 84 days in 2012. This will ensure that more sales are made to enable the company generate more revenue and hence profits. Similarly, the company’s operating cycle has been on the increase from 119 days in 2010 to 128 days in 2012. Measures should be taken to reduce this to acceptable levels as this will create cash flow to enable the company meet its liabilities. Generally, all the company’s liquidity indicators have been on the decline. It means that if the trend is to continue, the company may find difficulties meeting its current obligations and hence its profitability will also be negatively affected. Financial stability analysis For the three years that the company has been in operation, its financial stability indicators have shown mixed signs. For in stance, the company’s equity ratio improved from 58.8% in 2010 to 59.6% in 2011 before declining to 57.5% in 2012. A similar observation can be made of debt ratio. The decline in equity ratio is as a result of increasing current liabilities as long-term liabilities have remained fixed. This calls for the company to put up measures to reduce its current liabilities or increase its assets in a bid to ensure a desirable level of equity ratio is achieved and consequently the debt ratio is reduced accordingly. It is however worth noting that these ratios will be greatly affected in case the company is successful in acquiring the new loan it intends to and this will put its financial stability at stake. The company’s asset turnover has been on the rise since 2010 when it was 1.07:1, 1.20:1 in 2011 and 1.26:1 in 2011. Although this trend is desirable, the asset turnover is still very low and it means that the company should put up measures to increase the company’s efficiency in using its assets to generate revenue. It should be noted that the industry average is 3.30:1. The company’s ability to meet its interest obligation has greatly improved from 6.5 times in 2010 to 8.1 times in 2011 and eventually to 10.7 times in 2012. This is desirable as it shows the company can readily meet its interest obligations. However, it should be noted that the company’s times interest earned ratio could be negatively affected when the company acquires new loans unless it is invested in a project that is highly profitable. As such, incase the loan is approved; the management should ensure it is readily invested in a bid to boost the company’s ability to repay. Recommendations: As observed above, the company has experienced rising profitability over the years. Although the company’s profitability is still low, the rising trend is encouraging as it implies that the company’s ability to meet its financial obligations is on the rise. The company’s liquidity is however not encouraging as most liquidity indicators have shown mixed signs since the company’s inception in 2010. This is not desirable as it can affect the company’s day to day operations negatively and hence its ability to generate profits. The company has also been financially stable over the three years although the rising level of current liabilities has been affecting it (Kieso, 2006). In addition, the company’s request for the loan is meant to improve its profitability and is meant to establish a completely new business as part of the company. If the project is to succeed, the company will in no doubt be much more profitable and hence be better able to meet its financial obligations while generating more profits for the owners. Based on this, I recommend that the bank grants the loans requested. However, this should be subject to the company undertaking the following actions; i) Lower its dividend payout ratio from the 2012’s 90% to 40% in a bid to ensure more cash is retained for operations and for meeting the financial obligations resulting from the loan. ii) The company to increase its efficiency in using assets to generate revenue so as to ensure enough profits to repay the loan and interest. The company should also improve on its inventory turnover and debtors collection period in order to free more cash for the day to day operations while increasing its profitability. iii) The company to reduce current liability accumulation as this can affect the company’s operation and hence its ability to generate profits if the creditors are to ask for their money at once. iv) The company has only been paying interest for the current loan. With a new loan being granted, the company’s financial obligation is bound to increase and with this trend continuing, the company will eventually be unable to meet its financial obligations. As such, arrangements should be made to clear the current debt or convert it into share capital in a bid to assure the bank that the company is able to repay the loan and interest. Appendix: Limitations of using financial analysis to evaluate a company The method used above in evaluating the company’s suitability for the loan has numerous weaknesses which may make use of other evaluation means necessary. Some of the weaknesses include; i) Inherent weaknesses of the financial statements-financial statements data is recorded on a historical basis. As such, the values recorded may differ from the market values of assets and hence the financial ratios that use assets may not be completely accurate. In addition, the accuracy of the financial information depends on the how accurately the financial statements are prepared. If they are wrongly prepared, the financial analysis will also be wrong thus misleading the user. ii) Limited information –financial analysis only provides limited information regarding the company’s financial situation. They only show where a potential problem lies but fail to provide a solution for the problem. As such, solely depending on financial analysis may lead to bad financial decisions. The biggest weakness of financial analysis is their simplicity. By reducing a complex data set to a single figure, financial analysis at times misses the bigger picture. For instance, the bank may fail to grant a loan to a firm with a high debt to asset ratio which may even be safer than one with a smaller ratio owing to its special circumstances. For instance, the loan might have been acquired to acquire an asset with very high returns which has just been acquired. The company may use this returns to soon clear its debts but this is not communicated by the ratios which give a wrong impression. iii) Qualitative aspects –financial analysis is quantitative in nature. It does not provide qualitative information like management labor relations, management skills and customer’s satisfaction among other factors that are important for decision making (Weston, 2010). The financial analysis for instance will fail to tell us about the competitive environment within which the above company operates. In addition, the analysis will not tell one about the future prospects that the company has, the result of its investment in research and development or for instance about the new café that the above company intends to introduce. Financial analysis will also not inform us about the marketing campaigns that the company might be undertaking, its new pricing strategies or a decision by a group of customer to enter its market or to exit from the market. All these are important t factors that decision makers might need to consider when making financing decisions yet financial analysis fails to provide them. Owing to the above weaknesses, it would be important that those undertaking the analysis acquire more information regarding the company that might have implications on the company’s financial performance. Such information should include but not limited to the following; i) The current economic environment that might impact the company’s financial performance ii) The competitive environment within which the company operates iii) The company’s management labor relations that might impact on its financial performance iv) The company’s investment plans that might have caused the current financial performance as well as those that might have future impact on its financial performance v) The company’s customer profile as well as any marketing efforts that the company might be involved in vi) Any other factor that might have contributed to the company’s current performance. If the above factors are included in the financial analysis, the decision makers will be better placed to making more informed decisions that will be beneficial to the company as well as other stakeholders. References: Marcus, J2004, Essentials of investments, London, Rutledge. Kieso, D2006, Accounting principles, New York: John Willey & Sons. Weston, J2010, Essentials of managerial finance, Oxford, Oxford University Press. Read More