Financial Reporting - Research Paper Example

CONTENTS PAGE Calculation of Ratios for both years 2/3 Liquidity Ratios 4 Quick Ratios 5 Profitability Ratios 6 Return on capital employed (ROCE) 7 Return on Equity (ROE) 7 Profitability Ratios based on sale 7 Gross profit margin 8 Net profit margin 8 Efficiency ratios 9 Trade Debtors collection period 10 Payable payment period 10 Investment ratios 10 Debt to equity ratio 11 Interest Cover 11 Gearing Ratio 11 Conclusion 12 References 13/14 Report The report below will discuss about Gargoyley Plc, this is a public listed company which is required by law to prepare its financial statements annually. It is from its financial statements of the year ended 31st August 2014 and 2015 that we are going to analyse the financial ratios and compare its current year and its previous year performance. We shall begin with: Liquidity Ratios Liquidity ratios analyse the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current. Liquidity ratios measure how liquid a company is since a company can be profitable and the same time it can have serious cash flow problems. In the shareholder’s point of view, profitability is considered to be an important aspect of a company’s performance because it is from the profits that they receive dividends. However, addressing the key issue of liquidity, it is important for the company to have liquid assets to help in meeting its debts when they arise. Therefore, liquidity is defined as the amount of cash which can be raised quickly to settle company’s obligations. The liquid funds may include; cash, trade receivables, short-term investments with ready market, for instance, the shares, bills of exchange and fixed term deposits. In most cases sales are considered to be the most liquid asset for many trading companies. Liquidity ratios can be measured using the following methods: Current Ratio Current ratio is also known as working capital ratio. It is calculated as Current Ratio = Current asset Current liabilities Companies should have adequate current assets to help in meeting their current obligations when they fall due. The recommended threshold for a company’s current ratio is 2:1 however, a ratio of 1:5:1 is considered normal. Whilst giving recommendations about the current ratio it should be looked at in the light of what is normal for the business. Different businesses will differ in ratios, for instance supermarkets tend to have low current ratios because of very few trade receivables and very high payables. 2014 Ratio 2015 Ratios £’000 £’000 Liquidity Ratios Current Ratio Current assets Current liabilities 58 23 2.32 times 71 35 2.02857 times In this case, the company has enough current assets to meet its liabilities when they arise therefore the company is very liquid in both years. Quick Ratios This is calculated by eliminating inventory from the current assets thus providing an insight measure of the company’s ability to settle the liabilities when they arise. It measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets. It is an indication of short-term liquidity; the required threshold is 1:1 or 0.7:1. However, at times the company might have a higher quick ratio than the recommended one for instance 3:1 this will be fine for a company which has difficult in borrowing on short-term notes. On the other side higher quick ratios indicate that the business has too much idle cash of 3 against the threshold of 1 (Finance Management. 2014). These extra amounts should be invested in other profit generating projects. This matter can be viewed from a different light that the management of the company is incompetent in financial management. In our case the Quick ratio as follows: Quick Ratio Current Assets-Inventories 43 1.72 times 51 1.45714 times Current Liabilities 25 35 This indicates that Gargoyley Plc. Acid to test ratio is sufficient enough to clear the short term-debts. However, in case the acid test ratio is below the recommended threshold of 1:1 it’s a clear indication that the company relies so much on the inventory to pay off the short-term liabilities. The company can improve its acid test ratio by improving its turnover on the inventories disposing some of the unproductive assets and eventually improving on its collection period. Profitability Ratios Profitability ratios are also tools of financial analysis they are calculated on sales of the company. Profitability ratios are very vital especially when assessing how efficient or in efficient a company is performing by helping the management to take quick action to correct the situation. Businesses which are profit oriented their main objective is profit maximization because profits are blood of business in such case and without it the business cannot be termed as going concern. Therefore, the main reason behind the calculation of profitability ratios is to determine business efficiency. Profitability ratios are also used by the financial institutions when lending money. Mangers also pay to the company’s profitability because of their annual bonuses. Profitability ratios are categorized into two; they are those that are based on sales and those based on investment (Finance Management 2010). Gargoyley Plc profitability ratios have improved in the year 2015 compared to 2014. The improvement in the ROCE is as a result, of increase in net profit, this is contributed by the decrease in company’s operating expenditures. Therefore, Gargoyley Plc can be said to have good control over its expenditures thus improving its overall performance on ROCE. ROCE Net profit before taxation 100 29 10.2473% 47 15.3595% shareholders' fund 283 306 ROCE Profit before taxation and interest *100 34 10.2102% 52 14.6067% shareholders' funds +long-term loans 333 356 In this case the profitability ratios which are based on investments are as follows: 2014 Ratio 2015 Ratio 2014 Ratio 2015 Ratio ROCE (Return on capital employed) This is calculated to determine the rate of profits a company receives from the injected capital; this will include equity or the shareholders fund and the long term-debt. To determine whether the calculated ROCE is good or bad a comparison should be made with the company’s weighted average cost of capital. If ROCE is higher than WACC (weighted average cost of capital) the shareholders are getting value for their money as a result of the company creating value. As a result, the shareholders will continue to invest. However, if ROCE is less than WACC the company is considered to be losing by not creating value for the shareholders. Moreover, ROCE is a bench marking tool that is used by investors to compare companies operating in the same industry. Return on Equity (ROE) In this case ROE is as follows: 2014 Ratio 2015 Ratio Return on Equity Net Income *100 20 7.067% 35 11.44% Shareholders' Equity 283 306 When ROE is greater than cost of the capital the company is creating value for the shareholders, unlike, when ROE is less than the cost of capital, investors are not gaining from the company. At times ROE may increase when equity decreases and, this time; investors will not be gaining anything since the rate of debt will be high which then exposes the company to greater risk. Looking at the Overall performance of Gargoyley Plc in terms of ROE there is a significant increase from 2014 to 2015, thus one can make a conclusion that the company is highly geared and its main source of finance is equity financing. Profitability Ratios based on sale 2014 Ratio 2015 Ratio Gross profit ratio Gross profit *100 64 40% 86 43% Sales 160 200 Mark up ratio gross profit *100 64 66.6667% 86 75.4386% cost of goods sold 96 114 Net profit ratio net profit before taxation *100 29 18.125% 47 23.5% sales 160 200 Gross profit margin Gross profit margin is calculated as gross profit/sales, this is the first benchmark for business, and if the business is not doing well in this ratio then it is assumed that overall it is not performing well. Gross profit margin ratio is used to compare the company’s growth or its decline in the previous years. Moreover, the gross profit of a company is calculated by deducting trading expenses from sales by evaluating the pricing policy of the company and the company’s efficiency. In this case, the gross profit margin is as follows: 2014 Ratio 2015 Ratio Gross profit ratio Gross profit *100 64 40% 86 43% sales 160 200 Gross profit margin is used by various stakeholders since it’s a very important ratio some of the stakeholders who use this ratio include the financial institutions such as the bank. The ratio helps them in determining the capability of the business. The managers use the ratio to determine whether the business us efficient of inefficient. While, the shareholders of the business will use the ratio to determine their returns based on the invested capital. The reason Gargoyley Plc gross profit going up is as a result, of increase in sales, from 2014 to 2015 and also increase in gross profits. When the rate of gross profit margin is low it may be an indication of effective management or low cost of production. However, when the rate is high, it is an indication of a bad signal hence calling for a detailed analysis. Net profit margin Net profit margin is very crucial for the business managers strive hard to ensure that the business achieves high net profit margin. Net profit margin is what is left to the shareholders this; ratio is also used to measure efficiency since it is only after most activities are done efficiently that we can realise adequate margin of profit. It is important for the organisation to ensure the net profit margins are improved but in this case they have reduced and this call for the management to analyse the situation and find the reason for the decline. Gargoyley net profit margin has also improved from 18.125% in 2014 to 23.5% in 2015. The reason for the increase can be attributed to decrease in company’s operating costs. Net profit ratio net profit before taxation *100 29 18.125% 47 23.5% sales 160 200 Efficiency ratios 2014 Ratio 2015 Ratio Inventory turnover costs of goods sold Times 96 5.48571 times 114 6.51429 times Average inventory 17.5 17.5 Fixed assets turnover sales 160 0.53333 times 200 0.625 times fixed assets at net book value 300 320 Trade debtors collection period trade debtors *365 40 91.25 days 50 91.25 days credit sales 160 200 Trade creditors payment period Trade creditors *365 25 95.0521 days 35 112.061 days Total credit purchases 96 114 Efficiency ratios measure the ability of the organisation in utilising its assets and managing its liabilities. Like the ratio on the inventory turnover it demonstrates how well the company manages inventories. This ratio is expressed in number of times by indicating whether the inventories are being held for a long time or they are being sold quickly. In Gargoyley Plc case, inventory turnover has increased from 5 times to 6 times. This is, as a result, of increase in cost of sales although the average inventory has remained the same. Increase in inventory turnover means that the company is making more saes in the current year as compared to the previous year. 2014 Ratio 2015 Ratio Inventory turnover costs of goods sold Times 96 5.48571 times 114 6.51429 times Average inventory 17.5 17.5 Trade Debtors collection period This is expressed in number of days 2014 Ratio 2015 Ratio Trade debtors collection period trade debtors *365 40 91.25 days 50 91.25 days credit sales 160 200 And from this case, the numbers of days have remained the same despite the increase in credit sale. However, this can be viewed as an increase which is a bad sign which suggests that there is bad credit control. However, this can also be used to means that debtors are allowed to buy more and given longer time to make payments and the reason for selling more. Gargoyley creditors are taking long to pay and this may not be so good for the company because it is likely to increase the rate of bad debts. Payable payment period This represents the period taken by the company to clear its debt from the supplier. 2014 Ratio 2015 Ratio Trade creditors payment period Trade creditors *365 25 95.0521 days 35 112.061 days Total credit purchases 96 114 The trade credit payment period has increased from 95 days in 2014 to 112 days in 2015, this is a good indication that the suppliers have confidence within the company and have allowed more time to make sales and pay later which is a source of free finance. This is also a form of soft loan to Gargoyley Plc. Investment ratios 2014 Ratio 2015 Ratio Debt to Equity Debt *100 75 26.5018% 85 27.778 % Equity 283 306 Interest Coverage Profit before interest and tax Times 34 6.8 times 52 10.4 times Interest 5 5 Gearing Long-term debt *100 50 17.6678% 50 16.339 % Equity 283 306 These ratios indicate how the company is stable in long term financing. Debt to equity ratio This ratio measures the amount of debt use to run the company, this ratio indicates the rate of debt to equity. LT Debt to Equity Debt *100 75 26.5018% 85 27.7778% Equity 283 306 A higher debt to equity is better because but it should not be too high because it will be an indication that the company is suffering from financial distress. In this case the ratio has increased from 26% in 2014 to 27% in 2015 which is as a result of increase in equity and debt. In this case there is no need to worry. However, low debt to equity ratio is risky for the company because it can be easily bought by another company (Finance Management, 2011). Interest Cover This ratio measures the ability of the company to pay interest out of generated profits. 2014 Ratio 2015 Ratio Interest Coverage Profit before interest and tax Times 34 6.8 times 52 10.4 times Interest 5 5 Gargoyley Plc. interest cover has increase from 6.8 in 2014 to 10.4 in 2015; this is a good indication that the shareholders will receive interest from their investment. The interest cover is very satisfactory (Harvard Business Review, 2015). Gearing Ratio Gearing ratio measures the rate of risk that a company faces in the market that it is operating. A high gearing ratio indicates that a large portion of fixed return is being used. It is also an indication that returns to shareholders will grow more if profits grow (Finance Management, 2011). However, in this case, the gearing ratio has decreased from 17 in 2014 to 16 in 2015. This decrease could be associated with increased borrowing considering their debt and equity has increased. 2014 Ratio 2015 Ratio Gearing Long-term debt *100 50 17.6678% 50 16.3399% Equity 283 306 Dividend Yield Dividend Yield is expressed as a % 2014 2015 Dividend yield= Dividend per share *100= 10 = 7.9% 12 =4% Current share price 126 297 Dividends yield can also be compared to other possible investments, and therefore, the lower the dividends yield the more the market is expected to grow in the future. However, if dividend yield is high, the market is expected to grow at a slower pace. In our case, it is quite evident that dividend yield was quite high in the year 2014 compared to the year 2015. Therefore, Gargoyley Plc market growth was slower in 2014, while it in 2015 it was high. Dividend cover Dividend cover is expressed in times Dividend Cover= Profit after Tax Times =20 =2 times 35 = 2.9 times Dividends 10 12 Dividend cover measures the relationship between the available profits and the dividend payout. The higher the dividends cover the higher the probability that the company will sustain high dividends payments in future. In the year 2015 Gargoyley Plc rate of dividend cover was so high compared to 2014; therefore, promising higher returns for its shareholders. Share price 2014 2015 Earnings per share = P.A.T –Preference dividends = 20-10 =0.05 35-12 =0.115 Number of shares 200 200 Price earnings ratio/ P/E= Share Price = 10 =200 times 12 =104 times Earnings per share 0.05 0.115 Conclusion From the above computation and analysis Gargoyley Plc overall are financially stable from the calculation of profits to the gearing rations. The rate of borrowing is moderate although the company prefers equity financing rather than debt financing. Appendix Gargoyley Plc Calculation of ratios for year ended 2014 and 2015 2014 Ratios 2015 Ratios Times £ £ Liquidity Ratios Current Ratio Current Assets 58 2.32 times 71 2.02857 times Current Liabilities 25 35 Quick Ratio Current Assets-Inventories 43 1.72 times 51 1.45714 times Current Liabilities 25 35 Profitability Ratios ROCE Net profit before taxation 100 29 10.2473% 47 15.3595% shareholders fund 283 306 ROCE Net profit after taxation *100 20 7.06714% 35 8.95141% Shareholders fund 283 391 ROCE Net profit after taxation and preference dividends 36 13.9535 times 19 6.76157 times Shareholders’ funds- preference shares 258 281 ROCE Profit before taxation and interest *100 34 10.2102% 52 14.6067% Shareholders’ funds+ long-term loans 333 356 Gross profit ratio Gross profit *100 64 40% 86 43% Sales 160 200 Mark up ratio gross profit *100 64 66.6667% 86 75.4386% cost of goods sold 96 114 Net profit ratio net profit before taxation *100 29 18.125% 47 23.5% Sales 160 200 Efficiency ratios Inventory turnover costs of goods sold 96 5.48571 times 114 6.51429 times Average inventory 17.5 17.5 Fixed assets turnover Sales 160 0.53333 times 200 0.625 times fixed assets at net book value 300 320 Trade debtors collection period trade debtors *365 40 91.25 days 50 91.25 days credit sales 160 200 Trade creditors payment period Trade creditors *365 25 95.0521 days 35 112.061 days Total credit purchases 96 114 Investment ratios LT Debt to Equity Debt *100 75 26.5018% 85 27.7778% Equity 283 306 Interest Coverage Profit before interest and tax 34 6.8 times 52 10.4 times Interest 5 5 Gearing Long-term debt *100 50 17.6678% 50 16.3399% Equity 283 306 REFERENCES Accountingtools.com. 2016. Fixed Asset Turnover Ratio – Accounting Tools. [online] Available at: http://www.accountingtools.com/fixed-asset-turnover-ratio [Accessed Mar 2016] Finance Management. 2010. Profitability Ratios. [online] Available at: https://www.efinancemanagement.com/financial-analysis/profitability-ratios [Accessed 17 Mar. 2016]. Reserved, A.R. (2015) Liquidity ratios | example. Available at: http://www.myaccountingcourse.com/financial-ratios/liquidity-ratios [Accessed: March 2016] Read More