Financial Ratios of CC Clothing LTD - Case Study Example

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I understand that I can obtain further information on this matter at http://www.unisanet.unisa.edu.au/learningconnection/student/studying/integrity.asp Note: The attachment of this statement on any electronically submitted assignments will be deemed to have the same authority as a signed statement. Signed: Date: Signed: Date: Date received from student Assessment/grade Assessed by: Recorded: Dispatched (if applicable): 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 This report is prepared to analyse the financial ratios of CC Clothing LTD. The introductory part of it contains the summarized information about the main ratios that have been tackled herein. The part on profitability analyses the ratios that are used to estimate the level of profitability of a company. It has some pointers on the causes of the declining profitability of the company. The part on solvency has the analysis of ratios that are used to gauge the ability of a company to meet its financial obligations as and when they arise. This is followed by the analysis of the ratios measuring the financial stability of the company. It also contains the main judgement on the state of the company and other causes of its poor state. Lastly there is the conclusion of the findings of this report and the recommendations of the possible actions which can be taken by the management to remedy the situation. As part of the appendix, there is a statement on some of the shortcomings of relying solely on financial ratios to analyse the financial status of a company. Contents Introduction There are financial statements which have been prepared for the board of CC Clothing LTD. It is necessary to analyze these financial statements in order to make them more understandable. The aim of this report is to give explanations for the financial ratios obtained from the financial statements and also give a preview of their implications. This report will cover the financial ratios that show profitability, solvency and financial stability of a company. The coverage will be limited to the key ratios which may be easily compared to other ordinary companies. Though not included as part of the report, there is also an elaboration on some of the disadvantages that may be faced when one depends solely on the financial ratios to gauge the financial well being of a company. Profitability The key ratios that are used as indicators of profitability are: Returns on total assets, Returns on equity, Earnings per share and Earnings Yield. There is a general trend in these profitability ratios. They are all declining and therefore profitability is declining over the years. The averages of the Company in comparison to the industry averages are below par and this is an indication of the worsening financial position and performance of the company. The dividends paid out to the ordinary shareholders have been increasing over time while the profit after tax has been declining. On the other hand the Price Earnings ratio has been increasing over the years, which is a pointer to the declining earning capability of the company. The net sales over the years do not vary a lot and as they increased, so did the cost of the sales. Therefore the major cause of the declining profitability of CC Clothing LTD has been the increase in the selling and administration expenses and also a major increase in the interest expense in the last year, which is the year 2008. The gross profit percentage of the business is generally higher than the industry average, but the selling and administration costs of the business seems to be increasing dramatically and therefore having a negative effect on the overall profitability of the business. The selling and administration costs could be due to hiring of more staff, increased advertisement costs increase in the salaries and wages of the employees. The profitability of the company will continue to deteriorate if these trends are not reversed by cutting on the administration expenses like hiring fewer but more efficient staff, cutting on the costs of marketing and pegging the salaries and wages of some of the employees to the level of sales by the company. Liquidity Though there has been no specific trend followed by the Current ratio of the business, both the current ratio and the Quick ratio have declined considerably when the present ratios in 2008 are compared to the ratios in 2006. In comparison to the industry average, the CC clothing LTD is in a poor liquidity state. This state of poor liquidity is due to the fact that as the years go by, the current assets of CC Clothing LTD have been on a state of decline while the current liabilities have been increasing. The accounts receivables of the CC clothing LTD have been declining. This is an indication that the sales on credit by the company are being minimized or the sales on credit are reducing due to the general decline in the inventory held by the company. The inventory turnover of the business has been increasing gradually, but it is still way below the industry average. This means that the goods tend to take longer in the stores than they should before they are sold. Is not in a good liquidity position. Financial Stability The Debt ratio of the company has been increasing while on the other hand the Equity ratio has been decreasing. This is an indication that the Capitalization of the company has been becoming more and more reliant on debt than equity. This situation has been caused by the steady decrease in the shareholders’ equity and a dramatic increase in the current liabilities. The liabilities in this case have taken a generally upward trend while the shareholders’ equity has taken a generally downward trend as it keeps reducing. The times interest earned ratio has been fluctuating. It has been very high and very low, especially during times when the interest expenses are high. Over the years there has been an increase in the interest expense which is an indication of the increased current liabilities in terms of short term loans taken by the business. The company is getting more and more reliant on loans and this is not a good sign for the business. Even though the asset turnover ratio of the company has been increasing slowly, it is still way below par as it does not compare favorably with the industry average. A low asset turnover ratio indicates high inefficiency in the use of the business assets to generate income. There could be a number of reasons for this. Either the business is operating below its capacity, there are some employees who are not so conversant in using the machines or the inefficiency is caused by the machines themselves. At the moment the business is not financially stable as there are some areas which need improvement to achieve that. Conclusion In this report it has been found that CC Clothing has decreasing net profitability though its gross profit average is higher than the industry average. This is due to high level of sales and management expenses. The current assets are declining while the current liabilities are increasing. The effect of this is that the current and quick ratios are both very low thus putting the company in a poor liquidity state. This has resulted in decreased sales by credit due to the reduction in the inventory. The decreasing profitability and the poor liquidity status of the company have resulted into financial instability. This is evident in the increasing debt ratio and decreasing equity ratio as the company becomes more reliant on debt than equity. This has resulted into high interest expense and there is low asset turnover ratio. Recommendation It is recommended to the board that: To increase the profitability of the company, the sales and administration expenses should be reduced without affecting negatively the quality of the work done. The company should look for other sources of funds for its activities which may be less costly as compared to the loans used currently. The company should use more shareholders equity than debts for capitalization. The debt collection period should be decreased and the debtors turnover increased. The asset turnover should be increased by looking for the factors causing inefficiencies in the use of the company’s assets. Appendix – Part C In the preparation of financial statements, the accountants usually apply the cost principle. In this case the financial data is never amended to take into account inflation, any changes in price and deflation. The result is that the information obtained therefore is based on past economic situations which may not be in tandem with the current situation. The accuracy of the ratios obtained from the financial statements is highly dependent on the estimates. This may not be easy since costs are allocated to the various periods by estimation. There are also various accounting techniques which differ and can be chosen by different firms in analyzing their statements. A case in point is the use of LIFO or FIFO for inventory and the application of differing depreciation methods like straight line vs. full life. (CliffNotes, 2009). These varying techniques affect the financial ratios and it is therefore not easy to make comparisons of firms which chose different techniques. In an industry that is cyclical, it is hard to compare the companies’ performances if they happen to have fiscal year ends which differ. For a user who wants to know about a company and its operations, the financial statement ratios will not be able to give all the information that may be necessary for responding to all the questions that one may have. They are summarized and may leave one with even more questions. There are some companies which deal with a wide variety of goods and it is extremely hard to put them into classes which can be compared with others. (CliffNotes, 2009). When preparing the financial ratios, past information is used and even if according to it the company was doing well or poorly, it may not necessarily be a good pointer to how the company would perform in the future. A major problem with the financial ratios is that they can easily be manipulated by someone in order to achieve a certain objective and even to a point of fraud. (Dennis, Michael C. 1995) Reference List CliffsNotes.com. Financial Statement Analysis Limitations. 22 May 2009 . Dennis, Michael C. (1995) The limitations of financial statement analysis. AllBusiness. 22 May 2009. http://www.allbusiness.com/accounting-reporting/reports-statements/490273-1.html Read More