Ratio Analysis Accounting for Decision Making - Case Study Example

Ratio Analysis Accounting For Decision Making xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Executive summary The objective of this report is to perform and interpret financial ratios to establish the financial performance and financial position of Virgin Australia Holdings Ltd and Qantas Airways Limited. The report used ratio analysis of the financial statements of the two companies for the years 2010 and 2011. The report provides information that is vital to a shareholder who contemplates investing in either company. The report offers appropriate justification based on the ratio analysis and the term of investment. Ratio analysis as stated by Greite (2007) is a technique of financial analysis, which helps in evaluating the financial condition and performance of a company. The report has established that a shareholder should invest in Qantas Airways Limited since the company has a high return on assets of 2.28% compared to return on assets of Virgin Australia Holdings Ltd which was 0.51%. Moreover this rate has shown decline for Virgin Australia Holdings Ltd and improvement in the case of Qantas Airways Limited. This measure shows that the income-producing ability of the property to meet operating and financial obligations. Table of Contents Executive summary 2 Table of Contents 3 Introduction 4 Analysis and interpretation of ratios 4 Profitability 5 Profitability in relationship to sales 5 Profitability in relationship to investments 6 Efficiency 6 Asset turnover 7 Inventory turnover 7 Debtor’s turnover 7 Creditors’ turnover 8 Financial stability 8 Short term financial stability 9 Long term financial stability 10 Other relevant information 11 Limitations 12 Conclusions 14 Recommendations 15 References 16 Introduction The aim of the financial analysis is to determine the profitability, efficiency and financial stability in the short term and long term of Virgin Australia and Qantas airways. Virgin Australia Holdings Limited is a public limited company which has its airline operations in Australia. It was listed in the Australian stock exchange in 2003 and its ASX code is VAH. It deals majorly in transport services (airline operations) at both domestic (Australia) and international markets. Qantas airways was established in 1920 and its headquarter is in Mascot, Australia. It is stated in The Age (2012) that the main business of Qantas Airways Limited is the transportation of passengers. It has two airlines: Qantas and Jetstar both of which operates regionally, domestic and at international services. However, the company operates in other specialist markets like Qantas catering and Qantas holidays. The company has a strategy of reducing the intensity of capital. By 30th June 2011 the company operated 278 fleet passengers and five freighter aircrafts. Analysis and interpretation of ratios The objectives of financial reporting and financial statements are derived from the needs of the external users of accounting information. Stating objective of financial; statements would be simple if all the external users had the same needs and interests, but this is not the case. The disclosure principle requires that financial statements be complete in the sense of improving all information necessary to users of the statements (Picker, 2009). If the omission of certain information would cause the financial statements to be misleading, disclosure of such information is essential. Such information is useful to a shareholder in either of the companies in making rational investment and similar decisions. The major ratios that will be used in this report helps to determine the profitability, efficiency, financial stability and share performance of the two companies. Profitability These ratios indicate the ability of the company to generate profits or returns from investments. There are usually two major concerns in any investment: the return from investment and the accompanying risks. If an investment produces high returns but the corresponding risk inherent is exceedingly high such an investment is not desirable to an investor. The ultimate determination of an investment’s desirability is its capacity to produce income in relation to the capital required to obtain that income. The two aspects of profitability that will be considered in this section are profitability in relationship to sales and profitability in relationship to investments. Profitability in relationship to sales This category of profitability ratios indicates how profitable the sales activities of the company are. Under this category the report considers the gross profit margin and the net profit margin. Ratio Virgin Australia Holdings Ltd Qantas Airways Limited 2010 2011 2010 2011 Gross profit margin 9.8% 6.3% 10.97% 11.39% Net profit margin 0.60% -1.21% 1.24% 1.76% As can be seen from the table, both the gross profit margin and the net profit margin for Virgin Australia Holdings Ltd have been declining while that of Qantas Airways Limited has been increasing. This is a clear indication that the profitability of the two companies is different and a shareholder is best advised to invest in a company that makes profit. A negative net profit margin of -1.21% for Virgin Australia Holdings Ltd in 2011 shows that the company made a loss during that financial year. This being the case the company through its board of directors cannot declare any dividend to its shareholders. This is because dividends are only paid out of profit made during the year. Therefore, a shareholder who invests in Virgin Australia Holdings Ltd will forego his reward for investment with the company while a shareholder who invests with Qantas Airways Limited will be enjoying increased rewards every year since its net profit shows an improvement from year 2010. Profitability in relationship to investments This category of profitability ratios indicates how profitable the investment activities of the company have been. Under this category the report considers the return on equity and the return on assets. Ratio Virgin Australia Holdings Ltd Qantas Airways Limited 2010 2011 2010 2011 Return on equity 1.93% -4.28% 2.88% 4.26% Return on assets 1.98% 0.51% 1.76% 2.28% As can be seen from the table, both the return on equity and the return on assets for Virgin Australia Holdings Ltd have been declining while that of Qantas Airways Limited has been increasing. A high return on assets shows that Qantas Airways Limited is utilizing its assets in generating positive returns from its business activities. Efficiency Efficiency ratios indicate how effectively the company is using its assets in order to generate the sales revenue. The main ratios that have been used to indicate the level of efficiency of the two companies in this report are asset turnover, inventory turnover (days), debtors turnover (days), and creditors turnover (days). They are shown in the table below Ratio Virgin Australia Holdings Ltd Qantas Airways Limited 2010 2011 2010 2011 Asset turnover 76.86% 85.08% 69.17% 71.41% Inventory turnover (days) 0 days 0.57 days 8.45 days 9.12 days Debtors turnover (days) 10.72 days 11.46 days 21.17 days 20.6 days Creditors turnover (days) 39.7 days 44.2 days 46.4 days 42.6 days Asset turnover This ratio measures the extent to which assets are used efficiently. That is for every dollar invested there is so many dollars produced. This ratio has increased for Virgin Australia Holdings Ltd while for Qantas Airways Limited it has decreased. Inventory turnover The ratio measures the number of times in a year that a business enterprise sells its inventory. An inventory turnover of 9.12 days means that Qantas Airways Limited turned its inventory over 9.12 days in 2011 financial year. A high inventory turnover indicates that the company is not accumulating so many inventories which mean that cash is not tied up in inventory. Virgin Australia Holdings Ltd did not turn over its inventory in 2010 financial year since it has a zero inventory turnover in year 2010. Debtor’s turnover This indicates the length of time for the business to collect its debts from its customers. This means that in 2011 Virgin Australia Holdings Ltd took 11.46 days to collect debts. This ratio is higher for Qantas Airways Limited than Virgin Australia Holdings Ltd. For both companies the ratio has changed from 2010 which means the companies have revised their credit policy. Virgin Australia Holdings Ltd has increased its length of time taken in order to give its customers better credit terms. This has helped the company to increase its sales revenue. Qantas Airways Limited has decreased the duration taken to pay its debts by 3.8 days. This is a risky move since the company may run short of funds to meet the short term obligations which might force the company to be declared insolvent if creditors filed a bankruptcy suit against the company. However, it may be a sign of financial stability whereby the company wants to rest most of its liabilities. Creditors’ turnover This indicates the length of time for the business to pay its financial obligation due to its trade creditors. This means that in 2011 Virgin Australia Holdings Ltd took 44.2 days to pay its financial credits. This ratio has declined for Qantas Airways Limited while for Virgin Australia Holdings Ltd it has increased. For both companies the ratio has changed from 2010 which means the companies have revised their payment policy. Virgin Australia Holdings Ltd has increased its length of time taken in order to give the company time to utilise the credit for other business activities. This has helped the company to increase its ability to honour its financial obligations. Qantas Airways Limited has decreased the duration taken to pay its credits by 0.57 days. Financial stability Financial stability of a company is measured by the gearing ratios which indicate the extent to which the company has borrowed fixed charge capital in order to finance its assets. The report will consider five main ratios in order to offer a credible advice on the financial stability of Virgin Australia Holdings Ltd and Qantas Airways Limited. These are current ratio, quick ratio, debt asset ratio (total debt), debt equity ratio (total debt) and times interest earned (times). Ratio Virgin Australia Holdings Ltd Qantas Airways Limited 2010 2011 2010 2011 Current ratio 0.76% 0.65% 0.93% 0.90% Quick ratio 0.76% 0.64% 0.88% 0.85% Debt asset ratio (total debt) 75.90% 75.89% 69.93% 70.50% Debt equity ratio (total debt) 191.56% 177.04% 95.60% 98.05% Times interest earned (times) 1.55 Times -0.38 Times 4.16 Times 3.96 Times The financial stability of companies can be determined in the short term or in the long term. Short term financial stability Current ratio This ratio measures the ability of the company to pay the credit it has been extended by suppliers using its current assets. The ratio of the two companies is lower than 100% across the years which mean that the ability of the companies to pay its debts is poor. A shareholder is therefore discouraged from investing in these companies because of the risk inherent that the companies may be declared bankrupt. Quick ratio This ratio measures the ability of the company to pay the credit it has been extended by suppliers in the short term using its most liquid assets. The ratio of the two companies is lower than 100% across the years which mean that the ability of the companies to pay its debts using its most liquid assets is poor. A shareholder is therefore discouraged from investing in these companies because of the risk inherent that the companies may be declared bankrupt. There is no difference between current ratio and quick ratio for Virgin Australia Holdings Ltd in 2010 which means that the company had no inventory as at 2010. This is a risky situation as the company may incur stock out costs. Long term financial stability Debt asset ratio (total debt) Both companies maintain a low debt asset ratio which indicates that they are mostly financed through other finance but debt financing is not the major. This means the companies do not take advantage of tax benefit as a result of utilising the debt financing. Debt equity ratio (total debt) This ratio indicates the level of debt and equity in the financial structure of the company (Picker, 2009). This ratio is high for Virgin Australia Holdings Ltd (higher than 100%) than Qantas Airways Limited (less than 100%). This indicates that Virgin Australia Holdings Ltd is financed mostly through debt while Qantas Airways Limited is equity financed. Times interest earned (times) This ratio shows the ability of the company to pay interest on loan advanced. A high rate indicates that the company is profitable which may enhance its creditworthiness. A high times interest earned of Qantas airways shows that it has a larger safety margin and that the earnings after interest is high. Other relevant information The higher the return from investment the higher the corresponding risk. This means a shareholder cannot decide to invest in either of the company based solely on the return on equity since the associated risk may be exceedingly high to counteract any gains achieved. The quality of reported earnings should be factored in the comparison since ratio analysis ignores the qualitative factors – the importance of qualitative factors is insubordinate since ratio analysis is quantitative analysis. The comparative net profit margin of the two companies in 2011 shows that Qantas Airways was more profitable than Virgin Australia. However, it does not tell on the quality of the products produced by the two companies. Limitations This report is based on ratio analysis hence most of the limitations are related to limitations of ratio analysis as outlined below. It relies on accounting data – this means if the accounting data are not correct then the ratios obtained from these data will also be incorrect Ratio analysis gives historical information – this information tells us on the past records, which may not be a true representation of the current affairs of the company. The latest information that can be obtained by ratio analysis about the two companies is upto year 2011. It is impossible to compare the performance of these two companies for year 2012 before their calendar year is over to report the information used for ratio analysis in the financial statements of the companies. Ratio analysis does not have any meaning when used on its own. It has significance only if studied in appropriate context and when compared over a period. For instance, inventory ratio for Qantas airways in the year 2011 conveys no sense if it is not compared with the previous year 2010 or compared with inventory ratio of Virgin Australia in the same year 2011. Ratio analysis is not definite since it does not make concrete assertion hence it is possible to make wrong investment decision. It is not conclusive that since return on equity (ROE) of Qantas airways is higher than ROE for virgin Australia, then an investor should invest in Qantas airways. Ratios can easily be manipulated through creative accounting or using accounting policies that are inappropriate. In such a case the investment decision made out of this analysis will be misinforming. Ratios do not have standardization with respect to presentation formats and their interpretation. This makes the interpretation of ratios hard and in some case arbitrary. Subjectivity – since ratios have no general standards, two investors are likely to make differing interpretations from the same ratio. Conclusions Financial ratio analysis measures the income-producing ability of the company to meet operating and financial obligations. They are also helpful to lenders in assessing the risk of lending to investors on particular projects. Lenders are concerned whether assets of the company will generate sufficient income to service the debt and to ensure that the loan principal will be repaid. Qantas Airways is more financially stable than Virgin Australia in the short term as has been shown by current ratio and quick ratio. However, the long term financial stability of Virgin Australia is more promising in comparison with Qantas airways as depicted by debt asset ratio and debt equity ratio. Recommendations It is recommended for a shareholder to invest in Qantas airways because its profitability ratio is higher than that of Virgin Australia. This shows that the company is potential to make profit and declare dividend for the shareholders. The higher times interest earned of Qantas airways shows that the company is more profitable than virgin Australia hence ability to cover its interest payment. Both companies should report their financial statements in the same way. The use of different accounting practice makes the ratios incomparable (Deegan, 2010). Therefore, in order to compare Virgin Australia and Qantas airways through ratio analysis, they must adopt similar accounting practice. References Deegan, C., 2010. Australian Financial Accounting, 66th ed. North Ryde, NSW: McGraw-Hill. Greite, S., 2007. The Development of the Australian Accounting Standards after the End of the G4+1. Sydney: GRIN Verlag. Picker, R., 2009. Australian accounting standards. Australia: John Wiley & Sons. The Age, 2012. Fares to nosedive as Qantas gambles on higher capacity< http://www.theage.com.au/business/fares-to-nosedive-as-qantas-gambles-on-higher- capacity-20120824-24rpd.html>. Read More