Financial Profitability Ratio Analysis - Example

Student Name: Tutor: Title: Accounting Course: B-Nature of reporting entity An entity refers to a legal, fiduciary, or administrative arrangement, or organizational structure that has the ability to employ scarce resources for achieving specific objectives. Reporting entities refers to all entities whereby it is reasonable to anticipate the existence of users who rely on the general purpose financial reports for certain information which can be used by them for evaluating and making decisions concerning scarce resources allocations (Powell & Baker, 2005). Conditions necessary for categorization of a reporting entity include separation of management from economic interest, financial characteristics, and economic or political influence or importance (Brigham & Daves, 2009). This company has been categorized as a reporting entity due to the financial separation of management from economic interest. Administrative expenses and dividend paid shows that owners and management are separated, and the owners are dependent on the general purpose financial reports. The main users of the reports from the corporation are owners since they want to know how their business is being run, the government would like to know that the business engages in legal activities and pay taxes accordingly, the investors want to know that their money is being used wisely, and financial institutions want to know the financial stability of the corporation before lending money (Gibson, 2010). The fact that the corporation is a reporting entity would determine what kind of ratios to analyze and the manner in which to interpret the ratios to the various stakeholders. Every stakeholder is interested in a given part in the financial reporting of the business. Creditors may want to know how often debts are paid while owners will be interest in how many times stock is turned (Peterson, 2012). C-Ratio analysis Important ratios in this case can be analyzed as follows: Profitability ratio Profit margin = profit from ordinary activities after tax ÷revenues 2010 Gross profit margin =87,197÷1,060,867= 0.0821 2009 Profit margin = 27,649÷1,017,415 = 0.0272 2008 Profit margin = (81,681÷1,109,957) = 0.0736 Year 2008 2009 2010 Profit margin 0.0736 0.0272 0.016 Liquidity ratio Inventory turnover = cost of goods sold ÷average inventory balance 2010 Average inventory balance = (69721+26888) ÷2 = 48304.5 Cost of contract operations = 973,670 Inventory turnover = (973,670 ÷ 48304.5) = 20.15 = 20 to the nearest whole number 2009 Average inventory balance = (26888+95663) ÷2 = 30,637.75 Cost of contract operations = 989,766 Inventory turnover = (989,766÷30,637.75) = 32.30 = 32 (to the nearest whole number) 2008 Inventory balance = 95663 Cost of contract operations= 1,028,276 Inventory turnover = (1,028,276+95663) = 10.74 = 10 Year 2008 2009 2010 Inventory turnover 10 32 20 Current ratio = current assets ÷ current liabilities 2010 Current ratio = 423041÷221,990 = 1.9 2009 Current ratio = 295,912÷243,812 = 1.2 2008 Current ratio = 374287÷323,919 = 1.15 Year 2008 2009 2010 Current ratio 1.15 1.2 1.9 Financial profitability ratio Debt ratio = total liabilities ÷ total assets 2010 Debt ratio = (477,628 ÷ 730,692) = 0.65 2009 Debt ratio = (460,066 ÷ 665,310) = 0.69 2008 Debt ratio = (534,436÷767,858) = 0.696 Year 2008 2009 2010 Debt ratio 0.696 0.69 0.65 Capitalization ratio = total assets ÷total equity 2010 Capitalization ratio = 730,692÷253,064 =2.88 2009 Capitalization ratio =665,310÷205,244 = 3.24 2008 Capitalization ratio =767,858÷234,043 = 3.28 Years 2008 2009 2010 Capitalization ratio 2.88 3.24 3.28 D-Analysis report The profitability ratio indicates that the firm has not performed very well in the recent past. The profit margin was as follows: Year 2008 2009 2010 Profit margin 0.0736 0.0272 0.016 From the ratio it can be seen that the company did not perform well in the three year period. The profit margin in 2008 and 2009 was very small. This shows that the gross profit was very low and the company made losses in 2008 and 2008. The profit margin improved in 2010, and it can be seen that the company recovered from making a loss to earning a profit in 2010. The highest loss was made in 2009 and this was a further drop from the loss that was made in 2008. The company has to further improve its performance if it has to attract prospective investors. The business enterprise is yet to become a convincing profitable company. Two losses in a row is alarming for any investor (Palepu & Healy, 2008). The inventory turnover shows that the company was able to turn its inventory many times. Year 2008 2009 2010 Inventory turnover 10 32 20 Seemingly the inventory was highest in 2009 but surprisingly it is when the company made a huge loss. The inventory was turned less in 2010 but the company ended up registering a positive improvement on profitability. In 2008, the inventory turnover was lowest. The current ratio indicates that the company has a low liquidity level. However, the liquidity level has improved over the year to reach an impressive 1.9 in 2010. The ideal liquidity ratio is 2 where by the assets are expected to be two times more than the liabilities. Year 2008 2009 2010 Current ratio 1.15 1.2 1.9 The improvement of the liquidity ratio shows that the company has positioned itself to be effectively to meet its short term debts. The improvement will improve the image of the company and attract more investors. The debt ratio of the company has fluctuated the over the years. The debt ratio is still very high meaning that the company owes a lot to the creditors and hence it jeopardizes the capacity of the company to pay up its debts (Hooke, 2010). Year 2008 2009 2010 Debt ratio 0.68 0.69 0.65 The debt ratio of above 60% is high and makes the company to be prone to external influence. Excessive debt capital in the company can lead to instability and bankrupt when the company is unable to pay up its debts. The company has to reduce debt capital and inject more of equity capital (Kieso, Weygandt & Warfield, 2007). Capitalization ratio shows the reciprocal of percentage of assets offered by shareholders and the level of using gearing. The ratio shows that use of assets in the company is improving over time. Years 2008 2009 2010 Capitalization ratio 2.88 3.24 3.28 Despite the improvement, there is a lot that has to be done to fix the asset problem in the company. The limitation of this analysis is that one cannot see the operating activities that can be obtained for the company’s cash flows. There are some weaknesses or strengths of the company that cannot be deciphered by this kind of analysis. I would advise my parents not to invest in the company in its current position. The financial position of the company is still weak and it will take some monitoring of the developing trend in order to tell whether the company can be invested into. The company has to be financial stable and profitable in order to attract potential investors. References Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2007). Intermediate Accounting (12th ed.). Hoboken, NJ: John Wiley & Sons. Palepu, K.G. & Healy, P.M. (2008). Business Analysis & Valuation: Using Financial Statements. New York: Cengage Learning. Hooke, C.J. (2010). Security Analysis and Business Valuation on Wall Street + Companion Web Site: A Comprehensive Guide to Today's Valuation Methods. New York: John Wiley & Sons. Gibson, C.H. (2010). Financial Reporting and Analysis: Using Financial Accounting Information. New York: Cengage Learning. Powell, G. & Baker, K. (2005). Understanding Financial Management: A Practical Guide, New York: John Wiley & Sons. Peterson, P.P. (2012). Analysis of Financial Statements. New York: John Wiley & Sons. Brigham, E.F. & Daves, R.P. (2009). Intermediate Financial Management, New York: Cengage Learning. Read More