Financial Analysis for Country Road Limited and the Reject Shop Limited - Coursework Example

MAA103-Accounting for Decision Making Financial Analysis Report for Country Road Limited (CTY), and the Reject Shop Limited (TRS) Students Name: Instructor: Date Submitted: Table of Content Body 3 Efficiency Ratios 4 Liquidity Ratios 5 Gearing Ratios 5 References 13 Introduction Financial ratios are relative measure of two selected numerical values taken from an organization’s financial statements, and used by financial analysts in comparing the weaknesses, and strengths in company. These ratios are also important to managers, creditors, current and potential shareholders since they aid in decision making. The Country Road Limited (CTY) was started in 1974 by Stephen Bennett as niche women’s shirting business. Its main business is to design and retail quality apparel, home wares and related accessories. It distinguishes itself from others on its design, quality and brand. The Reject Shop Limited (TRS) was started in south Yarra, Victoria in 1981. The company sold seconds and discontinued lines hence the reject shop name. Today the company deals with general consumer merchandize which includes house hold cleaning products, cosmetics, basic furniture and kitchen ware. The objectives of this financial analysis are to establish the financial position and performance of CTY and the TRS. This will be achieved by viewing and interpreting the given ratios of both companies. Another objective of this analysis will be to determine the efficiency of the two companies in utilization of their assets. The analyses will determine the ability of two firms to meet their short-term financial obligation. The performance of the firms will be compared for the years 2009 and 2010, to determine the position of each firm in the industry. Body Referring to the provided table the following explained financial ratios were identified; The gross profit margin and the net profit margin. These are calculated as follows;  The return on assets is calculated as; The return on equity, is determined as follows;  The return on equity (ROE) is an indicator of the returns a company generates from its owner’s investment. The asset turnover is calculated as follows;  , and Capital employed = average debt liabilities + average shareholder’s equity. Efficiency Ratios Inventory Turnover Ratio =  Debtors’ turnover ratio shows the relationship between net credit sales and average accounts receivables of the year, and is calculated as;   This ratio measures the span of time it takes a company to make payments to its creditors. Liquidity Ratios The following are the liquidity ratios identified;   Quick Ratio shows short-term solvency of a business in a true manner, and is determined as; Current ratio is determined to work out firm’s ability to pay off its short-term liabilities. It is determined as; = Gearing Ratios Debt equity shows the relationship between long-term debts, and shareholders fund. This ratio is calculated from; Debts asset ratio is given by the formula below; This ratio compares total liabilities to shareholders funds. Time interest earned (times) is an indicator of a company's ability to meet its debt requirements. This is determined as; =  Profitability Ratios Profitability ratios are pointers of the profit earning capacity of a business. We shall discuss Gross profit margin and net profit margin. Gross profit margin expresses the relationship between gross profits to net sales, and is expressed in percentage (Thukaram, 2006). A decrease in gross profit margin indicates unfavourable purchasing, the instability of management to develop sales volume thereby making competition impossible. On the other hand, an increase in the ratio shows an increase in selling price of goods without corresponding increase in costs, opening stock valued at a figure lower than it should have been, and over evaluation of closing stock. There is no fixed standard for this ratio. Thukaram, (2006) asserts that in most cases 25% to 30% is the expected standard. CTY has an excellent profit margin compared to the expected standard because in 2009, the profit margin was 58.96%, a value higher than 58.16% for 2010. A decrease in profit margin in 2010 could be as a result of competition from new investors coming into the market. In 2009, TRS had 46.14% profit margin, a value relatively good compared to the standard. The value increased to 46.95% in 2010 as a result of stable management ability to develop large sales volume, and favourable purchasing power. CTY makes more profit than TRS, and so it is recommended to invest in the CTY business. Net profit margin shows company’s efficiency and soundness in controlling cost. The higher the margin is the better and the more effective the company is in converting revenue into actual profit. The net profit margin for CTY Company decreased from 6.42 % in 2009 to 4.85% in 2010. This could be as a result of increase in taxation rate, accumulated dividends that were not paid. This also could be due to low margin of safety, which could result to higher risk that led to decline in sales. The net profit margin for TRS Company increased from 6.91 % in 2009 to 6.95% in 2010. This translates to the company being most effective and profitable. Return on Equity (ROE) indicates company’s return generated on the owners' investment. Sometimes ROE is referred to as stockholder's return on investment; it gives the rate that shareholders are earning on their shares. If a company generate high returns relative to their shareholder's equity they pay their shareholders off handsomely, creating substantial assets for each dollar invested. This means the company require no additional equity investments. Both companies return on equity decreased from 2009 to 2010, but for shareholders in TRS Company had better return on every dollar invested. Return on assets (ROA) measures a firm’s success in using assets to generate earnings independent of the financing of those assets. It gives an idea of how good a business is at using its assets to generate earnings. The higher the ratio the better the company is because the company earns more on less investment. Both companies return asset decreased from 2009 to 2010, but for TRS Company was better at converting its assets to profit. Asset turnover is a measure of a company’s management ability to use its assets to make sales. High values of asset turnover suggest that the management is making better use of assets in making a higher rate of return on the total assets (Kimmel & Kieso, 2011). In CTY Company the asset turnover rate increase shows that the management is making better use of its assets to make profit. Its asset turnover for year 2009 is 2.42 times which increases in the year 2010 to 2.88 times. For TRS its asset turn over decreased from 2009 to 2010, indicating poor use of their assets, and its total return on asset (Needles, Powers, & Crosson, 2011). Efficiency Ratios These ratios indicate the vigorousness with which the company runs its activities. They demonstrate managerial laxity or efficiency, and the suitability of business policies in use. Inventory ratios show the number of times it takes to realize stocks in a year. CTY took 97.5 days to realize their stock in 2009, a decline to 87 days in 2009 due to management inefficiency or laxity. A stock turnover ratio for the year 2010 is preferred since it was higher. On the other hand, the stock turnover ratio for TRS improved from 65 days in 2009 to 74 days in 2010, an indication of improved efficiency which could be associated with improved promotional techniques, and use of more experienced management team. Comparing the two companies, CTY is better than TRS in both years. Debtor’s turnover shows the number of days it takes to collect cash from credit customers after making a credit sale. The lesser the number of days the better and the more efficient is the debtor policy. CTY took 3 days in 2009 to collect cash from their credit customers. This however, increased to 6 days in 2010. This indicates an inefficient debtor policy because as a rule, cash should be realised from credit customers as fast as possible. Discounts can be allowed to the debtors to enable them to honour their obligations promptly. TRS does not offer credit to their customers which means that they only sell on cash basis. This is however, not a good approach in the modern business world where investors are out to maximize sales and the overall profit margin. CTY is therefore better compared to TRS though there is a need to manage the debtors’ policy to avoid the risk of default. Creditor’s turnover shows the number of days it takes the business to pay the suppliers after purchasing on credit. CTY took 69 days to clear their obligations in 2009, which reduced to 62 days in 2010. This might have strained the business in honouring its obligations. TRS however, took 26 days in, 2009 which increased to 30 days in 2010. This is because they had more days to clear their debts. The number of days should however not be so many so as to discourage the creditors from supplying goods on credit. Comparing the two companies CTY is better because their credit period is higher in both the years. Financial Stability; Long-term and Short-term Liquidity Ratios These ratios indicate the ability of the firm to settle its obligations. A business that is not able to honour its obligations is said to be insolvent. This ratio is useful to the lenders and purchasers. An insolvent business will find it difficult to access credit facilities from lenders or the lenders will have to charge higher rates of interest to cater for the high credit risk. Current ratio shows the number of times the current assets can cover the current liabilities. A ratio of 2:1 is desirable. In the year 2009 CTY had a current ratio of 1.11 while in 2010 the ratio was 1.33. These two ratios are not desirable because the current assets are not adequate to cover the current liabilities. The business is therefore insolvent and not in a position to honour its short-term obligations and will also finds it difficult to access credit facilities. The current ratio of TRS is 0.868 in 2009 and 1.02 in 2010. This company is also insolvent hence will face similar problems as CTR. Quick ratio is a liquidity ratio which shows the number of times the relatively liquid current assets can cover the current liabilities. In calculating the quick ratio, stock is usually deducted because it takes relatively longer time to realize. A ratio of 1:1 is desirable. CTY had a quick ratio of 0.47 in the year 2009 and 0.33 in 2010. The company is not in a position to meet its current liabilities using the most liquid assets. The ability to meet these obligations has also declined by 0.14. Gearing ratio This category of ratios is used to evaluate the long term solvency of a firm. Debt asset ratio or total debt shows the proportion of debt in a company’s financing. The higher the ratio the higher the proportion of debt financing in the company’s capital structure (CPA, 2004). CTY had debt asset ratio 47.07 % in 2009 which declined to 34.37 % in 2010, implying that the extent of debt financing was high at a percentage of 47.07 which is not good for the company because it is risky to its creditors who will offer credit at a higher rate to account for this risk. TRS has a very high proportion of debt financing which is actually more than half of the company’s financial structure. Of the two companies CTY is better because its debt financing is less than 50 %. This company is highly leveraged and could be in danger if the customers demand repayment of debts. Debt equity ratio is the proportion of debt capital relative to the owner’s capital. To compute this ratio, the data from the previous fiscal year is used. A ratio greater than one means that assets are mainly financed with debt while a ratio less than one means that a greater percentage have been financed with equity (Gibson, 2011). If the company is financed more with debt then it is in a risky position when the interest rates are high because of the additional interest that has to be paid out for the debt. CTY’s debt equity ratio of 88.49% in 2009, and 52% in 2010 means that most of assets its’ have been financed with equity. The ratio for TRS is greater than one meaning that this is a risky company and can collapse if its lenders demand for their payment. CTY is the best company for an investor because he is assured of the progress of the business. Times interest earned is a gearing ratio which indicates the ability of the business to finance interest charges on long term loans. This ratio is mainly used by investors in order to understand the ability of a company to meet its obligations. This ratio is a manifestation of excess funding that is available to a company after it has paid off its interest and expense (Bragg, 2010). A ratio close to one means that a company runs a high risk of dishonouring its debts, whereas a higher ratio means that a company is operating with extra cash, hence not risky. In year 2009 CTY Company, was operating with an extra cash flow. This is however not the case in 2010 because it was at a high risk of defaulting on debt payment. TRS was being run on high risk of dishonouring its obligations because the times interest ratios are very low. Limitation Ratios are normally computed using historic information. Due to this, they reflect past business performance. Accounting ratios do not consider the effect of inflation over a time. Some companies can employ window dressing techniques to make their financial statement look strong, and also different companies have different accounting practises which can distort comparisons. Ratios carry with them the weakness of financial statements. If the financial statements have been manipulated the ratios will be misleading. A company may have some ratios that may look good, and others that look bad making it difficult to tell whether the company is strong or weak. Conclusion In general, Country Road Limited should improve on the management skills to ensure that they are consistent in their performance. Their business is at risk of poor performance over a time. Reject Shop management knows how to maintain and retain suppliers. It also makes extra effort to improve its asset on return so that they can make more profit. Recommendations I recommend investors to adopt the Reject Shop management business style for better returns. References (CPA), W. H. Accounting for managers. New York: 2004; McGraw - Hill Companies, Inc. Bragg, S. M. Business Ratios and formulas: A comprehensive Guide. 2010; New Jersey: John Wiley and Sons. Gibson, C. H. (2011). Financial Reporting & Analysis; 2011; Ohio, South Western Cengage LLlearning. Kimmel, P. D., & Kieso, D. E. Financial Accounting:Tools for Business Decision Making. 2011; New Jersey: John Wiley and Sons.inc. Needles, B. E., Powers, M., & Crosson, S. V.. Principles of Accounting. 2011; Ohio, South Western Cengage. Thukaram, R. M. Management Accounting. 2006; New Delhi, New Age International (p) Ltd. Read More