Evaluation of the Profitability, Liquidity, and Stability of Balloons N Stuff Pty Ltd for Waratah Bank - Case Study Example

EVELUATION OF THE PROFITABILITY, LIQUIDITY AND STABILITY OF BALLOONS N STUFF PTY LTD FOR WARRATAH BANK [Enter the date of submission] Prepared by [Enter your name] Executive Summary Balloons n stuff ltd is a party supplies company that is considering expansion into online trading. For the company to implement this expansion, they need financing from the Warratah bank. Warratah bank carried out a financial analysis of the company so as to find out if it was eligible for the loan. The financial analysis included the analysis of the price/earning ratio so as to find out the profitability of the company. The liquidity of the company was also considered and the current ratios of the company were analysed. Finally, the financial stability of the company was tested by the analysis of the debt, equity and capitalization ratios. The low price earning ratio was a bad indicator of the future growth of the company. The current ratio indicated poor liquidity and the high debt ratio was a sign of an unstable company. It is not advisable for the Warratah bank to approve the loan due to the financial instability of the company. The bank should also carry out other analysis since financial analyses do not show the full picture of the position of a company. Contents Introduction Balloons n stuff ltd is a party supplies company that has a diverse product range in both product quality and type. It is a private company, owned by two brothers, Stuart and Neville Rold and is not listed in the stock market. It sources its generic products from China and the Philippines while the more pricey products are made in Europe, in Italy, France and Spain. In the past, Balloons n stuff has used catalogues as their marketing tool but with the technological advancement, they wish to expand and incorporate online trading into their business. When the company was starting up, the two brothers got a loan from the Warratah bank amounting to $160,000. Their online expansion idea will cost them further and they wish to obtain another loan amounting to $240,000. They have approached Warratah bank for this additional amount. The purpose of this report is to evaluate the financial stability of the company so as to decide whether it is wise for the Warratah bank to loan the two brothers the $240,000 they need for expansion. The company will be judged on its profitability as well as liquidity. This analysis will be limited to the financial statement analysis only. This is a reliable area to carry out the analysis but it will not produce results that can be comfortably relied on as 100% image of the company. Since Balloons n stuff is a young company, only three years old, there are many other factors, other than financial statements, that could indicate the stability of the company. By confining this analysis to financial statements only is not conclusive. Profitability The aim of every business is to bring in profits at the end of every trading period. Profitability is the item that receives the most concern of every business owner or manager. This is because, a non-profitable business is headed for failure and all the funds pumped into the business would be lost. The profitability of a company is also important because it is one of the major factors considered when determining the companies worth and bottom line. It is also used by investors to rate companies when choosing where to invest. The profitability ratios of a company clearly display the overall efficiency of the business and its performance (Stickney, Brown & Wahlen, 1999, p. 125). Price/earning ratios The price/earning ratio has been used overtime to evaluate the profitability of a business. The price/earning ratio is the evaluation of the current share price of the company compared to its earnings per share. It is calculated as; P/E ratio  (Stickney, Brown & Wahlen, 1999, p. 127) For Balloons n stuff pty ltd, the market value per share is $20. This was the view of both Stuart and Neville when they contributed $20,000 for the issuing of 1,000 shares. The P/E ratio can be calculated as: P/E ratio  A P/E ratio of 3.38 can be considered as a low P/E ratio. This could mean that the company, Balloons n stuff is generally of low value and the expectations of the company to increase in earnings are very low. It could also be an indication of its lack of publicity since it is not listed in the stock market therefore, it is not available for scrutiny hence its worth has not been discovered (Fridson & Fernando, 1999, p. 78). Dividend ratio The dividend ratio is the fraction of the company’s income that is used to pay the dividends to the share holders. The dividend ratio is calculated by dividing the dividends paid out by the net income of that trading period. In the case of balloon n stuff, this ratio is not applicable because the company is not listed in the stock market therefore, there are no dividends paid out (Fridson & Fernando, 1999, p. 78). Sub-conclusion on profitability The price/earning ratio is used to determine the profitability of balloons n stuff ltd. The price earning ratio was found to be small. This could be an indication of the low expectations of the company’s income growth. It could also indicate the low value of the company or its lack of exposure hence its true value has not yet been discovered. The use of this ratio to determine the profitability of the company cannot be conclusive and other factors and ratios need to be considered (Fridson & Fernando, 1999, p. 78). Liquidity Liquidity is the measure of the accessible money a company has in cash or other cash equivalents. Liquidity is important to a company since it ensures that the company has enough money for it to run and meet all its obligations (Graham, Meredith & Price, 2003, p. 57). Current and quick ratios The current ratio is the ratio used to measure a company’s ability to meet and fulfill its short term cash obligations. The current ratio is calculated by dividing the current assets with the current liabilities. Current ratio=  (Graham, Meredith & Price, 2003, p. 57) Balloons n stuff ltd does not have many assets but it has a piece of property worth $210,000. This is a long term asset and it might not be easily converted in to money if there was an urgent need for money. There was also a $30,000 cash input. This is the current asset of the company. The liabilities are the already existing cash obligations in the business. Balloons n stuff had obtained a loan from the Warratah bank of $160,000. The company must pay back the loan. This is a cash obligation that must be met. These figures can be used to calculate the current ratio of the company: Current ratio=  A current ratio below 1 indicates a poorly liquidated company that is not in a position to meet its day to day cash obligations. The quick ratio is also used as an indicator of the liquidity of a company. It is used to refine the current ratio since it includes the short term investments made by the company in the calculation as assets. The formula used is: Quick ratio=  (Graham, Meredith & Price, 2003, p. 58) Sub-conclusion on liquidity Liquidity is an important factor in every business. Especially in this case where the company, Balloons n stuff wants a loan. Getting financing from a financial institution is one of the avenues of improving the liquidity of a company but the fact that the loan must be repaid in a given period of time should be considered. The long term growth of the company must be put into consideration before Warratah bank can advance any money to Balloons n stuff. A loan is considered a liability due to its repayment and if the company is not liquid enough to handle the repayments, then the loan is better not given to the company. In this case of balloons n stuff ltd, the company is not in sound liquid condition and addition of extra liabilities could hurt the company. This fact could be overlooked if the financial growth of the company is expected to rise (Graham, Meredith & Price, 2003, p. 57). Financial Stability Debt and equity ratios The debt ratio is a ratio used to show the financial stability of a company. It is a comparison of a company’s debt, which is considered a liability, to its assets, both current and long term. Debt Ratio=  (Stickney, Brown & Wahlen, 1999, p. 135) In balloons n stuff ltd, the total debt is $160,000 and the total assets are the property worth $210,000 and the $30,000 cash input. Debt ratio=  This translates into 66% debt ratio. This is a very high debt ratio and it indicates a weak equity position. These figure shows that balloons n stuff has taken on itself a great risk. The equity ratio, just as the debt ratio, indicates the amount of leverage a company is using. The difference between the debt ratio and the equity ratio is that the equity ratio measures the amount of assets financed by the stock holders thus a low equity ratio would translate to good results for the stock holders. Since balloon n stuff was not listed in the stock market, the equity ratio is not considered (Leopold & John, 1997, p.63). Sub-conclusions of financial stability According to the figures obtained above, the financial stability of the company, balloons n stuff ltd is questionable. With a high debt ratio of 66%, the company is not ready to commit to another liability in form of another bank loan. The company is already in a situation that can only be referred to as a risky situation. It is not in a financially stable condition to take on another loan (Leopold & John, 1997, p.63). Conclusion The financial analysis of Balloons n stuff ltd can be used to indicate the financial position of the company, its strengths and weaknesses. From the analysis of its profitability, the profit/earnings ration was found to be small. This can be taken to mean that the company is expected to grow financially at a very small rate in the coming years. It could also be an effect of the company not being listed in the stock market. Its true value has not yet been discovered hence the low value of its shares. The analysis for the liquidity of the company showed that the company was not liquid enough to handle its cash obligations. The final analysis of its financial stability showed that the company is not at a very stable position since it had a very high debt ratio. When all of these factors are put into consideration, awarding another loan to the company may overburden the company financially due to its already high debt ratio. The company may also have difficulties paying back the loan since its liquidity is not up to recommended levels and from the financial analysis, the financial growth of the company is expected to move up at a slow pace. Warratah bank should not give the company the loan but since this financial analysis may be biased, the bank should investigate the condition of the company through other analysis’ so as to have a complete picture of the company’s condition. Recommendation Given the findings of this analysis, Warratah bank should not give the company the loan. This decision is based on three major findings of the analysis: A small profit/earnings ratio indicating expected slow growth and low value of the company Poor liquidity of the company indicating the company’s lack of ability to meet its cash obligations promptly The company’s high debt ratio indicating lack of stability. The bank should however carry out other types of analysis so as to ensure that the company has been scrutinized in full. Appendix – Part C Disadvantages of basing real world financial decisions solely on financial statement analysis Financial stamen analysis has been a very useful tool for business analysis for many years. It is a mode of simplifying the financial statements of a company thus the financial position of the company can be quickly seen without going through a lot of paper work. This kind of analysis also aids in the comparison of two or more companies. This kind of comparisons come in handy for investors as they are looking for businesses to invest in. financial statement analysis also gives a clear picture of the trend each business has been following over a given number of years and the future trends can easily be mapped. This is especially important when the business is looking into expanding (Stickney, Brown & Wahlen, 1999, p. 159). Financial statement analysis does come with its limitations. For instance, in the comparison of two different companies by use of financial statement analysis, the results will not be 100% accurate. This is due to other factors that may influence one company but not the other thus the comparison is not made on fair grounds. Some factors like market regulation and structure could adversely affect the business of one company thus its financial analysis could indicate a poor status. When financial analysis is does using ratio analysis, the ratio analysis is done using figures of the past business periods. This gives a clear picture of the past but most financial analysis is not carried out to analyze the past but the future. The figures of the past are applied to the future without consideration of changes that might have occurred (Fridson & Fernando, 1999, p. 108). Financial statements also do not cover the employees of the company. Employees are a very important asset to any company and the loss of some vital employees could bring a company to its knees. The omission of these skilled people in the analysis does not give a clear picture of the company. Some financial analysis could be misleading. Take for instance the price earning ratio, a high value could mean a stable company with high profits. It could also be as a result of overpriced shares. These limitations clearly show that the sole dependence on financial statement analysis for all business decisions is not a good idea. There are other factors that are not considered in the financial analysis that are of great effect to the company (Graham, Meredith & Price, 2003, p. 88). For a conclusive analysis of any company, other factors, a part from financial factors, must be considered and their effect on the company should also be considered. Factors like market regulations adversely affect the company’s business and should be considered. Potential growth of a company must not be derived from the companies past financial reports. Some factors such as internet trading and advertising, outsourcing labour from cheaper countries and even recycling play a great part in the growth of a business. If these factors are not considered, the full picture of the company cannot be viewed and good business decisions should not be based on non-conclusive facts (Leopold & John, 1997, p.83). Reference List Stickney, C., Brown, P. & Wahlen, J., (1999). Financial Reporting, Financial Satement Analysis and Valuation: A Strategic Perspective. 6th Edition, New York: McGraw Hill. Fridson, M. & Fernando, A., (1999). Financial Statement Analysis: A Practitioners Guide. 3rd Edition, New York: John Wiley and Sons, Inc. Graham, B., Meredith, S. & Price, M., (2003). The Interpretation of Financial Statements. New York: Harper & Row Pulishers, inc. Leopold, B. & John, W., (1997). Analysis of Financial Statements. 5th Edition, New York: McGraw Hill. 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