Interpretation of financial statement - Essay Example

? Interpretation of Financial ment Contents Contents 2 COMPUTATIONAL OF KEY FINANCIAL RATIOS 3 Liquidity Ratios 3 Quick / Acid Test Ratio 3 Asset Management Ratios 3 Trade Receivables Collection Period 3 Fixed Asset Turnover 4 Total Asset Turnover 4 Debt Management Ratios 4 Trade Payable Payment Period 4 Gearing Ratio (Debt Ratio) 4 Profitability Ratios 5 Operating Profit Margin 5 Net Profit Margin 5 MARKET RATIOS 6 Earnings per Share 6 Book Value per Share 6 INTERPRETATION OF FINANCIAL INFORMATION AND RATIOS 6 Liquidity Ratios 7 Asset Management Ratios 7 Debt Management Ratios 8 Profitability Ratios 9 Market Ratios 9 QUESTIONS FOR THE FINANCE DIRECTOR 10 Bibliography 10 COMPUTATIONAL OF KEY FINANCIAL RATIOS Assumption The number of days in a fiscal year is assumed to be 360. Liquidity Ratios Current Ratio Current Ratio = Current Assets / Current Liabilities (2011) = 20,030,000 / 15,760,000 =1.27 x (2010) = 15,880,000 / 6,250,000 =2.54 x Quick / Acid Test Ratio Quick Ratio = (Current Assets - Inventory) / Current Liabilities (2011) = (20,030,000 - (9,380,000)) / 15,760,000 =0.68 x (2010) = (15,880,000 - (7,380,000)) / 6,250,000 =1.36 x Asset Management Ratios Inventory Turnover Inventory Turnover = (Inventory/Cost of Sales) * 360 (2011) = (9,380,000/35,200,000)*360 = 95.93 days (2010) = (7,380,000/39,220,000)*360 = 67.74 days Trade Receivables Collection Period Trade Receivable Collection Period = Trade Receivable / (Annual Sales / 360) (2011) = 10,650,000 / (61,000,000 / 360) =62.85 Days (2010) = 8,500,000 / (73,200,000 / 360) =41.80 Days Fixed Asset Turnover Fixed Asset Turnover = Net Sales / Net fixed Assets (2011) =61,000,000 / 50,890,000 =1.20 x (2010) =73,200,000 / 37,700,000 =1.94 x Total Asset Turnover Total Asset Turnover = Net Sales/ Total Assets (2011) =61,000,000 / 70,920,000 =0.86 x (2010) =73,200,000 / 53,580,000 =1.37x Debt Management Ratios Trade Payable Payment Period Trade Payable Payment Period = Trade Payable / (Cost of Sales / 360) (2011) = 4,950,000 / (35,200,000 / 360) =50.63 Days (2010) = 2,630,000 / (39,220,000 / 360) =24.14 Days Gearing Ratio (Debt Ratio) Gearing Ratio (Debt Ratio) = Total Debt / Total Assets (2011) = (33,760,000) / 70,920,000 = 47.60% (2010) = (17,250,000) / 53,580,000 = 32.19% Debt to Equity Ratio Debt to Equity Ratio = Total Debt / Total Equity (2011) = (33,760,000) / 37,160,000 = 90.85% (2010) = (17,250,000) / 36,330,000 = 47.48% Interest Cover (TIE) Interest Cover = (Earnings before Interest and Taxes + Interest Expense) / Interest Expense (2011) = (12,920,000+ 2,000,000) / 2,000,000 = 7.46x (2010) = (16,905,000 + 1,700,000) / 1,700,000 = 10.94x Profitability Ratios Gross Profit Margin Gross Profit Margin = Gross Profit / Sales (2011) = 25,800,000 / 61,000,000 = 42.30% (2010) = 33,980,000 / 73,200,000 = 46.42% Operating Profit Margin Operating Profit Margin = Operating Profit / Sales (2011) = 14,920,000 / 61,000,000 = 24.46% (2010) = 18,605,000 / 73,200,000 = 25.42% Net Profit Margin Net Profit Margin = Net Profit / Sales (2011) = 7,320,000 / 61,000,000 = 12.00% (2010) = 9,578,000 / 73,200,000 = 13.08% Return on Assets Return on Assets = Net Profit / Total Assets (2011) = 7,320,000 / 70,920,000 = 10.32% (2010) = 9,578,000 / 53,580,000 = 17.88% Return on Equity Return on Equity = Net Profit / Total Equity (2011) = 7,320,000 / 37,160,000 = 19.70% (2010) = 9,578,000 / 36,330,000 = 26.36% Return on Capital Employed (ROCE) Return on Capital Employed = (Earnings before Interest and Taxes/Capital Employed)* (2011) = 14,920,000/55,160,000 = 27.05% (2010) = 18,605,000/47,330,000 = 39.31% * Capital Employed = Total Assets – Current Liabilities MARKET RATIOS Earnings per Share Earnings per Share = Net Profit / (Average no. of Outstanding shares) (2011) = 7,320,000 / (20,000,000) = ?0.37 (2010) = 9,578,000 / (18,000,000) =?0.53 Book Value per Share Book Value per Share = Common Equity / (Average no. of Outstanding shares) (2011) = 37,160,000 / (20,000,000) = ?1.86 (2010) = 36,330,000/ (18,000,000) = ?2.01 INTERPRETATION OF FINANCIAL INFORMATION AND RATIOS BLS Ltd., manufacturer and supplier of customized furniture and fittings in the UK construction market has expanded its operations in newer markets in recent times. The company’s performance improved significantly up till 2010 as the new management which took over in 1996 made strong decisions and adopted an approach based on quality and perseverance. However, analysis of the company’s financial ratios suggests that its financial performance has deteriorated considerably during the last year. Liquidity Ratios The current ratio of the company is just acceptable at 1.27. However this ratio has declined from 2.54 to 1.27. This is a worrying sign for the company as it implies that the company is just about covering its current assets with its current liabilities. In other words, the company is finding it much more difficult to meet its short term obligations now than a year ago (Besley et al. 2008). As a result, the working capital of the company has also decreased by a significant margin. Consequently, BLS Ltd.’s liquidity position has also worsened. The decrease in Quick/Acid Test Ratio from 1.36 to 0.68 is also quite alarming. This ratio is obtained by removing inventories from the equation which are considered to be the least liquid of all assets. This ratio implies that the company is covering just around 68% of its liabilities. The chief reason for these changes is the increase in current liabilities by more than 100% as the company has expanded its activities. Hence, after comparison with last year, it can be concluded that the liquidity position of the company has become poor. Asset Management Ratios The inventory turnover of BLS Ltd. has drastically increased from 67.74 days to 95.93 days. This suggests that now the company takes around 28 days more to complete its one cycle of inventories (Megginson et al. 2008). The primary reason for this change is the increase in inventories over the last year. This has mainly resulted from company’s new operations and projects. However, it is still a concerning issue for the management (Arnold, 2008). The Trade Receivable Collection period has also risen from 41.80 days to 62.85 days, implying that the company now takes around 3 weeks more to collect its credit sales. This has occurred as the trade receivables have increased. This increase in the collection period indicates flaws in the credit policy of the company. The Fixed Asset Turnover Ratio of the company has declined from 1.94 to 1.20. This has happened because the company has increased its fixed or non-current assets comprising of land and buildings, plant and equipment, and motor vehicles by a notable margin. This may not be a worrying factor as the company is developing itself into a bigger one; however, the worrying aspect is the decrease in sales by around ?12 million. Likewise, the Total Asset Turnover ratio of BLS Ltd. has fallen from 1.37 to 0.86. The above ratios hint that the company is not managing its assets in an efficient manner. Debt Management Ratios The Trade Payable Payment period of the company has increased from 24.14 days to 50.63 days suggesting that the company is taking almost twice the number of days to pay its trade debts than what it used to take in 2010. The basis for this occurrence is the fact that the company has increased its trade payables considerably in the last year, largely due to the expansion of activities. The Gearing ratio or the debt ratio has enhanced by 15.41% implying that the company’s debt has increased much more in comparison to the increase in its assets. Presently, 47.60% of funds have been provided by the creditors. Though leverage magnifies the earnings, yet the high increase in debt is not a good symptom for BLS Ltd as too much of debt leads to financial difficulty which in turn may result in bankruptcy (Bull, 2008). The Debt to Equity ratio has shot up to almost 91% which has to be a big concern for the management as well as all the other stakeholders. In such a situation, creditors might not be willing to lend more to the company. If this ratio increases any further, then this might lead to bankruptcy (Gitman, 2009). The Interest Cover or the TIE Ratio has dropped from 10.94 to 7.46. It indicates that the earnings before interest and taxes (EBIT) can decline by 7 .46 times before the company fails to meet its annual interest costs. This has happened mainly due to decreased EBIT in the year 2011. Consequently, the company’s ability to pay off its accumulated interest has reduced. It is now operating in a lower margin of safety (Besley et al. 2008). Hence, the Debt Management ratios show that BLS Ltd is not being able to manage its debt in an organized manner. In fact, there seem to be certain issues related to strategic planning (Morden, 2004) Profitability Ratios The Gross Profit Margin and Operating Profit Margin of the company have fallen by around 4% and 1% respectively. The Net Profit Margin has also decreased by around 1%. These ratios have gone down primarily because the profits at all levels – gross, operating and net have declined in the last year. The Return on Assets and the Return on Equity have also dropped by a substantial margin of around 7% each. The explanation for this decline is primarily the fall in net profit during the last year. The decline in net profit has been sharper in comparison to the rise in total assets and total equity. Thus, the company is not obtaining adequate return on its assets and equity. This is certainly a cause of worry for all the stakeholders of the company (Brealey, 2008). The ROCE ratio has also gone down harshly by almost 12%. The basic reason for this decline has been the decrease in EBIT along with an increase in Capital Employed which has mainly been caused due to the greater accumulation of non-current assets. Thus, the company’s profitability and return has undergone a serious decline over the last year. Market Ratios The earnings per share of the company have also dropped by ?0.16.This is not a positive sign for BLS Ltd. as its stockholders’ earnings have fallen. Moreover the reputation of the company has also been negatively affected in the industry. The attractiveness of the company might have fallen in the eyes of the potential investors (Baker et al. 2005). The book value per share has also gone down by ?0.15. Similar to other ratios, market ratios have also been disappointing for the company. Thus, the overall financial performance of BLS Ltd has been poor in the last year (Gibson, 2009). QUESTIONS FOR THE FINANCE DIRECTOR Q.1. Can you brief us with a trend analysis of sales over the last 12 months as the decline in revenue has been quite substantial? Kindly also let us know about the expected sales trend in the near future? Q.2. Our Company’s Debt to Equity ratio is almost 91% now. A slight increase might be very dangerous and could lead to bankruptcy. Can you present a precise forecast as to what can we anticipate in coming days with regard to our borrowings and debt? Q.3. The Interest Cover (TIE) ratio is a good indicator of any company’s debt management (Brigham et al. 2012). However in our case, it has declined sharply over the last year. In your opinion, do you expect the implications of the TIE Ratio to be realistic? In other words, are things under our control presently? Bibliography ARNOLD, G. (2008). Corporate financial management. Harlow, Financial Times Prentice Hall BAKER, H. K., & POWELL, G. N. (2005). Understanding financial management: a practical guide. Malden, Mass. [u.a.], Blackwell BESLEY, S., & BRIGHAM, E. F. (2008). Essentials of Managerial Finance. Mason, Thomson/South-Western. BREALEY, R. A. (2008). Principles of corporate finance. McGraw-Hill Education Singapore. BULL, R. (2008). Financial ratios: how to use financial ratios to maximise value and success for your business. Oxford, CIMA. GIBSON, C. H. (2009). Financial reporting & analysis: using financial accounting information. Mason, Ohio, South-Western/Cengage Learning. GITMAN, L. J. (2009). Principles of managerial finance. Boston, Pearson/Prentice Hall. MORDEN, T. (2004). Principles of management. Aldershot, Hants, England, Ashgate. MEGGINSON, W. L., & SMART, S. B. (2008). Introduction to corporate finance. Mason, South Western Educational Publication. Read More