Nature and Function of Accounting for Service Firms - Case Study Example

Executive Summary Wonderfun PLC is the company of leisure equipment, sports centres and theme parks and operates in North of England. The company has been very attractive for the investors because of its overall performance during the last five years as compared to other companies operating in the same industry. In order to evaluate whether, the investors should invest in Wonderfun or not, this report has been prepared. This report evaluates the financial health of Wonderfun by calculating the financial ratios of company for the last five years (2005-2009). Because of the availability of information, only key ratios have been calculated and interpreted. To analyse the current position of Wonderfun, the trends in financial ratios have been seen and the performance of company with other companies has been compared by taking the industry averages. Based on analysis, few recommendations have been provided to the company and investors. The financial ratios analysis has shown that Wonderfun PLC has been performing above than market average during the period 2005-2008. However, the performance of company has been declining slightly from 2005-2008. The year 2009 appears to be a tough year for the company, as its profits have reduced and debt and liabilities have increased. Still, the company has paid the same dividend in 2009, as it has paid in 2008. Moreover, Wonderfun has also pursued expansion strategy in 2009, which have enhanced the liabilities of the company; however, the sales of company are improving after this expansion. It has been recommended to the company that it can improve its performance in coming years by reducing its operating expenses such as selling and distribution costs. Moreover, it has been suggested to investors that Wonderfun is still a good company to invest in because of its excellent past performance, declining industry performance in 2009 (which also affected company) and potential of increasing revenues because of expansion strategy. Main users groups and needs of the analysis Various groups need financial information and the nature of their uses also varies. The main groups of users may include owners of the company, managers, prospective owners, banks or lenders, suppliers of materials, government bodies, related industry regulatory authorities and employees or unions (ACS). The needs of analysis for these users groups also vary for example, investors may want information to decide whether to invest in the company or not. The suppliers of materials may need information to evaluate whether the company is profitable enough to pay back trade payables. Government regulatory bodies may need financial analysis for tax purposes and employees may need information to analyse stability of their employment. Analysis of Wonderful PLC Return on Capital Employed Elliott & Elliott have defined Return on Capital Employed as net profit divided by capital employed (equal to total assets). The ROCE ratios of the company for the last five years show a declining trend. In 2005, 2006 and 2007, the ROCE ratios calculated for the company were 26%, 24% and 20% respectively, whereas, in 2008 and 2009 they are 9% and 5% respectively. The figures shows that in 2007, company was generating around 20% on investments however, in 2009 it is generating only 5% on investments. The decline in ROCE is not because of external factors but because of internal factors as it is evident from the fact that industry averages for ROCE have been 22% and 20% in 2008 and 2009 respectively. Therefore, ROCE ratios predict a decline in the profitability of company. Net Profit Margin The net profit margin shows the cost control of Wonderfun and the last five year ratios show that company is facing a decline in its net profit margin over the last five years. From 2005 to 2007, net profit margin ratio of the company has declined from 15% to 13% however, in 2008 and 2009 they are 8% and 5% respectively which are less than industry averages of 14% (2008) and 13% (2009). The decline in net profit margins of company predict a decline in efficiency of the company to covert its revenues into actual profit. Like other companies operating in same industry, Wonderfun is facing the same business conditions but its performance is lower. Gross Profit Margin Gross profit margin ratios of Wonderfun are showing a continuous decline over the last five years. In 2008, gross profit margin ratio is 40% as compared to 46% in 2007, 48% in 2006 and 50% in 2005. In 2009, the ratio has further declined to 33%, which is even lesser than industry average of 40%. The gross profit ratios are showing that although Wonderfun has been able to cover its operating and other expenses however, the financial health of company is declining. Secondly, as industry average of gross profit margin has also decreased by 5% in 2009 which means that costs of goods sold or pricing policies have changed drastically in year 2009, however, Wonderfun has been majorly affected as its gross profit margin has declined by 7% from 2008 to 2009. Inventory Period The calculations of inventory period for Wonderfun are showing the average time for which the inventory is held. From year 2005 to 2007, company’s average inventory period is around 30 to 33 days however; in 2009 it has drastically increased from 36 days (2008) to 62 days in 2009. Since the companies incur huge costs in holding and maintaining inventory, therefore, some organizations do get advantage in this regard. Previously, Wonderfun was reporting inventory holding quite near to the industry average, however, in 2009, the inventory holding period has increased by 26 days as compared to 2008. Trade receivable period The trade receivable period suggests the days taken by Wonderfun to receive its payment owed. The trade receivable period of Wonderfun is quite stable as company in 2005 incurred 41 days to recover its receivables and in 2008, it incurred 40 days and even lesser in 2009 (34 days). The declining number of collection period is a positive sign, thereby, showing that Wonderfun is incurring fewer days to turn its receivables into cash. Moreover, the industry average is 38 days, which further enhances the advantage of the organisation. Trade Payable Days Trade payable days give an idea about days taken by a company to pay its trade creditors. From 2005 to 2008, the trade payable days of Wonderfun were around 39 to 42 days, however, in 2009; they have increased to 66 days. It means the company is taking a relatively longer time to pay its trade creditors, which is not a positive sign. If, I compare it with industry average, it is found that industry average payable days are 45 days, which are very less than 66 days. It can harm the company because the trade creditors will be more willing to pay the companies with less number of payable days outstanding. Current Ratio Current ratios of Wonderfun for the last five years show whether the business has enough resources to pay its bills or not. The current ratios of the company are showing are declining trend which means either the current assets are declining or the current liabilities are increasing. Actually, for Wonderfun, both the current assets and current liabilities have increased however; the increase in liabilities is relatively higher than increase in current assets. In 2009, the current ratio of company has declined to 1.485 times as compared to 1.8 times in 2008. Moreover, previously company was having $2.4 in current assets for every dollar of current liabilities however, it has declined now. However, company is still able to maintain a significant current ratio of more than 1 therefore; even the inventory period of company has increased in 2009, the trade receivable period has declined. Acid Test Acid test ratios of Wonderfun are showing the ability of company to cover its immediate current liabilities without selling inventory. Acid test ratio has declined in 2009 and it has become less than 1, which means that company may not be able to pay its current liabilities and current assets are dependent on inventory stock of company. On the other hand, from 2005 to 2008, the acid test ratio is showing a declining trend, still the value is great than 1. Gearing Ratio Gearing ratios are showing leverage situation of Wonderfun and it has found that from 2005 to 2008, company had very low gearing ratio, even below than industry average. However, in 2009, company gearing ratio has increased to 41% as compared to 15% in 2008. It shows that company is being considered riskier as its creditors’ fund is increasing against owner’s equity. Limitations of Ratios The major limitation of these ratios is that none of these is meaningful enough to present the picture of the company. Therefore, to reach on conclusion, several ratios were required, to pain a situation of the company. Some account balances used in the calculations of ratios may increase or decrease at the end of the year, which do not give the true picture of the financial position of company during the year. For example, the inventory period is showing that on 31st December 2009, the inventory holding days were 63 as compared to 37 days in 2008. It can be because of the reason that company acquired more inventories before the year end, which may distort the real picture. In short, yearend ratios may not be the true representatives of company’s financial situation. Moreover, various limitations are ratios specific for example, current ratio used here, does not predict the short term solvency of the company alone. Moreover, current ratio is not telling about the quality of assets, as it is only the measure of assets’ quantity (Accounting form Management). Therefore, it only gives a hint about the liquidity of Wonderfun. Return on Capital Employed does not give a true idea about company because the decline in ROCE is generally perceived as decline in return; however, it does give an idea that investors are more attracted by the company (Finance Scholar). The decline in ROCE may also predict that company has been able to employ more capital as it expanded its operations. These are assumptions, which are only made because of lack of information. Moreover, sometimes the management intentionally makes the decisions and the ratios are affected negatively, however, such things cannot be predicted through ratio analysis, unless information is provided by management. Conclusion and Recommendations The financial ratio analysis of Wonderfun shows that the company has been performing very good from 2005 to 2007, and the situation of the company has been also satisfactory in 2008, however, the year 2009, appears to be a tough years for Wonderfun PLC. The decline in net profit margin and gross profit margin ratios show that company’s profitability has declined in year 2009. The increase in inventory period and trade payable period and decline in current ratio further support the idea that Wonderfun might be facing difficulties in bearing its expenses. The first problem which the company is incurring is that it is getting 75 percent of its turnover from three major customers. This enhances the competition of the company with other companies in the industry. As a result, Wonderfun PLC faces price challenges and high competition. The reason is that 75 percent sales coming from three customers, enhance the bargaining power of the company thereby, putting them at advantageous position. Moreover, the step of the company to increase its customer base is the positive sign of concern of company regarding the bargaining power of customer. It may give a positive hope to investors that the expansion in customer base will increase the revenues and reduce the selling price pressures on Wonderfun. Therefore, the current strategic decision of expanding its production may attract more investors for the company. Secondly, profitability ratios apparently shows a decline in profitability of Wonderfun, however, income statement shows that in year 2009, the company has faced increase in its sales because of customer base expansion. Even the cost of goods sold has increased; still the gross profit for year 2009 is greater than last year gross profit. However, the decline in net profit is because of the increase in selling and distribution costs. Therefore, the company should take into consideration its operating expenses. Moreover, the decline in other operating profit has also contributed towards the decline in overall net profit. The management of the company can develop strategies to reduce operating costs, which may enhance profitability of company. Third, the past years performance of Wonderfun shows that company has been able to provide significant return on investments to its investors. In 2009, not only the performance of Wonderfun has declined but the industry averages are also showing the declining performance of other companies in the same industry, however, Wonderfun’s performance has been more alarming. On the other hand, expansion of company shows that sales of company has increased in second half of 2009 and more increase is expected in coming years. Furthermore, Wonderfun has paid out significant dividend in 2009 (same as paid in 2008), even being less profitable in 2009, which shows that investors are getting suitable returns on their investments. Therefore, it is recommended to investors that although the financial ratios of Wonderfun do not make it an attractive option to invest in, however, the industry condition, the current expansion strategy of company and dividend payout are the factors which seem to encourage investments in Wonderfun. Bibliography Accounting form Management. (n.d.) Current Ratio. [Online] Available from: http://www.accountingformanagement.com/current_ratio.htm#Limitations%20of%20Current%20Ratio [Accessed 14 June 2010]. ACS. (n.d.) Nature and function of accounting for service firms. [Online] Available from: http://www.acs.edu.au/download/samples/book1.pdf [Accessed 14 June 2010]. Finance Scholar. (n.d.) Return on Capital Employed. [Online] Available from: http://www.financescholar.com/return-capital-employed.html [Accessed 14 June 2010]. Appendix Table 1: Financial Ratios Values   Formula 2009 2008 Return on capital employed Net profit/capital employed 3400/65500*100 4720/50000*100 Net profit margin Net Income After Taxes/Revenue 3400/74,880 4720/58,000 Gross profit margin Revenue - Cost of goods sold/Revenue (74880-49,920)/74880 (58,000-34,800)/58,000 Inventory period (inventory x 365 days) / cost of sales (8,600* 365 days) /49,920 (3,500 x 365 days) /34,800 Trade receivables period (Average Accounts Receivable)*365 / (Sales) (7,000)*365 / (74,880) (6,400)*365 / (58,000) Trade payables days (Average Accounts Payable)*365 / (COGS) (9,000) *365/ (49,920) (3,800) *365/ (34,800) Current ratio Current Assets/Current Liabilities 15600/10,500 10800/6,000 Acid test Cash +Accounts receivables +short term investments/current liabilities 7,000/10,500 900+6,400/6,000 Gearing ratio long term debt / shareholders equity 16000/39,000 6000/38,000 Quick Ratio Current Assets - Inventory/current liabilities (15600-8600)/10500 (10800-3500)/6000 Debt Ratio Total Debt/Total Assets 16000/65,500 6000/50,000 Return on Assets Net Income/Total Assets 3400/65,500 4720/50,000 Return on Equity Net Income/Total shareholders equity 3400/39000 4720/38000 Table 2: Financial Ratios   Formula 2009 2008 Return on capital employed Net profit/capital employed 5.19083969 9.44000000 Net profit margin Net Income After Taxes/Revenue 4.54059829 8.13793103 Gross profit margin Revenue - Cost of goods sold/Revenue 33.33333333 40.00000000 Inventory period (inventory x 365 days) / cost of sales 62.88060897 36.70977011 Trade receivables period (Average Accounts Receivable)*365 / (Sales) 34.12126068 40.27586207 Trade payables days (Average Accounts Payable)*365 / (COGS) 65.80528846 39.85632184 Current ratio Current Assets/Current Liabilities 1.48571429 1.80000000 Acid test Cash +Accounts receivables +short term investments/current liabilities 0.66666667 1.21666667 Gearing ratio long term debt / shareholders equity 41.02564103 15.78947368 Quick Ratio Current Assets - Inventory/current liabilities 0.66666667 1.21666667 Debt Ratio Total Debt/Total Assets 0.24427481 0.12000000 Return on Assets Net Income/Total Assets 0.05190840 0.09440000 Return on Equity Net Income/Total shareholders equity 0.08717949 0.12421053 Read More