Accounting, Decisions, and Accountability - Essay Example

Accounting, Decisions and Accountability Executive Summary This project of making a recommendation of continuing with inherited investment or not requires an evaluation of financial statements of Sing Chip Ltd. For the purposes of evaluation the financial stability of the company, tools of ratio analysis have been used. The company was showing its brilliance as per its performances in the year 2005. In the very next year the company fell down like leaves falling from tree in autumn. The company tried its best but could not fully recover in 2007. The only sign of brilliance from management was shortening of recovery period from receivables and thereby lessening of operating cycle. This certainly provided some help to dwindling liquidity and working capital finance of the company. The company is not even in a position to maintain a better interest coverage. Gross profitability showed some recovery signs in 2007 but the initiative was taken away by overheads and other non-operative expenditure resulting into very marginal net margin recoveries before taxes and interests (EBIT). Though net margin evaluation has been based on EBIT, it is necessary to point out that even such small recovery was taken away by interest, taxes and extraordinary items, and finally the year 2007 turned into a huge loss year. The detailed analysis here in this writes up shows that company is facing more difficulties than the available opportunities. Introduction Chia Liang Chu inherited 200,000 shares in Sing Chip Ltd. from her grand mother. The inheritance put her in dilemma of keeping or selling the shares. Accordingly a financial analysis was required of the financial statements of Sing Chip Ltd., before any recommendation could be put forward to Chia Liang Chu. Three years financial statements have been analyzed in this write up using financial ratios as method of analysis. The analysis have been made to evaluate, profitability, liquidity, and financial stability (solvency) of the company, considering its performances over a period of three years, in order to arrive at logical conclusion, so that a proper recommendation is made to Chia Liang Chu. Profitability Profitability of an entity is viewed from two different angles. One is profitability in relation to turnover or sales, and other is profitability in relation to investment. From the point of view of sales, profit is considered by calculating Gross profit ratio and Net profit ratio. In relation to investments, profitability is considered as per rate of return on equity or the ROE, and profitability as per return on assets or ROA. Gross Profit ratio is defined as the difference between net sales and cost of goods sold. It shows the margin left after meeting manufacturing and/ or trading costs. Gross profit measure efficiency of production as well as pricing. Net Profit ratio, on the other hand, shows the overall efficiency of production, administration, selling, pricing, and even tax management when considered after interest and taxes. Jointly gross profit and net margin ratios provide a valuable understanding of the cost and profit structure of the entity and enable the analyst to identify sources of business efficiency or inefficiency. The gross profit of Sing Chip Ltd. is fluctuating very heavily and putting its effect of fluctuations on net margins as well. Gross profit has come down from an impressive 18.49% in 2005 to a very depressing 2.8% in 2006, and then there is a recovery in 2007 when gross profit ratio reached 9.2%. The reason for such fluctuation in gross margins is basically the dwindling sales which came down to $14838000 in 2006 from formidable $18849000 in 2005. Such downfall can not be termed as routine corrections of sales in competitive market. It may be due to fall in quality of the production line, or some other reasons because of which management might have taken a stand off reduction in price. But reduction in prices is ruled out as such a move should have impacted in increasing sales. Sales suddenly lost momentum in 2006 and this could be attributed to some other market reasons. With decrease in gross profits in 2006, net margins plunged to a loss as the company could not bear the effect of perhaps fixed overheads in the administration costs.Net profits also made recoveries in 2007after bearing the brunt of 2006 onslaught from gross margin.Net margin rose to 2.49% in 2007 from a deep net loss of 11.19% of sales in 2006. It appears that company got rid of loss contributory factors of 2006. Let us now analyze profitability in relation to investments. One of the measures is Return on Equity or ROE. “The Return on Common Equity (ROE) measures the return earned on the common stockholders’ investment in the firm. Generally, higher this return, the better off the owners.” (Lawrence J. Gitman, p.69, 2006). This ratio tells us the earning power on shareholders’ book investment. The profits taken into accounts for this ratio are operating profits after interest and taxes. The reason is that shareholders are interested in what profits are exactly available the. Analyzing this ratio for Sing Chip Ltd., the picture comes as a very dismal performance of equity invested by shareholders. In 2005 company was earning a marvelous 21.12% on equity, and then the great fall and ratio is (-)29.08% in 2006; and still struggling at (-) 11.35%. Because of loss shown by negative net profit margin of 11.09% the company just added to its woes by huge interest expense $628000 in 2006 and showed a huge final loss giving us a very dismal (-) 20.8% ROE. It was an almost management complete failure on pricing and overhead expenditures. However, management certainly took some steps to safeguarded investments by managing ROE to (-) 11.35% A more ratio used in the analysis of profitability is the return on assets or the ROA. “The Return on Total Assets (ROA), often called the Return on Investments (ROI) measures the overall effectiveness of management in generating profits with available assets. The higher the firm’s return on total asset, the better.” (Lawrence J. Gitman, p.68, 2006). Here the earning before interest and taxes have been used to add a different angle to measures return on assets. But the show of Sing Chip Ltd. is similar as it was when we took profits after interest and taxes, though there were no taxes involved during three years of analysis of ROE. ROA gave us encouraging 2005 with 2005 with 8.51%, loosing 2006 with (-) 7.02%, and recovering 2.23% of ROA in 2007. The reasons for these fluctuations are similar as explained above in ROE. There is another turnover ratio called Assets Turnover ratio. Assets turnover ratio describes the relative efficiency with which the company uses its total assets to generate output. The asset turnover ratio is connected with the utilization of all assets by the company, be those are current or non- current. Naturally the higher the ratio is, the better it is for the company. Sing Chip Ltd. has 0.89 asset turnover in 2007 as compared to 0.67 in 2006, and 0.75 in 2005. The assets of Sing Chip Ltd. have not been fully utilized over the years. There is always extra capacity available to execute more sales. But the only interesting analyses is that the best utilization of assets came in the year 2007 at 0.89 and not even its best year 2005, when it was 0.75. That shows that Sing Chip Ltd. was trying its best in 2007 to come out of the debacle of 2006. In nutshell the company has a very bad year 2006, where it lost its creditability of good performance in 2005. But recoveries in 2007 are showing signs of brilliance that occurred in 2005 and it is assumed that the company would come out loosing and gloomy atmosphere created by 2006 profitability performance. Liquidity Current ratio and quick ratio have been used to evaluate the liquidity of the company. Essentially the idea is to compare short term obligations with short term resources available to meet these obligations. Liquidity ratios are generally based on the relationship between current assets (the sources for meeting short term obligations) and current liabilities. Current ratio is most popular and widely used ratio to analyze liquidity of a company. Higher the current ratio, higher is the ability of the company to meet its current obligations. In a way current ratio indicates the safety of funds due to short term creditors. Thus, current ratio is a measure of margin of safety to the creditors. The current ratio of 2:1 is considered optimum in general for all businesses and industries, but this standard also differs from industry to industry. Quick ratio is another form of current ratio and takes into account the most liquid of current assets into account for calculations, e.g., it sans inventories from current assets. Quick ratio is standardized at 1:1 ratio but again depends upon the industry concerned. Both these ratios are showing a very delicate liquid position of Sing Chip Ltd. The current ratio in 2007 is mere 0.96 and quick ratio is 0.61. Anything can happen to Sing Chip when the company will not be able to find liquidity to meet current obligations. The situation is so delicate that even banks will shy away from funding the company. First of all profitability is at its low ebb after the debacle of 2006, as net margin in 2007 is just 2.49%; and secondly return on equity is showing a big loss of 11.25%. Coupled with dismal profitability is the very delicate liquidity position, which has remained as such over the period of three years. Current ratio was reasonably good at 1.89 in 2005 but again slumped down to 1.33 in 2006 and now mere 0.96. At no stage it is showing any sign of recovery, as was shown in profitability. Quick ratio repeats the same story from very good 1.63 in 2005 to low 1.05 in 2006 and now an inconsiderable 0.63. The only way whereby the company can save its position is to raise debt equity and use funds for short term purposes till its liquidity come back to a normal position. Financial Stability (Solvency) Determination of solvency is a study of the effect of combination of factors ranging from the efficiencies shown by inventory turnover to operating cycle of the company till the effects of liquidity status of the company. Let us first start with inventory turnover ratio. “Inventory Turnover ratio tells us the rapidity with which the inventory is turned over into receivable through sales. Generally higher the inventory turnover, the more efficient the inventory management of a firm.” (James C.Van Home, 2002) For Sing Chip Ltd. Inventory turnover ratio is showing a inefficiency creeping into the system, as it is plunging down from 9.01 times in 2005 to 7.98 times in 2006, and 7.74 times in 2007. The effects are very clear. Sales are dropping, profitability on equity is negative, and liquidity is dwindling. As the inventory turnover creates receivables through sales, the recovery of receivable is also great contributing factor in consideration of solvency of the company. Let us observe average collection period of receivable that in fact is the real strength provider to the attributes of solvency of a company. In fact “average collection period, or average age of accounts receivable, is useful in evaluating credit and collection policies.”(Lawrence J. Gitman on Average Collection period, 2006). The company policy of recoveries from receivable is working very well, and this is the only aspect where the company is achieving as planned. Average collection period has come down from 133 days in 2005 (when the company was enjoying real good days to sales and overall profitability) to 117 days in 2006 (which was the worst year for company’s all round activities that brought down the company with a thud), and to only 87 days in 2007. All this has happened because of squeezed liquidity. The company was forced to exploit the internal resources as much as possible and reducing the average recovery period was one of those rare resources with the company. Management really shows the brilliance of its policies in this aspect of administering recoverable. The goods results on this front brought down the overrating cycle of the company. The operating cycle came down from 174 days in 2005 to 163 days in 2006, and finally to 134 days in 2005. The reduction in operating cycle would have provided some much needed relief to tight working capital of the company. There is another aspect to judge the financial stability or solvency of the company. A ratio called ‘Times Interest Earned Ratio’ “indicates how well the firm’s earnings can cover the interest payment on its debts.” (NetMBA). This is also called interest coverage. Sing Chip Ltd. has interest coverage ratio of 6.91 times in 2005 which came struggling to a poor 0.73 days in 2007. Here lies the entire story of Sing Chip Ltd.’s solvency . The company is certainly in deep trouble in meeting its current liabilities. Interest coverage ratio has retold the story of poor liquidity ratios. Company’s financial stability is week as shown in its capitalization ratio. Equity capitals used in financing total assets of the company are not enough. Assets are 3.47 times the capital investment in 2007. That means company is dependent a lot on long term liabilities for assets financing. The result is payment of interest on those long term liabilities is creating problem in working capital management. A sort of vicious circle is created. Losses are shrinking the liquidity for the company and the already dwindling working capital facing trouble at meeting event the interest payments on long term liabilities. One can say that company is not financial stable. Conclusion Singh Chip has not really risen well enough after the occurrence of great debacle in its financial stability or solvency position in the year 2006. 2005 was great in all respect. One can assume that thereafter the company could not cope with revolution of innovation in electronic goods. The company perhaps could not face the market competition in 2006 and sales came down hugely. The result was an all round dismal performances, and now in 2007 the company is facing real trouble of financial stability with very poor financial results. Recommendation There is no point in carrying on with the investment with Sing Chip Ltd. But the time is not ripe to sell the shares held by Chia Liang Chu. It is suggestible for her to wait till prices of shares reaching at some level of respectability, as Chia Liang Chu only inherited the shares from her grandmother; and also any need for emergent requirements of fund has not been there. Total Words used: 1113 Reference List 1. Lawrence J. Gitman, Principles of Managerial Finance, LPE Eleventh Edition, Chapter 2 Financial Statements and Analysis, page 69, 2006 2. Ibid, Chapter2 Financial Statements and Analysis, page 68, 2006 3. Ibid, Chapter2 Financial Statements and Analysis, page 61, 2006 4. James C. Van Home, Financial Management & Policy, LPE Twelfth Edition, chapter 12, Financial Ratio Analysis, page 374, 2002, reprint 2005. 5. NetMBA, Financial Ratios, Interest Converge, viewed on April 7, 2008, http://www.netmba.com/finance/financial/ratios/ Read More