Profitability and Liquidity Analysis - Essay Example

Formulae 2009 000 000) Return on equity (ROE) 154×100 ÷ 756 = 20.3 % 111×100 ÷ (795+756)/2 = 14.3 % Return on assets (ROA) 234× 100 ÷ 984 =23.8 % 167× 100 ÷ 1083 = 15.4 % Gross profit margin (500 ÷ 1,180) ×100 = 42.4% (450 ÷ 1,200) ×100 = 37.5% Net Profit Margin (234 ÷ 1,180) × 100 = 19.8% (167 ÷ 1,200) × 100 = 13.9% Profitability Analysis: Profitability ratios are very essential for an organization and indicate the combined effect on its operating results (Wood and Sangster 1999). Prolong Limited’s ROE has decreased from 2009 to 2010. This means that shareholders are getting lesser return on their investments. The decrease is due to the fall in net profits available to the shareholders. Prolong ltd’s ROA fell drastically from 23.8% in 2009 to 15.4% in 2010 due to increase in interest costs which reduced the net income. Gross profit margin indicates the earnings generated by one dollar sales of the company. Prolong Limited’s gross profit margin decreased from 42.4% in 2009 to 37.5% in 2010. This can be due to the considerable increase in the cost of goods sold from $680,000 in 2009 to $750,000 in 2010. Prolong Limited’s net profit margin was 19.8 % in 2009 and decreased to 13.9 % in 2010. This was due to the increase in the operating expenses of the company. This rise in costs can be due to the rise in the inflation rate in the economy. Prolong Limited should take measures to control their costs of producing the goods. Although Prolong Ltd earned a profit of $111,000 in 2010, its profitability worsened when compared to the profit of $154,000 in 2009. Hence the company should take drastic measures to lower its cost by reducing inefficiencies and increase its revenue to ensure that the company remains profitable in the years to come. Liquidity Analysis: Formulae 2009 ($’000) 2010 ($’000) Current ratio 282 ÷ 228 = 1.24 times 396 ÷ 238 = 1.66 times Quick asset ratio (282 – 148) ÷ 228 = 0.588 times (396 – 236) ÷ 238 = 0.672 times The ability of a company to repay its debt is known as its liquidity. A current ratio of less than 2 in both the years indicates a worse liquidity position of Prolong Ltd. Prolong Ltd’s current ratio has increased from 1.24 in 2009 to 1.66 in 2010. The quick asset ratio also improved from 0.588 times in 2009 to 0.672 times in 2010. 60% of the current assets are tied up in stock due to which the liquidity position of the company is not very good. Prolong Ltd does not have ample cash to repay its creditors and due to this amount owed to the creditors have increased. Prolong Ltd should improve upon its liquidity position so that it can repay its debt on time. The overall liquidity of the company in 2010 has improved because of the bank loan taken by Prolong Ltd. But still, the creditors of Prolong Ltd are accumulating and it would be difficult for Prolong Ltd to repay its debt if the company does not generate ample cash through sales. Moreover, most of the cash of Prolong Ltd is tied up in non-current assets. Prolong Ltd can generate cash by selling off some of their non-current assets which will improve their liquidity position. Prolong Ltd should take drastic measures to improve its liquidity otherwise it would be very difficult to remain in the business. Efficiency Analysis: Formulae 2009 ($’000) 2010 ($’000) Asset turnover ratio 1180 ÷ 984 = 1.20 times 1200 ÷ (1083+984)/2 = 1.16 times Days inventory 148 × 365 ÷ 680 =79.44 days (236+148)/2 × 365 ÷ 750 =93.44 days Days Creditors 234 × 365 ÷ 680 = 125 days (76+234)/2 × 365 ÷ 750 = 75 days Days debtors 102 × 365 ÷ 1180 =31 days (156+102)/2 × 365 ÷ 1200 = 39 days Asset turnover indicates the sales that are generated from $1 investments in assets. Prolong’s Ltd asset turnover remained relatively stable in 2009 and 2010. Although the sales increased marginally by $20,000, the total assets increased by $99,000. The investment in the assets was not translated into the corresponding increase in sales revenue. Days inventory ratio of Prolong Ltd indicate that it took 79 days on average to sell the goods in inventory in 2009 and 93 days in 2010. The days inventory has increased in 2010 and this high days inventory figure is not very beneficial for the company. Days debtor ratio indicates days taken to convert debtors to cash and days creditor ratio indicates the average number of days Prolong Ltd take to pay its creditors. In 2009, Prolong Ltd had a very high days creditors ratio of 125 days. This can be detrimental for the company as creditors would become reluctant to lend money to Prolong Ltd. But in 2010 Prolong Ltd paid most of their creditors due to which days creditors fell to 75 days. The days debtors ratio increased from 31 days in 2009 to 39 days in 2010. This is not a very good sign for the company. Prolong Ltd can encourage customers to pay early by offering cash discounts which would help them in improving this ratio. Financial stability analysis: Formulae 2009 ($‘000) 2010 ($‘000) Debt ratio 228 ÷ 984 =0.23 times 288 ÷ 1,083 =0.27 times Debts to Equity Ratio: 228 ÷ 756 =0.30 times 288 ÷ 795 =0.36 times 756 ÷ 984 =0.77 times 795 ÷ 1,083 =0.73 times Debt ratio measures the percentage of funds provided by sources other than equity (Brigham and Ehrhardt). Although total liabilities increased from 2009 to 2010, the increase was matched by a relatively similar increase in total assets. Hence the debt ratio of Prolong Ltd remained stable. Prolong Ltd had a very low debt ratio of 0.23 in 2009 and 0.27 in 2010. The reason for the slight increase in the debt ratio was the bank loan of $50,000 taken by Prolong Ltd. This low debt ratio indicate that Prolong Ltd finances most of its operations through equity. The debt to equity ratio of Prolong Ltd increases from 0.3 in 2009 to 0.36 in 2010. The increase is due to the bank loan of $50,000 taken by Prolong Ltd to finance its operations. The shareholder equity ratio decreased slightly from 0.77 times in 2009 to 0.73 times in 2010. This indicates that at the time of liquidation of the company 73% of the total assets will be claimed by the shareholders. The financial stability ratios of Prolong Ltd indicate that they are financing most of their operations using equity. In 2010, some of the financing was done through taking a long term bank loan of $50,000. b) Prolong Ltds liquidity has improved in 2010 as indicated by the improvement in the current ratio and quick asset ratio. However, the liquidity ratios of Prolong Ltd are well below average which indicates that Prolong Ltd does not have enough liquid assets to pay off its debt. The days creditor ratio has decreased drastically from 125 days to 75 days. This also shows that Prolong Ltd has started paying their creditors on time. However, Prolong Ltd does not have any liquid assets at their disposal. Prolong Ltd has only $4000 cash at bank and hence they will have lots of difficulty in paying off their debts in future. A low debt ratio is favorable for the companys creditors. Prolong Ltd has a very low debt ratio of 0.27 which means that only 27% of the total financing is done through debt and the rest is done through equity. Hence if Prolong Ltd faces liquidation, creditors will have more chances to receive their owed money. Hence we should lend money to Prolong Ltd as long as they are profitable and have a low debt ratio. Moreover we should offer cash discounts to Prolong Ltd to encourage them to make quick payments. References (Wood and Sangster 1999). Wood, F. and Sangster, A., 1999. Business Accounting 1, 8th ed., Pearson Education. (Brigham and Ehrhardt 2003). Ehrhardt, M.C. and Brigham, E.F., 2003. Financial Management, 11th ed., South-Western College. Read More