Watleys Financial Ratios Analysis - Case Study Example

Watley’s Financial Ratios Analysis

Financial ratios are important managerial accounting technique that allow managers to make decision making based on regular operations of the business. Ideally, financial ratios combine the aspects of balance sheet and income statement to yield critical data for making strategic decisions. This paper analyzes ratios such as activity, gearing, liquidity, and profitability, which are related to Watley’s company. Since each category of ratios have various subdivisions, this paper will look at current ratio, average collection period, return on sales, and debt ratio as a representation of liquidity, profitability, and gearing ratios respectively.

Based on both statement of financial position and income statement, rations of Watley company were as follows:

• Liquidity Ratio- Current Ration

2014 = = = 1.1 2015 = 2.29

• Activity Ratio – Average debt collection Period

Average debt collection period =

2014 =

• Profitability Ratio – Return on Sales

• Gearing Ratio – Debt Ratio

Analysis Based on the Results

Watley’s Liquidity Ratio – Current Ratio

According to Watley’s financial statements, the current ration in 2014 was 1.11 while that of 2015 was 2.29. Making decision based on the figures would imply that Watley is on a positive trend and is doing much better in 2015. However, the increase in current ratio is nothing to celebrate because the individual components depict a financially troubled firm. For example, the inventory and trade receivables increased from £90 and £160 in 2014 to £140 and £260 in 2015 respectively. In as much increase in trade receivables and inventory depict increase in current assets, there is an underlying risk with the two elements. Inventory refers to the stock at hand awaiting sales while trade receivables are in form of credit sales. If anything affects the market environment that hinder Watley from selling, then the inventory as a good as nothing because they lack immediate monetary value. Furthermore, a change in supply pattern can render the stock expensive and compel the firm to trade at a loss. Similarly, trade receivables are tricky to handle due to the issue of bad debts. While Watley hopes to collect the trade receivables, conditions may shift thereby making the client to default in payment, which becomes worse if they transform in bad debts.

I recommend that the company should consider the bigger picture rather than relying on the figures. Indeed, a current ratio of 2.29 looks promising but other factors such as industry standards and competitors status should come into play. Importantly, the company should consider increasing its cash deposits rather than having high account receivables value. Even if Watley uses accrual accounting basis, having high value of account receivables can plunge the company into cash flow issues. Still, use of just-in-time policy of inventory management should assist in reducing the inventory at hand because of market volatility. Periodic evaluation of current ratio is critical to Watley firm because it determines the direction a company takes and the strategic decisions a manager makes. In the above case, the increase in liquidity ration could imply that Watley is stabilizing or using lean working capital cycle. A high current ratio also facilitates the firm’s ability to meet immediate financial obligations.

Activity Ratio – Average Collection period

Just as trade receivables ratios, average collection period is best used in combination with other liquidity ratios. A short collection period implies prompt payment and better management of trade receivables. On the contrary, longer collection periods reflects a troubled business, which may not meet its short term financial obligations. Waltey’s average collection period in 2014 is 17.73 days while that in 2015 is 26.93 days. The declining average collection period concurs with the value of account receivables that increased from £300 to £480 in 2015. When credit management is poor, it reflects on average collection period and value of account receivables. Therefore, it is accurate to say that Watley’s credit management efficiency declined in the financial year 2015.

I recommend that Watley’s management should aim to solve the collection period issue sales and credit management perspective. The figures above indicate that Watley is operating on a 30-day credit terms for their clients. While the company is making efforts to maintain the average collection period below 30, the trend from 2014 to 2015 indicates a worrisome situation because it could pass the 30-day mark in 2016. Ideally, the nature of typical business dictates credit sales, but the problem is uncertainty concerning when a client will make the cash payment.

Watley should improve its credit collection mechanism to avoid cash flow problems, which could hamper operations of the company. First, Watley should understand the market to allow it know good and bad payers. Collecting information on creditors concerning their trading as well as payment behavior is necessary. An effective credit management system should keep customer information updated so that appropriate measures are taken to caution Watley from risking its cash flow. Additionally, Watley accounts department should send invoices in time as well as payment reminders. As a matter of fact, electronic invoices or electronic payment modes are the best. Confusion should arise in customer payment information to avoid delays. Lastly, weekly debtors’ meeting should be a priority for sales and accounting teams to keep updates on the account receivables.

Profitability Ratio- Return on Sales

Profitability ratio indicates whether the company is making losses or positive income. Return on sales (operating profit margin) determines efficiency of profit generation from the revenue. Watley’s return on sales in 2014 is 0.12 (12%) while that of 2015 is 0.085 (8.5%). Again, it’s a declining trend that confirms poor performance of the company. While sales revenue increased from £3290 in 2014 to £3520 in 2015, the net income value reduced from £400 in 2014 to £300 in 2015. A close scrutiny reveals that the value of overheads and cost of sales increased to £1600 and £2020 respectively in 2015. Therefore, it is accurate to say the increased overheads was the major contributor to reduced profits. Investors and lenders always checks profitability ratios before deciding whether to finance a company or not. Low profitability ratio implies that a company is performing poor in the industry, which should be an alarm for it to improve on weak areas.

I recommend that Watley should find ways of reducing their cost of sales. In most cases, cost of sales increase due to logistics involved in moving items from one point to another. Aspects such as transport and handling of items should have lean management to avoid increasing overheads associated with such sales activities. Performing market research to determine average material supply options and cheap distribution channels is important because it gives Watley cost advantage. Competitor’s analysis is key in ensuring that the company does not stock and offer expensive materials when the market dictates a lower figure. Price policies are very sensitive because of the nature of a product elasticity, a factor that Watley should consider well. Additionally, Watley should reduce the selling and administrative costs associated with the sale of products. However, sales team should coordinate to negotiate for better prices as well because managing internal costs drivers without increasing income from outside is not helpful as such.

Gearing Ratio – Debt Ration

Gearing is the determination of company’s leverage status, which illustrates the extent to which firm’s activities are financed by owners’ finances. In other words, gearing ratio indicates company long term financial position, which increase confidence in investors that their investments will be stable. Watley gearing ratio in 2014 and 2015 is 0.3032 (30.32%) and 0.25 (25%) respectively. The figures indicate a dwindling leverage status of the firm concerning its financial position. An examination of balance sheet indicate that Wately’s fixed assets value reduced while current assets increased in 2015. In as much as current liabilities declined in the financial year 2015, it could not enhance the gearing ratio.

I recommend that Watley should increase its investment portfolio to generate more assets. The current asset value is not reliable because it has majority of account receivables and inventory whose actual cash payments are not guaranteed. I think the debt ratio should indicate high asset value to make enhance the company stability in the long-term. Diversifying income sources and increasing asset base will make the company leverage status increases.

Conclusion

From the above analysis, only the liquidity ratio depicts a positive change (from 1.1 to 2.29). However, profitability, activity, and gearing ratios all have negative change from financial year 2014 to 2015. It is clear that the company is heading to a financial turmoil in the near future if current strategic management orientation remains. Watley should overhaul its investment portfolio, capital structure, and credit management policies. Coordination among financial controller, credit manager, and sales team should ensure that average collection period improves. Return on sales will increase if internal controls minimize unnecessary overheads. In summary, Wately has a capacity of performing better but enhance financial and credit control will make it best.