Analysis of the Financial Position of the Company - Essay Example

Company D MEMORANDUM May 20, 2009 The Chief Executive Officer Quelinda Steward Analysis of the Financial Position ofthe Company (based on Ratios and Trends) The year-on-year net sales growth of Company D, at 8.76%, turns out to be higher than the increase in its cost of merchandise sold, which is computed at 7.30%. This has resulted to gross profits for Year 8 that have increased by 12.15%, reflecting the 1.46% (8.76% minus 7.30%) difference between the increase in the two totals. This favorable scenario means that the increase in sales has not triggered a proportionate increase in the total cost of sales. The measures designed to cut costs related to the purchase, freight, handling or delivery of the company’s purchases may have been implemented successfully to reflect this cost improvement. The minimal increases in the company’s total operating expenses (9.48%) and the significant increase (94.12%) in the net interest income earned during Year 8 have generated a net increase of 21.19% in Company D’s net earnings. In line with the positive changes in Company D’s income and expense levels during Year 8, its Income Before Tax Return on Equity has increased from 27.20% in Year 7 to 30.79% in Year 8. This rate of return identifies Company D as one that delivers a much higher rate of returns as compared to the other companies in the industry, which have accordingly generated return on equity rates of 8.1%, 17.2% and 29.7%. This capacity of the company to earn more than the average member of its industry constitutes a valuable strength. The same is true with the company’s Gross Margin Ratio and Income Before Tax Margin Ratio which, at 31.09% and 10.08%, respectively, turned out to be higher than their Year 2007 counterparts. In consonance with the company’s relatively high Return on Equity when compared with those of the others in the industry, its Gross Margin Ratio – an indication of what the companys pricing policy is and of what the true mark-up margins are – turns out to be higher than the 27.3% industry average and its Income Before Tax Margin Ratio, which reveals the profit generated by the company using the money invested by its shareholders, is a lot higher than the 3.4%, the industry’s average. Thus, both its Gross Margin Ratio and Income Before Tax Margin constitute major strengths for the company, as well. Based on the foregoing, it can be concluded that Company D is among the best performers in its industry in terms of profitability. Meanwhile, the company’s comparative balance sheets for Years 8 and 7 showed that its current assets increased during Year 8 only by 15.01% while its current liabilities increased by 24.55%. These increases have led to a current ratio for Year 8 (computed at 1.7) that is lower than its equivalent for Year 7 (1.8). The greater increase in the company’s current liabilities as compared to the increase in its current assets has lowered the overall liquidity level of the company. For Year 8, it has less liquid resources, at $1.7, available for every $1-debt that would fall due in the short-term (one year) period. The company’s low current ratio makes it fall below the prevailing average ratio in its industry, which is reported at 2.1. This is, therefore, something that management would have to act on. It has to have sufficient cash and similar liquid resources to be able to meet its short-term liabilities; otherwise, its daily operations would be adversely affected since it is payables to suppliers and the regular expenses of the company’s operations that require cash. Not arresting this unfavorable situation might also cause the company’s credit ratings to suffer and would lead its suppliers and creditors (banks) to discontinue the credit terms and lines that the company is currently enjoying. The computed acid-test ratio, at 0.4 for Year 8 versus 0.6 for Year 7, reflects further the company’s incapacity to pay its current liabilities using the most liquid of its resources. Just like the company’s current ratio, its acid-test ratio falls below even lower than the industry’s low average, 0.6. This, again, should alert the company’s management to address its unhealthy liquidity level. Both the company’s current ratio and acid-test ratio spell out a critical weakness that the management would have to see to. While trying to trace the cause of this decrease in Company D’s liquidity level, the Days’ Sales Uncollected is evaluated as the possible culprit. However, the computed Days’ Sales Uncollected for Company D are 7.4 and 6.7 for Years 8 and 7, respectively, and these figures are way lower than the industry averages, the optimum of which is cited at 27.2. Company D, therefore, takes a lot less days to collect its receivables. Being more efficient than the rest the industry at converting receivables to cash, Company D should secure and not lose this advantage. Its Days’ Sales Uncollected figure represents a strength that has to be maintained. On the other hand, the company’s Days’ Dales in Inventory, at 80.7 and 65.6 in Years 8 and 7, respectively, turn out to be a lot higher than the industry’s average, which is set at 55.2. This means that Company D requires a longer time to convert its inventories to cash and that its inventories stays longer in its storerooms and shelves. This signals the need to review the company’s flow of operations or transactions cycle. The people manning the purchasing and sales departments would have to work on a better pacing of purchasing – one that would mean purchasing less without compromising the prices and without compromising the volume of sales. If it is possible for the company to lessen its volume of purchases to match the pacing of its sales, then smaller volumes of purchases would improve the company’s liquidity levels (current and acid-test ratios) and Days’ Sales in Inventory, which currently turns out to be a weakness on the part of the company. Company D would also have to take a look at how it can improve its Total Asset Turnover, which stands at 2.1 for both Years 8 and 7, while the industry’s average is reported at 2.9. The company’s low total asset turnover signifies that it is not able to utilize its assets and resources to maximize its productivity; it denotes a lack of efficiency for the company’s capitalization (total investment provided by the shareholders and by the company’s creditors). The company’s management would have to think of ways to raise higher revenues through the use of the company’s existing assets. That would result to an improved Total Asset Turnover, which currently can only be regarded as a weakness. The industry’s average Debt to Equity ratio is 1.6 while Company D’s has been fixed at 0.4 for both Years 8 and 7. The company’s Debt to Equity ratio designates it as a low-risk debtor, one that banks might be willing to lend more to; consequently, its Debt to Equity ratio can be counted as one of the company’s strengths. The ratio establishes that Company has no solvency-related problems and that it has sufficient resources to pay up its liabilities. The company can then contemplate availing of more loans; this would mean increasing its debt to equity ratio, which presently stands low compared to the industry average. Borrowing more, though, would mean taking in additional risk. It should, therefore, be done only if there are viable projects for the company to invest the loan proceeds in and to ensure that the required interest and principal payments can be met by the projects projected cash flow. I trust that this brief report will be of good use. (Sgd) Quelinda Steward Works Cited White, Gerald, Ashwinpaul Sondhi & Dov Fried. The Analysis and Use of Financial Statements. New York: John Wiley & Sons, Inc., 1998. Read More