Interpretation of Accounts - Assignment Example

? Interpretation of Accounts Introduction Absolute raw data about the company such as revenue generated, profit earned, total capital employed or total debt involved cannot provide any meaningful information unless they are converted in the form that can help make necessary decisions. It is here that the various financial ratios come handy in describing the status of the company. The company’s performance can be judged from several accounting and profitability ratios such as liquidity measurement ratios, profitability ratios, debt ratios. The ratios give information about the company’s health and help in decision making to investors, creditors, job seekers and other stakeholders. The company’s current status can also be judged by comparing them with previous years’ financial data or ratios to arrive at the conclusion how the company is faring. Advantages and Limitations of the Financial Ratios On advantage side, it helps read and simply the financial statements. The companies in the same group can be compared with each other. It also helps to understand the trend when compared with the previous years’ financial data. By going through a few numbers, one can quickly assess about the status of the company. On limitations side, it cannot explain the difference between two companies from two different industries or groups. It cannot provide correct information when two different accounting standards are followed, for example, USGAAP and UK accounting standards (Accounting Explained, 2012). Having realized the importance of various financial ratios, it would be now most appropriate to do some ratio analysis for Pompomi. Financial Performance of Pompomi Financial Performance of Pompomi can be judged from several accounting and profitability ratios (Financial Ratios, 2012). Current assets as at 31/09/09 ?195,700 Current liabilities as at 31/09/09 ?43,500 Current Ratio = Current Assets / Current Liabilities = 195,700/ 43,500 = 4.50 Acid-test Ratio Acid-test ratio, also known as the quick ratio, takes into account the most liquid current assets that are available to cover current liabilities. It excludes the raw material stock, finished goods inventory or other current assets that cannot be quickly converted to cash. Acid-test ratio = (Accounts receivable + Cash and Equivalents) / Current Liabilities Given, Current liabilities as at 31/09/09 ?43,500 Cash at bank ?20,000 Cash in Hand ?26,500 Accounts Receivable ?100,000 Thus, Acid-test ratio = (100,000 + 26,500+20,000) / 43,500 = 3.37 It is true that higher the quick ratio, the better it is for the company as it is an indication of liquidity to cover the current liabilities. Acid-test ratio is a conservative measurement of company's current liquidity. If the current ratio and acid-test ratio are very close then it is an indication that the company's current assets are not dependent on inventory. However, if the accounts receivables take considerable time to recover (several months instead of several days) then acid-test ratio can certainly mislead the people regarding its quickness to provide liquidity. In this perspective, it becomes essential to know about the average time taken by debtors to pay the money they owe to the company for their finished goods purchases. Debt to Equity Ratio of Pompomi The debt-equity ratio is a comparison of total debt to total equity of a company. The ratio also gives information about the company's leverage position that in turn, is an indication of the risk profile of the company. Higher debt-equity ratio can be risky during recessionary phase of the business because huge interest outgo may suppress the profit of the company significantly. Even it may cause liquidity issues impacting working of the company. This does not mean that zero debt company is always good. When the company is in growth phase, its fund requirement is huge and that is usually met through raising debts to a reasonable extent. Debt-equity ratio between the industry groups varies widely; it essentially depends upon the nature of business and the growth phase it is passing through. Debt-equity ratio = Total liability/ Shareholder’s equity Total Liability = Current liability + long-term liability = ?43,500 + ?18,000 Shareholder’s equity = ?700,000 Thus, debt-equity ratio = (43,500 + 18,000) / 700,000 = 0.088 Debt-equity ratio, in case of Pompomi, is extremely low and the company fulfills most of its fund requirements from its shareholders. Gross Profit Margin The gross profit margin measures the profitability of a firm before adjusting overhead costs. It indicates about the efficiency of the firm to use its resources such as labour, material. Comparing gross profit margins with the competition gives fairly a good idea, how the company's businesses are managed. Gross profit margin is represented as (Revenue - cost of sales) / Revenue In case of Pompomi, revenue for the year ended 30/9/2009 = ?668,400.00 Cost of sales = ?396,000 Thus, gross profit margin = (668,400 - 396,000) / 668,000 = 40.78 % Net Profit Margin Net profit margin is given by profit after tax/revenue. It has been assumed that there is no tax applicable on the available profit of the company. Based on profit and loss statement for the period ended 30/9/2009, Pompomi’s net profit margin = 128,450 /668,000 = 19.22% Net profit margin is a good indicator of the profitability of the company. Since net profit margin is arrived at after deducting all overheads and finance costs, it tells about the actual profitability of the company. That is why in common parlance, it is known as a bottom line in the profit and loss statement. Net profit margin, when compared with the previous years’ performance, provides fairly a good idea about the company’s current performance. It can also be used to compare the performance against the competing companies so as to make a clear judgment whether the company is faring better or worse. Return on Capital Employed Return on capital employed is a measure that gives indication how efficiently the company used funds in the business. In case of Pompomi, as per the balance sheet of the year ended 30/9/2009, the total employed fund in the beginning of the year is 700,000+18,000 = 718,000 (net profit is not generated at the beginning of the year, hence not included in the total fund employed). Based on this, return on capital employed = 128,450/718,000 =17.88% Comparison of the Ratios between 2009 and 2008 All essential ratios of the Pompomi for both the years have been enumerated in the following table so that meaningful comparison can be made to evaluate the latest performance compared to the previous year. Parameters 2008 2009 Change Current Ratio 3:1 4.5:1 Increased Acid test Ratio 2:1 3.37:1 Increased Debt to Equity Ratio 1:1 0.088 Decreased Return on Capital Employed 20% 17.88% Decreased Net profit margin 18.36% 19.22% Increased Gross Profit margin 40% 40.78% Increased Debtors Collection Period 60 days 54.6 days Decreased Creditors Payment Period 75 days 36.8 days Decreased Current Ratio and Acid Test Ratio The current ratio and acid test ratio both in 2009 have increased over 2008 by nearly 50 percent that is significant and shows that currently, the company can meet its liabilities even more comfortably than it was possible during 2008. The reasons for increase in liquidity ratios lie in decreased current liabilities of the company. Also, its current assets have increased. This augurs well for reducing its working capital requirements for matching production or company can increase its production without significant increase in working capital. Surely, this indicates more efficient management of working capital funds. Net Profit and Gross Profit Margin Net Profit and Gross profit margin both have gone up in 2009 over 2008 to some extent, if not significantly; that certainly augurs well for the company. The company has been able to realise higher price for its products in 2009 relative to 2008. This indicates that the company’s products enjoy good reputation in the market and the company’s products can easily compete with the products offered by the competition on one to one basis. Debt to Equity Ratio In the year 2009, it seems that the company has retired most of its debt as it shows very little long term liability. This appears to be a major change over 2008 where the long term liability was significant. In a difficult and sluggish economic period, it is always in benefit to have lesser debt burden as obligatory interest payout may push the company to a difficult situation. During booming economy, the companies have been found to expand using debt as it helps increase equity valuation of the company. For the company to enhance its equity valuation, it becomes necessary that company adopts appropriate debt-equity ratio for its financial needs. Damodaran (2008) argues that "increasing debt can increase the value of some firms" and "for the same firm, debt can increase value up to a point and decrease value beyond the point" (p.17). Increasing equity valuation is also one of the objectives of the finance manager in the long run. At the same time, too much debt in the company to finance its operations could be harmful in the recessionary period when margins of profit are under pressure and sales are impacted. The point is that the Pompomi must adopt appropriate debt-equity ratio as a capital structure to finance its needs that not only helps enhance equity valuation of the company but do not burden the company from the excessive debt. Return on Capital Employed Return on capital employed shows nearly 2 percent decrease in 2009 over 2008. On this parameter, the company has not performed as well as it did during 2008. Perhaps, this could be because the company is not aggressive enough to exploit its available resources to the fullest extent. Debtors Collection and Creditors Payment Period Debtors collection period has gone down by at least 5 days from 60 days in 2008 to nearly 55 days in 2009. This shows heightened efficiency in collecting receivables from the debtors of the company. Debtors collection period has significant impact on the company’s working capital needs and any efforts in reducing the same are always commendable. At the same time, it has also been noticed that creditors payment period in 2009, while comparing with 2008, has gone down. If this has happened in order to extract extra discount on the major supplies then it is certainly in the benefit of the company in increasing its profitability. Its immediate impact can be felt in the gross profit margin of the company while other things remaining unchanged. It is pertinent to note here that creditor payment period has gone down much steeply compared to debtors collection period and this can be explained by either heightened bargaining power of the creditors or the company pays them fast snatching extra discount from them. Increased gross profit margin also supports this argument assuming there has not been a significant change in the sales price per unit. Recommendation on Improving the Business for Each Ratio Current Ratio Since the current ratio has increased, the company is fairly in a good position to cover its liability. This increases the creditors’ confidence on the company for they are likely to get their money in time. It is obvious that more suppliers line up to supply their goods where there payment is safe. This increases the negotiation power of the company while deciding and entering into contracts with the suppliers to receive their raw material supplies and other consumables. Acid Test Ratio Similarly, increased acid test ratio informs about the increased levels of the companies and that can be used to extract good discounts on the supplies by making cash payments whenever possible. Gross Profit Margin Gross profit margin can be increased further if available surplus cash is used to reduce the cost of sales by asking for cash discounts on the raw material supplies. It is advisable to set target of gross profit margin with some increment that will make the company to constantly work on this issue. Net Profit Margin Net profit margin takes into account overhead and finance costs. Any reduction in overhead costs will help increase net profit margin and that can best be achieved by efficient work distribution among the employees. Retiring debt also helps reduce finance cost and saving on this front is always welcome, particularly when own surplus fund is available. Return on Capital Employed It is essential to estimate and assess the real need of capital in the business. Return on capital employed can be enhanced by judicious use of available land, building, machinery and equipment and that needs to be thoroughly assessed. Debtors Collection Period Efforts should always continue on decreasing debtors collection period quarter after quarter by tapping new markets and new regions where rivals do not offer a formidable challenge to the company. Creditors Payment Period New suppliers need to be constantly explored as it is never advisable to depend on limited suppliers and for that procurement department must look out for other available avenues. Summary of the Issues and Remedial Measures On major issue, the return on capital employed has decreased by about 2 percentage points that needs to be looked into more intensely so that more judicious use of resources can be made. The company needs to also determine how it wishes to expand in future because a profitable company with good past history can negotiate for a low-cost debt for future expansion and thus, increase its valuation. Conclusion Thus, from the above analysis, it is quite clear that a lot can be revealed about the company by deciphering the information that is available – in the form of several financial ratios such as liquidity, investment and profitability and can be inferred how the company is faring relative to its rivals as well as own past performances. Financial ratio study provides a veritable opportunity to anyone who wants to know about the real status of the company either as a creditor, investor, employee or customer. References Accounting Explained (2012). Advantages and Limitations of Ratio Analysis. [Online] Available from http://accountingexplained.com/financial/ratios/advantages-limitations Accessed 31 January 2013] Damodaran, A. (2008). Debt and Value: Beyond Miller-Modigliani. Stern School of Business. [Online] Available from http://people.stern.nyu.edu/adamodar/pdfiles/country/levvalue.pdf [Accessed 31 January 2013] Financial Ratios (2012). Arab British Academy for Higher Education. [Online] Available from http://www.abahe.co.uk/Free-En-Resources/Financial-Analysis/Financial-Ratios.pdf [Accessed 31 January 2013] Read More