The Financial Performance of Macey and Daley - Assignment Example

Introduction Macey and Daley are two companies in the same industry. A ratio analysis has been used to determine which company performs better and will prove to be a wise choice of investment. The factors that affect their respective performances have also been highlighted. A detailed evaluation of various business dynamics has given a complete picture of the quality of functioning of both businesses. Analysis of the Financial Performance of Macey and Daley The liquidity position of Macey is appropriate with enough ability to repay its short term obligations without having too much idle cash or having too much tied up in inventories. Daley has a current ratio of 1.3: 1 which is lower than Macey’s despite having both, more current assets and liabilities. It is however, still enough to meet its short term obligations. Both companies have a good liquidity position, which prevents them from having to sell off their inventory in order to pay their short term debts. Without liquidating their inventories, both companies can easily manage their short term obligations through their most liquid current assets. Daley has a better inventory turnover ratio which indicates that it takes less time to sell off its finished products. With less cash tied up in inventory and considerably lower cost of goods sold, Daley takes approximately 10 days less than Macey to convert its goods into sales. Customers of Daley are taking twice as long to repay the company which means that the receivable collection is not timely. Compared to Macey, Daley has a lot tied up in the form of receivables, more than 1.5 times as much as Macey. Its sales are also approximately $300 million less than Macey’s. Macey’s receivable collection seems to be within their average length of time taken to recover cash. These figures indicate that both the firms deal in some sort of fast moving consumer goods to able to recover cash within 2-3 days. Daley’s utilization of fixed assets is better than Macey’s with a ratio of 8.9 times. For every $1 invested in fixed assets, Daley is making $8.9 in sales. On the other hand, Macey is making only $5.5 in sales for every $1 invested in fixed assets. Macey has higher sales than Daley but it also has approximately twice the amount of fixed assets. This signifies that Macey has too much invested in fixed assets. Daley, despite having higher current assets and lower sales than Macey’s, has a better total asset turnover. Macey’s investment in fixed asset seems to be unnecessary and is affecting its ability to generate sufficient sales with regards to the amount of fixed assets it holds. Macey has twice the amount of total assets as compared to Daley and hence is having trouble generating a healthy volume of business. In terms of the gross profit margin, both companies are competing against each other for better performance. Macey having a higher amount of sales also has accordingly a higher cost of goods sold. Daley, on the other hand despite having lower sales and lower cost of goods sold, has a higher gross profit in dollar value. This shows that Daley’s cost of sales are controlled and minimized to a great extent as compared to Macey’s. The net profit margin however, shows discrepancies. From a neck to neck gross profit margin ratio, the net proft margin shows a difference of approximately 4% between the two companies. Despite having higher sales, Macey has approximately 3/4th the amount of net income that Daley has. This signifies problems in the management of Macey’s expenses. Macey’s expenses are not in control which is bringing down its net profit margin. Daley seems to be generating a stable amount of net income from the sales it makes. With a higher net income and lower amount of total assets, Daley’s return on assets is twice that of Macey’s. Macey’s high costs and over investment in fixed assets has resulted in it not receiving an adequate return on its investment in assets. Macey’s has almost 2 times the amount of ordinary shares and 7 times the amount of share premium. However, Daley has more than 2 times the amount of retained earnings that Macey has. The return on investors’ money is 2 times higher in Daley than in Macey. With higher net income available to common stockholders and lower common equity than Macey, Daley’s investors get a return of 68% while Macey’s get only 31%. This shows that Daley is doing a good job with the investors’ money as compared to Macey. Limitations of Ratios Although ratio analysis is a universally accepted means of comparing the performance of companies within the same industry, it does however, have its limitations and is not completely fool-proof. All companies have their own rules of which accounting principles to use which means that values will differ. Depreciation alone has two different methods, straight line and diminishing value methods and each gives a different depreciation value. Hence when accounting principles differ, the ratios calculated may be misleading. If accounting practices are changed from one year to another, then the ratios calculated may not remain reliable anymore. Comparability will be drastically reduced. Inflation and its effects on prices, are also a cause for ratios being less reliable. It may cause the value of assets that have been previously purchased to be seriously understated. Hence if a company that has been around for years is being compared to another that is relatively new, then inflation will cause discrepancies in the ratios that are calculated. The older firm will then have a higher fixed asset turnover. Also, any two companies that are being compared with one another must be compared in light of industry averages and ratios of previous years to make a more comprehensive assessment of the company’s performance. Year on year analysis will help determine whether a company is improving against its performance in previous years or not and a comparison with the industry averages will help uncover if the company’s performance is in line with that of other similar firms in the industry. Any one ratio can also not be looked at in isolation. A company’s performance is to be determined after a thorough analysis of all the various aspects of its operations and then a conclusive evaluation must be made to ensure that a correct version of the evaluation is taken into consideration, especially while investing. Some figures are only found in the statements at one point in time such as inventories. Seasonal factors come into play and affect the ratios calculated from one month to the other. Average figures must be used for accuracy and comparability. Some ratios also differ from industry to industry. Hence one ratio may be considered a sign of excellent performance in one industry while considered below average in the other. Window dressing techniques are also a major problem with ratios. Companies can borrow money to improve their liquidity position and pay it back after a few days when the window dressed ratios have been used to delude investors. The most difficult part of a ratio analysis is the overall judgment that is made regarding a company’s financial position. Accounting Principles and Concepts All financial statements, income statement, balance sheet, cash flow statement and the statement of owner’s equity are made based on some basic accounting principles and concepts. Most importantly the business is considered to be separate from its owners hence the accounts of the owners are kept separate from those of the business. This principle is known as the accounting entity principle. It is also assumed that the business will continue indefinitely and hence is a going concern. It is not expected to be liquidated in the near future. The time period principle is used which states that the economic activities of a business will be divided into artificial periods that allow ease of record keeping or calculation to the business. (Investopedia, 2011) The historical cost concept is highly important because according to it, all assets are recorded on the price at which they were bought at (cost to the company) and not the fair market value at any time period. This however, means that the balance sheet may give outdated figures that are no longer relevant. In the income statement the revenue recognition principle is used that requires the company to record revenue when it is actually realized and not when the cash for it is received. This is the accrual basis of accounting. The cash flow however, is made on cash basis and not accrual. The matching principle is perhaps the most important one for the generation of the income statement. This principle states that all revenues must be matched with their corresponding expenses. Expenses are to be recorded in the time period when they actually help earn the revenue and not when the cash is paid for them. Some other principles that are used include the consistency principle whereby the accounting practices used must remain same from year to year. Also included, is the conservatism principle which advices an accountant to use figures that do not overstate assets or income and are considered conservative. Recommendations: One of the most important ratios to look at while deciding to invest in a company is the return on equity which measure the return an investor will get on the money that has been invested in the company. Based on this ratio, Daley is performing far better than Macey with a 68% ROE, more than twice the ROE of Macey. (Peavler, 2010) Daley’s expenses are under control and its cost of sales seem to be minimized which has allowed much greater profit than Macey’s despite Macey having an upper hand in terms of dollar value of sales. (Morning star, 2010) Daley’s profitability ratios show a much better picture than Macey’s. Daley is also efficiently utilizing the fixed assets it has invested in and has successfully generated a sufficient volume of business. Daley’s efficiency ratios also show that its inventory management is strong. A little trouble with receivables not being collected as quickly as Macey’s is detected. However this issue is considered minor because it also has a larger amount of cash than Macey. The fixed assets that have been invested in are allowing Daley to generate a healthy amount of sales. Daley’s liquidity position although not as good as Macey’s, is not in any imminent danger. It has the ability to pay off short term debts without having to liquidate its inventories which means that it has a stable liquidity position also. Overall, Daley seems to be a better choice than Macey based on the liquidity, asset management and profitability ratios. Macey’s low ROE and lack of control over expenses, makes it a bad choice for investment. Daley shows good growth prospects, with high retained earnings and good profits. These will ultimately benefit the investor in the long run. Hence between the two, Daley is recommended to the investor. Appendix Ratio Analysis Liquidity Ratios Macey Daley Current =1.5: 1 =1.3: 1 Quick =1.1: 1 =1.1: 1 Efficiency Ratios Inventory Turnover = 122.8 times =131 times Days Sales Outstanding = 2.7 days =4.3 days Fixed Asset Turnover =5.5 times =8.9 times Total Asset Turnover =4.1 times =5.95 times Profitability Ratios Net Profit Margin on Sales =6.6% =9.7% Gross Profit Margin =26.5% =27.9% Return on Total Assets =27%% =57.9% Return on Common Equity =30.9% =68.1% References Investopedia. (2011). GAAP. Available: http://www.investopedia.com/terms/g/gaap.asp. Last accessed 31st July 2011. Morning Star. (2010). Efficiency Ratios. Available: http://news.morningstar.com/classroom2/course.asp?docId=145093&page=3&CN=com. Last accessed 31st July 2011. Peavler, Rosemary . (2010). Determining Profitability is Important to Company Investors. Available: http://bizfinance.about.com/od/financialratios/a/Profitability_Ratios.htm. Last accessed 31st July 2011. Read More