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Ratio Analysis


1.      Introduction

In order to analyze the operating and cash flow performance and the financial position of Burdekin Ltd for the year ended 30 June 20X2, the following figures are calculated and summarized for the interpretation: the necessary ratios (Figure 1), vertical analysis of the profit and loss account details of 20X2 (Figure 2), and horizontal analysis of the balance sheets of 20X1-2 (Figure 3).

Operating performance

Operating performance

Profitability ratios

20X2

20X1

 

Return on total assets (ROA)

6.7%

-

 

Return on equity (ROE)

10.7%

-

 

Profit margin

5.3%

-

 

Earning per share (EPS)

17.9 cents

-

 

 

 

 

Cash flow performance

Liquidity ratios

20X2

20X1

 

Current ratio

2.4 :1

2.3 :1

 

Quick ratio

0.62 :1

0.68 :1

 

Average debtor collection period

32.9 days

 

 

Average creditor payment period

49.5 days

 

 

Inventory turnover

187.3 days

 

 

 

 

 

Financial Position

Financial stability ratios

20X2

20X1

 

Debt ratio

33.1

43.3

 

Equity ratio

66.9

56.7

 

Asset turnover ratio

1.25 times

 

Figure 1: Ratio Analysis

Net sales

1,046,000

100%

Purchases (costs of goods sold)

706,500

67.5%

Operating expenses

213,550

20.4%

Figure 2: Vertical analysis of profit and loss account details

 

20X2

20X1

Percent change

Assets

 

 

 

Current assets

 

 

 

Cash at bank

49,500

45,400

+ 9%

Bank bills

10,000

5,000

+ 100%

Account receivable

89,000

99,750

- 10.8%

Inventory

390,000

335,000

+ 16.4%

Prepaid expenses

40,000

12,500

+ 220%

 

578,500

497,650

+ 16.2%

Non-current assets

 

 

 

Net equipment

361,000

239,600

+ 50.7%

Total assets

939,500

737,250

+ 27.4%

 

 

 

 

Liabilities

 

 

 

Current liabilities

 

 

 

Bills payable

26,500

16,000

+ 65.6%

Accounts payable

146,400

137,500

+ 6.5%

Accrued expenses

13,000

16,000

- 18.8%

Provision for income tax

55,000

50,000

+ 10%

 

240,900

219,500

+ 9.7%

Non-current liabilities

 

 

 

Debentures

70,000

100,000

- 30%

Total liabilities

310,900

319,500

- 2.7%

 

 

 

 

Shareholders・ equity

 

 

 

Paid-up capital, $1 par value

350,000

275,000

+ 27.3%

Share premium reserve

175,000

25,000

+ 600%

Retained profits

103,600

117,750

- 12%

Total shareholders・ equity

628,600

417,750

+ 50.5%

Figure 3: Horizontal analysis of balance sheets of 20X1-20X2

2.      Discussion

The interpretation of the above analysis is discussed in the following sections:

Operating performance

Profitability analysis is important for creditors and shareholders to evaluate the operating performance during the year and forecast potential profitability of the company in the long-run.

The ROA and ROE indicates how efficiently the company uses those resources invested in it.  In 20X2, the company has produced a ROA of 6.7% and ROE of 10.7%.  That means, the management of Burdekin through its operating activities produced 6.7 cents in profit after tax for every dollar invested in assets and 10.7 cents in profit after tax for every dollar invested by the shareholders・ equity.  The ROE is greater than ROA (10.7% compared to 6.7%) which means that the company was able to earn more from borrowed funds.  Hence, the earning of the company is more sensitive to profit changes as the interest in respect of the loans must be paid regardless of profit level.  Yet, the ROA and ROE should be compared with previous years・ figures, or the company・s target, or other companies within the same industry to determine the efficiency.

The profit margin indicates the margin that the company makes on its sales and its expected to remain reasonably constant.  The company has produced a rate of return on sales revenue of 5.3% in 20X2, which means the management of Burdekin through its operating activities has produced 5.3 cents in profit after tax for every dollar of sales revenue earned.  According to the provision for income tax, the profit of the company has been improved by 10% in 20X2, provided the tax rate and accounting method is same as 20X1.  Yet, this rate should be compared with data from past years and the industry standard to be more useful.  However, the costs of goods sold (67.5%) and the operating expense (20.4%) as a proportion to sales revenues are significantly high in the year.  It must be investigated whether it is industry norm or caused by poor performance as these costs directly influence the profit margin of the company.

The EPS is concerned with the profits available to shareholders after tax and tells an investor how much profit each share has earned during the accounting period.  The management through its operating activities has earned 17.9 cents per share on the average outstanding ordinary shares for the year.  In general, the higher the EPS, the more confidence an investor or potential investor will have in the company.  Hence, it must be compared with data of past years for its efficiency.

Cash flow performance

Liquidity analysis is to evaluate the cash flow performance of the company.  It is important to see whether the company has problem to meet its short-term obligations which may reduce its opportunity to operate in the long run due to liquidation problem.

The current ratio measures the adequacy of current assets to meet its short term liabilities and reflects whether the company is in a position to meet its liabilities as they fall due.  The company shows a slight improvement in the relationship between current assets and current liabilities.  It is because the increase of current assets (16.2%) is more than the increase of current liabilities (9.7%). 

However, the company shows a poor quick ratio less than 1:1 for both years.  The quick ratio measures whether the company has sufficient resources (cash and debtors) to settle its liabilities.  Unlike inventory which takes longer time to convert to cash, the company can encourage debtors to pay more quickly in the event of severe liquidity difficulties.  The quick ratio of 20X2 (0.62:1) is even worse than 20X1 (0.68:1).  It means the company would have problem to meet its immediate obligations in an emergency.  It also implies that the company is too dependent upon short-term borrowings such as trade creditors for funding of its day to day operations and will be forced to cease trading if any of these funding is suddenly withdrawn. 

When reviewing the current ratio and quick ratio together, it signifies that the company has excessive investments in current assets.  For example, inventory accounts for about 67% of current assets and there is significant increase in prepaid expenses, which could be put to better use.

Average debtor collection ratio measures the number of days between a credit sales taking place and the company receiving cash payment from a customer.  It seems an average collection period of 32.9 days is normal but would depend on the industry norm.  Average creditor payment period measures the average number of days that a business takes to pay its suppliers for goods purchased on credits.  The average credit payment period is 49.5 days may be good as it represents a source of free finance.  However, it may also indicate the company is unable to pay more quickly because of liquidity problems.  The negative impacts would include a poor reputation as a slow payer and may not be able to find new suppliers, and the foregone cash discounts for prompt payments.

The inventory turnover measures the number of days on average the company holds stock.  The inventory turnover of the company is 187.3 days which is very high.  There are several possible reasons: the company bought the stocks in larger quantities to take advantages of trade discounts or has increased stock level to avoid stock-out or expected increase in prices.  However, it may be regarded as a bad sign, for example it may reflect the lack of demand for the goods or poor stock control which eventually leads to stock obsolescence and related write off.

Financial position

Financial stability analysis is to evaluate the ability of the company to continue operations in the long term, satisfy its long-term commitments, and whether there is sufficient working capital to operate successfully.

Debt ratio measures the margin of safety to the creditors of the company in the event of liquidation with a relationship of total liabilities and total assets, so the lower the ratio, the greater the asset protection to the creditors.  The debt ratio of the company has been improved from 43.3% to 33.1% for 20X2.  It is caused by a significant increase of total assets by 27.4%.  In contrast, equity ratio measures the margin of safety to creditors of the company in the event of liquidation with a relationship between shareholders・ equity and total assets, so the higher the ratio, the greater the asset protection to the creditors.  The equity ratio of the company has been improved from 56.7% to 66.9% for 20X2.  It is caused by a significant increase of shareholders・ equity by 50.5%.  Both ratios show that the liquidity of the company is improved and there is greater asset protection to the creditors.

Asset turnover ratio measures how effectively the company utilizes its assets and indicates how much each dollar invested in assets generates in sales.  In general, the higher the ratio of sales to assets, the more efficiently the assets are being utilized.  During the year of 20X2, the company is able to use its assets to turn over of 1.25 times in sales revenue.  However, this ratio has been lowered by the significant new investment: the purchase of new equipment at the cost of $160,000.  Hence, this ratio is only useful for comparing with previous periods or with industry norm.

3.      Conclusion

During the year of 20x2, Burdekin Ltd appears to be experiencing increases in profits and is able to earn more from borrowed funds.  However, there are a high proportion of costs of goods sold and operating expenses to the sales revenues earned which needs to investigate and control for better operating performance.  Cash flow performance is not satisfied as the company is too dependent upon trade creditors for day to day operations.  The high inventory should be investigated and controlled to avoid the possibility of liquidation in an emergency situation.  Finally, the financial position of the company is stable for the long term as it has great asset protection to the creditors.

4.      Recommendations

In general, Burdekin Ltd should control expense to release cash for funding daily operations and improving operating performance.  The following recommendations are therefore suggested: 

(1)            Get rid of any fully depreciated assets and/or those which no longer produce anything useful, and use sale and leaseback assets in the long term.

(2)            Inventory control:

                             i.                Stop producing excess until reaching the bare minimum of stock pile

                           ii.                Shorten the number of days it takes to convert raw materials to finished goods

                          iii.                Monitor and enforce stringent quality control to decrease wastage

                         iv.                Apply Just-in-time or other appropriate stock management process

(3)            Cost control

                             i.                Decrease direct costs by searching other suppliers

                           ii.                Reduce unnecessary expenses

(4)            Review budgetary system for better cash flow control.


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