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Ratio Analysis


1.0   Introduction

Ms Sandra Kok has recently got 20,000 shares of Heavymetal Metalworks Ltd from her uncle.  She is considering whether:

ˇP         she should sell the shares to bring her income or to pay off some of the $30,000, 11% mortgage loan on her own business; or

ˇP         hold the shares as an investment.

In order to analyze the performance and financial position of Heavymetal Metalworks Ltd, an analization of the financial statements in profitability, liquidity and solvency of the company will aid in making this decision.

2.0              Information Provided

Following information is provided for the report analysis (see appendix 1):

ˇP         Comparative profit and loss statement for the years ended 31 December 1997 and 1996;

ˇP         Comparative balance sheet as at 31 December 1997 and 1996 (with selected 1995 amounts also provided).

3.0              Financial Analization

An analysis on the financial position of the company is important in order to forecast the companyˇ¦s ability to pay its debit and the profitability level.  All the ratios and other appropriate dates have been presented per appendices 2-6.

3.1          Profitability

The business of the company is declining.

                   3.1.1        The return on total assets is declining by 0.6% compared to year 1996.  It means the companyˇ¦s efficiency in using the entityˇ¦s asset to generate operating profit is lower.  The significant increase in the investment in property, plant and equipment that does not conform to the decrease of profit margin and thus it may be an excessive investment.  The same happens on the return on ordinary shareholdersˇ¦ equity, which is dropped by 2.2%.  The company has gained a return on the assets financed by the creditors and preference shareholders more than the interest or dividends paid to them. 

3.1.2        Net sales are increased by 13% in year 1997, but gross profit is in fact dropped by 2% as a proportion of net sales revenue.  The main reason is apparently the increasing of cost of good sold and it is presumed that the company did not transfer this to the selling price.  The net profit margin is therefore declining.  There is one more reason for this declining trend which is the operating expense.  According to the economic of scale, operating expense should be relatively decreased with sales growth.  However, the company is still using the same percentage of operating expense at 22.4% as a proportion of net sales revenue as year 1996 which eventually resulting an increase of expense.

3.1.3            Earning per share and dividend payout also indicates a declining trend for the company.  One important point has to evaluate is the significant increase of retained profit as a proportion of net sales revenue as this is directly affecting the profit to be gained for the shareholders.  If the excessive retained profit is for future development, it may be good for the company.  While if it is for any hiding anticipated problem, it has to further evaluate.

3.2                Liquidity

The company shows an improvement in liquidity.

3.2.1            The current ratio for year 1997 is 2.54 : 1.  The ability to satisfy the companyˇ¦s obligation in the short-term debt is in a reasonable position and shows an improvement. Prepaid expense has a significant increase in which may hide some unknown factor like provision for future expense or loss.

3.2.2            The quick ratio is near to 1 in year 1997.  It has been improved and indicates the ability of the company can meet unexpected demands from liquid current assets.  It is because the cash at bank is increased by 66.7% compared to year 1996.  Although the percentage of account receivable is decreased to 7.5% as a proportion of net sales revenue for year 1997, it shows an increase ratio of 13.3% compared to year 1996.

3.2.3            Receivables turnover and average collection period ratios are improved.  The effectiveness of collections is considered a favorable trend. 

3.2.4            Inventory turnover is also improved and indicates the liquidity of inventory is in a favorable trend.

3.3          Solvency

The solvency of the company is in a fair position due to high amount of gearing.

3.3.1            The debt ratio is increased by 6.2% and alternatively the equity ratio is decreased by the same percentage compared to year 1996. It indicates the company with high amount of gearing from mortgage on property, plant and equipment.  While comparatively the earning power is decreasing.

3.3.2            Asset turnover ratio is improved to 1.24 times in year 1997.  The company still shows the effective using of its assets to generate profit since net sales revenue has been increased. 

3.3.3            Times interest earned is decreased to 4.08 times for year 1997.  The ability to satisfy periodic interest payment from current profits is declining due to the diminishing of profit margin.  However, the profit is still adequate for interest coverage.

4.0           Conclusion and Recommendations

4.1.1        The report is recommended according to the limited information provided and below has to be considered for decision making.    

ˇP         Only two years data has been provided which may not be able to justify the companyˇ¦s future performance.  It is more realistic to compare with trend over a number of years, like 5 years, which may be more significant in assessing the companyˇ¦s performance.

ˇP         There is no financial information for the other companies in the same industry.  The ratios are also influenced by industry practice so a comparison with same industry can reveal deviations from competitorsˇ¦ operating result.  

4.1.2            Heavymetal Metalworks Ltd is a metal goods manufacturing company.  The manufacturing industry in the country is diminishing due to high labour and operating cost.  Most manufacturers move their production to developing countries for better profit margin.  However, the company still invested a high percentage here. Although the company shows an improvement in liquidity and fair position in solvency, it does not show a good future prospect due declining of profit and may lose competition in long run. 

4.1.3        As a conclusion of above, holding the shares in short term is fine but for long term, this is to recommend that Ms Sandra Kok should sell the shares to gain the income.  She can pay off some of the mortgage loan and deposit the balance funds in saving or time deposit account for earning further interest.


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