Understanding and interpreting financial data - Coursework Example

Understanding And Interpreting Financial Data (Cci) Registration Number Module Number and of Assignment Date of Submission 1 INTRODUCTION The vast competition and globalization that businesses face today means necessary steps to ensure continuous growth must be put in place. One method of doing this is the analysis of financial ratios. It is a tool for interpreting the financial statements to assess financial and management performance. In this case, Bravo Ltd can obtain financial ratios using their latest financial statements and comparing the results with a competing business within the same industry. Alternatively, a business with the best business practice and a good track record is chosen as a benchmark for Bravo Ltd's improvement. 2 FINANCIAL RATIOS There are several types of financial ratios available that will benefit Bravo Ltd: Liquidity Ratios, Asset Management Ratios, Profitability Ratios and Gearing Ratios. Each ratio is measured differently and used according to the necessary analysis needed. 2.1 Liquidity Ratio This measures the ability of Bravo Ltd to meet its short-term financial liabilities as they fall due. It is of particular interest if Bravo Ltd wishes to extend its short-term credit facilities. There are two kinds of Liquidity Ratio - Current Ratio and Quick Ratio. Current Ratio = Current Assets / Current Liabilities. Quick Ratio = (Current Assets - Stocks) / Current Liabilities Stocks are excluded in the calculation because stocks may include items that have uncertain liquidation values. Ideally, a ratio of 2 is considered safe for the former while a ratio below 1 is recommended for the latter. 2.2 Asset Management Ratio This measures how well Bravo Ltd utilizes its assets for the benefit of its business. Having a sound ratio will ensure that Bravo Ltd is better received by would-be investors. We will look at Inventory Turnover, Receivables Turnover, Average Collection Period and Fixed Asset Turnover. Inventory Turnover = Cost of Goods Sold / Inventory Receivables Turnover = Credit Sales / Accounts Receivables Average Collection Period = 365 / Receivables Turnover Fixed Asset Turnover = Sales / Fixed Assets Generally, a high turnover ratio is preferred. 2.3 Profitability Ratio There are several ratios available that can measure the ability of Bravo Ltd to generate profits from its sales. These include Gross Profit Margin, Return on Assets and Return on Equity. Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales Return on Assets = Net Income / Total Assets Return on Equity = Net Income / Shareholders' Equity A good profit margin is essential in any form of business to ensure there is always enough cash to run its operations. Thus, it is also important that receivables are collected on a timely basis. 2.4 Gearing Ratio This assesses the financial risk of Bravo Ltd. A high gearing ratio poses risks if Bravo Ltd is unable to meet its financial obligations as this can very well lead to bankruptcy. Therefore, it is important that this is constantly monitored. The ratio is used is Debt to Equity Ratio. 3 FINDINGS RATIO 2007 ('000) 2008 ('000) Working Result Working Result Current Ratio 1770 / 560 3.16 2490 / 840 2.96 Quick Ratio 1770 - 930 / 560 1.50 2490 - 1250 / 840 1.48 Inventory Turnover 3020 / 1770 1.71 4550 / 2490 1.83 Receivables Turnover 4940 / 820 6.02 6850 / 1230 5.57 Average Collection Period 365 / 6.02 60 Days 365 / 5.57 66 Days Fixed Asset Turnover 4940 / 2600 1.90 6850 / 3210 2.13 Gross Profit Margin 1920 / 4940 39% 2300 / 6850 34% Return on Assets 460 / 4370 11% 450 / 5700 8% Return on Equity 460 / 3810 12% 450 / 4860 9% Debt to Equity 560 / 3810 15% 840 / 4860 17% Our findings show that Bravo Ltd has a good Liquidity Ratio. Its Current Ratio is 2.96 (3.16 in 2007) and its Quick Ratio is 1.48 (1.50 in 2007). This means Bravo Ltd is more than able to generate enough cash to settle its short-term liabilities. There has only been a slight change in its Liquidity Ratio over two years. As a guide, a current ratio of 2 is ideal. In this case, it might be said that Bravo Ltd is under utilizing its current assets. At a glance, Bravo Ltd's assets are being managed efficiently. Its Inventory Turnover is 1.83 (1.71 in 2007), which shows that Bravo Ltd is trading better. Its inventories increased by 34% in 2008 whereas its sales increased by 38% in the same year. Although this is a good sign, Bravo Ltd should take note that over increasing its inventories may adversely affect its business performance. This is because costs associated with holding inventories for too long can be very expensive. As such, managing its inventories well is recommended. The Average Collection Days is 66 (60 Days in 2007). Although Bravo Ltd is able to meet its short-term liabilities; it should still make an effort to improve the collection of its debts. The credit term given to its customers is not stated; however, as a guideline, 30 days is recommended. In this case, Bravo Ltd's customers are enjoying twice the normal credit terms and this is unhealthy. The profitability of Bravo Ltd is sound. Its Gross Profit Margin of 34% (39% in 2007) is quite high. The 5% drop might be attributed to 51% increase in its cost of goods, although its sales only increased by 38%. Bravo Ltd should analyze further the cause of this rise - whether the efficiency of its production dropped resulting in more defective goods or simply over-buying to benefit from bulk discounts that its suppliers could have offered. Concerning the latter, Bravo Ltd should analyze the cost and benefits of buying in bulk, ensure these are fast moving and will not be obsolete. Otherwise, the decision to buy in bulk may have an adverse effect on its profitability. The Return on Assets and Return on Equity ratios declined slightly. At 8% and 9% respectively (11% and 12% respectively in 2007), these can still be improved on. The Gearing Ratio is quite low at 17% (15% in 2007) and should not cause an alarm. 4 LIMITATIONS The financial statements of Bravo Ltd provided do not contain sufficient information to perform the analysis well. There is no breakdown of the Non-Current Assets and for the purpose of this report, is taken to mean as Net Fixed Assets. Similarly, there is no breakdown of the Current Liabilities and it is unsure what constitutes this amount. For the calculation of the Debt to Equity Ratio, the Current Liabilities is assumed to be short-term borrowing and therefore, do not present a fair view. Perhaps, Bravo Ltd has no short-term borrowings at all. The use of financial ratios in itself is limiting as it relies on profit values. Since profits are historical, Bravo Ltd cannot solely rely on the findings. Bravo Ltd's accounting policies, such as depreciation method, can also affect its profit. In addition, it would be more reliable if the results can be compared with a similar business within the same industry that has been benchmarked for its financial and operating performance. 5 CONCLUSION Although there are limitations in the analysis of financial ratios, this tool is still highly used by investors and management in assessing the overall performance of its business. As such, Bravo Ltd should perform such analysis on a regular basis, taking into account external factors such as the current economic situation. Relying solely on this historical analysis would not benefit the business in its future growth. *** End *** References: 1. Belverd E. Needles. Financial Accouting. Paperback, 2006. 2. Frank Wood and Alan Sangster. Business Accounting 2 (v. 2). Paperback, 2005. 3. Paul D. Kimmel, Jerry J. Weygandt, and Donald E. Kieso. Financial Accounting, Study Guide: Tools for Business Decision Making. Paperback, 2009. Read More