It is very important to know that how important is to evaluate the financial performance of a company. When we want to recognise the performance of individuals and particular departments or we want to invest into the business. Either we evaluate the company on the bases of security and risk management or we want to make a business deal with the company. We cover these entire topics while analyzing the financial performance of company. Pamela Peterson drake (2007)
"It is selection, evaluation, and interpretation of financial data, along with other pertinent information, to assist in investment and financial decision-making". (drake2007)
Financial analysis can be used internally and externally. Internally it may be used to evaluate the performance of individual and different departments, productivity of different projects and making credit policies. And externally it can be used to identify the area of investment and other important things such as credit worthiness of borrowers.
Expert says the financial data required financial analysis from different source. The basic source is annual report of a company like income statement, balance sheet and cash flow statement, but some other source are very effective for financial analysis such as print media, electronic media and stock price indices.
Economic data can be used for financial analysis like gross domestic product (G D P) and consumer price index which indicate the current performance and future plans of a company.
Because some time the data provided by company does not show true picture that’s way analyst recommend to get information from economic data such as consumer, spending, producer, price and competitor.
Moreover resent event may be used for financial analysis like adding new products in portfolio and acquiring some new businesses or mergers.
Keeping in view all above discussion in simple words the financial analysts get the relevant data and information from internal and external sources, evaluate it and interpret the analysis on current and future condition of a corporation.
Now I start working on my assignment, I have been given a income statement, balance sheet of company and I need to analysis the given account by using any method and after that I have to produce a reflective commentary on the bases of given account.
In this assignment, I shell use the method of financial ratio as a tool. Because financial ratio analysis is to be considered the best method of study
I have an income statement and balance sheet of a MG Fabrication plc; for the year 2008, 2009 and 2010. I shell consider all data from these income statement and balance sheet.
Classification of ratio;
Ratio simply shows the mathematical relationship between two numbers. For example you have 200 books and 100 pens. The ratio of books to pen is 200 / 100, we can explain as 2:1 or 2. Financial ratio analysis always shows a number or information. For example if we calculate the ratio between current asset and current liability. It is a comparison between current assets (inventory, receivable, and cash) and current liability (payable, overdraft and loan interest)
So in simple words when we say current ratio of 2:1 or 2, so its means we have two time current asset as compare with we need due in near future to satisfy obligation.
Ratio can be fall in several groups:
financial leverage ratio
return on investment ratio
Now I calculate above ratio one by one with respect of given data.
According to Pamela, these ratios reflect the capacity of an organisation to satisfy its near future obligation. There are three types of liquidity ratio.
1. Current ratio: is the ratio of current asset to current liability, indicates a company’s ability to satisfy its current liability with its current assets. It is calculated as:
Current ratio = current assets / current liability
current ratio = 28207 / 2408 = 11.71
current ratio = 40225 / 4447 = 9.04
current ratio = 54805 / 6238 = 8.78
2. The quick ratio is: is ratio is the ratio of quick assets to current liability.
Quick ratio = current assets – inventory / current liability
2008. Quick ratio = 26663 / 2408 = 11.07
2009. Quick ratio = 37137 / 4447 = 8.35
2010. Quick ratio = 48629 / 6238 = 7.79
3. The net working capital to sales, it is calculated as
Current asset – current liability / sales
2008. Net working capital = 25799 / 254591.4 = 0.101
2009. Net working capital = 35778 / 400981.4 = 0.089
2010. Net working capital = 48567 / 553736.3 = 0.087
These ratios tell us whether the company is generating a notable return for its investors
These ratios include:
Gross profit margin is ratio of gross profit to sales and calculated as
4. Gross profit margin = (gross profit / sales) X 100
2008. Gross profit margin = 50918 / 254591.4 X 100 = 19.99
2009. Gross profit margin = 66830 / 400981.4 X 100 = 16.66
2010. Gross profit margin = 82742 / 553736 X 100 = 14.94
5. The operating profit is a ratio of operating income before interest and tax to sales and calculated as:
Operating profit margin = operating income / sales X 100
2008. Operating profit margin = 25459 / 254591.4 X 100 =9.99
2009. Operating profit margin = 35006 / 400981.4 X 100 = 8.73
2010. Operating profit margin = 43936 / 553736.3 X 100 = 7.93
6. Return on capital employed (ROCE) expresses the profit before interest and tax as percentage of capital employed.
Capital employed = ordinary share capital + reserve +preference share + long term liability, or total assets – current liability.
Roce = PBIT / capital employed X 100
2008. 25459 / 28547 X 100 = 89.18%
2009. 35006 / 38650 X 100 = 90.57%
2010. 44553 / 48599 X 100 = 91.67%
7. RONA = PBIT / capital employed (including long term liability) X 100%
2008. Rona = 25459 / 28547 X 100 = 89.18%
2009. Rona = 35006 / 38650 X 100 = 90.57%
2010. Rona = 44553 / 45511 X 100 = 97.67%
8. ROTA = PBIT / total assets X 100%
2008. Rota = 25459 / 30955 x 100 = 82.24%
2009. Rota = 35006 / 81.22 x 100 = 81.22%
2010. Rata = 44553 / 578924 x 100 = 76.91%
These ratios show how well assets are used calculated as a debtor days, creditor days, and stock turnover.
9. Debtors days = trade debtors / credit sales x 365 days
2008. Debtors days = 1544 / 254591.4 x 365 = 2.21 days
2009. Debtors days = 3242 / 400981 x 365 = 2.95 days
2010. Debtors days = 7411 / 553736.3 x 365 = 4.98 days
10. Creditors days = trade credit / credit purchase x 365 days
2008. Creditors days = 1729 / 203673.11 x 365 = 3 days
2009. Creditors days = 3459 / 33415.19 x 365= 3.77 days
2010. Creditors days = 5126 / 47994 x 365 = 3.97 days
11. Stock turnover ratio = average stock / cost of sales x 365 days
2008. Stock turnover = 772 / 203673.11 x 365 = 1.38 days
2009. Stock turnover = 1544 / 334151.197 x 365 = 1.68 days
2010. Stock turnover = 3088 / 4709941.1 x 365 = 2.39 days
12. Cash operating cycle:
The length of time it takes to convert an investment of cash in inventory of back into cash considering that some purchases are made on credit.
Cash operating cycle = debtors days + inventory turnover – creditors days
2008. = 2.21 + 1.38 – 3 = 0.59
2009. = 2.95 + 1.68 – 3.77 = 0.86
2010. 4.98 + 2.39 – 3.97 = 3.4
13. Cost of sales to sales ratio:
It is calculated as
Sales ratio = cost of good soled / sales x 100
2008. Sales ratio = 203673 / 254591.4 x 100 = 80%
2009. Sales ratio = 334151.197 / 400981.436 x 100 = 83%
2010. Sales ratio = 470994.1 / 553736.3 x 100 = 85%
14. Gearing ratio:
Gearing ratio measures the relationship between total employed and prior charge capital. It is given as:
Gearing ratio = borrowing (all long term loan + overdraft) / (capital + reserve) x 100
2010. = 3088 / 46559 x 100 = 6.35
Financial leverage ratio:
Financial leverage ratios tell us about financial risk which has taken on. There are two types of financial leverage ratio.
The total debt to asset ratio indicators the proportion of assets that are financed with debt (both short and long term debt):
15. Total debt to asset ratio = total debt / total assets
2008. Debt to asset ratio = 2408 / 30955 = 0.07
2009. Debt to asset ratio = 4447 / 43097 = 0.10
2010. Debt to asset ratio = 9326 / 57924 = 0.16
Now, I start commentary based on ratio analysis of MG Fabrications plc;
I have assigned limited words for commentary that’s way I would not go to deep in every ratio. I would discuss some main ratio.
These ratios tell us about capacity of company to satisfy its short-term commitments. In MG Fabrication plc; current ratio showing decreasing trend, in 2008 it was 11.71% but in 2010 it shows 8.78% so it indicating gradually decreasing. Quick ratio also is showing same situation. So we can say in 2008 the firm was more able to bear its short-term obligation in comparison with 2010. And if look at on balance sheet, the firm also has some interest of loan but 2008 and 2009 there was no loan and interest has to be paid.
These ratio tell us about profit, it indicates whether corporation producing handsome profit against investment. When we analysis about given firm, we see gross profit margin net, net profit, operating profit and return on capital employed. These ratio showing negative trend in every year, in 2008 gross profit margin was approximately 20% of total sales but in 2009 MG Fabrications plc; generated 16.66% gross profit for its investors. It is 3.5% less as compare last year and in 2010 it generated only 15.94% which was less. And if we look at on net profit, it indicate same trend from 10% to 7.9%in respective year and firm has to pay some loan as well.
Return on capital employed (ROCE). RONA, and ROTA tell us about profit before interest and tax with capital employed, capital employed (including long term loan), and with current ratio.
MG Fabrications plc; the data showing continues negative trend in its profit. In 2008 and 2009 difference was just one point but in comparison with 2010 we see big difference because firm has some long term loan and its total assets also decreasing.
Another way to analysis the financial performance is to calculate the debtors’ days’ creditors days and stock turnover days. According to (Pamela Peterson drake. 2007) these ratios can be used to calculate the output produced by particular assets, like stock or debtors or company all assets.
In given firm debtors days are increasing from 2008 to 2010, and creditor’s days also increasing from 2008 to 2010. it means company need more time to cover its receivable every following year, and also time limits increasing to its liabilities, but it does not mean that company is an good situation. If we calculate the percentage of receivable and payable days it can be calculated as:
2008. Debtors days (2.21) and creditors days (3).
2009. Debtors days (2.95) and creditors days (3.77)
2010. Debtors days (4.95) and creditors days (3.97)
Growth = current year / last year x 100 – 100
2008 v 2009
Growth = 2.95 / 2.21 x 100 – 100 = 33%
2009 v 2010
Growth = 4.98 / 2.95 x 100 – 100 = 69%
2008 v 2009
Growth = 3.77 / 3 x 100 – 100 = 25%
2009 v 2010
Growth = 3.97 / 3.77 x 100 – 100 = 5%
We can understand better in this way
2008, 2009 debtors days growth (33%) and creditors days growth (25%)
2009, 2010 debtors days growth (69%) and creditors days growth (5%)
It showing MG Fabrications plc; receivable time is increasing fast as compare payable time increasing slowly. It means company need some more investment to fulfil its obligations.
Stock turnover days are also increasing and showing negative sign for MG Fabrications.
Cash operating cycle of firm is expending every, its means the time to convert the cash into the inventory (stock) and back into cash (asset) are increasing. So we can say it is a sign of slow production and slow sales.
Cost of sales is also increasing from 80% to 85%in 2008 to 2010, it means the firm purchasing cost increasing and ultimately profit is decreasing.
Conclusion of commentary:
Keeping in view all above discussion and analysis of MG Fabrications plc; I considered all data from the income statement and balance sheet of the firm and adopted method of ratio analysis. The figure, I got from different ratios showing overall negative performance of MG Fabrications plc; during the years 2008 to 2010.
The financial performance of firm gradually decreasing if it continued so, business can be collapsed. I would not go to deep because we have discussed it in reflective commentary. Now I would go for suggestions.
MG Fabrications plc; need some investment.
By adopting new technology cost of goods has to be decreased and sales should increase.
The creditor’s days should be increased in comparison with debtor’s days.
Cash operating cycle should be fast and show decreasing time length.
Limitation of Methodology:
Although while analysing the financial performance of company, ratio analysis system to be considered the best methodology. But this method has some limitations like it does not cover competition and inflation aspect. (Harold Kent baker, Gary E. Powell 2005)
According to William lasher 2008, the shortcomings of ratio analysis is neglect resent events into the market like arrival of new products, acquiring new company and mergers.
Big multinationals companies’ operate different division in different industries; it is not possible for them to develop a different account different industry. That’s way ratio analysis system is best for Small Corporation. (Eugene F. Brigham, Philip R. Daves 2010)
It is true ratio analysis tell us overall financial performance and productivity of a company but it does not cover other financial measures like risk management moreover some time comparison of ratio may be mislead on some count a company can be adopted new accounting standard. (Angelico A. Groppelli, Ehsan Nikbakht 2000)
According to Philip R. Daves "seasonal factor can be distort a ratio analysis. For example the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus the one just after the close of canning season. The problem can be minimize by using monthly average for inventory (and receivable) when calculating turnover ratio".
Some time comparison shows wrong result because companies can be adopted different diversity like LIFO and FIFI. (Joel G. Siegel, Jaek. Shim 2006)