Financial Analysis of Australian Fungi Importers Pty Ltd - Case Study Example

Financial Analysis of Australian Fungi Importers Pty Ltd Name: University: Course: Tutor: Date: Introduction This report has been prepared as an evaluation of credit risk posed by our client’s, Australian Fungi Importers Pty Ltd’s, proposed bank loan. It is our company policy to carry out sufficient due diligence before issuing bank loans or extending existing credit facilities. This report will analyze the financial data of our client over a period of three years to help determine credit worthiness or otherwise of the client. Financial analysis will look into the liquidity, profitability and projected financial stability of the client. It is important that default risk is kept at an acceptable and reasonable level. I believe the analysis carried out will enable you to make the appropriate lending decisions. Profitability Analysis The main aim of a business is to make profit. It is important for any business to make profits since prolonged periods of losses threaten the going concern of the business. Profitability ratios are important tools in assessing the business performance in terms of its profitability. Return on Assets This ratio is calculated by dividing, profit before interest and tax by total assets. It shows how well the management is utilizing the assets at its disposal to generate sales (Helfert, 1987). The company’s return on assets has improved modestly over the year from 15.5% in 2010 to 18.5% 2011 and then to 28.7 % in 2012. The trend indicate improved utilization of assets, however the ratio is poorer than the industry average of 38%. This may not be badly off considering that Australian Fungi Importers Pty Ltd has been in operation for only 5 years and return on assets is improving. Shareholder Return Ratios These ratios include earnings yield, dividend yield, return on shareholder’s equity among others (Williams, 2003). They are usually vital when analyzing financial data of listed firms. This is because they are the main drivers of share prices that affect market capitalization of a firm which impacts on capital growth of shareholder’s investments (Williams, 2003). However as Australian Fungi Importers Pty is not a listed company their use is of little significance. Profit Margins The gross profit margin of the company was relatively stable over the period averaging 55.4%. This was higher than the industry’s average of 49%. The ratio indicate that the company manages its direct costs better that its competitors. This could be attributed to better supply chain management and better utilization of labor. This could also be because the main shareholders work for the company effectively and they have better knowledge of their European imports. Profit before tax is an indicator of how well indirect expenses are being managed (Friedlob, 2003). The main expenses include selling and administration costs as well as interest expenses. The company recorded an improving profit before tax over the years, 12% for 2010, 13.4% for 2011 and 20.9% for 2012. This shows a rapid improvement and it actually bettered the industry’s average of 18.7% in the final year. This indicates that the company is increasingly managing its indirect expenses better. Net profit margin shed more light on tax management efficiency (Friedlob, 2003). The profit after interest and tax and profit before tax grew at fairly the same rate over the period, this indicate that there was no radical impact of tax management. Liquidity ratios Current and Quick Ratios These ratios look into the ability of an organization to meet its short term obligations as and when they become due (Mock, 1967). Current ratio is calculated by dividing current assets by current liabilities; larger ratios indicate better liquidity (Mock, 1967). This ratio has a worsening trend; it was 4.9 to 1, 4.7 to 1, and then 3.4 to1, in 2010, 2011 and 2012 respectively. Quick ratios are calculated in a similar manner as current ratios but inventory/stock is not in current assets. This takes into account the fact that inventory/stock is not always liquid and also appreciate the fact that it may actually have a lower realizable value than indicated in the financial statements. The quick ratio was 2.8:1 in 2010, 2.6:1 in 2011 and 1.9:1 in 2012. This shows a deteriorating ratio. However judgment should be made after considering the industry’s average. Since Australian Fungi Importers Pty Ltd deals in fast moving products, it may not be unusual to operate with very low quick and current ratios. Operating Cycle This shows the time taken for a company to obtain inventory or purchases, to convert them into sales and to collect the proceeds from debtors (Mock, 1967). Longer operation cycles indicate poor work capital management as it increases short-term financing requirements. The operating cycle of Australian Fungi Importers Pty Ltd was 112 days in 2010,106 in 2011 and 128 in 2012. This shows that the operating period is worsening overall as the number of days has increased. Good Cash management requires good working capital control, this would be essential to ensure the company has sufficient liquid cash to pay its financial obligations including loan principal and interest. The longer operating cycle can be attributed to longer credit period of 40 days in 2012 compared to 33 days in 2010. Over the three years inventory turnover days has increased by 10 days; this also adversely affects the operating cycle. Stability Analyses Capitalization ratio- this is a measure of how much debt has been used to support a company’s operations and shows the amount of debt in the capital structure of the company (Eisen, 2000). It is calculated by dividing long term liabilities by shareholders equity plus long term liabilities (Eisen, 2000). This ratio has been stable over the period averaging 1.8 to 1. This is because Australian Fungi Importers Pty Ltd did not make any substantial changes in its capital structure such as borrowing more funds or raising more equity. Asset turnover- this ratio shows how well the company is generating revenue from its assets (Eisen, 2000). The client’s asset turnover ratio was 1.1:1, 1.2:1 and 1.2:1in 2010, 2011 and 2012 respectively. This was way below the industry’s average of 3.7:1, this indicate that Australian Fungi Importers Pty Ltd has over invested in noncurrent assets or it is underutilizing available capacity. Times interest earned ratio- shows number of times interest can be covered by earnings on a pretax basis. The client’s ratio has improved over the period from 6 times in 2010 to 9.3 times in 2012, as earnings before interest and tax improved over the same period. The company also seems to be cash rich with balances of $ 86,000, $ 92000 and $ 81,000 in 2010, 2011 and 2012 respectively. Recommendation One of the major considerations before giving loans is the purpose and intended use of funds raised. In the case of Australian Fungi Importers Pty, the company seems to be having a sound business case. Having already been the market leaders in their niche, one can have confidence in the client’s intended investment venture. The company seems to be having sufficient security to back the amount of loan it is seeking. The company has existing bank mortgage of $325,000 secured on property. This is a substantial sum compared to the property’s cost of $575,000; however the firm’s capitalization stands at a safe $875,000. Cash flow is also important as the company will need to have adequate liquid cash to settle its interest and principal as and when they fall due. The company seems to be having good liquidity considering the cash asset in its balance sheet. The ratio analyses carried out above indicate that almost all significant ratios are improving over time. These give confidence in the client’s ability to service its future credit burden. Other non financial considerations should be taken into account before issuing this loan. The shareholders take an annual salary that amount to 45% of the required finance. The bank should enquire whether the shareholders are willing to provide additional funding. Based on the above, I recommend that the bank advance the loan. Australian Fungi Importers Pty Ltd is a high growth company and will be a significant client in future. The default risks presented by this client are acceptable and manageable. APPENDIX Shortcomings of Financial Statement Analyses Financial statements do not give the true drivers of performance. This is particularly true where a company relies heavily on specialist human resource input or internally generated knowledge. These things are not captured in the financial statement as International accounting standards do not permit capitalization of internally generated intangible assets such as goodwill, brands and customer lists. This means that they are not included in financial analysis (Williams, 2003). Financial statements also only show a snapshot at a particular time. The statement of financial position only shows assets and liabilities at that particular date. This may change significantly within a short time, for example, sale of a subsidiary after the reporting date significantly changes the financial position of a company. Most financial ratios and trends analysis are meaningless in the absence of proper comparatives. It is difficult to find a similar company in terms of gearing, financial and business risk and cost structure. Financial statements are prepared on a historical basis and are not forward looking. Relying on historical data to make future financial decision implies that past trends will be replicated in the future. This is not always the case especially in dynamic markets where business environment has changed drastically, this leads to relying on inappropriate data. To remedy the above weaknesses, non-financial analysis should be carried out. This may involve carrying out an environmental scan using models such as PESTEL or Porters 5 forces model. These analysis help identify the opportunities and threats to the company. Pestel analysis involves looking at the political influences, environmental factors, legal requirements, technological trends and socio-economic factors that may affect the operations and financial position of an organization (Palepu & Healy, 2008). The porter five forces model looks at the power of players in the market such as clients, suppliers and competitors. It is insightful because the impending entry of a competitor may significantly affect the future financial position of a firm and such matters cannot be reflected in historically presented financial statements (Palepu, & Healy, 2008). Studying market trends is also important. Turnover growth by 5% in times of economic recession may be wrongly interpreted as marginal whereas in times of economic boom returns may grow independent of management’s decisions/effort. Non financial performance should be taken into account. Matters of environmental friendliness are becoming more popular as people globally embrace ecologically friendly products and processes. Companies are increasingly publishing environmental reports and having eco-audits. Corporate social responsibility can also be used to measure performance. Companies may provide data on work place safety, such as number of accidents per month. Supporting the local communities is part of social responsibility, building schools, assisting the needy in the society and job creation is part of non financial performance. Corporate bodies that exercise good corporate citizenship tend to do well financially as customers like to be affiliated with them (Heath, 2002). Finally customer satisfaction is key to good financial performance. Customer feedback in form of questionnaires, customer satisfaction surveys or online comments can be used to assess performance. Companies that have good customer relationship management practices are good performers generally. References Eisen, J. 2000. Accounting. New York: Barron's Educational Series. Friedlob, G. & Schleifer, L. 2003. Essentials of financial analysis. New Jersey: J. Wiley. Heath, E. 2002. Morality and the market: ethics and virtue in the conduct of business. Boston: McGraw-Hill. Helfert, E.1987. Techniques of financial analysis. New York: Irwin. Mock, E. 1967. Financial decision-making. Washington: International Textbook Co. Palepu, K. & Healy, M. 2008. Business analysis & valuation: using financial statements. Ohio: Thomson/South-Western. Williams, J. 2003. Financial accounting. Boston: McGraw-Hill/Irwin. Read More