Financial Ratios of Prolong Ltd - Case Study Example

Running Head: Financial Analysis Financial Analysis Name Tutor Institution Course Date GSBS6200 ASSIGNMENT 2 Financial ratios of Prolong Ltd We want to use the liquidity, profitability, efficiency and financial stability ratios to ascertain on whether there is any growth in the business by analyzing the trends over time. These ratios are useful in determining the firm’s performance and its financial position. i. Profitability ratios The gross profit margin measures the gross profit earned on sales and takes into consideration the cost of goods sold by the firm (Birt and Gregory, 2010). The other costs are meaningless in calculating the gross profit margin. The formula below represents the gross profit margin: Gross profit margin = (sales – cost of sales)/ sales     2010 2009 Sales   1,200,000 1,180,000 cost of sales   750,000 680,000 Gross profit   450,000 500,000 Gross profit margin   0.38 0.42 The net profit margin measures the net profit earned on sales and takes into consideration all the costs the firm incurs.   2010 2009 Sales 1,200,000 1,180,000 Net profit 159,000 234,000  Net profit margin 0.13 0.20 Return on equity is used to measure the shareholders wealth by determining the profits earned for each dollar that has been invested in the firm’s stock. It is given by the formula below: Return on equity = Net income/ shareholders equity   2010 2009 net income 39,000 84,000 shareholders equity 1,083,000 984,000  Return on equity 0.04 0.09 Return on assets measures how efficiently a firm utilizes its asset in generating profits and its determined by the formula below: Return on assets = Net income/ Total assets   2010 2009 net income 39,000 84,000 shareholders equity 845,000 756,000  Return on assets 0.046 0.11 Looking at the above-calculated ratios, the gross profit margin has slightly declined from 0.42 to 0.38. This may be as a result of the purchases on vehicles, fixtures and furniture’s made during the year. There is also a slight decline in the net profit ratio from 0.20 to 0.13 and this may be as a result of the extra costs the firm incurred during the year. The return on assets has decreased from0.11 to 0.046 while the return on equity has also decreased from 0.09 to 0.04. The differences are because of the reduced net income from 84,000 to 39,000. ii) Liquidity ratios These ratios provide information about a firm’s ability to meet it obligations in the short-term. The first liquidity ratio is the current ratio given by the ratio of current assets to current liabilities. You find out that creditors prefer a high current ratio because they are assured that their risk is reduced while the shareholders prefer a lower current ratio so that more assets are used in helping the business grow. That is why the financial statements should reflect a true and fair view regarding the financial information presented such that the users can rely on it for decision-making purposes.   2010 2009 current assets 396,000 282,000 current liabilities 238,000 228,000 current ratio 1.66 1.24 Then we have the quick ratio given by the current assets less inventories over the current liabilities. The quick ratio does not consider the inventories because inventories is composed of items that are difficult to liquidity and values that have the element of uncertainty when it comes to liquidity. The quick acid ratio is just an alternative measure of liquidity. 2010 2009 current assets less inventories 160,000 134,000 current liabilities 238,000 228,000 Quick ratio 0.67 0.59 The current ratio has increases from 1.24 to 1.66 while the quick ratio has a slight increase from 0.59 to 0.67. This may be as a result of the increase in current assets during the year. As pointed out earlier, such an increase will only favor the creditors since their risk has been reduced meaning they have a degree of surety that their obligations towards the firm can be met. iii) Efficiency ratios There are two common assets turnover ratios, the receivables turnover and inventory turnover (Birt and Gregory, 2010). Receivables turnover = annual credit sales/Accounts receivables Days debtors = 365 / Receivables turnover   2010 2009 Credit sales 1,200,000 1,180,000 Receivables 156,000 102,000  Receivables turnover 0.13 0.09 Days debtors 2,807 4,056 The receivables turnover, which is an indicator of how quickly the firm collects its debts, has increased from 0.09 to 0.13. Also the numbers of days that credit sales remain in the accounts receivable account has reduced from 4,056 days to 2,807 days. This great improvement is due to the firm’s improvement in collecting its dues from debtors. There are advantages to be realized when the debtors collection reduces of course. One, the liquidity position of the firm improves. There are debtors at the end of the period are likely to be less and also chances of writing off bad debts are minimal. Also, the expenses that would have been incurred in following up bad debts reduce. Inventory turnover = cost of goods sold /Average inventory Days inventory turnover = 365/ Inventory Turnover   2010 2009 cost of goods 750,000 680,000 Inventory 236,000 148,000 inventory turnover 3.17 4.59 days inventory turnover 115 days 80 days The inventory turnover has decreased from 4.59 to 3.17 an indicator that the stocks take longer in stores before they are turned into sales. The number indicator of days that stocks remain on hand has increased from 80 days to 115 days, a poor indicator that the firm is holding its inventories in the stores a longer period compared to the previous trading period. This is not good as the sales will be affected in such a way that they reduce. Therefore, the firm should look into a way of solving this issue regarding holding stocks for longer period. Some of the issues may be that the customers might have switched their interest to a competitors commodity leading to less sales, and in return more stocks being held for longer period. In such a case, it is vital to conduct a customer survey and analyze the markets to determine what customers really need. The days of creditors = (annual credit purchases/annual credit ors) 365 days   2010 2009 Credit purchases 750,000 680,000 creditors 76,000 234,000 Days creditors 3,602 1,061 From the table above, the number of days credit purchases remain unpaid by the creditors has increased from greatly from 1,061 to 3,602 days. Such a change has been caused by the decrease in the number of creditors. iv) Financial stability The financial stability is used to provide an indication of the firm’s solvency in the long-term. Solvency is a state said to occur when the total assets of the firm are more than its liabilities or debt. If the liabilities are more than the assets then the firm is said to be insolvent as it is not in a position to meet its obligations. There are two ratios commonly used, the debt ratio, equity ratio and debt to equity ratio. Debt ratio = Total debt / Total assets Debt-to-Equity Ratio = Total Debt/Total Equity Equity ratio = Total Equity/ Total assets   2010 2009 debt ratio 0.046 - equity ratio 0.46 0.51 Debt to equity ratio 0.1 - The debt ratio has increased from nil to 0.046 and this is as a result of the bank loan acquired during the year. On the other hand, there is a slight decrease in the equity ratio from 0.51 to 0.46. This slight decrease may have been caused by the increase in the total assets during the year. Finally, the debt to equity ratio has increased from zero to 0.1 as a result of the acquired bank loan by the firm during the year. The increase in the debt ratio and the debt to equity ratio is an indicator that the firm is unable to become insolvent in future. This means that in future it might be faced with difficulties of settling its long term obligations. Previously in year 2009 the values of these two ratios were nil therefore it is still early to conclude that the solvency of the firm is at risk. It would be justifiable to make serious analysis in the subsequent trading periods. On the other hand, the equity ratio has decreased slightly from 0.51 to 0.46 an indicator that the assets available have reduced the ability of generating wealth to the shareholders. b) Performance of Prolong Ltd If the suppliers supply to the firm a substantial number of items on credit terms the accounts payable will grow large with time. We have noted that the number of times that the stock is to be turned into sales has reduced meaning by the time the stock items are sold, a long period will have passed. The effect is that the firm may get is the problem with its liquidity ratio. This is because t the rate at which the sales revenue will flow in reduces also making the firm unable to pay the suppliers earlier enough. This might result to a conflict between the firm and the suppliers in future requiring either a change in credit terms or the suppliers withdrawing their services from the firm. The effect may also extend to other suppliers who were previously interested in offering their services. The other problem may be posed to the profitability of the firm as it may go down. This is due to the reason that the credit sales reduces while the substantial amount of credit purchases goes up. Therefore, the firm should deeply take into account early in advance the adverse effects that can be posed if it is to accept the terms of that firm which is considering in supplying substantial items in credit terms. Not only will this affect only the supplier but other stakeholders of the firm. Reference Birt and Gregory Boland (2010). Accounting: Business Reporting for Decision Making. Wiley and sons publishers. Read More