Financial Performance of Digital Solutions Associated Plc - Case Study Example

Introduction to Accounting [Student’s Name] [Institution Name] [Tutor’s Name] 20 March, 2013 Executive summary This paper is a report for the managers of Digital Solutions Associated plc, DSA giving a recommendation on which office should be closed. The report contains analysis of the financial performance of each of the Leicester, Nottingham and Kettering divisions. This report makes an analysis and interpretation of accounting ratios for the three divisions. The report evaluates the profitability, liquidity and stability (gearing) of the Leicester, Nottingham and Kettering divisions to determine which of the three divisions should be closed. The report is based upon a thorough analysis of the financial statements of the three divisions for the year to 31 December 2012. The report makes recommendations regarding the closure of one of its divisions and it is expected that the managers will follow recommendations from this report when making this important decision. The report has recommended that DSA should close Nottingham division. This recommendation has been arrived at after analyzing the financial performance of all the three division which established that Nottingham division is not financially attractive as Leicester or Kettering divisions. Introduction The best measure of financial performance of a company is not what the company earns. It is how those earnings are valued by the investors (Amenc and Le Sourd, 2003). When analyzing the company’s performance, investors will consider the risk inherent in the operations of the firm, the time pattern over which the earning rise or fall, the quality and reliability of reported earning among other factors. The management of the firm should try maximizing the wealth of the company’s shareholders through achieving possible value of the firm. For the purpose of financial statement analysis, emphasis will be made on the balance sheet and the income statement. The income statement reveals the performance of the company during a particular period of time, for instance, for the period ended 31 December, 2012. It shows the revenue from sales and various costs including wages and salaries expense and taxes which the company has incurred during the period. The balance sheet states the company’s assets, liabilities and equity as at a particular date Factors to consider before closing any of the divisions The managers of DSA should take into considerations many factors before deliberating on which office to close. The managers should make a thorough analysis of the financial reports of the divisions in order to ascertain the profitability, liquidity and stability (solvency) of the divisions in question. Profitability A profitable division has high chances of meeting its debt obligations as opposed to a division that constantly realize loss out of its operations. The profitability of the division is determined by the profitability ratios of the division. These ratios indicate the ability of the division to make profits or returns from its investment (Davis, et al., 2009). This includes profitability in relationship to sales and profitability in relationship to investment. Since profitability ratios are measures of the ability of the business to make profits or returns from its investment, profitability indicators of 35.38%, 23.33%, and 51.85% for Leicester, Nottingham and Kettering divisions respectively suggest that all the divisions are profitable. The higher the percentage is the higher the profitability of the division. Therefore, based on this analysis the management of DSA should close Nottingham division since it is the least profitable. There are several measures that can be taken to guarantee the future profitability of the divisions. One of the ways is ensuring the productivity of employees is maximized by using the right number of workers. The reason being a firm cannot pay good salaries and other privileges to its employees without reducing its profits. This is the case because such privileges constitute a cost chargeable to the income statement thus reducing profit for the period. Liquidity A business venture that has a good liquidity position is in a better position to honour its financial obligations when they become due for payment. The liquidity of the business is shown through the liquidity ratios. These ratios measure the ability of the business to meet the short term financial obligations of the business as and when they fall due. As the current ratio is a measure of the ability of the business to meet its short term debts from its current assets current ratios of 2.5:1, 1.2128:1 and 1.1176:1 for Leicester, Nottingham and Kettering divisions respectively suggests that all the divisions have good liquidity position and should be able to meet its current liabilities when they fall due. However, if we consider the quick ratio we arrive at a more precise judgment for the case at hand. This ratio overcomes the major limitation of the current ratio as a measure of liquidity which is the inclusion in the current assets figure some assets that may not be highly liquid, such as stock. The quick ratio, which does not consider stock, helps to offset this problem. The ratio reveals the extent to which current liabilities could be covered by current assets excluding stock. The quick ratios for Leicester, Nottingham and Kettering divisions are 1.2273:1, 0.4255:1 and 0.6471:1 respectively. The ratio for Nottingham division is the minimum which shows the division is not in a position to pay its debt obligations from its very liquid assets. Stability (solvency) Financial stability of a company is measured by the gearing ratios which indicate the extent to which the company has borrowed fixed charge capital in order to finance its assets. The report will consider debt ratio in order to offer a credible advice on the financial stability of the three divisions. A stable business can continue being in business for a long time and is not likely to default in its debt repayment. As stability ratios are measures of the extent at which the business has borrowed fixed charge sources of finance in order to finance its assets, solvency indicators of 0.1818:1, 0.4947:1 and 0.2019:1 for Leicester, Nottingham and Kettering divisions respectively suggests that all the divisions have a heavy debt burden against its assets. This implies that the claims of the creditors against the assets of the business are maintained at the maximum and therefore the management of DSA should close either of the offices since there is the fear of the divisions being declared insolvent. Recommendations This report recommends that your firm should close Nottingham division. This is because the division is the least profitable as has been established by its low profitability ratio of 23.33%. In addition the division is not in a better position to pay its debt obligations from its very liquid assets compared with either Leicester or Kettering divisions since its quick ratio of 0.4255:1 is the least. The report recommends that the managers consider increasing debt financing. This is because all the divisions maintain low debt asset ratio which indicates that they are mostly financed through other finance but debt financing is not the major. This means the divisions do not take advantage of tax benefit as a result of utilising the debt financing. It is also recommended in this report that Kettering division should retrench some of its employees since its wages and salaries component in its income statement for the period ending 31 December 2012 is very huge which is not reflected in its turnover. This will help to reduce the cost charged against the profit made by the division since wages and salaries are charged against the profit of the division. This by extension will improve the profitability of the division hence a sure way absorbing the shock resulting from the heavy fine imposition on the company. Conclusion The report has analyzed and interpreted the accounting ratios as calculated from the financial statements of Leicester, Nottingham and Kettering divisions to determine which of the three divisions should be closed. The report used the profitability, liquidity and stability of the divisions to arrive at a conclusion that Nottingham division should be closed. These tests, though not a conclusive evidence for closing a division, they form good basis for making decisions from an informed position. The primary limitations of accounting ratio analysis as a technique of financial statement analysis are: Ratios are retrospective and do not directly incorporate forecasts of future performance of a firm. Ratios only indicate potential problem areas; they do not identify causes of problems. Ratios do not provide absolute measures for evaluation; rather they must be analyzed against some standard. The choice of an appropriate standard for comparison can sometimes be a difficult one. Ratio analysis does not have any meaning when used on its own. It has significance only if studied in appropriate context and when compared over a period. References Amenc, N. and Le Sourd, V., 2003. Portfolio theory and performance analysis. New Jersey: John Wiley and Sons. Davis, D. et al., 2009. Companies and other business structures: commercial law. Oxford: Oxford University Press. Read More