The Horizontal Analysis
In the horizontal analysis of the company, one considers the various line items in the income statements and the balance sheet with similar items in the previous years. Looking at the year 2008, the company did not perform well. In terms of sales, there was a decrease in the sales compared to the year 2007. There was a decrease of $ 897,000 which is 15% of the sales revenue.
As a result of the low sales, the company suffered a loss in the gross profit. The profit reduced from $1.6M to $1.4M. When analysing the expenses, the website creation and maintenance is a fixed expense that was at a standard price throughout the years. The other variable operating expenses and research and development expense reduced for the year 2008. There are expenses such as administrative salaries, executive compensation, employment taxes, payroll taxes and depreciation which did not vary at all compared to the year 2007. There was an increase in expenses in the utilities and other general and admin expenses.
An increment in expenses should be supported in efficient and effective operations. The company should have mechanisms to ensure that the increase in expenses goes hand in hand with higher sales revenues or profits. Then the increase will be justified. The company has shown that it is able to control its expenses however; there should be strategies to increase the sales revenues.
The balance sheet horizontal analysis shows more of the company’s strengths and weaknesses. In 2007 the cash and cash equivalents had decreased by 54.6% compared to 2006. The company improved its cash balances by increasing the amount by 275.4% in 2008. It was a good effort although the excess cash can be used for investment in short-term securities. The company in 2007 had raised their investment in short term securities by 10.8%. However, the company did not invest in the year 2008 as the balances were constant. This was not a wise decision. The company did well to reduce its accounts receivable by 15% in 2008 in order to reduce the amount of money tied up in current assets. In 2007 the accounts receivable had increased by 164.3% compared to 2006. The company did well to reverse the trend. There was an increase in the raw materials inventory however it was not a significant amount.
The company maintained the amount range it had been operating at for the three years. The work in progress balances were constant: there was no change. In 2006, the balances had been less by 31.8%. The company should consider going back to lesser balances in order to reduce the cash conversion cycle. The company has been steadily increasing its balances in other current assets. These could be prepaid expenses which is a great sign. There was no change in the fixed assets for the three years. The company should explore more investment in fixed assets to increase the production capacity. With the capability to produce more, it will have to look into ways of selling more products in the market and get higher revenue.
The company has been steadily increasing its accounts payable which is not advisable. Lengthening the period of payment improves the liquidity of the company. There has been a steady increase in the accrued expenses. This is not a good sign and the company should aim to reduce the expenses. The long-term liabilities and shareholder’s equity balances have not had significant changes. They have remained in the same range which is okay.
The Vertical Analysis
In this analysis the line items of the income statement are evaluated as a percentage of the net sales while the line items of the balance sheet are analysed as a percentage of the equity capital. In analysing the income statement, several things emerge. The company has been able to maintain the operating expenses at a constant percentage of the net sales figure of 6.7% for the whole three years. It has been a constant figure.
The general and admin expenses have not been constant, as a percentage figure of the net sales figure, it has been fluctuating. In the year 2006, it was at 17.1%. In the year 2007, the company had a commendable year where the expense reduced to 15.5%. All the expenses shot up in the year 2007 but also the sales of the company shot up. In the year 2008, there was a serious problem. Most of the expenses were constant while some shot up however the sales of the company did not shoot up as the figures for the previous year. More expenses were incurred to achieve lower sales. This shows inefficiency or ineffectiveness of the company. Due to the low sales, the company suffered low profits. The operating income in 2007 was 5.3% of the net sales however in the year 2008; it was only 1.9% of the net sales.
In the balance sheet, comparing the current assets of 2007 and 2008, the company significantly increased the cash balances from 2.3% to 10.3%. The company may have felt that the cash balances are low at $118,549. However, the increase was too high. The cash balances were increased up to five times. Too much liquidity policies inhibit the company from investing in profitable ventures. The short-term investments, raw materials inventory, work in progress and other assets had no change; they remained constant over the two years. The company should have invested more in the short-term investments in order to increase the profitability. The accounts receivable balances reduced from 16.6% to 14.1%. The company performed well in this area. The debt collection period should ensure that the company has not tied up a lot of its money in accounts receivable.
The fixed assets of the company that is the land, manufacturing plants and offices and furniture, fixtures and equipment remained constant. The company should have invested more in fixed assets in the business in order to increase their capacity in production. In the liabilities section, the company’s accounts and notes payable increased from 4.5% to 6.1%. This is a good sign since a delay in paying creditors increases the liquidity of the firm. Accrued salaries and other accrued liabilities remained constant. In the shareholder’s equity section, the common shares, paid in capital and treasury stock remained constant. There was an increase in the retained earnings from 27.2% to 28.1%. It was good for the company to increase the retained earnings. However the company should strive to earn more profits. The retained earnings in 2007 increased from 23.3% to 27.2%, a higher increase compared to the increase in 2008.
The Ratio Analysis
In analysing the ratios of the company, several areas of concern emerge. The current ratio of the company has been decreasing over the years. In the year 2008, the ratio was at 5.35. The current ratio is the relationship between the current assets and the current liabilities. It measures the ability of the company to use its short-term assets to finance the payment of its short-term obligations. It analyses the liquidity of the firm. The company has therefore been losing its liquidity and the management should look into the situation before it becomes too serious.
The same problem is noted in the acid-test ratio. The ratio is similar to the current ratio only that the inventory and the prepaid expenses are excluded from the current assets. It takes the assets which are considered to be more liquid. Again, the company has been reducing its liquidity and it is at its lowest in the three years to stand at 4.25. The ratio is above the recommended ratio in the industry is 2:1. The company should ensure the company is above the ratio. The ratio is however in excess and the company should start looking into how it can use excess liquidity for profit making.
The company has been on the right direction when it comes to the debt ratio. The ratio reduced to 45.9. The debt ratio is a measure of the company’s assets that are being financed by debt. The company has therefore been reducing on its obligations and using other means to purchase its assets which is advisable so that the company is not highly geared. The company however showed negative direction in net profit and gross profit margins. There was a decrease in the margins in the year 2008 compared to the year 2007.
In the year 2008, the operating profit margin reduced by a big margin. In the year 2007, the margin stood at 5.3% however in the year 2008, the rate came down to 1.3%. This shows that the company performed poorly. This ratio measures the amount of the company’s revenue that is left after the company has paid for its variable expenses such as employment benefits, wages and raw materials. The operating margin should be at a healthy level since it shows the percentage of revenue available to pay for fixed costs such as the interest on debt. Since the company’s sales revenue went down in 2008, the operating income margin reduced. The company should work hard to increase its sales revenues.
The average collection ratio of the company was constant at 43.8. This shows that the company did not change its policies or procedures when it came to the period the debtors were allowed to pay the debts. The company however should strive to reduce the period since it is performing poorly. The collection period can be reviewed later when the company starts picking up and making more sales.
There are however serious concerns when it comes to the earnings per share and the price earnings ratio. The shareholders of the company at the end of a financial year are
concerned with the earnings on their shares and the dividends receivable. In 2007, the EPS was at 0.20 but in 2008 it reduced to 0.04. Another line item that doubled was the price earnings ratio. It was at 49.67 but now it doubled to almost half of the previous figure to stand at 83.33. The ratio shows the comparison between the market share price and the earnings per share. A higher ratio shows that investors in the future expect the company to perform better despite the challenges the company has been facing. It is however a ratio that is used well when analysed in comparison with price earnings ratio of other companies. Its competitor, Two wheel racing had a lower ratio at 29. This shows that the investors and market confidence is higher in Competition Bikes than in its competitors.
The other concerning ratio is the return on capital employed or equity which reduced from 8.5% to 0.8%. This is a measure of the returns that the company’s investments give the company in relation to the capital employed. This shows that in the year 2008, the assets did not give as high a return as the previous year.
The return on total assets was also poor since it reduced to 0.8% in 2008 in comparison to 4.5% in the previous year. The last ratio to be analysed is the times interest earned ratio. It reduced from 5.27% in 2007 to stand at 1.77% in 2008. The company performed poorly when it came to ratio analysis and the operational weaknesses should be addressed.
Trend Analysis
The trend set by the company in the year 2008 when it comes to the sales figures is
not a favourable trend. Taking 2006 as the base year, in 2007 the company’s sales went high with the company’s sales standing at 133% of the sales at 2006. However in 2008, the sales went low with the company’s sales standing at 113% of the 2006 sales. Taking the 2008 sales and forecasting the sales for the next three years shows that the sales increase will be very low. By 2011, the sales for 2007 will not be achieved!! The company should therefore work to have a progressive sales figure over the years consistently.
Working Capital Management
The company should have efficient working capital management. The recommended working capital ratio is 2: 1 however the company has a high current ratio of 5:1. The company can improve its working capital management in various ways. First of all, it is observed that the company pays its suppliers or creditors after 15 days. However, the company’s creditors pay the company after a period of twenty days. The company should strive to reduce its average collection period. This refers to the amount of time it takes a company to receive money from its debtors or customers. Lesser collection periods are perceived to be the optimal or correct way to handle the company’s financial affairs. This is because the company will not take a longer period of time to convert its receivables into liquid cash (Gill, Biger & Mathur, 2010).
The company should also enter into talks with the suppliers in order to lengthen the credit period from 15 days to 30 days. Once the company is able to agree with its debtors and creditors it will have worked to increase its cash conversion cycle. This is defined as the period a company takes to convert its raw materials or inputs into cash by receiving cash from the debtors. It is made up of three components. It is made up of the amount of time taken to sell the inventories, the debt collection period and the creditor collection period. The cash conversion cycle of the company now stand at = 25days + 30 days + 15 days= 70 days.
The company as observed from its ratio has a high current ratio. This can be disadvantageous to the company. Its competitor, two wheel racing has reduced its working ratio to 4.1. A company should be able to manage its working capital requirements as a delicate balance between liquidity and profitability (Shelton, 2002). An adverse working capital ratio spells liquidity constraints on the company and it will not be able to settle its short term obligations in time and in ease. Creditors will not be impressed by the late payments and it may give the company a bad reputation in the market place. This will be disastrous as most companies rely on credit purchases in order to trade in the market place. Facing credit restrictions will strain the company. However, at the same time the company should be careful not to tie all its cash in inventory and cash receivables (Nazir & Afza, 2009).
The excess working capital should be used to assist the company to generate profit. It should be used to increase the shareholder’s wealth. The business should therefore reduce its working capital held up in current assets and invest in capital projects or fixed assets (Appuhami, 2008). The excess cash can also be used in other investment which will generate more cash flows for the company such as treasury bills and bonds. The company should avoid tying up its funds in the inventories and accounts receivables. The business however should not use aggressive working capital strategies which will increase the company’s profitability but at the risk of the company becoming insolvent (Padachi, 2006).
Internal Controls in the Purchasing Process
There are several risks that can emerge in the procurement or purchasing process which the management should be aware of. The internal controls that the company has should mitigate the identified risks. Looking at the purchasing process of Competition Bikes Inc, several risks emerge. There is the risk of ordering items that are already within or items in excess. It is therefore appropriate for the user department to requisition for what they need. They should explicitly write what it needs. The user department in the company is the production department. The purchasing department confirms the orders then asks for quotations from three suppliers in the industry.
The tendering and approval processes are processes that are vulnerable to fraud and corruption. There should be the presence of other officials from senior management and the finance department to ensure that the process is transparent and the correct procedures are adhered to. This prevents collusion between the suppliers and officials in the company especially the staff in the procurement department. Once the supplier has been chosen, the purchase order is sent. The other risk in the purchasing process is that the items delivered may not be at the prices, quality and quantity that were ordered.
There has to be a purchasing official who will confirm the packing note corresponds
with the purchasing order. Once everything is in order, the production department will receive the goods and confirm that everything is in order. The finance department will receive the invoice to pay from the purchasing department however it will only pay for the items on confirmation that the correct processes have been adhered to.
The finance department should have a copy of the requisition order, the purchase order, the delivery note and the invoice. All the item details in all these documents should tally. Where there are discrepancies, the head of finance will carry out investigations. The verification process before payment is critical since suppliers and company officials can work to defraud the company. The company should document the step by step processes in the whole procurement processes showing segregation of duties and the approving authorities. This will assist the management to mitigate procurement risk. Errors, fraud and other irregularities will be detected early.
Compliance with Sarbanes-Oxley requirements
The Sarbanes-Oxley requirements were set forth after the corporate scandals of companies such as Enron and WorldCom that shook the world. There are several requirements that the management are tasked with. The Act requires four things from the senior management. The senior management must accept the responsibility of establishing and implementing the internal controls over the firm’s financial reporting. The Competitor Bikes Inc has complied with the first requirement in its disclosures in the financial statements.
The second requirement is that the management is expected to disclose the effectiveness of the internal controls over the financial reporting process. The second requirement has also been fulfilled as the management of Competitor Bikes Inc disclosed that they assessed the internal controls over the financial reporting and found the system to be effective. The Act also requires the management to identify the framework that was used to assess the effectiveness of the internal controls. The Competitor Bikes management also complied with the third requirement and disclosed that they used the COSO (Committee of Sponsoring Organizations framework of the Treadway Commission). There is however a fourth requirement which the company did not comply with. The external auditors of the company are expected to attest to the fact that the management assessment of the internal controls is effective. In the Competitor Bikes Disclosures, there is no statement by the external auditors on the management’s assessment of the internal controls. The company needs to ensure that this requirement has been adhered to.
In analysing the section on the purchasing controls that the company has, it shows that the company has not complied with other Sarbanes-Oxley requirements when it comes to the assessment of internal controls. First of all, the company is required to carry out a fraud risk assessment. The internal controls in place should be able to prevent and detect fraud and other irregularities timely. The existent purchasing controls contain several loopholes as there are no specified controls when it comes to approval and validation controls.
There should also be controls over the financial year end reporting when it comes to cut offs. This is an area that can lead to material misstatements in the company accounts. It is also a vulnerable area of accounting manipulation. The company should have adequate internal control system covering this area.
The company is also expected to reveal all the off-balance sheet items. This is also an area prone to abuse. The management may be tempted to manipulate the assets in order to make the financial position of the company more favourable.
Non-Compliance Corrective actions
The management should critically analyse purchasing function and formulate policies and procedures with appropriate internal controls. All other processes in the company such as sales, production, human resource and marketing should be assessed in terms of fraud controls and clear guidelines included in the policies
The company should generally assess both the design and operating effectiveness of the internal controls. Weak controls are ineffective as they can give rise to situations where they are manipulated. The management should not be able to override the controls. The management should understand the flow of processes in all the departments. The policies should trace the entire transaction in all the related departments and show the specific internal controls in all the sub-processes.
Conclusion
Overall, there are several steps that the company has to take to improve its performance. The company should strategize and find innovative ways to increase its sales revenue. The 15% decline was due to the sponsors cutting back in supporting the professional riders. It is not good to be dependent on one main source of revenue. When the revenue source is cut off, the company suffers. The company should also look at its working capital requirements. It is not good for the company to have excess cash tied up in stocks and cash and cash receivables. The money can be used in generating profit for the company. The company should have a skilled professional in charge of its working capital requirements. The company can invest in short-term securities where it can earn interest income. The company should also work on its return on assets and capital employed. The shareholder’s value is enhanced when the return is higher. In the year 2008, the return on assets and capital employed reduced.
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