Analyzing Financial Statements 2013
Ratio analysis makes it possible to compare performance within the current year against performance in previous year. A trend can be established to determine areas which are expanding and the ones contracting.
The profit margin ratio is one of the profitability ratios and indicates the extent to which costs of goods sold are being controlled in relation to sales income.
The inventory turnover ratio is one of the efficiency rations and measures the efficiency of the business in keeping its inventory as low as possible in relation to sales; the more time the inventory is turned over, the more profit the business will generate.
The total asset turnover ratio measures the efficiency of the company in how it uses its assets against the sales that generates. It is one of the efficiency ratios.
2. Information and analysis
Super Kool Industries VS industry averages
The effect of an apparent change in pricing policy which has led to increased sales volume is not reflected in the inventory turnover ratio. The company turned over its average stock 4.4 times during the year 2010 compared to 4.5 times in the previous year, almost the same. It is also quite similar to the industry average, which may indicate that the turnover of inventory within the industry is slow.
The total asset turnover ratio has decreased from 0.75 in 2009 to 0.67 in 2010 and it is below the industry average of 1.2. This may indicate that the company has a problem with some of the asset categories, or all of them, within the total assets, i.e., inventory, receivables, or fixed assets. It may be possible that the company is not selling inventory fast enough, but this would not be the case as the inventory turnover asset is quite similar to the industry average for 2010; however, the level of inventory has been increased from 60,000 in the year 2009 to 93,000 in the year 2010, as per the Balance Sheet. On the other hand, the company may take too long to collect payments and the credit balances may also take too long to clear. The accounts receivable balance has increased, as per the Balance Sheet, by 53,000 from the year 2009 compared to the year 2010. It is also possible that the company is not utilizing all its assets efficiently to generate sales; the company has increased its plant and equipment, but the ratio has decreased, being lower than the industry average which in 2010 is 1.2. The low ratio shows that the company’s sales are sluggish.
The level of inventory has also increased from 60,000 in the year 2009 to 93,000 in the year 2010, which indicates a high risk of inventory becoming obsolete or damage and unable to be sold. It also ties up part of the cash that the company requires to improve its liquidity.
The company has a cash flow problem as its liquidity ratio, the quick ratio, is below 1, and lower than the industry average. Although it has improved slightly in the year 2010, 0.6, compared to 0.56 in the year 2009, it shows that the company’s weakness in its ability to pay its liability in the short term.
In the year 2010 a total of 63% of the company’s assets are financed by the creditors and 37% is financed by the owners, compared to 55% financed by the creditors and 45% financed by the owners in the year 2009. As the debt to total assets ratio is high, the risk associated with the company’s operation is also greater. Consequently it indicates low borrowing capacity of the company, which in turn will lower the company’s financial flexibility. The company is in danger if creditors start to demand repayment of debt. The industry average is 40%.
The accounts payable has also increased from 115,500 in 2009 to 195,300 in 2010, which indicates that the company is using its creditors to finance the company and confirms the cash flow issues that it has, making it difficult for the company to meet its liabilities. And it has also borrowed more from the bank by increasing its bank loan. Consequently the creditors are financing a higher percentage of the company compared to the owners. It may represent a risk of the company that is unable to generate positive cash flow.
The Income Statement shows that the earnings before interest and tax have decreased despite the increase in sales and gross profit. That is because the operating expenses have increased more than the gross profit. The company has not been able to control its operating expenses in relation to sales.
On the other hand, the inventory turnover ratio indicates that the company is at the same level as the industry average, but it does not mean that the company could not do betters due to the fact that the company has turned over the inventory slower than it should and that is affecting its earnings and its liquidity and it is not turning over the inventory fast enough to increase sales and improve cash flow.
The total asset turnover ratio in 2010 is 0.67, which is lower than the industry average and that may be because the company is being very slow in selling inventory. Besides, if it is also increasing its accounts receivable balance and taking longer to collect payment from customers it may indicate that the company is facing a liquidity issue which may lead to possible insolvency of the company or difficulties to generate positive cash flow.
The quick ratio also confirms the liquidity issues above mentioned as it is below 1 and also below the industry average. A reasonable quick ratio is 1.5, but the company has a quick ratio of 0.6 in the year 2010. It is a sign that the company is facing cash flow problems when it comes to meet its liabilities when they fall due. That may explain why the company is financed by creditors on a higher percentage, when it should have higher percentage financed by its owners. It may be because it has a liquidity deficiency which would make more difficult for the company to meet its liabilities.
The Balance Sheet shows that the current assets and the fixed assets have been increased; however, the current assets are lower than the current liabilities. It may also be possible that the increase in fixed assets may have been financed by further debt as the long-term liabilities have also been increased.
3. Conclusion
The company shows in the Income Statement an increase in sales and gross profit, but it has a cash flow problem and it would find it very difficult to meet its liabilities when they fall due. It would also be in difficulties if the creditors decided to demand repayment of debt. There is too much financed by the creditors, and, although it has increased its assets, it has also increased its long-term liabilities.
The company has a very high balance in the account receivable which needs to be address and a better credit control system needs to be put in place. On the other hand, it may consider to review its credit terms with its customers so payment can be made earlier or offering an early payment discount in order to incentive prompt payment. If the credit control or the collection period does not improve and the company does not address the issue in order to reduce that balance and to receive the money owed to it faster, it may face the risk of a higher level of bad debts. The longer the period is the more difficult the collection will be and the company will reduce its chances of receiving payment.
The financial ratios show the weaknesses of the company and the areas required for improvement. The ratios may indicate that, in an attempt to become competitive, the company has taken more risk by increasing its borrowings, relaxed its credit control and been financed by creditors; it is also possible that it has a very poor credit control or lack of it and it has not reviewed its credit terms with its customers or they may be paying its creditors faster than they can afford.
There may also be a lack of financial management and cost control. Although the company is profitable by looking at the Income Statement, however, its existence as a going concern may be at risk if it does not address its liquidity issues, as profit and cash are not the same thing and no company can survive without the cash or if it is unable to generate cash, which is connected to timing, compared to profit. Therefore a profitable company can become insolvent.
The company is performing, as it is making profit, but it does not seem to control its costs of goods sold and overheads as well as it should. On the other hand, it shows a lack of cash which affects the liquidity of the company. It also shows a lack of control on acquisition of fixed assets and the financing of the company, as it is mainly financed by debts and creditors; that affect its cash flow position.
Sources: Income Statement, Balance Sheet and Financial ratios.
