Introduction
The report discusses the outcome of the financial analysis of Fresh Fashion for the period of three years beginning 2014 .As part of this analysis, we will exclusively focus on liquidity assessment, and inventory and account receivable management of the company. While the sole objective of framing this report is to appraise the investment opportunity in the company’s stock, however, since we are only using financial ratios as the tool of assessment, we will also discuss some of the limiting factors of financial ratios.
Ratio Analysis
Financial ratios allow us to transform raw financial figures into useful multiples, which can then be used to construe the financial standing of the company. Below discussed are some of the financial ratios of Fresh Fashion for the year 2015 and 2016:
i) Liquidity Analysis
Liquidity ratios help us construe the working capital position of the firm and how well it can meet its short-term obligations. Our calculations revealed that compared to 2015, the liquidity position of Fresh Fashion has improved up to a commendable level. Beginning with the current ratio of the company, the multiple increased from 1.84 to 2.3 on account of 47.2% increase in the current assets compared to 17.64% increase in the current liabilities. We also analyzed the liquidity position using quick ratio and found that the multiple increased from 0.73 to 0.94. However, it is considerable that over the year time, the cash holding of the company decreased by nearly 60% and a greater proportion of the increase in the current assets was sourced through 75% increase in the accounts receivable.
Therefore, we propose a neutral rating for the liquidity position of the company.
ii) Account Receivable and Inventory Management
In order to access the accounts receivable and inventory management process of the company, we calculated the concerned efficiency ratios. Important to note, these ratios allow us to analyze the effectiveness of the management in relation to the assets owned by the company. As for inventory management, our calculation revealed that compared to 98 days of inventory period in 2015, it takes one more additional day for Fresh Fashion to sell its inventory. Additionally, compared to the industry average of 65 days for the inventory turnover, the increase in inventory turnover period is more worrisome for the company and for the investors also, because higher is the inventory turnover period, more will be a burden on the liquidity position as capital remains invested in the inventory for a long period of time.
On the other hand, as for receivable period, the trend was ebullient; albeit the trend seems to be sustaining only for a short period of time. During 2016, Fresh Fashion collected its bills in approximately 46 days compared to 57 days in 2015. Even though this might have added much needed cushion to the liquidity position of the company, however, two factors raise our concerns whether the company will be able to continue the trend in 2017. Important to note, during 2016, 88% of the company’s sales were on credit basis compared to 80% in 2015. Therefore, with additional debtors, it is probable that in 2017, the company might witness delayed payments and bad debts and this might badly affect the liquidity position of the company.
Limiting factors for the ratios
i)Current Ratio
Calculated as the ratio of current assets to the current liabilities, this ratio indicates the proportion of current assets owned by the company relative to the current liabilities. However, since the ratio includes the inventory balance held by the company, the difference in the inventory valuation methodology adopted by different companies can affect the utility of the ratio. For instance, if one company in the industry is using LIFO inventory valuation, the value of closing stock will be lower compared to the other company, which values its stock using FIFO inventory valuation. In this case, current ratio loses its utility.
ii) Gross Profit Ratio
Calculated as the ratio of gross profit to the revenue figures, this profitability ratio suffers from the limiting factor that it doesn’t consider all costs into consideration and moreover, it is a subjective choice for the company to include the relevant costs, which he considers to be cost of direct production. Therefore, there is no set consensus as what is the acceptable gross margin ratio. Therefore, no analysts prefer to comment on the profitability position of the company using gross profit ratio alone; rather, the profitability analysis is always clubbed with operating margin ratio or the net profit margin ratio.
c) Inventory Turnover Ratio
Inventory turnover ratio reveals how quickly the company sells goods, i.e. from the time they purchased till the time they are sold. Even though this ratio is important for the company, however, since it only reveals average days of turnover, the company is unable to find out turnover of each individual product. For instance, if the company holds the inventory of an ancillary product, which it does not sell on the seasonal basis only, the inventory turnover ratio will still consider this inventory balance even though its performance has no major influence on the company’s cash cycle.
Recommendation and Conclusion
Referring to the above discussion, we issue a hold recommendation for Fresh Fashion’s stock as even though the liquidity and asset efficiency has improved marginally, however, the company is betting majorly on the credit sales, which in the upcoming year can turn deleterious for it considering decreasing cash balance and net profitability. Therefore, we recommend you not to invest in the company’s share immediately and rather wait for another year to see how effectively it collect its increased receivables and earn sustainable profits.
References
Kaplan . (2012). Financial Analysis and Techniques. USA: Kaplan Inc.
Mulligan, T. (n.d.). The Disadvantage of the Gross Margin Ratio. Retrieved January 25, 2017, from http://yourbusiness.azcentral.com/disadvantage-gross-margin-ratio-7456.html
Tracy, A. (2012). How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet.
Ulrich Wiehle, M. D. (2005). 100 IFRS Financial Ratios. Cometis AG.
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