Executive Summary
This work is about the preparation, appraisal, and interpretation of financial statements. The financial statements considered herein are Cash Flow Statement, Trading Profit and Loss Account (Income Statement), and the Balance Sheet of SIMPLECO PLC. Based on the provided information, the above statements are prepared and analysed so as to determine the financial position of the company. The analysis involves calculation and interpretation of the financial ratios. These ratios fall under three categories: profitability ratios, liquidity ratios, and leverage ratios. A conclusion is finally made concerning the performance of the company based on its financial position.
Introduction
Financial statements play a very important role in assessing the financial performance of an organization. Such statements show the financial position of the organization at the stated time. When preparing the financial statements, it is important to handle every item correctly since any slight error results into a wrong conclusion.
Profitability ratios are derived from both the Income Statement and the Balance Sheet. These ratios measure the general profitability of the company with regard to the profit generated. Considered herein are the Return on Investment, Operating Profit Margin, Gross Profit Margin, Return on Equity, and the Investment ratios.
Liquidity ratios measure the ability of the company to meet its short-term obligations. Considered herein are the Current ratio and the Net working Capital Ratio. Leverage ratios, on the other hand, indicate the degree at which the company is funded by the non-owners. In this work, I have considered the Debt equity ratio, and the Interest cover ratio.
The following ratios are suggested to be used to help give an in depth understanding of the financial health of the Simple Company Plc. Basically; analysis is geared towards the profitability ratios, leverage ratios, activity ratios and the liquidity ratios. For the profitability ratios, net profit margin ratio is analyzed to show the profitability of the company. Profitability ratios show how effectively a company uses different funds to generate profit or returns. Leverage ratio analysis is undertaken to determine the extent to which the company has been funded by the non-owner supplied finances. Activity ratios measure the degree of efficiency that the company is using its various assets to help in revenue generation. It besides indicates how actively assets are. Liquidity ratios however are used to determine the capability of a company to meet its maturity demand and whether it is in a position to pay off its operating trade payables.
Liquidity ratios
Current ratio
This is a liquidity ratio determining the ability of the company’s current assets to balance off current liabilities hence indicating the liquidity position of the company. A situation where the current ratio is high indicates a better liquidity position of the company, otherwise poor liquidity position.
Current ratio formula
Working
=Current Assets /Current Liabilities
=900,000/102,000
=8.8:1
The current ratio of 8.8:1 is extremely high and this indicates that the company has a better liquidity position. There are sufficient current assets that help the company meet short-term maturity obligations with a lot of ease. It shows that the company is more liquid thus able to meet its short-term maturity obligations.
Net working Capital Ratio
This ratio as well shows the capability of any company to meet its short-term maturity obligations.
Formula
Working
{current Assets-current liabilities}/net Assets
= {900,000-102,000}/1,743,000
=0.46:1
The net working capital ratio of the company is worse indicating that the working capital is not sufficient to meet short term obligations. This indicates poor liquidity position of the company. It should be higher than 46% due to reason that when it’s higher, the firm becomes more liquid.
Leverage ratios
Leverage ratio measures the degree to which a company has been funded by non-owner supplied finances. It shows chances that a company will not be able to set off its debts. Too much non-owner supplied funds presents a financial risk to a company.
Debt equity ratio
This ratio shows level of non-owner funding in a company.
Formula
Working
=Debt/ Net worth or shareholders funds.
=375,000/1,743,000
=0.22:1
The company’s debt equity ratio is moderate (0.22:1), signifying that every £1 invested in the company by the owners, the creditors have only put 22 cents. This shows that debt equity is under check by the company and likely not to get out of control any soon. It generally indicates that non-owner financing in relation to amount supplied by owners is moderate.
Interest cover ratio
Formula
Working
=(Net profit + interest + tax)/Interest payable
= 1093,000/ 50,000
=21.86:1
From the calculation, it’s evident that interest cover ratio is 21.86% signifying that the level of interest payable is under control.
Profitability ratios
Return on Investment
This measures the rate at which a company’s assets generate returns to help maximize profit.
Return On investment
Working
(Profit Before Interest and Tax/Capital Employed) X100
1093000/(1000000+1043000+375000) X100
45.2%
Return on investment ratio measures the profitability of the assets towards generating returns for net profit maximization. This ratio shows that less asset is efficiently put in use to generate returns. A 45.2%rate of return is a low value for a profitable firm. It thus signifies that there is laxity or inefficiency in using assets to generate income for the company.
Operating profit margin
This measures the general profitability of the company with regard to the profit realized compared to sales revenue.
Operating Profit Margin
Working
(Profit before interest and Tax/sales) X 100
(1093000/1500000) X 100
72.9%
From the workings, it is evident that the company makes a profit of 72.9%. For a newly established company, this is a good start as the company is able to realize more than half, extra 72.9% earnings. It shows that the firm is profitable and more investments can be made to improve returns.
Gross Profit Margin
Gross Profit Margin
Working
(Gross profit/sales) X 100
(1400000/1500000) X 100
93.33%
A 93.33% margin indicates that the company is highly profitable.
Return on equity
Formula
Working
= Earnings after Tax/ Ordinary shares + Net profit
= 1043,000/ (1,000,000 + 1043,000)
=0.51:1
A ratio of 51% of return on equity shows how efficiently the company is using the owner’s capital to generate returns. There is only a return of 51% from the owners’ capital.
Investment ratio
Earnings per share
Formula
Working
(Net profit less preference dividend)/issued ordinary shares
= 1043,000/500,000
=2.086
This is the return expected by an investor for every share held in the firm.
Price earnings ratio
Formula
Working
Market price per share/earnings per share
= 2/2.086
=0.96:1
0.96 is the return amount expected by a shareholders for every £ invested in the company.
How Ratio Analysis can be useful to predict the financial health of a firm and its limitations
A firm’s ratio analysis comes with different objectives. Basically, firms undertake to compute these ratios to evaluate the information gathered from the computation of financial income statements, balance sheet and cash flows statements. Profitability, liquidity, leverage, market ratio and cash flow ratios present useful information about a firm’s financial position. Profitability ratios help predicts a firm’s profitability status in the short term. It is of importance in financial health analysis in that it shows how effectively a company uses different funds and even assets to generate returns. The ratio helps predict the efficiency with which the firm uses various funds to generate profits (Bernstein and John, 2000). For instance, net profit margin ratio help predict financial position of a firm by showing the management’s capacity to control the diverse expenses in the firm to realize profit.
Leverage ratios predict to the investors the extent to which a firm has been financed by non-owner supplied funds. It predicts chances of a company’s ability to set off its debts. Too much non-owner supplied funds predicts a financial risk to a company. In situations where debt ratio and debt equity ratio are higher for instance predict poor financial health of the firm as it’s a clear indication that the firm is not in position to run with owners’ funds in case outsiders pull out (Bernstein and John, 2000).
Liquidity ratios on the other help predict the firm’s capability to meet its short term maturity obligation like for example how efficiently current assets settles current liabilities. It thus predicts the liquidity position of any firm (Eric, 1999).
Financial ratios thus generally predict how profitability, turnover and market ratio influences stock return. This results in a firm’s trend analysis. A firm is thus in a position to notice good and bad trends and adjust as deemed right (Eric, 1999).
However, there are a number of drawbacks of ratio analysis when employed in predicting financial health of a firm. Ratios are computed from historical data. A company’s historical data is not a good indicator of its future. This makes a company operate towards a bleak future. Besides, their computation is undertaken at a point and this is likely to be affected by short term changes. This implies that they cannot be used for long term planning (Eric, 1999). Another limitation is their likelihood of not presenting exact comparison to other companies. Various firms use diverse accounting policies and methods, for instance, on provisions and depreciation. The variation in accounting policies employed makes comparison of financial status impossible. Using ratios to carry out inter-company comparison is difficult. This is because it’s not easy to group companies in assorted industries due to diversification. Lastly, in case of a monopolistic company, it’s always complex to carry out inter-company comparison (Daniel, 1997).
Conclusion
The main financial statements, whose importance cannot be overlooked, in evaluating an organization’s performance are the income statement, balance sheet and the cash flow statement. Depending on the transactions carried out within the considered financial period, the above statements can be prepared as given above. The evaluation of these statements dictates that ratios must be calculated; whose analysis reveals the financial strength or weakness of the organization. A high value of the profitability ratios indicates that the company is profitable. Profitability results from good use of the assets and equity as measured by the return on investment and return on equity respectively. A high value of gross profit margin, operating profit margin and net profit margin all depict the firm’s profitability. A high value of liquidity ratios indicate that the firm is able to meet its short-term obligations, while a high value of leverage ratios indicate that the firm is financed by the non-owners. The interpretations of the individual ratios are elaborated in the case study of the SimpleCo PLC.
References
Bernstein, L. and John, W., 2000. Analysis of Financial Statements. McGraw-Hill
Daniel, L., 1997. Advanced Accounting. McGraw-Hill College Publishing.
Eric, P., 1999. Analyzing Financial Statements. Friedman Lebahar.
