Financial analysis else referred to as accounting analysis is the assessment of the financial performance of the firm using its financial statements (Schroeder, Richard, Clark, & Cathey, 2009). Financial analysis helps the managers, investors and other stakeholders understand the stability, viability, and profitability of a firm or a project being undertaken by the company, thereby, helping in making appropriate investment decisions.
There are various distinct method of conducting a financial analysis that can be applied to any firm. One of the most common methods is horizontal analysis, else referred to as trend analysis. Horizontal analysis involves the comparison of financial ratios across a series of accounting or reporting period (Schroeder, Richard, Clark, & Cathey, 2009). For instance, comparing the performance of a company over a period of financial years to understand the profitability trend thus inferring whether management is making the right investment decisions. The second is the ratio analysis, which is a mathematical comparison of financial categories. It helps the stakeholders understand the internal performance of the firm and points to areas that need improvement (Mark). Crossly related to this is vertical analysis, which is a proportional analysis entailing comparing each line item of the financial statements as a percentage of another item most commonly sales. The proportions can be used in one reporting period analysis to show the performance or different aspects of the organization or over a period of time in trend analysis (Schroeder, Richard, Clark, & Cathey, 2009).
Financial ratio analysis
As aforementioned, financial ratio analysis involves the comparison of items or categories in the financial statement. Financial ratios are the resulting proportions expressed either as percentages or fractions. They are the most used financial analysis tools in the business performance analysis of most businesses (Financial Ratio Analysis, 2013). Financial ratios can also be used to compare the performance of different firms within an industry, or across various industries. They are easy to compute and understand and can be used to compare big and small companies. Different financial ratios communicate the performance of different aspects of the firm.
Fixed assets turnover ratio (FATR)
FATR is the proportion of net sales as compared to net fixed assets (Deegan, Michael, & Unerman, 2006). It indicates how well a company is employing its fixed assets to generate sales. A high FATR indicates that the company is effective in the use of its fixed assets to generate sales. A low FATR indicates that the company has excess capacity, has over-invested in fixed assets or is ineffective in using its fixed assets to generate sales.
Gross profit margin (GPM)
GPM is a proportion of the revenue collected less the cost of goods sold to the total revenue collected (Deegan, Michael, & Unerman, 2006). GPM reveals the financial health of a firm by revealing the proportion of sales that is available to pay for additional expense and profit. A low GPM may point to the firm being unable to pay its operational expenses and other additional expenses in the future. GPM is an important indicator of the expected profitability of the firm although, in itself, GPM does not directly indicate the profitability of the firm. It is advisable that a profitable company maintains a stable GPM unless the firm or the industry is undergoing drastic changes, such as, introduction of new production techniques, which affect the costs of goods sold (Schroeder, Richard, Clark, & Cathey, 2009).
Administration expenses to sales (AETS)
AETS is a measure of the efficiency of assets utilization. It shows the level of overhead costs required supporting a given level of revenues. When used in trend analysis, AETS is expected to decrease over time as the firm grows thereby, gaining economies of scale (Deegan, Michael, & Unerman, 2006). It is calculated as the distribution expense expressed as a fraction of sales.
Distribution cost of sales
This is another measure of efficiency showing the proportion of revenues allocated to covering distribution costs (Schroeder, Richard, Clark, & Cathey, 2009). A distribution cost to sales may indicate that the firm is not strategically placed and might be far from its consumers, or it has an ineffective distribution system. As the company gains economies of scale, the ratio should reduce (Deegan, Michael, & Unerman, 2006).
Net profit margin
This is the proportion of revenues remaining after all operating expenses, interest, tax and preferred stock dividends, but not common stock dividends have been deducted from the net sales (Deegan, Michael, & Unerman, 2006). Net profit margin shows the proportion of sales that remains as profit for the investors. A positive net profit margin indicate that the firm is earning profits for its investors, and a negative one indicate a net loss.
Current assets ratio (CAR)
CAR is both a liquidity and efficiency ratio measuring the ability of the firm to pay off its short-term debts from it stock of current assets (Deegan, Michael, & Unerman, 2006). CAR is a ratio that compares the total current assets to the total current liabilities held by a firm. It is most important to the creditor, but in general, all investors including creditors use CAR to assess the potential of a company paying its debts. A high CAR is preferred as it shows that the firm can meet its debts easily (Schroeder, Richard, Clark, & Cathey, 2009).
Mark up refers to profit expressed as a proportion of the costs of goods sold. It is commonly calculated as the difference between selling price and the total cost of production (Schroeder, Richard, Clark, & Cathey, 2009). A high markup may indicate that the firm is overpricing its products, or it is effective in controlling the cost of production. On the other hand, a low markup indicates that the firm is ineffective in controlling production cost.
Acid test ratio
It is closely related to CAR. It tests the ability of a firm to meet its current liabilities without having to sell its stock. It is the comparison of current assets less the stock to the current liabilities. An acid ratio of at least one is preferable.
Stock turnover ratio (STR)
STR is an efficiency ratio that show how effectively a company manages its inventories by comparing the average stock held over the reporting period to net sales in the period (Deegan, Michael, & Unerman, 2006). STR is important as it indicate whether the company’s purchasing is reflected in its sales. A low STR indicates that the company is ineffective in turning purchases into sales and may be incurring unnecessary storage costs.
Return on capital employed (ROCE)
ROCE is an efficiency ratio that shows how effectively a company utilizes its total capital to generate profits (Schroeder, Richard, Clark, & Cathey, 2009). ROCE compares operating profits to capital employed and shows how much profit is made for each dollar invested. A high ROCE shows that the firm is effective in generating good profits given some capital.
Financial performance of Electrical Spares Ltd.
For the case of Electrical Spares Ltd, financial ratios will be used to conduct a trend analysis. The financial ratios given will be grouped into two major categories: efficiency and liquidity ratios. The two categories will be discussed to understand the financial performance of Electrical Spares Ltd.
Liquidity position of Electrical Spares Ltd
Current assets ratio is the most commonly used liquidity ratio. Companies commonly seek to maintain a current assets ratio at a minimum of 1 or 100% (current ratio- Liquidity Ratio – Working capital ratio, 2014). A CAR of one indicate that the company can settle all its current liabilities at any given time using its current assets. This means that, in the event that there is a need to settle all the current liabilities; a company can do so by liquidating its current assets. The CAR of Electrical Spares Ltd has been maintained above 1.22 over the three years. This means that for all the three reporting period, the company had the capacity to pay its current liabilities from its current assets. There is no defined trend in the behavior of the CAR for the company over the last three years. However, it has remained fairly stable ranging from 1.22 to 1.26. The CAR however indicates that the firm liquidity is attractive, and creditors need not worry as to whether credits issued to the firm will be compensated in time. However, the acid test ratio has remained below 1. This indicates that the firm cannot compensate all its debts without selling its stock. This means that in case the firm has to compensate all its short-term liabilities, it would be hard as it might be impossible to dispose of its stock to balance off current liabilities with current assets that can be easily liquidated. However, this is not bad for the firm as it is hard to find a situation when all the current liabilities require be compensated all at once.
Efficiency performance of Electrical Spares Ltd.
Fixed assets turnover ratio and ROCE are among the most critical efficiency indicators (Schroeder, Richard, Clark, & Cathey, 2009). Electrical Spares Ltd has maintained an FATR above one over the last three years. This is a good indicator showing that the firm is sales amounts to more than the value of its fixed assets. There is a good trend where the FATR has been growing at a steady rate of 0.2, per period. This indicates that the efficiency, with which the firm is applying its fixed assets in generating sales, is improving an indicator in improvement in efficiency of using its fixed assets. However, there is a discord in the trend of ROCE, the trend indicates that the ROCE of Electrical Spares Ltd dropped from 2013 to 2014. This indicates that although the efficiency of fixed assets uses improved, on overall, the efficiency of using total capital decreased. Relating this to the liquidity analysis, we realize that the company may have used more debt capital to finance its operations which led to the reduction in the efficiency of total capital. This is reflected in the net profit margin which declined from 2013 to 2014.
There is a discord in the trend between gross profit and net profit margins. The GPM has been growing over the three years while NPM decreased from 2013 to 2014. Relating this to the trends of fixed assets turnover ratio, CAR, and ROCE, it can be inferred that Electrical Spares Ltd has increased the interest expense holding all other factors constant. However, this is not conclusive as there may be other factors that may have affected the trend. For instance, the trend of the distribution costs indicates that the efficiency of the firm in controlling distribution costs has been decreasing. This may be attributed increase in overall transport costs in the region of operation. The administration expenses to sales ratio indicate that the firm is gaining efficiency in controlling production overhead probably due to improved economies of scale, which means that the trend observed in the distribution costs to sale ratio may be exogenously influenced.
The markup of the firm is improved from 2013 to 2014 indicating that either the firm’s efficiency in reducing the production cost is improved or that there was an increase in the prices of the firm’s products. The company has maintained a relatively high stock turnover ratio for the three years which points to an efficient inventory management.
In conclusion, Electrical Spares Ltd has a strength in inventory management. Another strength is that it is improving the utilization of fixed assets and it thus making improving in making profit for the investors. The company also enjoys a good liquidity position which may allow it to extend its debt financing further. The company is also taking advantage of improved use scales of production. However, the company has a weakness in converting the gross margin profit to net profit. In addition, the company is ineffective in controlling distribution expenses, and there is a need for an improved strategic distribution system that will change the upward trend to downwards.
The fixed assets turnover ratio indicates that there have been improvements in the use of fixed assets. However, the ROCE tells a contradicting story where the efficiency in use of total capital employed to create sales profits is reducing. The profitability indicators suggest that the efficient use of capital is declining. However, this may point to the increase in the use of debt capital. To come to a conclusive inference however, it is important to analyze the solvency ratios including debt ratio, that measures solvency by analyzing the proportion of a firm’s total liabilities to the total assets (Financial Ratio Analysis, 2013). Debt to equity ratio should also be analyzed along the debt ratio. The two ratios will show whether the company has turned to the use of debt capital thereby bettering the efficiency of fixed assets use and reducing net profit margin and ROCE due to increases in interest expense. Earnings per share (EPS) should be used to assess the effect of the change in the capital structure, the earning per share (EPS) should be used. This will show whether the change in capital markup has a positive or negative effect on the level or return per dollar invested by the shareholders (Schroeder, Richard, Clark, & Cathey, 2009).
current ratio- Liquidity ratio – Working capital ratio. (2014). Retrieved from http://accounting-simplified.com: Current Ratio – Liquidity Ratio – Working Capital Ratio – See more at: http://accounting-simplified.com/financial/ratio-analysis/current.html#sthash.Tz6Avjkf.dpuf
Deegan, Michael, C., & Unerman, J. (2006). Financial accounting theory. Maidenhead: McGraw-Hill Education.
Financial Ratio Analysis. (2013). Retrieved from myaccountingcourse.com: http://www.myaccountingcourse.com/financial-ratios/
Mark, R. (n.d.). Ratio Analysis. Retrieved from Corporate Finance Live: http://www.prenhall.com/divisions/bp/app/cfl/RA/RatioAnalysis.html
Schroeder, Richard, Clark, M., & Cathey, J. M. (2009). Financial accounting theory and analysis: text and cases. Wiley.