The Limitations Of Financial Analysis Finance Essay
Financial Analysis is a process of identifying the capabilities, strengths and weaknesses of a business. It helps to show the financial position of a business and is used to analyse the financial statements to figure out how the business will be behaving now and how it will behave in future. This task is carried out by the firm to understand and improve the situation of a company.
PURPOSES OF FINANCIAL ANALYSIS
Profitability: Financial Analysis helps to examine the earning capacity and profitability of the company. Financial statements are analysed to inspect profit or loss in a given period. It helps to present the solvency of the business. It describes the current and future situation of the business based on the financial statements
Growth: Financial Analysis helps to present the growth of the business based on the financial statements. It shows that specific growth by percentage which helps the business to organize and plan strategically for the future. It brings the clear picture of the business and shows that if it can provide benefits to its investors etc.
Comparison: Financial Analysis helps to compare the business with its competitors and rivals. It is the best tool to check that where the business is going wrong so that the management could improve it. It also provides the trend of the business.
LIMITATIONS OF FINANCIAL ANALYSIS
Different Accounting Methods: Financial Analysis helps a lot to compare two firms but the problem here in this process is that two different firms could use different analysis methods which could lead to confusion. In such situation, it makes difficult to clearly compare two firms. Different accounting methods will provide different results and this will lead to misleading future plans.
Accuracy of Financial Statements: There is no guarantee that the audited financial statements are accurate. So if there is something wrong in the computations, it could lead to further mistakes in financial analysis. This could lead to other problems. There is also a big problem that financial analyses do not provide any information about the loss of major customers. It does not include the qualitative factors and elements as it is completely deals with monetary terms.
1.Growth In sales %
2. Growth Profit Margin %
3. Growth Profit Mark up %
4. Administrative Expenses %
5. Selling Expenses %
6. Financial Expenses %
7. Net profit Before tax %
8.Return on Equity %
9. Return On Assets %
10. Inventory turnover
11. Age of account receivable
12. Current Ratio
13. Liquid Ratio
14. Debt Equity Ratio
15. Equity Ratio
16. Interest Cover
Growth in sales
(Current sales –pervious year sales) / Pervious sales * 100
2009=5000-5300*100 2010= 6000-5000 *100
= -5.67 =20
Gross profit margin
(Gross profit ÷sales) * 100
2009= (1450/5000)*100 2010= (2100/6000)*100
=29 = 35
Gross profit mark up
(Gross profit /cost of goods sold)*100
2009= (1450/3550)*100 2010= (2100/3900)*100
Total administration expense/sales/*100
2009=(375/5000)*100 2010= (490/6000)*100
Total selling expenses /sales*100
2009= (425/5000)*100 2010=520/6000)*100
Total financial expense/sales *100
Return on equity
Net profit after tax / average stockholders’ equity *100
2009= (545/5000)*100 2010=(900/6000/)*100
Average stockholders’ equity
(Opening stockholders equity +closing stockholders equity) /2
Return on assets
Net profit after tax /total assets *100
= 10.04% =12.06%
Cost of goods sold/average inventory
2009=(3550/1500) 2010= (3900/1750)
=2.36times =2.22 times
(Opening inventory +closing inventory)/2
2009= 600*365 2010=660*365
Current assets –inventories)/ current liabilities
2009= 2515/1120 2010=2520/1590
(current assets –inventories)/current liabilities
(Current assets-inventories)/current liabilities
=7.83 times =6.63times
Debt equity ratio
Total liabilities/stockholders equity
2009= 112+515 2010=1590+930
Earnings before interest & tax/interest
= 7:48 =6.63
Financial Analysis Report for Academic Bookstore Ltd
The purpose of this report is to present the financial analysis findings of Academic Bookstore Ltd. This report is being prepared for the Directors of Academic Bookstore Ltd. Financial Statements are used to determine the financial position of the business. This report presents the outcome of the analysis and provides some useful recommendations for the higher management so that they can improve the performance of the company. Financial Statements of Academic Bookstore Ltd was used to get the financial information of past and present to plan strategically for the future. This report will provide an overall analysis of the company which will include profitability, assets utilization and financial stability
Body of the Findings
Profitability ratios and percentages are financial metrics which are used to measure capacity to generate profits and control the expenses at the same time for a given period of time. These financial metrics are very important for any business to evaluate the exact position of it in the market. In this report the profitability ratios and percentages of Academic Bookstore Ltd are used to evaluate the situation of the company. These ratios and percentages will clearly indicate the increase or decrease in profit, loss or expenses. Earning profit is the first expectation of any business. Profit is the money that the company earns by providing services or manufactured goods etc. This section will cover all the profitability ratios and percentages like, growth in sales, gross profit margin, gross profit mark-up and expenses, net profits and returns on assets and equity etc.
1.1 Growth in Sales
It is the growth in sales as compared to the previous year or a given period of time. So in Academic Bookstore Ltd, the growth in sales percentage for 2009 was very low. It was -5.66% which shows that company was not doing good business but the company realize the situation and handle it carefully. In 2010, the growth in sales increased by 20% which is a good sign. The company came out of the minus figure. It shows that company is strong to earn profits. It is good for the company and its stakeholders.
1.2 Growth Profit Margin
Growth profit margin shows the profit margin for the company which it earns because of the growth in sales. Here in this case, the Academic Bookstore Ltd is doing really good. The growth profit margin was 29% in 2009 which was then increased to 35% in 2010. Gross profit margin serves business in long run because it is a saving for the company for paying future expenses. So the financial analysis shows a clear picture of financial health of the Academic Bookstore Ltd.
1.3 Gross Profit Mark-up
Gross profit mark-up shows the mark-up of the company that it uses on goods purchased for sale. By analysing the financial statements I can say that Academic Bookstore Ltd is doing well in business. Because of the growth in sales, gross profit mark-up gone up from 40.84% to 53.84% which is a good sign. It shows that company is performing well in business. There is a clear difference of 9.22% between gross profit mark-up of 2009 and 2010.
1.4 Administration Expenses
The administration expenses are related to the whole company’s general administration expenses as they are not just related to one particular department. It includes the general administration expenses like office staff wages, depreciation, sundry expenses etc. The financial statements of Academic Bookstore Ltd show that there is an increase in these expenses from 7.50% to 8.17% in the period of 2009 to 2010. It is obvious that if the business is growing then it will automatically increase the expenses. As compared to the growth in sales, this increase in administration expenses is not too much but the management should take it into consideration so where possible; they can try to decrease these expenses.
1.5 Selling Expenses
Any expense which is directly or indirectly incurred by the selling activities is known as selling expense. It shows that how much the company spend to sell the goods. In 2009, the Academic Bookstore Ltd spent a percentage of 8.90 as selling expenses which was increased in 2010 as 9.17%. This is a nominal expenditure which is necessary to earn more profit and I can say that company is doing good and saving money.
1.6 Financial Expenses
Financial Expenses includes interest and mortgage expenses which are clearly related to the financing. It includes the long-term debt interest expense. In the case of Academic Bookstore Ltd, the financial expenses are gone up by more than 1%, from 1.60% to 2.67%. So here company is paying huge amount in forms of interests and mortgages which is not really good. Such dramatic increase in finance expenses can hurt the company’s reputation as it will be under a huge debt.
1.7 Net Profit before Taxes
Net Profit before taxes is the profit that earned by the company by selling good or providing services before paying the taxes. These taxes must be paid on time to avoid in problems in future. In Academic Bookstore Ltd, the company is doing really well as the net profit before paying out the taxes is increased 10.90% to 15%. This is a result of increase in sales. However we must keep in mind that the company still have to pay the taxes and then calculate its net profits.
1.8 Return on Equity
Equity or owner’s equity is the capital investment by the owner of the company. Return on equity is a measure to evaluate the profitability of the company by checking that how much profit is generated by the company with a specific amount contributed by the investors. There is a significant increase in return on equity in Academic Bookstore Ltd. The company’s return on equity shows a growth of 8.41% from 18.80% in 2009 to 27.21% in 2010. So the company is doing well by earning enough good profits for its owner.
1.9 Return on Assets
Return on Assets is a technique to evaluate the capacity of the company to use its resources to produce and increase the income. It assesses the amount of profit generated by the assets which are used in company. It gives an overview about the management that how effective it is in using its assets to generate earnings. The return on assets in Academic Bookstore is increased from 10.03% in 2009 to 12.60% in 2010. It is a good sign for the company and its investors.
2. ASSET UTILIZATION
Asset Utilization describes the profit that is being earned by using the assets of the company. There are many ratios comes under the asset utilization that explains the turnover and the details of our spending in the business. It shows the long term and short term investments. These ratios help the management to get the best out of its assets and resources to make revenues and show total revenues as compared to expenses. These ratios act as an efficiency indicator of asset utilization for the company. So asset utilization shows that if the company is wasting its assets or using it properly to gain profits and revenues.
2.1 Inventory Turnover
Inventory turnover is used to show the number of times the inventory of the company is sold or replaced by new inventory. If the inventory turnover shows a low inventory, it is not good for the company because it basically says that the inventory is just sitting in the warehouse for long time and not earning any revenue for the company. A low inventory turnover could be a result of overstocking. So inventory turnover shows that how frequently any company can flush out the inventory from its system for a given period of time. So in Academic Bookstore Ltd. The inventory turnover is gone down 2010 as compared to 2009 from 2.37% to 2.23% which is not a good sign.
2.2 Age of Accounts Receivable
Age of accounts receivable shows the company that how many days it will take to company to receive money from its debtors. It is a periodical report which shows all the outstanding balances from its customers or debtors. If the number of days is less then it’s good for the company because company is getting its money soon which can be used for further investment or spending on the expenses. But a larger number of days for accounts receivable is not good. In the case of Academic Bookstore, the age of accounts receivable in 2009 was 73 days but in 2010 it decreased to 57.36 which is a good sign. Company is getting the money soon from its debtors which will increase the revenue of the company.
3. FINANCIAL STABILITY
Financial Stability defines the financial stability of the company. It is a measure to evaluate the total debts and available funds which will further show the solvency of the company. Financial stability helps the company to meet its long-term and short-term financial needs. So the financial stability shows the total assets as compared to total liabilities in the company. It can be also describes the process of managing risks and enhance the economic situation. If a company is not stable then it could lead to bankruptcy. So it is important to do a financial analysis and find out the financial stability ratios like current ratio, equity ratio, debt ratio etc.
3.1 Current Ratio
Current ratio is normally used to measure the liquidity of the company. It is basically shows the ability of the company to pay back it’s liabilities with its assets. It mainly deals with current assets and current liabilities. It shows per dollar available to pay the same liabilities. It describes the situation of the company for the near future that if the company can par back it’s liability in future or not. Current assets are the assets which can be converted into cash quickly. So in the case of Academic Bookstore Ltd, the ratio was 2.25:1 in 2009 and in 2010 it dropped down to 1.58:1. So this is not a good sign for the company because the company is gown down in terms of its liquids. It could face liquidity problems in future. An ideal ratio is 2:1 which shows that every 1 dollar liability there is 2 dollar assets available.
3.2 Liquid Ratio
Liquid ratio shows the ability of the company to pay back it’s short term liabilities and debts. It is also called a quick ratio as it calculates the quick assets and current liabilities. An ideal ratio for liquid ratio is 1:1 which shows that for every one current liability there is one current asset available so that the company can pay back the liabilities on time. If the company is paying the current liabilities on time then it earns reputation in the market and can get investments from investors. In 2009, the liquid ratio was 0.73:1 which then came down to 0.45:1 in 2010. This is not a good sign. The company will be unable to pay back its current liabilities. To keep a good reputation in market, company needs to pay back the debts on time.
3.3 Debt Equity Ratio
Debt Equity Ratio is a measure of company’s financial leverage which is calculated by dividing the total liabilities by the equity of stockholders. It is a measure of relationship of capital contributed by creditors and shareholders. It is also known as risk, gearing or leverage. It is equal to long term debt divided by shareholder’s equity. So investing in a company which has higher debt ratio could be risky for the investors. The Academic Bookstore Ltd’s debt equity ratio was 0.74:1 in 2009 but it increased to 1.06:1 in 2010. So it could be risky for the company and investors. But it is not true in every case because it totally depends on how the company is operating.
3.4 Equity Ratio
The equity ratio is used to measure the share of total assets which are financed by the stockholders. It describes that how much equity can be used for financing the assets.
So the equity ratio only requires two inputs from the balance sheet owner’s equity and total assets to calculate it. The equity ratio for Academic Bookstore Ltd in 2009 was 0.57:1 which was slightly decreased in 2010 as 0.49:1. So the situation of the company is changed slightly but it’s not too bad.
The company keeps the cash into different accounts to earn interest on it which is then further recorded into the income statement as income. For some companies the interest is less but for some other companies like insurance companies it is a good source of income. Interest rate for the Academic Bookstore Ltd, was 7.81% and in 2010 it was decreased to 6.63%.
Main Problem Areas:
1. Current Ratio
2. Liquidity Ratio
3. Administration Expenses
4. Debt Equity Ratio
1. Current Ratio decreased in 2010 which is a problem for the company. It was 2.25:1 in 2009 but came down 1.58:1 in 2010. It shows that company will be unable to pay back its liabilities in future. Management needs to improve the performance to increase the current ratio so that the company remains in a stable condition.
2. Liquidity Ratio is also decreased in year 2010 as compared to 2009. It is a big problem because it will be unable to pay back its current quick liabilities. If the company is unable to pay back the short term debts then it will bring down the reputation of the company and no one will invest in the company. Management need to work on it and other related aspects that influence the ratio.
3. Administration Expenses are also increased in 2010 as compared to 2009 which is another problem. It incurred more expenses which bring down the benefits of the company. Management need to work on it to improve the performance and decrease the administration cost by merging the departments etc.
4. Debt Equity Ratio is also an important area which is increased in 2010. It was 0.74:1 in 2009 but in 2010 it increased to 1.06:1 which is a problem. Investors will look at the company as a risky business. Management need to work on the contributing factors to decrease the ratio.
Best Performance Areas:
1. Increase in Sales: Academic Bookstore Ltd is doing well in sales. The sales are increased in 2010 which is good for the company. Company is earning more profits and revenues from sales. Company’s sales were decreased dramatically in 2009 but then company handle the situation carefully and got an increase in sales by 20%.
2. Decrease in Age of Accounts Receivable: The age of accounts receivable is the area where company performed really well. In 2009 the age of the accounts receivable was 73 days but in 2010 it came down do 57.36 which is good. It shows that company is getting outstanding money quickly than the last year.
The financial analysis report for Academic Bookstore Ltd. presents a clear picture of the business. It analyzed the financial statements to check the profitability, asset utilization and financial stability of the company. It shows a three year comparison to evaluate the company position in the market, profits, revenues and expenses as well. So it shows the trends of the company. Company performed well in the sales field because it increased by 20 % in 2010 which is really good for the company to increase the profits and revenues. As the sales increases, the operating expenses also increased simultaneously. A comparison for 3 consecutive years is always good to check where the company is going up or where it is going down. It also shows that company has done a good in getting the money from accounts receivables. All the ratios are analyzed in order to get an overview of the whole company. This report also describes the financial stability in form of many ratios like current ratio, liquid ratio, debt equity ratio, equity ratio etc. These assignments are not clearly describes everything of the company but helps to understand the trends and situation which further helps in improving the performance. It helps to check if the company is still gaining profits or is going down. So this report will be quite helpful for the top management authorities to understand the current and clear picture of the business and will help to improve it. This report will provide the assistance to Directors of the Academic Bookstore Ltd to improve it in all the key areas given above in the report.
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