Comparison of financial performance
As the whole question is based on hypothetical data with actual interlinked values of ratios, therefore it is good to use some figures to demonstrate the understanding of question and calculate the ratios of ABC Limited and XYZ Limited.
Firstly it is good to frame the balance sheets of both companies with same or different assumed figures as provided in the question.
It is provided that both companies have same level of fixed assets. Therefore value of fixed asset of both the companies has assumed to 50000$ each.
Long Term debt of both companies are same so the value of long term debt has been assumed to 20000 $ each.
Current liabilities of both companies are same so the value of long term debt has been assumed to 10000 $ each.
Current Ratio of ABC Limited is 3 times therefore the value of current assets will be 3 * current liabilities= $10000*3 = $30000.00 and that of XYZ Limited it was 1.8 times that will amount to $10000*1.8 = $18000.00.
Now, there is need to draw the profit and loss account with the help of given information.
Both the companies have same level of sales. Therefore sales of both the companies taken to be $60000.00
As Gross profit is same for both companies, it shows that cost of sales of both companies is also same. Gross profit is assumed as 65%. Similarly operating profit is same of both the companies that make operating expenses also the same. Operating profit margin is assumed as 25%. Interest rate on long term debt is also same. Let assumed to be 10%. Tax rate is also given as same, so it is assumed as 30%.
Below is the balance sheet and profit and loss account after feeding the above assumptions.
|
Profit and loss Statement of ABC Limited |
|
|
Particulars |
Amount |
|
Sales |
$ 60,000.00 |
|
Less: Cost of sales |
$ 21,000.00 |
|
Gross Profit |
$ 39,000.00 |
|
Less: Operating Expenses |
$ 24,000.00 |
|
Operating profit |
$ 15,000.00 |
|
Less: Interest expenses @10% |
$ 2,000.00 |
|
Earnings before tax |
$ 13,000.00 |
|
Less: Tax @30% |
$ 3,900.00 |
|
Earnings after tax |
$ 9,100.00 |
|
Net income |
$ 9,100.00 |
|
Balance Sheet of ABC Limited |
|||
|
Liabilities |
Amount |
Assets |
Amount |
|
Current Liabilities |
$ 10,000.00 |
Current Assets |
$ 30,000.00 |
|
Long term debt |
$ 20,000.00 |
Fixed assets |
$ 50,000.00 |
|
Equity Capital |
$ 40,900.00 |
||
|
Retained Earnings |
$ 9,100.00 |
||
|
$ 80,000.00 |
$ 80,000.00 |
|
Profit and loss Statement of XYZ Limited |
|
|
Particulars |
Amount |
|
Sales |
$ 60,000.00 |
|
Less: Cost of sales |
$ 21,000.00 |
|
Gross Profit |
$ 39,000.00 |
|
Less: Operating Expenses |
$ 24,000.00 |
|
Operating profit |
$ 15,000.00 |
|
Less: Interest expenses @10% |
$ 2,000.00 |
|
Earnings before tax |
$ 13,000.00 |
|
Less: Tax @30% |
$ 3,900.00 |
|
Earnings after tax |
$ 9,100.00 |
|
Net income |
$ 9,100.00 |
|
Balance Sheet of XYZ Limited |
|||
|
Liabilities |
Amount |
Assets |
Amount |
|
Current Liabilities |
$ 10,000.00 |
Current Assets |
$ 18,000.00 |
|
Long term debt |
$ 20,000.00 |
Fixed assets |
$ 50,000.00 |
|
Equity Capital |
$ 28,900.00 |
||
|
Retained Earnings |
$ 9,100.00 |
||
|
$ 68,000.00 |
$ 68,000.00 |
Using the above data it is now possible to figure out the ratios required:
|
Ratio Calculation |
|||
|
Ratio |
Formula |
ABC Limited |
XYZ Limited |
|
Working Capital turnover |
Net Sales/Working Capital |
3.00 |
7.50 |
|
Working Capital |
Current Assets/Current Liabilities |
$ 20,000.00 |
$ 8,000.00 |
|
Total Assets Turnover Ratio |
Net Sales/Total Assets |
0.75 |
0.88 |
|
Return on Assets |
Net Income /Total Assets |
11.38% |
13.38% |
|
Return on Equity |
Net income/Equity capital |
22.25% |
31.49% |
|
Debt/Total Assets |
Debt/Total Assets |
0.25 |
0.29 |
Comparison of financial performance
- Liquidity: The liquidity ratio provides information related to liquid assets of a company as compared to the liabilities. The liquidity position of a company indicates its ability to meet its current liabilities from its asset position. The company should maintain sufficing liquidity in order to meet its financial obligations. This requires the company to maintain cash balance from its existing assets so that it can meet its liabilities as soon as they become due on the date of payment. As depicted from above, the current ratio of the ABC is greater than the XYZ therefore liquidity of ABC is much better than the XYZ. The XYZ Company is recommended to raise sufficient amount of cash from its asset base so that it can effectively meet its obligations for improving its credit rating.
- Profitability: The profitability ratio is used for assessing the ability of a company to generate earnings in comparison to its expenditure incurred for a specific reporting period. The ratio determines the capacity of a business to generate income in comparison to expenses incurred by it conducting its daily operational activities. Profitability of XYZ is better than the ABC as XYZ Limited has earned higher percentage of return on assets and equity as compared to ABC Limited. The XYZ Company should place emphasis on improving its income generation by reducing its expenditure incurred on daily operational activities. The increase in the profitability position is required to reach its corporate objectives of maximizing shareholder value and thus promoting the long-term growth and development.
- Leverage: The leverage position of a company determines the incorporation of debt in its capital structure. The business corporations use debt in addition to equity for financing its daily operational activities. However, in this context it is important for a company to generate sufficient cash for meeting its debt obligations. The leverage position of a company indicates the amount of cash it should maintain to appropriately pay of its debt obligations. XYZ Limited is more leveraged as compare to ABC Limited as debt to asset ratio of ABC is lower than the XYZ. This is an issue of major concern for the company as it has lower liquidity position and high leverage that can result in difficulties in meeting its debt obligations in the long-term.
- Activity: The activity ratio is used to analyse and evaluate the capacity of a business company to transform its asset, liability into the cash or sales. The company should be able to quickly transform its asset base to cash for measuring its efficiency position. XYZ Limited is more efficient in using the resources to convert them in sales as compare to ABC Limited (Asquith and Weiss, 2016).
In order to solve this question following level of equity and debt has been assumed in both the companies.
|
ABC Limited |
|
|
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
|
XYZ Limited |
|
|
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
It has been said that there is no change in operating profit of both the companies in next three years so it can be said that net profit of both the companies will same as interest expenses and tax rate of both companies are same. Only the value of retained earnings will be different in all the three years in case of XYZ Limited because has distributed only 50 % capital has been distributed by XYZ Limited and rest it was retained. In case of ABC Limited all profits are distributed. So there will be change in value of retained earnings (Equity) in case of XYZ Limited not in case ABC Limited. Lets assumed that both companies make net profit of 10000$ each year.
Change in Equity, debt and debt equity ratio of both the companies in next three years.
|
Year 0 |
Year 0 |
||
|
ABC Limited |
XYZ Limited |
||
|
Long Term Debt |
$ 20,000.00 |
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
Equity |
$ 30,000.00 |
|
Debt to Equity Ratio |
0.67 |
Debt to Equity Ratio |
0.67 |
|
Year 1 |
Year 1 |
||
|
ABC Limited |
XYZ Limited |
||
|
Long Term Debt |
$ 20,000.00 |
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
Equity |
$ 35,000.00 |
|
Debt to Equity Ratio |
0.67 |
Debt to Equity Ratio |
0.57 |
|
Year 2 |
Year 2 |
||
|
ABC Limited |
XYZ Limited |
||
|
Long Term Debt |
$ 20,000.00 |
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
Equity |
$ 40,000.00 |
|
Debt to Equity Ratio |
0.67 |
Debt to Equity Ratio |
0.50 |
|
Year 3 |
Year 3 |
||
|
ABC Limited |
XYZ Limited |
||
|
Long Term Debt |
$ 20,000.00 |
Long Term Debt |
$ 20,000.00 |
|
Equity |
$ 30,000.00 |
Equity |
$ 45,000.00 |
|
Debt to Equity Ratio |
0.67 |
Debt to Equity Ratio |
0.44 |
Looking at the above table it can be said that there is no change in debt equity ratio of ABC Limited, while there is change in XYZ Limited (Feldman and Libman, 2011).
The market value of bond is calculated as the present values of coupon payments and maturity value. In the given case ABC Limited has issued 10 years bonds that are issued 3 years back that means 7 years to maturity whereas XYZ Limited has issued 8 years bonds that are issued 4 years back that means 4 years to maturity. Both the bonds have same coupon rate and yield to maturity. So it can be said that market value of XYZ limited bonds will be greater than the bonds price of ABC Limited as main difference will arise due to present value of maturity value of bond. Present value of maturity payment of lesser year bonds will be greater than the bonds that have higher years to mature.
Beta of any company refers to how the return of that company will fluctuate to the returns of the market. So beta mainly depends upon the market return and return that individual stock generates in the market. So it can be said that beta of two firms in same industry differs due to the return and risk that individual stock contains in the market (Moles, Parrino and Kidwell, 2011).
There are various ways to reduce the current ratio and they are as under together with the risk associated with each alternative:
- Value of cash assets can be reduced such that it decreases the value of current assets but no change in the current liabilities. Due to this there can be shortage of cash availability. For example, the value of current ratio is 3:1 and thus it can be assumed that the value of current assets is 3, 00,000 and the value of current liabilities is 1,00,000. The value of cash in the total value of current assets if estimated to be 70,000 and reduced by an amount to 20,000 due to increase in prepaid expenses then it will reduce the current ratio by a significant amount. Now, the new current assets will be 250000 and the current ratio will be 2.5.
- Inventory can be sold at discount and credit period is allowed for more than 1 year. In this alternative, current asset will be converted into non-current assets and will directly impacts the operating cash cycle. For example, the value of inventory is valued at 1,00,000 in the overall value of current assets and is now significantly reduced to 20,000 indicating a net decrease in the value of inventory by 80,000 due to physical damage. The value of current assets is 2,20,000 and as such the value of current ratio will decrease to 2.2
- Current liabilities can be increased through purchasing the fixed assets or through late payment of various expenditures. There will increase pressure on the company to settle the liabilities that can hamper the operations (Ferran and Ho, 2014). For example, the value of current liabilities is increased by 50,000 from the initial value of 1, 00,000 due to increase in accounts payable and thus amounting to 1,50,000. The value of current ratio as such will be 2:1.
References
Asquith, P. and Weiss, L.A 2016. Lessons in Corporate Finance: A Case Studies Approach to Financial Tools, Financial Policies, and Valuation. John Wiley & Sons.
Feldman, M. and Libman, A. 2011. Crash Course in Accounting and Financial Statement Analysis. John Wiley & Sons.
Ferran, E. and Ho, L.C. 2014. Principles of Corporate Finance Law. OUP Oxford.
Moles, P., Parrino, R. and Kidwell, D.S. 2011. Corporate Finance. John Wiley & Sons.
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