Implications Of Financial Ratio Analysis And Application Of Budgeting

Limitations of Financial Ratio Analysis

Following are implications of the ratio provided for the lending decision:

• Current ratio: Current ratio reflects the ability of company to pay the short term liabilities. In year 2016, the current ratio was 3.1 times whereas it was reduced to 2.1 times in year 2017. It indicates that short term solvency position of Borrower’s company has been reduced in the current year as compared with previous year. The current ratio of 2.1 times in current year shows that company has enough assets to pay the current liabilities as it arises.
• Quick Ratio: Quick ratio is also an important indicator of liquidity position of the company as it takes it into account only those assets those are capable of converting into cash and cash equivalent very rapidly. Quick ratio of Borrowers Company has increased in year 2017 as compared to previous year that shows improvement in quick assets and company has now more assets to pay the short term liabilities.
• Asset Turnover Ratio: This ratio indicates how frequently company uses total assets to earn the revenue. This ratio has been decreased in year 2017 as compared to year 2016 that indicated company efficiency to use the assets to produce the revenue has been decreased in current year (Damodaran, 2011).
• Cash Debt Coverage: This ratio shows level of operating cash flows as against the debt liabilities of the company. As this ratio is less than 1 it indicates that company has very less cash flow to pay back the debt capital. Although, there has been rise in this ratio that indicates increase in flow net cash flow from the operating activity.
• Profit and Earning per share: Profit of company has been decreased in current year by 8% as compared with previous reflect the poor profitability position. The EPS of Borrowers Company has also reduced from $3.30 to $2.50 that indicates poor position of the company in the market in current year.

Although above ratios shows Company has stable liquidity position but poor profitability position in the current year as compared to previous year made the financial position of the company unfavorable. These ratios are not relevant for evaluating the debt worthiness of the company.

B: 

The three ratios that need to be calculated for analyzing the decision of the debt worthiness are as follows:

• Debt Equity Ratio: This ratio helps to know the level of debt against the shareholder equity capital of the company. It will provide current level of debt and also shows increase in debt level will change the capital structure to make it leveraged firm or not.
• Interest Coverage Ratio: This ratio tells times the company can pay interest expenses on the debt capital it is charge on the profitability of the company. This ratio will guide whether company has enough profitability position to bear the increase in interest expenses (Davies and Crawford, 2011).
• Debt ratio: This ratio will provide information on level of debt capital used to finance the total assets of the company.

C:

There are some drawbacks associated with the use of financial ratio analysis that limits the application of technique in investing and credit decisions. The most significant limitation associated with the use of ratio analysis technique is that it is not suitable to be used on a stand-alone basis and the results obtained need to be benchmarked against some specific criteria such as industry norm, aggregate economy and past performance. Also, it is not regarded to be a useful technique for carrying out comparison of the financial performance of the companies that differ on the basis of size and also belongs to different industry groups. The ratio analysis sometimes does not provide an actual depiction of the financial performance of a company as the financial statements are subjected to distortion by the economic and seasonal factors. In addition to this, the use of different accounting methods and policies can provide uneven comparison of the companies that belong to even same sectors. Also, there may be some good and some weak financial ratios which make it difficult for investors to predict the future growth potential of the company (Tracy, 2012).

Answer 1.2:

A:

B:

It can be stated on the basis of trend observed in net sales that its sales have shown a fluctuating trend as compared with the sales of base year of 2013. The sales in the year 2014 has decreased to 95.57% in comparison to the base year while from the year 2015-2017, the sales have shown an increasing trend. The profit after tax has shown an increasing trend from the year 2014-2017 in comparison to the base year. The trend analysis results have shown that despite of a decrease in the net sales in the year 2014 the net profit after tax have increased. This means though the company has collected smaller amount of sales in comparison to the base year but it has incurred less operating expenses that lead to increase in its profit after tax in comparison to base year. The profit after tax has increased in proportion to the increase in net sales from the year 2015-2017 as compared to the base year 2013. This indicates that the company ability to realize sales is increasing with a significant improvement in its operational efficiency leading to declining operational expenses and increase in the profit after tax (Kimmel et al., 2010).

Schedule of Expected Cash Receipts from Debtors

Answer 1.3:

A:

(New Zealand Post Group: Annual Report, 2017 and 2016)

(Note: Financial Data has been provided in appendix section)

Discussion on Ratio Analysis

• Profitability Ratios: The ratio depicts the ability of the company for realizing earnings in comparison to the overall expenditure incurred during a specific period of time. The profitability position of New Zealand Post has been examined with the calculation of following ratios:
• Operating Profit Margin: It indicates the profit realized by the company after meeting its variable cost of production. It is depicted from the calculation of the ratio from the above table that its operating profit margin has decreased from 2016 to 2017 to a large extent.
• Return on Assets: The return on assets ratio of the company has also comparatively declined from 0.76% to 0.03% from the year 2016 to 2017 which depicts that its ability to realize revenue from assets have decreased significantly (Lumby and Jones, 2007).
• Net Profit Margin: Its net profit margin has increased significantly from 9.49% to 10.45% in the year 206 to 2017.  Thus, it indicates that the efficiency of New Zealand Post to reduce its operational expenses has increased and this increases the percentage of revenue available for the company after meeting all the significant expenses.
• Return on Equity: The return on equity ratio of the company has decreased significantly from 2016 to 2017 from 11.52% to 7.21%. This indicates that the ability of the company to generate returns for the shareholders have reduced to a large extent (Tracy, 2012).

Financial Stability

• Debt Ratio: The debt ratio of the company has increased from the year 2016 to 2017 as depicted in the above table. This indicates that financial leverage on the company is increasing.
• Debt to Equity Ratio: The debt-equity ratio of the company has also increased over the time period of 2016-2017 as presented in the above table. This indicates that company is incorporating more debt in comparison to equity in the year 2017 as compared to the year 2016 (Moles and Kidwekk, 2011).
• Interest Cover: The interest coverage ratio of the company has reduced to a large extent from the year 2016 to 2017 as depicted in the above table. This indicates that the ability of the company to meet its interest expenses on outstanding dent has reduced (Szydlowska, 2018).

Assets Utilization

• Asset Turnover ratio: The company have maintained a steady growth rate over the year 2016-2017 in relation to asset turnover as depicted in the above table. This indicates that the value of its sales in relation to the value of its assets has remained steady (Ross, Jaffe and Kakani, 2008).

Thus, it can be stated on the basis of profitability analysis of the company that its profit earning capacity has reduced in the year 2017 as compared to the year 2016. In addition to this, the financial stability ratios have indicated that it is adopting more use of debt in its capital structure which is not a good sign for the future growth of the company. Also, it is not able to improve its efficiency of generating sales from asset utilization. This all indicates that the financial health of the company has deteriorated in the year 2017 as compared to the year 2016. This is also not indicative of good sign of potential growth of the company (Papadopoulos, 2011).

B:

Cash flow from operating activity ratio provides an overall assessment of the liquidity position of a company. It is calculated by dividing the cash flow from operations by the current liabilities that need to be repaid by the company within 1 year and is represented in the balance sheet. Thus, if the operating cash flow ratio is greater than 1, it indicates that the company is generating more cash from its business operations for meeting adequately its current liabilities in the specified period and vice-versa. On the other hand, the earnings figure reflects the net profit that indicates the actual profit that has been realized after meeting all the significant expenses of operation, interest and taxes. Thus, if the cash flow from operations is less than the earnings figure then the company might have a poor financial health. This is because it is not having sufficient liquidity for meeting its current obligations although its accrued profit level might be good (Weston and Brigham, 2015). This may indicate that the company is not highly effective in meeting its current obligations due to its inefficiency in collecting its accounts receivables. The business companies adopt the use of accrual basis of accounting and thus the earning figure indicates the net profit to be realized by the company by taking into account the amount of accounts receivables. Thus, if the cash flow from operations is less than the earning figure then the company financial condition cannot be regarded as good as there is possibility of default o its part as its credit obligations become due (White, 2014).

Cash Budget

Solution 2: Application of management accounting tools to business decision making: Budgeting

Answer 2.1:

A:

B:

C:

The cash requirement of $ 85000 to pay the business installment of new machinery can be easily met as cash balance at the end of February month is $151300. After paying the business installment of $ 85000, Hamilton still left with $ 66300 to bear expenses of next month (Brigham and Ehrhardt, 2013).

Answer 2.2:

A:

B:

C:

D:

Variance analysis is used for quantitative investigation of the difference between the planned budgets to the actual outcomes realized. The technique is used for identifying the deviation by the business managers as compared to the standard results need to be achieved. This helps the business managers in identifying the loopholes in the company performance and thereby developing strategic actions for overcoming the inefficiencies identified. However, the use of the technique is quite complex and may lead too much emphasis placed on analysis of the factors responsible for causing deviation in the financial performance. In addition to this, all type of variances identified might not be available in the accounting data and therefore it may become quite difficult for acting upon variances (Heisinger, 2009).

References

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.

Damodaran, A, 2011. Applied corporate finance. John Wiley & sons.

Davies, T. and Crawford, I., 2011. Business accounting and finance. Pearson.

Heisinger, K. 2009. Essentials of Managerial Accounting. Cengage Learning.

Kimmel, P. et al. 2010. Financial Accounting: Tools for Business Decision Making. John Wiley & Sons.

Lumby,S and Jones,C. 2007. Corporate finance theory & practice. Thomson.

Moles, P.  and Kidwekk, D. 2011. Corporate finance. John Wiley &sons.

New Zealand Post Group: Annual Report. 2016. [Online]. Available at: https://www.parliament.nz/resource/en-NZ/51DBHOH_PAP71461_1/a10a65873a87dfd0f44d6f4560840fd57f04618e [Accessed on: 18 May 2018].

New Zealand Post Group: Annual Report. 2017. [Online]. Available at: https://www.nzpost.co.nz/sites/default/files/uploads/shared/annual%20reports/2017-nzpost-annual-report.pdf [Accessed on: 18 May 2018].

Papadopoulos, P. 2011. Investment Report – Fundamental Analysis/ Ratio Analysis: Comparative Approach between two FTSE 100 corporations Vodafone plc and British Telecom Group. GRIN Verlag.

Ross, A., Jaffe, J. and Kakani, R.K. 2008. Corporate Finance. Pearson.

Szydlowska, K. 2018. Ratio analysis. Financial Position of a company. GRIN Verlag.

Tracy, A. 2012. Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. RatioAnalysis.net.

Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.

White, G. 2014. Cash flow is king when judging a company’s prospects. [Online]. Available at: https://www.telegraph.co.uk/finance/comment/10806302/Cash-flow-is-king-when-judging-a-companys-prospects.html [Accessed on: 18 May 2018].

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