Introduction - JustAnswer



Introduction

Financial statement of a company contains mere figures. Absolute figures are useful but they do not convey much meaning. In terms of accounting ratios, comparison of these related figures makes them meaningful. Ratio Analysis gives a better understanding of the financial condition and performance of a business concern. It also helps in comparing the financial condition of the company with peer companies.

According to Myers, ratio analysis is a "study of relationship among the various financial factors in a business “

Professional Confectioners’s financial ratios are much below the industry average. compared to last year, the current year has shown a negative trend that is it is lower than last year and if the company continues to work like this then company will finally be much more below the industrial average. Banks are not willing to lend to Professional Confectioners because their short term as well as long term debt paying capacity is not very attractive.

Financial ratios are useful indicators of a firm's performance and financial situation. Professional Confectioners has to immediately find ways to improve its financial health. Meaning of each financial ratio is explained to Pehr Weisengraf . Some recommendations are given how can Professional Confectioners can improve its financial health and so can make financial ratios attractive. Unless its financial ratios look attractive to the lenders, they will find it difficult to arrange fund.

Financial Ratios

Ratio analysis is an excellent method for determining the overall financial condition of a company. It puts the information from a financial statement into perspective, helping to spot financial patterns and helps the company in finding weak areas and what should be done to improve financial health of the company.

Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:

• Liquidity ratios

• Activity Ratios

• Financial leverage ratios

• Profitability ratios

These broadly classified ratios contain many ratios.

Liquidity ratios:

* Current ratio

* Liquid /Acid test / Quick ratio

Activity ratios:

* Inventory/Stock turnover ratio

* Debtors/Receivables turnover ratio

* Average collection period

* Creditors/Payable turnover ratio

* Working capital turnover ratio

* Fixed assets turnover ratio

* Over and under trading

Financial Leverage ratios or long term solvency ratios:

* Debt equity ratio

* Proprietary or Equity ratio

* Ratio of fixed assets to shareholders funds

* Ratio of current assets to shareholders funds

* Interest coverage or debt service ratio

* Capital gearing ratio

* Over and under capitalization

Profitability ratios:

* Gross profit ratio

* Net profit ratio

* Operating ratio

* Expense ratio

* Return on shareholders investment or net worth

* Return on equity capital

* Return on capital employed (ROCE) ratio

* Dividend yield ratio

* Dividend payout ratio

* Earnings Per Share Ratio

* Price earning ratio

Bankers are mainly interested in liquidity ratios and financial leverage ratios.

Banker has calculated some ratios and based on these ratios banker has decided to not to lend to the company. Meaning of each of the ratios calculated by the banker are given below:

Current ratio and Quick Ratio are liquidity ratios and throws light at liquidity position of the company and whether company can honor short term debt obligations or not.

Current Ratio: Current ratio tells whether company is able to meet its current obligations by measuring if it has enough assets to cover its liabilities. The standard current ratio for a healthy business is two, meaning it has twice as many assets as liabilities.

Professional Confectioners’s current ratio is 1.7 which is below standard current ratio as well as industry average (2.4). It indicates that company is facing liquidity crunch and may not be able to meet short term debt obligations.

Current Ratio = Current Assets / Current Liabilities.

Quick Ratio: Tthe quick ratio (also called acid test ratio) measures a business' liquidity it excludes inventories when counting assets as inventories can not be converted to cash quickly always. It calculates a business' liquid assets in relation to its liabilities. The higher the ratio is, the higher your business' level of liquidity. The optimal quick ratio is 1 or higher.

Professional Confectioners’s Quick ratio is 0.4 which is below standard current ratio as well as industry average (0.8). It too indicates that company is facing liquidity crunch and may not be able to meet short term debt obligations.

Quick Ratio = (Current Asset – Inventory) / Current Liability

Debt Ratio: Debt ratio is a financial leverage ratio. Financial leverage ratios provide an indication of the long-term solvency of the firm. Lower the debt ratio, better the long term solvency position of the company.

Debt Ratio = Total Debt / Total Asset

Company’s debt ratio is 0.89 as compared to industry average of 0.65. Company’s debt ratio increased from 0.81 to 0.89 this year. It indicates that company’s debt is increasing and debt as a percentage of asset is more as compared to industry.

Debt to Net Worth Ratio : Debt to net worth ratio used in the analysis of financial statements to show the amount of protection available to creditors.

Debt to Net Worth Ratio = Total liabilities / Total stock holder’s equity

A high ratio usually indicates that the business has a lot of risk because it must meet principal and interest on its obligations.

Professional Confectioners’s Debt to Net Worth Ratio is 2.9 as compared to industry average 1.9. It indicates that company has a lot of risk because it must meet principal and interest on its obligations.

Inventory Turnover Ratio: Inventory turnover ratio tells how often company’s inventory turns over during the course of the year. Because inventories are the least liquid form of asset, a high inventory turnover ratio is generally positive. But unusually high ratio as compared to the industry average means company is losing sales because of inadequate stock on hand.

Professional Confectioners’s Inventory Turnover Ratio is 4.3 times/year as compared to industry average of  7.1 times/year . It means company’s inventory is not moving fast enough.

Inventory Turnover Ratio= Cost of Good sold/Average inventory

Collection Period: Average collection period indicates how quickly your customers are paying . Ideally, the average collections period should less than credit terms plus 15 days.

Collection Period= Accounts Receivable X 365 days

Professional Confectioners’s collection period is 43 days as compared to industry average of 34 days. It indicates customers are not paying quickly. Company should ensure than customers should pay on time.

Net Sales to Working Capital Ratio: This ratio measures the number of times accounts receivable turn over during the year. The higher the turnover of receivables, the shorter the time between sale and cash collection. High Net Sales to Working Capital Ratio is good for the company.

Net Sales to Working Capital Ratio = Sales / Net Working Capital

Net Working capital = Current asset – Current liabilities

Professional Confectioners’s Net Sales to Working Capital Ratio is 9.7 as compared to industry average of 12.6. This indicates that company has scope to improve the time between sale and cash collection.

Net profit on sales ratio and Net Profit to Equity Ratio are Profitability ratios. These ratios provide the information about the company's bottom line (Net Profit).

Net Profit on Sales Ratio: Net Profit on Sales Ratio is defined as Profit after tax divided by Sales. This ratio is used to is used to measure the overall profitability. It also indicates the firm's capacity to face adverse economic conditions such as price competition . Higher the ratio the better is the profitability.

Professional Confectioners’s Net Profit on Sales Ratio is 3.8 as compared to industry average of 9.4. Obviously company is not as profitable as other companies in the industry are.

Net Profit to Equity Ratio: The profit to equity ratio measures the rate of return on investment.

If this return is low, then the capital could be better employed elsewhere.

Net profit to equity = Profit After Tax /) Owners equity

Professional Confectioners’s is 18.3 as compared to industry average of 13.4. It means company is giving more return to the equity holders as compared to other companies in the industry.

A look at all these ratios shows that financial ratios of Professional Confectioners are much below the industrial average. It is also clear that as compared to last year, the current year has shown a negative trend that is it is lower than last year. And if the company continues to work like this then company will finally be much more below the industrial average. Only place where Professional Confectioners outperformed the peers is Net profit to Equity ratio.

Company’s ability to meet short term debt obligations is not very good (evident from current ratio and quick ratio). Also, company’s long term solvency is not as good as peers have (evident from Debt ratio and Debt to net worth ratio). Inventory is not moving fast, customers are not paying at time, company’s profitability is not at par with peers.

It seems company is struggling and owner MUST do something immediately to improve the financial health of the company.

Recommendations-

➢ Professional Confectioners ‘s current assets is reducing from the last year and to the industry average or current liabilities are on an upward trend, which is a negative effect on company. So, he should first of all try to improve his current assets. Unless current ratio and quick ratio are improved, bankers will not lend the company.

➢ There should be minimum required stock and owner should maintain a proper communication between the suppliers and customers that is he should maintain proper justing time approach. Also, company should ensure that inventory moves faster.

➢ Customers are not paying at time. Company must devise strict credit policy and should have a better collection mechanism in place.

➢ Company should avoid taking debt for sometime as debt ratio is very high. When debt ratio comes down to industry average, bankers will feel safe to lend to the company.

Financial Ratios of Exxon Mobil and performance of Professional Confectioners:

Exxon Mobil is world largest integrated oil company ranked #2 in Fortune 500 companies listing.

Four important ratios of Exxon Mobil, Professional Confectioners and S&P are as follows:

|Sr. No. |Financial Ratio |Professional |Exxon Mobil |S&P |

| | |Confectioners | | |

|1 |Current Ratio |1.7 |1.5 |1.4 |

|2 |Quick Ratio |0.4 |1.2 |1.1 |

|3 |Debt to Net Worth Ratio |2.9 |2 |2 |

|4 |Net profit on sales Ratio |3.8 |9.5 |9 |

Evidently, important financial ratios of Exxon Mobil is very close to of S&P. Professional Confectionarers is showing very poor financial health as compared to Exxon Mobil. Exxon Mobil has presence in oil and gas exploration, production, supply, transportation and marketing worldwide. Company has reserve of of 12.8 billion barrels of oil equivalent. It has 37 refineries in 20 countries with throughput capacity of 6.2 million barrels per day.

Current Ratio of Professional Confectionarers is better than of Exxon Mobil but Quick Ratio is much much lower. Quick Ratio does not consider inventory as inventory can not always be converted to cash very quickly. Low Quick Ratio of Professional Confectionarers indicates that very large part of current assert of Professional Confectionarers is inventory. Professional Confectionarers has not been able to move its inventory fast (which is evident from Inventory Turnover ratio). Even collection period of the company is very high. Obviously company is losing sales. This statement is supported by low profit margin of the company too. Net profit on sales Ratio of the company is much below of Exxon Mobil and S&P. Company is operating at very low profit margin. In a competitive scenario where increasing price is not feasible, company has to look into cutting operating cost and increasing operating efficiency to improve its profit margin.

Debt to net worth ratio of the company is higher than of Exxon Mobil. It indicates that company is heavily in debt. No wonder, banker refused to lend to Professional Confectionarers.

Conclusion

Professional Confectionarers is in poor financial health and its financial health is detoriating (as financial ratios have fallen from last year). Company is not having liquidity (low current ratio and quick ratio), It has huge inventory build up, slow inventory movement, very high debt, low profit margin, very high collection period. In comparision to industry as well as market (S&P), company is showing very bad performance. Company is in need of fund but bankers are not lending. Bankers are not convinced that company can meet its short term as well as long term debt obligations. Company’s long term solvency condition is also not very good. When we compare the financial ratios with last year’s ratios, we see that trend is negative.

Excess debt, low sales, low working capital, high inventory and high collection period are severe problems with the company. Professional Confectionarers is going through a bad phase. Pehr Weisengraf immediately needs to take steps to improve financial health of the company. Unless company’s financial ratios are not comparable with the industry, bankers (as well as other stake holders) will not have faith in the company and ability of its management.

Reference:

1. Stephen F. Jablonsky, Noah P. Barsky.(2001). "The Manager's Guide to Financial Statement Analysis", Second edition. Publisher: Wiley

2. David S. Chesnick. (2000). "Financial Management and Ratio Analysis for Cooperative Enterprises". United States Department of Agriculture Rural Business–CooperativeServiceRBS ResearchReport 175

3. Charles K. Vandyck. “Financial Ratio Analysis: A Handy Guidebook”. Trafford Publishing

4. Retrieved on April 8th 2009

5. Retrieved on April 8th 2009

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