Analysis Of Profitability And Liquidity Ratios

Background and Abstract

A report has been prepared having 2 questions. The 1^st question includes the profit and loss account and the balance sheet based on which the profitability and liquidity ratios have been calculated for the 2 companies ABC Ltd and XYZ Ltd and the performance of the companies have been analysed based on the same (Boccia & Leonardi, 2016). Furthermore the inventory turnover ratio as well as inventory turnover period both has been calculated with respect to how fast the companies can replace and sell the inventory during the period. N the 2^nd case study, the Altman’s Z-Score has been calculated using the given inputs for the 4 given companies and the scores which are less than the Z-score have been analysed for the respective risk. Furthermore, the performance of the companies has been evaluated based on the Z-score and area of concern has been mentioned (Alexander, 2016).

The profitability and the liquidity ratios of both the companies has been shown below for the year 2016.

1. Profitability ratios
	Gross Profit ratio = Gross Profit / Sales	ABC Ltd. Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	XYZ Ltd.
	Gross Profit							2430	2430
	Sales							4,500	3,600
	Result							54.0%	67.5%
	Net Profit ratio = Net Profit / Sales	ABC Ltd.	XYZ Ltd.
	Net Profit							2166	2170
	Sales							4,500	3,600
	Result							48.1%	60.3%
	Return on capital employed = Net income/total capital	ABC Ltd.	XYZ Ltd.
	Net Profit							2166	2170
	Average Capital Employed					2,368.00	2,223.00
	Result							91.5%	97.6%
	Return on Assets = Net income/total assets	ABC Ltd.	XYZ Ltd.
	Net income							2166	2170
	Total Assets							2,557	2,261
	Result							84.7%	96.0%

(Amt in OMR)
Ratio Analysis for the year 2016
2. Liquidity Ratios
	Current Ratio = Total current assets/ Total current liabilities	ABC Ltd.	XYZ Ltd.
	Total current assets						399	199
	Total current liabilities						189	38
	Result							2.11	5.24
	Liquid ratio /Quick Ratio = (Total current assets – Inventory – Prepaid expenses)/ Total current liabilities	ABC Ltd.	XYZ Ltd.
	Total current assets – Inventory – Prepaid expenses			179	39
	Total current liabilities						189	38
	Result							0.95	1.03
	Gearing Ratio = (Total Debt/Total owners’ equity) or ((Total assets- total owners’ equity)/total owners’ equity)	ABC Ltd.	XYZ Ltd.
	Total Debts							0	0
	Total owners’ equity						2368	2223
	Result							0.00	0.00
	Debt Ratio = Total Debt/Total assets	ABC Ltd.	XYZ Ltd.
	Total Debts							0	0
	Total Assets							2557	2261
	Result							0.00	0.00

Profitability ratios are the measure of how the company has been earning profit and how it been utilising the capital employed and the assets in generating the sales and overall income for the company. As such, 4 profitability ratios have been computed namely the gross profit ratio, net profit ratio, return on capital employed and the return on assets (Bromwich & Scapens, 2016). Gross profit is the measure of what is the profit generated by company post covering the direct costs and Net profit is the measure of profit profits generated by company post all the direct and indirect costs. From the above ratio analysis, we can see that in terms of profitability, the company ABC Ltd. Has earned 54% of the gross profit and 48.1% as net profit. On the other hand, XYZ Ltd. Has earned gross profit of 67.5% and net profit of 60.3% as a percentage of the sales (Werner, 2017). This goes on to show that both the companies are earning healthy profit share but the performance of XYZ in this respect has been much good as compared to ABC Ltd. Furthermore, in terms of the return on capital employed, the company ABC has made 91.5% whereas XYZ has made nearly 97.6%. This goes on to show that both the companies have been on the profit spree and has been giving more than expected returns to the shareholders. However, in terms of return on assets which shows how the assets have been used to generate the sales of the company, the performance of both the companies again has been good as ROA for ABC and XYZ has been 84.7% and 96% respectively. The profitability ratios computed above shows that both the companies have been profitable in the year 2016 however ABC Ltd has outclassed XYZ Ltd and there is always a scope of improvement (Choy, 2018).

Question 1

On the other hand, liquidity ratios have also been computed and they are the measure of whether the company would be able to meet the short term as well as long term liabilities. It shows the measure of liquidity and solvency of the company and if the company will be able to honour the liabilities on time and will not default in this respect. The current ratio is the measure of the current assets available to cover off the current liabilities and is at 2.11 times for ABC Ltd and 5.24 times for XYZ Ltd. Similarly, the quick ratio measures the liquid assets available with the entity to pay off the short term liabilities is at 0.95 times for ABC and 1.03 times for XYZ (Kew & Stredwick, 2017). The ideal industry trend for both of these ratios is 2 times and 1 time respectively and thus it shows that both the companies are doing exceptionally well in terms of liquidity but again XYZ has outclassed ABC Ltd. The gearing ratio which is the measure of debt to equity in the company is zero for both of them and again the debt to total assets ratio of both the companies is zero since both of them is an all equity company. This shows that both of them are doing the business mainly with equity capital and thus there is no burden of payment of debt and interest. It also gives an opportunity to the company to make use of the debt in future at low cost and thus get the benefit of lower weighted average cost of capital (Fay & Negangard, 2017).

1. The inventory turnover ratio and the inventory turnover period for both the companies has been shown below.

3. Efficiency Ratios
	Inventory Turnover =  COGS/Inventory	ABC Ltd.	XYZ Ltd.
	COGS							2070	1170
	Inventory							220	160
	Result							9.41	7.31
	Inventory Turnover Period = 365/Inventory turnover	ABC Ltd.	XYZ Ltd.
	No. of days							365	365
	Inventory Turnover						9.41	7.31
	Result							38.79	49.91

From the above shown ratio, we can see that ABC Ltd.’s inventory turnover ratio is 9.41 times and that of XYZ Ltd is 7.31 times, indicating that ABC Ltd is replacing the inventory 9 times in a year whereas company XYZ is doing so only 7 times in a year. Furthermore, from the inventory days, it can be seen that the company ABC takes 39 days on an average to sell and replace the inventory whereas XYZ takes nearly 50 days to clear off the stock (Linden & Freeman, 2017). This only goes off to show that the inventory cycle of ABC is much less than the XYZ Ltd. The benefit with ABC is that the carrying cost will be less and the stock will be cleared much early leading to less of stock losses. This shows efficiency of operations and good internal control practices being enjoyed by the company. Less of inventory days indicates that the company has planned it inventory holding well and thus the overhead cost of the company would be less in such a scenario (Goldmann, 2016).

1. The Z-score has been calculated for all the four given companies and has been tabulated below:

Calculation of the Z score for the companies
Company	A	B	C	D
Net current assets	5,000	4,500	5,500	15,000
Retained profits	19,000	54,000	54,000	54,000
EBIT	6,500	4,000	-3,500	12,500
MV of shares	9,000	5,250	16,000	254,000
Total Assets	54,000	254,000	204,000	454,000
Total Debt	34,000	24,000	189,000	254,000
Sales	54,000	34,000	254,000	504,000
A = Working Capital/Total Assets	0.09	0.02	0.03	0.03
B = Retained Earnings/Total Assets	0.35	0.21	0.26	0.12
C = Earnings Before Interest & Tax/Total Assets	0.12	0.02	-0.02	0.03
D = Market Value of Equity/Total Liabilities	0.17	0.02	0.08	0.56
E = Sales/Total Assets	1.00	0.13	1.25	1.11
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E	2.10	0.52	1.64	1.74

Profitability ratios

Based on the above analysis, the companies which are at risk in terms of Z-score are B, C and D as all of them have the Z score less than 1.8 and it shows that they will be declared bankrupt in the future. The ranking of the company from high to low can be given as B, C, D and A (Heminway, 2017). Even company A has a Z score of 2.10 and is thus likely to be declared bankrupt in the future in case the situation arises. It shows that the creditors as well as the investors need to be worried with respect to the dues of the company. The main reason for the lower Z score can be lower working capital, adverse current ratio, more proportion of debt in the capital structure and lower earnings as a percentage of the total assets of the company (Sithole, et al., 2017).

The Z score is basically a cumulative reflection of 5 ratios. It is a standard score as to how far the standard deviation is away from its mean (Jefferson, 2017). It shows the deviation of a given data point i.e., above or below the mean. There are various correlation and it can be zero, positive or negative. In case the score turns out to be zero, it means the score is near to the mean and is average. Positive score represents the point which is above in the distribution curve and negative score reflects the point which is below in the distribution curve. In case the score is between 0-1.8, it indicates the company will be declared bankrupt in the future, in case the same is lying between 1.8-3, the company is likely to declare insolvency and in case the Z-score is above 3, the company will not be bankrupt and thus enjoys a good position in the market and has a sound financial health both in terms of liquidity as well as profitability (Trieu, 2017).

1. Based on the Z-score of the companies, the performance of the company can be analysed and evaluated. There have been five ratios which has been used. The interpretation of the same is as follows:
2. Working Capital/Total Assets (WC/TA): It shows the ability of company to meet the current obligations with current assets. It is a measure of financial distress of the firm. All the companies are struggling in this category however, company A is best amongst the all and Company B is the worst(Meroño-Cerdán, et al., 2017).
3. Retained Earnings/Total Assets (RE/TA): It shows the leveraging effect of the company as to how the company is reinvesting its profit. Companies with lower ratio indicate the capital expenditure is financed through borrowing and with higher ratio, that the same is financed through retained earnings. Again company A is financed 35% from equity and company D is financed only 12% out of equity making it the most risky in terms of debts.
4. Earnings before Interest and Tax/Total Assets (EBIT/TA): This shows the return on assets. Company A is good in this making 12% whereas company C is having negative returns.
5. Market Value of Equity/Total Liabilities (ME/TL): This shows the measure to which the market value of the company will be impacted in case it goes insolvent. This shows that company A, B and C are having miniscule market value of equity whereas company D is having higher market value(Johnson, 2017).
6. Sales/Total Assets (S/TA): This is a measure of how the company handles competition and how it uses the assets to generate the sales. This shows that company A and D are better off in utilizing the assets in generating the sales whereas company B has the worst performance.

Looking at the above parameters and the performance of the companies, it can be told that company A is best amongst the all and company B has been performing worst amongst the all.

References

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