Discuss about the Companies Efficient Distribution and Management.
The aim of this paper is to do financial analysis of the given company Efficient Distributors and try to solve the hurdles they are facing in keeping within the limit of the bank overdraft. Using the financial statements provided some ratio analysis has been done and we have tried to identify the problem. After identification of the problem we have looked at possible solutions and their implementations.
Efficient distributors are the given company whose three years’ financial data we have been proved with. They have been having issues with their liquidity status and for this purpose we have used ratio analysis and looked at the advantages as well as the limitations of ratio analysis. Ratios across various areas such as liquidity, activity and profitability have been calculated to get an overall view of the companies operating efficiency as well as profitability.
Ratio Analysis
Ratio analysis is a useful tool for financial analysis and it simplifies a lot of complex numbers into simple data. (Kothari, 2004)For example, a profit of 15 million AUD in context doesn’t tell much about profitability of a company but a ROE of 12% does tell a potential investor the kind of returns he can expect after investing in the stock.
Profitability Ratios
Return on Equity
Return on Equity or ROE is the return on shareholders’ equity and obtained or calculated by dividing net income with the shareholder’s equity. (Damodaran, 2007)
Return on Assets
Return on Assets or ROA is the return on the total assets employed by the company, it is obtained by dividing the net income with total assets. (Gibson, 2012)
Gross profit margin
Gross profit is calculated by subtracting cost of sales from revenues and then gross profit margin is calculated as percentage of revenues. (Bajkowski, 1999)
Net Profit Margin
Net profit margin is calculated by dividing net income as a percentage of total sales or revenues.
Summary of the ratios
It is observed that while the ROA was 3.9% for the year 2015 it has improved significantly to 7.5%. However not much can be looked into it as a significant profit are eaten up by depreciation expense. And the improvement in ratio has much to do with the diminishing value of assets and also to the significant decrease in depreciation expenses. Gross Profit margin has also marginally improved to 55% from 53.33%. Gross profits are quite high but when we look at net profit margins we see that they fall significantly to 10% and 6.11% respectively. While the net profit margins have improved on account of reducing depreciation expenses they are still very low as compared to gross profit margins and that has much to do with high operating costs of efficient distributors. ROE just like the other profitability ratios has shown an improvement from 7.65% to 13.61%.
Liquidity ratios
Current Ratio
The current ratio is obtained by dividing the current assets with the current liabilities. It is a measure of the liquidity position of the company and generally below 1 is considered a risky position to be in, however this number is highly industry specific. (Bajkowsi, 1999)
Quick Ratio
Quick ratio calculated much like current ratio is considered a better measure of liquidity because it subtracts inventory from the current assets to calculate the ratio. The reasoning is high inventory levels make the current ratio bloated and don’t give a fair idea about company’s liquidity position.
While the current ratio has shown a decline of 8% from 1.83 to 1.68 the quick ratio has shown an even steeper decline percentage wise of 12% from 0.78 to 0.68. The current ratio would look fine but such a difference between the two ratio indicate that Efficient distributors are parking a significant portion of their current assets in the inventory which is hampering their liquidity position on a short term horizon.
Cash flow ratios
Cash flow ratio has been calculated by dividing the operating cash flow with the net sales for the year. While the figure for 2015 was 0.26 that for 2016 is 0.19. The decrease in cash flow is due to decrease in depreciation expenses and increased tax payments.
Activity ratios
Inventory turnover
Inventory turnover is obtained by dividing the total sales with the inventory. The number is a measure of the rotations of inventory done in a year and hence a higher number is always better. (Kirkham, 2010)
Receivables Collection period
Receivables collection period is obtained by using the formula 365/Receivables Turnover. Receivables turnover is gain given by the formula Accounts Receivables/Total Sales.
Summary of the two ratios
The inventory turnover while in 2015 was 3.87 has increased to 4.71 bodes well for the company as it means that they are managing their inventory better. Similarly, average collection period has also improved from 60 days to 45 days which means that the company is realising g their payments faster. This would mean a reduction in working capital.
Cause of the current situation
Poor inventory turnover can be seen as a probable cause for the current situation of Efficient Distributors. Not only does it severely impact that their liquidity ratios but also it means increased financing costs on the working capital which consequently affects the profitability as well. Even though the profitability ratios have improved not much can be seen in it as because as discussed earlier decreased depreciation expenses have inflated these ratios.
Proper inventory management techniques so that not too much capital is blocked in it would be recommended course of action for Efficient Distributors. Apart from that to further improve their receivables collection period would bode well for Efficient Distributors. It is seen from their financial statements that in 2016 41000 out of 69000 of current assets is invested in inventory which is almost 70%. Ideally they should aim to get this figure below 50%.
b.) Limitations of analysis
Apart form that the biggest advantage of financial ratios which is simplifying complex data can sometime be its biggest drawback as well as it tends to distort information. (Oysazar, 2012) For example, as seen in our scenario improvement in certain ratios would tend to paint a picture that company has improved its performance significantly however that is not the case and the real reasons behind improvement in the ratios has become evident only after close investigation of the reasons behind it which is not possible for a layman to do.
c.) Additional information required
For any ratios be it profitability, activity or liquidity are industry specific. Hence unless the nature of industry is known and industry averages are not known it is very difficult to determine whether the number is good or bad. For example, an inventory turnover of 4 might be considered very good for an automobile manufacturing industry whereas that of 4 for a retail business of fast moving items would be considered extremely poor. Therefore, having industry averages would have given us a fairer idea about the position of Efficient Distributors. Secondly statement of cash flows hasn’t been provided and hence we are not able to ascertain where they are spending the money. Unless we have an idea as to where the money is going the analysis wouldn’t be holistic.
The purpose is to analyse the given information and charter possible future courses of action which would be in the best interest of all the parties involved and at the same time be ethical in nature.
Facts
Allendale is in the boat building business and has a debt of 10 million AUD for which they always need to maintain a current ratio of 2:1 and their post-tax ROA should be higher than 10%.
Stake-holders
The stake-holders of Allendale are its employees, its vendors and customers, the financial institution from which it has borrowed money and the owners, promoters and other share-holders.
Problem
Since an inventory item is valued at a higher price this has inflated the value of current assets and therefore increase the ratio as well. Since current ratio is given by current assets to current liabilities an increase on the numerator side with the denominator being constant would obviously deflate the ratio. The ROA which is given by Net income to total assets should never be less than 10%. Allendale has provision for bad debts on their balance sheet which is currently 0.3 million AUD however this would not be sufficient as the bad debts would be 0.5 million AUD since an account payable of 1 million would only be paid in half. Consequently, as a result of this ROA would fall.
With the two requisite parameters falling below safety margin, the company would face threat of bankruptcy as the bank would pull its loan back and employees would lose the job. This would happen only if Tom the accountant was to report it. Hence he faces an ethical dilemma.
The two ethical principles that are relevant to this particular problem is utilitarianism and deontology. The first principle states that any action should have the interest of maximum group of stakeholders whereas the second principle states that a person should focus on the action rather than the outcome. (Bazley, et al., 2014)
Possible Course of Action
Based on the problems there are the possible courses of action that Tom can opt for.
He can choose to keep quiet about the matter thus helping the company stay afloat and everyone including himself keeps their jobs,
The second course of action can be that he reports the anamolities observed without worrying about the outcome and fulfilling the ethical responsibilities that his role as as an accountant asks him to perform.
Thirdly he can also opt to barely report the matter to higher authorities and chose to shrug off any responsibility that might come with him taking an action.
Evaluation of Actions and Choice of Action
While his first course of action would benefit maximum stakeholders group in the overall moral code of ethics it seems to be a very poor decision. The second course of action though might be detrimental for a lot of stakeholders seems the ethically right thing to do. (Chonko, 2012)Tom should go for the second course of action and that would be also in best interest of corporate governance as he and his company would be making balanced disclosure.
While facing an ethical dilemma a person should act in a morally correct manner and one which his profession demands. As an accountant it is Tom’s job to be balanced and make disclosures timely, fairly and in an unbiased manner.
The purpose of this paper is to examine the case of Giggling brothers a wine retailer who have been facing problems due to lack in co-ordination between the accounts and the purchasing department. The problems are due to cash flows which occur due to excessive inventory. The management is of the opinion that the problems are a result of not having proper accounting systems in place. Hence we try to analyse whether computerised accounts can bring about a difference.
Current accounting and reporting systems
Currently the accounting systems in place at Giggling Brothers are manual. What happens is that the accounting department communicates to the purchasing department when their stocks are depleted to a certain point and then the purchasing department orders new stock. The inventory levels are maintained manually which can never be easy because it involves a lot of tedious work which is sometimes beyond the scope of manual systems. (Raoa & Rao, 2009) Perpetual inventory system needs to be maintained for which a proper IT infrastructure needs to be enabled. (CMA, 2013)
Benefits of a IT enabled system
If an IT enabled system is in place the inventory levels would be reported properly. The benefits are twofold. First of all, inventory is managed properly, secondly reporting system when computerised would enable all departments to know about inventory levels on a real time basis. This would mean that less investments in inventory and hence the company wouldn’t face problems of cash shortages which it has been facing frequently earlier. (Kot S., 2011)Secondly it would also mean that in times of high demand the company doesn’t face stock outs which can be detrimental for their business. Similarly, another problem that the company seems to be facing is incorrect reporting of demands by the sales department. Again having computerised systems would enable forecasting of demand and it would enable the purchasing department to order better. This in effect would again reduce costs associated with holding excess inventory.
Cost benefit analysis
Cost benefit analysis is a useful tool which helps determine the usefulness of a capital investment. Now if we were to do a cost benefit analysis we would have to determine the benefits associated with implemented the computerised accounting and reporting systems and whether their benefits in the longer run exceed the costs. (Precision Group, 2010) A good tool for this could be taking NPV of the benefits after the implementation of IT enabled systems in both reporting and accounting departments. Suppose if we the company were to invest 25,000 dollars in getting their systems designed and their WACC is 8% a good way of doing cost benefit analysis could be whether their benefits provide them an IRR of more than 8% or else another way could be to see if the Present values of these cash flow discounted by 8% are more than 25,000 dollars which is the initial amount spent to get the system designed.
Since the problem are arising due to lack of coordination between four levels or departments i.e. the management, sales department, purchase department and the account department it is necessary that all these departments be represented and have a say in the design of the accounting systems. (CMA, 2013)The sales department grouse is that management has unreal expectation of sales and hence they should be involved in how sales forecasts are carried by these systems. Sales department has grouse that the accounting department doesn’t communicate them about the levels of account receivables. Hence systems need to be in place which update the sales team about status of accounts to be collected. For example, certain customers aren’t given more credit than warranted because that raises the risk of bad debts as well. Accounting department has a problem that they are not consulted about expenditures and are not updated about credit history of customers. If they are taken into the mix systems can be enabled where each customer would have a credit rating and payment history which would help the sales team to decide how much credit and on what terms should sales be made to certain customer based on patterns of their purchases over the course of time.
Similarly purchase department and management also need to work in tandem and decide what purchasing patterns they want to establish so that they can achieve a balance. Neither do they want to hold excessive inventory nor do they want to face the risk of stock outs.
Conclusion
It is clearly evident from our analysis that comutersied accounting systems can sort out the various coordination problems between the various departments of Giggling which are leasing to issues such as cash shortages and mis timed marketing drives. Not only that but also it can lead to a lot of other benefits such as better inventory turnovers, reduction in accounts collection period. All these would have a positive effect on the efficiency productivity and profitability of Giggling.
References
Bajkowsi, J., 1999. Financial Ratio Analysis:Putting the numbers to work. AAII.
Bajkowski, J., 1999. A Look at the Corporate Cash Flow Statement. AAII.
Bazley, M., Hancock, P. & Robinson, P., 2014. Contemporay Accounting. s.l.:Cengage Learning.
Burns, J., Hopper, T. & Yazdifar, H., 2004. Management accounting education and training: putting management in and taking accounting out. Qualitative Research in Accounting and Management, pp. 1-29.
Chonko, L., 2012. Business Ethics, Arlington: s.n.
CMA, 2013. Management Accounting: Roles and Challenges ahead. On Targer Direct, 19 August.
Damodaran, A., 2007. Return on Capital (ROC), Return on Invested Capital (ROIC), s.l.: Stern School of Business.
Gibson, C. H., 2012. Financial Reporting and Analysis. New York: Cengage Learning.
Kirkham, R., 2010. Liquidity Analysis Using Cash Flow Ratios and Traditional Ratios: The TelecommunicationsmSector in Australia. Journal of New Business Ideas & Trends , 10(1), pp. 1-12.
Kot S., G. K. S. R., 2011. THEORY OF INVENTORY MANAGEMENT BASED ON DEMAND. Polish Journal of Management Studies.
Kothari, S. P., 2004. Financial Statement Analysis, s.l.: MIT Sloan School of Management.
Oysazar, H., 2012. Advantages and Disadvantages of Financial Ratios. [Online]
Available at: https://yourbusiness.azcentral.com/advantages-disadvantages-financial-ratios-1679.html
Precision Group, 2010. Manage Budgets and Financial Plans. s.l.:s.n.
Raoa, C. M. & Rao, K. P., 2009. INVENTORY TURNOVER RATIO AS A SUPPLY CHAIN PERFORMANCE MEAUSRE. Serbian Journal of Management, pp. 41-50.
Tugas, F. C., 2012. A Comparative Analysis of the Financial Ratios of Listed Firms Belonging to the Education Subsector in the Philippines for the Years 2009-2011. International Journal of Business and Social Science , 3(21).
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