Financial Statements Evaluation And Management Accounting Tools

Evaluation of Financial Statements

Ratio analysis plays an important role in analyzing the financial health of the company. They provides the bird’s eye view of the company’s operational and financial performance by analyzing the financial numbers. In the given case, Mary Norton, the manager of Borrower’s Ltd. has provided some details and ratios. These ratios are

• Current ratio(Momoh, 2018) – This is an important liquidity ratio, and reflects the company’s ability to pay its current liabilities from its current assets; it is calculated by dividing current assets with current liabilities. Hence, the company’s ability to pay off its current liabilities is reflected from its current ratio.

The ideal current ratio is 2:1. If the current ratio is below than 1, than it means that the company’s liabilities are greater than the company’s assets. This is not a good signal for company’s health as the company does not have sufficient current assets to settle its current liabilities. Further, if the current ratio is greater than 3, than although it shows that the company is having sufficient current assets for paying its current liabilities but on the same hand, it reflects the company’s inability to properly utilize its current assets.

In the given case, the current ratio of Borrowers Ltd. is 2.1:1 in the year 2017, which is the perfect current ratio and shows that the company has sufficient current assets to pay off its current liabilities by simultaneously utilizing its current assets effectively.

• Quick Ratio (Momoh, 2018) – Quick ratio is company’s ability to pay off its current liabilities from its quick assets. Quick assets are those assets which can be converted into cash within a period of 90 days or in a short term period, and is calculated by subtracting inventories and prepaid expenses from current assets.

The higher the quick ratio the better it is, however too high quick ratio reflects the company’s inability to properly utilize its quick assets. The Ideal quick ratio is 1:1.

In the given case, the quick ratio of the company is 1.4:1 in year 2017 as compared to 0.8 in year 2016. Hence, it reflects that the company has sufficient quick assets to pay off its current liabilities and moreover, the company’s quick ratio has been significantly improved from the last year.

• Assets turnover ratio(Momoh, 2018) -Assets turnover ratio shows that the efficiency of company’s assets to generate the sales revenue and is calculated by dividing net sales with the average assets. This ratio is higher the better as higher ratio indicates that the company’s is generating more revenue per dollar of assets.

In the given case, the company’s asset turnover ratio has fallen from 2.8 to 2.2 which means that the revenue generated per dollar of asset has fallen from 2.8 to 2.2.

• Cash debt coverage(Accounting for Management, 2018) – Cash debt coverage ratio is the company’s ability to pay off its current liabilities from its cash generated from operations and is calculated by dividing cash generated from operations with the current liabilities. Generally, the cash debt coverage ratio of 1:1 is considered good. However, the higher the ratio the better it is.

In the given case, the company is having cash debt coverage ratio of 0.2 in year 2017 as compared to 0.1 in year 2016, it means that the company’s cash generated from operations are unable to pay off the company’s current liabilities. This ratio is unfavorable to the company and reflects that the cash generated from operations is insufficient to cover the liabilities and the company can face liquidity crunches in the future.

• Profit- Profit is the important element and driving factor for any business, in the given case, the profit of the company has fallen by 8% in the year 2017 as compared to profit in year 2016, so it in unfavorable for the business.  

• Earnings per share- Earning per share is the amount of income generated by business on every share held by the investors. This is an important ratio for the investors as it shows the amount earned by them on their investments. Since, the profit earned has gone down, the EPS of the company is also down by $0.8 as compared to earlier year.

The other three ratios to be included are:

• Profit Margin ratio- This is an important profitability ratio and is calculated by dividing net profit with net sale. This shows the % of profit generated as compared to sales. Or in other words, the profit per $ of sale. From this ratio, the company’s profitability performance can be evaluated.

• Debt to Equity Ratio- This ratio shows the proportion of debt and equity in the capital structure of the company and is calculated by dividing total liabilities with total shareholder’s equity. It helps in evaluating whether additional loan can be granted to the company or not to maintain the optimum debt to equity ratio.

• Debt Service Coverage Ratio– This ratio reflects that whether the company’s operating profit are sufficient to meet the debt service obligations. This ratio is most useful in evaluating the company’s eligibility for further loan and the company’s credibility to pay off the loan and interest in the future.

The limitations of ratios analysis for credit and investing decisions are  (Bragg and Bragg, 2018):

• The ratios are calculated on the basis of current business conditions, if these conditions changes, than the ratio analysis will be no use.
• The results of ratio analysis has many interpretations and it depends upon person to person, that how he interprets the results.
• The ratio analysis is based on the historical information and does not take into account the future transactions.

The trend analysis is as below:

Items	Year 2017	Year 2016	Year 2015	Year 2014	Year 2013
Net Sales	4,555.20	4,350.90	3,222.20	2,943.70	3,080.30
Increase in Sales ($)	204.30	1,128.70	278.50	(136.60)
Increase in Sales (%)	4.70%	35.03%	9.46%	-4.43%
Profit After Tax	966.20	1,166.20	919.90	799.30	462.90
Increase in PAT ($)	(200.00)	246.30	120.60	336.40
Increase in PAT (%)	-17.15%	26.77%	15.09%	72.67%

The above trend analysis shows that the company’s sale has been decreased in Year 2014 and its PAT has been increased. Similarly, for the years 2015 and 2016, the company’s sales and profit both have been increased as compared to previous years whereas in the year 2017 the sale has grown by 4.70% whereas the PAT has gone down by 17.15%. Overall, the company’s trend was positive till the year 2015 as PAT was growing and from the year 2016, the PAT has started to decline.

Calculation of the ratios for New Zealand Post Group:

Particulars	Formula	Calculations
2017	2016
Profitability Ratios
Operating Profit Margin	EBIT / Net Sales	(25+6)/890	(170+27)/1485
		3.48%	13.27%
Return on Assets	EBIT / Average Total Assets	(25+6)/((1818+20260)/2)	(170+27)/((20260+19201)/2)
		0.28%	1.00%
Net Profit Margin	Net Profit / Average Total Assets	109/((1818+20260)/2)	152/((20260+19201)/2)
		0.99%	0.77%
Return on Equity	Net Profit / Average Owner’s Equity	109/((1285+1293)/2)	152/((1293+1154)/2)
		8.46%	12.42%
Financial Stability
Debt Ratio	Liabilities / Total Assets	533/1818	18967/20260
		0.29	0.94
Debt to Equity	Liabilities / Equity	533/1285	18967/1293
		0.41	14.67
Interest Cover(Times Interest Earned)	EBIT / Interest Expense	(25+6)/6	(170+27)/27
		5.17	7.30
Assets Utilization
Assets Turnover Ratio	Net Sales / Average Total Assets	890/((1818+20260)/2)	1485/((20260+19201)/2)
		8.06%	7.53%

Ratio Analysis for Financial Health

The company’s profit have fallen sharply which is reflected by Operating profit margin ratio which has been reduced from 13.27% to 3.48%. Almost all the profitability ratios show a decline in current year except net profit margin ratio which has been increased from 0.77% to 0.99%, which shows that the net profit per $ of assets has been increased. Moreover, the return on assets and equity ratios has also fallen from 1% to 0.28% and from 12.42% to 8.46%, which means that the return generated on assets and equity has reduced, this is because of reduced profit. Overall, the profitability ratios are not satisfactory.

The financial stability ratios also show a steep decline from last year. The debt ratio has reduced from 0.94 to 0.29 showing that the liabilities have significantly reduced as compare to total assets of the company. Moreover, the debt equity ratio has also declined from 14.67 to 0.41 meaning thereby that the debt component in the capital structure of the company has reduced significantly. Moving towards, Interest coverage ratio, which has declined from 7.30 to 5.17 this year. Which means that the company’s operating income is 5.17 times of its interest obligation. Overall, the financial stability ratio seems to be satisfactory.

Moving to assets utilization ratio which has been increased from 7.53% to 8.06%, it means that the net sales per dollar of assets has been increased, which is a good signal for financial health of the company.

Yes, cash flow from operating activities is an important ratio for financial decision making, however, we don’t agree with his view that if the cash flow from operations is less than the earnings figure, then the company is in a poor financial health and has poor investment prospects. This is so because, the cash flow from operations is calculated after netting off of investing and financing activities, which are also an integral part of the business. So, to check the financial health other aspects like non-cash items like non cash income and expense and cash flow from investing and financing activities should also be taken care off.

Although, it is good if the cash flow from operations are greater than the earnings, but it is incorrect to say that the business has poor financial health if the cash flow from operating activities are lower than the earnings.

Schedule of Expected Cash Receipts from Debtors
			(Amount in $)
Particulars	January	February	Total
Sales	60,000	55,000	115,000
Credit Sales for the month	42,000	38,500	80,500
Collection from debtors
In the month of sale	16,800	15,400	32,200
In the month after sale	–	25,200	25,200
Total cash collection from debtors	16,800	40,600	57,400

Cash Budget
			(Amount in $)
Particulars	January	February	Total
Cash Collections
Cash sales	18,000	16,500	34,500
Collection from debtors	16,800	40,600	57,400
Capital contribution received	85,000	–	85,000
Total cash collections	119,800	57,100	176,900
Cash Payments
Payment to suppliers	–	35,000	35,000
Office salaries	10,000	12,500	22,500
Cash withdrawal by Owner	3,000	3,000	6,000
Total cash payments	13,000	50,500	63,500
Net increase/(decrease) in cash	106,800	6,600	113,400
Opening cash balance	–	106,800	–
Expected closing cash balance	106,800	113,400	113,400
Minimum cash balance	15,000	15,000	15,000
Excess cash	91,800	98,400	98,400

Yes, the business can pay the instalment of $ 80,000 that will be due on the new machinery, as the company has an expected cash balance of $113,400 at the end of 28 February, 2018.

Sales budget in units
Particulars	October	November	December	Total
Sales	22,000	27,000	32,000	81,000
Sales (in units)	22,000	27,000	32,000	81,000
Sales budget in Dollar
				(Amount in $)
Particulars	October	November	December	Total
Sales	22,000	27,000	32,000	81,000
Sales price per unit	5.5	5.5	5.5	5.5
Sales amount	121,000	148,500	176,000	445,500

Purchase budget in units
Particulars	October	November	December	Total
Sales	22,000	27,000	32,000	81,000
Add: Desired Finished Goods inventory	8,100	9,600	9,000	26,700
Total units to be purchased	30,100	36,600	41,000	107,700
Purchase budget in Dollar
				(Amount in $)
Particulars	October	November	December	Total
Units to be purchased	30,100	36,600	41,000	107,700
Purchase price per unit	4	4	4	4
Purchase amount	120,400	146,400	164,000	430,800

Cash Budget
				(Amount in $)
Particulars	October	November	December	Total
Cash Collections
Cash sales	108,900	133,650	158,400	400,950
Collection from debtors (WN-1)	9,900	12,100	14,850	36,850
Total cash collections	118,800	145,750	173,250	437,800
Cash Payments
Payment to suppliers (WN-2)	93,600	98,400	120,400	312,400
Total cash payments	93,600	98,400	120,400	312,400
Net increase/(decrease) in cash	25,200	47,350	52,850	125,400
Opening cash balance	17,000	42,200	89,550	17,000
Expected closing cash balance	42,200	89,550	142,400	142,400
WN-1: Schedule of Expected Cash Receipts from Debtors
Particulars	September	October	November	December
Sales	99,000	121,000	148,500	176,000
Credit Sales for the month	9,900	12,100	14,850	17,600
Collection from debtors
In the month after sale		9,900	12,100	14,850
Total cash collection from debtors		9,900	12,100	14,850

WN-2: Schedule of Expected Cash Payments to Creditors
					(Amount in $)
Particulars	August	September	October	November	December
Purchases	93,600	98,400	120,400	146,400	164,000
Credit Purchases for the month	93,600	98,400	120,400	146,400	164,000
Payments to Suppliers
2 months after purchase			93,600	98,400	120,400
Total cash payment to suppliers			93,600	98,400	120,400

Variance analysis is the investigation of the differences and reasons of such differences between planned and actual activities. It helps in managing budgets and planning and controlling the actuals. It acts as a control mechanism and helps in lowering the deviations from budgets. It also helps in fixing the responsibility of the involved department.

The limitation of variance analysis is that if the budgets are not made with care and after taking into relevant factors, then the actual numbers achieved can be much deviated from budget numbers, and in such a case, the purpose of budgeting gets defeated.

References:

Momoh, O. (2018). Current Ratio. [online] Investopedia. Available at: https://www.investopedia.com/terms/c/currentratio.asp [Accessed 10 May 2018].

Momoh, O. (2018). Quick Ratio. [online] Investopedia. Available at: https://www.investopedia.com/terms/q/quickratio.asp [Accessed 10 May 2018].

Momoh, O. (2018). Asset Turnover Ratio. [online] Investopedia. Available at: https://www.investopedia.com/terms/a/assetturnover.asp [Accessed 10 May 2018].

Accounting for Management. (2018). Current cash debt coverage ratio – explanation, formula, example and interpretation | Accounting for Management. [online] Available at: https://www.accountingformanagement.org/current-cash-debt-coverage-ratio/ [Accessed 10 May 2018].

Bragg, S. and Bragg, S. (2018). The limitations of ratio analysis. [online] AccountingTools. Available at: https://www.accountingtools.com/articles/what-are-the-limitations-of-ratio-analysis.html [Accessed 10 May 2018].