An integrated approach with effective administration, adequate financing and capable human resource may lead a business organisation towards the path of goal attainment. Disintegration among these elements may lead towards its own demise sooner or later. Pace Leisurewear Ltd is a company that designs and manufactures the casual and leisure clothes aimed particularly at the younger, higher-income market. It was established by Jill Dempsey and Mike Greaves, who are the Managing Director and Production Manager of the company respectively.
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By observing the case study of this company, we know that the company is in trouble because the letter from the company’s bank was asking it for the reduction in the overdraft. This letter from the bank has made them worried because if they can’t keep up the overdraft, they will not be able to fulfil the big order by Arena, which was one of the several national chains of casual and sportswear stores that was placing substantial orders with Pace. It shows that they were facing liquidity problem. A general outlook of the case study putting aside the financial statements provides us with some other difficulties that the company was facing.
Trading of the company during the recession period was a problem. Moreover, recession itself was a problem for the company. Though it was a big company, the production director Mike was looking after the financial matters. There was no one within the company who had any great financial expertise. When there was a problem, the company’s auditors were normally asked for advice. The company is facing poor cash situation as conveyed by Mike Greaves which might be result of their spending on fixed assets like plant. Declaration of no further investment in the company by the largest shareholder Keeble States also came as a shock to the company when there was a hope that Keeble States would invest money and they would be able to issue overdraft. Also, an indifference of the largest shareholder in the affair of the company can be regarded as a problem. Such indifference directly affects the operation of company that ultimately, has the effect on financial situation of the company.
Breaching of the overdraft limit over the past few years by the company functioned as a proof of their dishonesty. Also, we can identify that the company was running along with the conflict between the largest shareholder Keeble brothers and the other board members. The other board members were bringing forth the idea of introducing another major shareholder, which was against the wish of Keeble brothers. So, the company was facing the problem in decision making.
A quick look upon the balance sheet of the company, gives us the information that there is a massive increment in the non-current assets. Though investment in the non-current assets is good for the company in the long run, it may cause problem to the company in its day to day operation. It may create an inadequacy of working capital which is necessary for daily activities. The amount of trade receivables has increased which indicates that the goods are being sold on credit.
Calculation and Interpretation of Financial Ratios
The income statement and balance sheet are the traditional basic financial statements of a business enterprise. They do not give all the information related to the financial operations of a firm. Still, they provide some extremely useful information to the extent that balance sheet mirrors the financial position on a particular date in terms of structures of assets, liabilities and owners’ equity and others and profit and loss account shows the results operations during a certain period of time in terms of revenues obtained and the cost incurred during the year.
In depth analysis of financial statements is supported with ratio-analysis. It is the most widely used technique of financial statement analysis. Ratio analysis is a systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined. Ratios are relative figures reflecting the relationship between variables. A single figure by itself has no meaning but when expressed in terms of related figure, it yields significant inferences. Ratios can be divided into profitability ratio, liquidity ratio and activity ratio.
To analyse the financial statement and condition of the Pace Leisurewear Ltd, the method of ‘ratio analysis’ is used as a major tool. Here, return on capital employed, return on equity (shareholders’ fund), gross profit margin, net profit margin, inventory holding period, average collection period for trade receivables, sales to capital employed ratio, current ratio, quick assets (liquid or acid test) ratio and gearing ratio are used as major tools for the interpretation of business condition and financial statements, though there are other tools for the interpretation. Calculation and interpretation of these ratios provide us with the information about liquidity, profitability and efficiency of the company. The calculation and interpretation of the ratios can be shown as below:
Calculation
S.N.
Description
Formulas
Year before last
Last Year
a)
Return on Capital Employed
=20.05%
=29.60%
b)
Return on Equity
=18.15%
=32.51%
c)
Gross Profit Margin
=46.48%
=48.16%
d)
Net Profit Margin
=14.99%
=20.61%
e)
Inventory Holding Period
=117.74 days
=182.84 days
f)
Average Collection Period
=42.10 days
=60.98%
g)
Sales to Capital Employed
=1.34 times
=1.44 times
h)
Current Ratio
=1.76 times
=1.13 times
i)
Acid Test Ratio
=.78 times
=0.47 times
j)
Gearing Ratio
=34.40%
=42.30%
Return on Capital Employed (ROCE)
ROCE ratio tells us how much profit we earn from the investment the shareholders have made in their company. If the company has low ROCE ratio, it is using its resources inefficiently, even if its profit margin is high. The higher the ratio the more efficient is the use of capital employed.
In context of the Pace Leisurewear Ltd, ROCE ratio was increased in the last year than the year before last. From the calculation, we got, it was 30% in the last year whereas it was 20% in the year before last. So, we can say that the company had better performance in the last year than the year before last.
Return on Equity
This ratio indicates the profitability to the shareholders of the firm with deduction of all expenses and taxes.
In context of this company, the return on equity ratio was increased which is good for the company. It was 32.5% in the last year and 18% in the year before last.
Gross Profit Margin
It indicates the efficiency of operations and firm’s pricing policies. The larger the gross profit margin, the better for the company. It looks at how well a company controls the cost of its inventory and manufacturing of its products and subsequently pass on the cost to its customers.
From the calculation we found that the gross profit margin ratio was increased. It was 46.16% in the year before last and 48.16% in the last year which is good for the company.
Net Profit Margin
This ratio measures the relationship between net profit and sales of a firm. A high net profit margin in ratio is an indicative of adequate return to the owners as well as enables a firm to withstand adverse economic conditions. A low net profit margin ratio has the opposite implications.
From the calculation, we found that the net profit margin ratio was increased. It was 8.91% in the year before last and 13.10% in the last year. It shows that the company was selling well which is good for the company.
Inventory Holding Period
A high number of days inventory indicates that there is lack of demand for the product being sold whereas a low days inventory holding period may indicate that the company is not keeping enough stock on hand to meet the demands.
It is known from the above calculation that the inventory holding period for the company in the year before last was 63 days and for the last year it was 95 days. So, this extension in the inventory holding period is a problem for the company which obstructs the path of cash generating.
Average Collection Period of Trade Receivables
This ratio indicates the speed with which debtors/accounts receivables are being collected. A short, collection period implies prompt payment by the debtors. It reduces the chance of bad debts. Similarly, a longer collection period implies too liberal and inefficient credit collection performance.
From the calculation, we found that, the collection period for the debtors/accounts receivables for the year before last was 42 days whereas for the last year it was 61 days. So, it indicates that the company was inefficient in its credit collection performance. This delay in the collection of receivables, may have adverse effect in the liquidity position and also there lies possibility of accounts receivables being bad debts.
Sales to Capital Employed Ratio
It is the ratio which indicates the relationship between the capital employed and sales revenue. The higher the ratio the higher is the revenue, the lower the ratio the lower the revenue.
From the calculation, we found that the ratio of capital employed in the year before last was 1.34 times and for the last year it was 1.44 times. It indicates that the Pace Leisurewear Ltd was generating more revenue.
Current Ratio
The ratio of total current assets to total liabilities is current ratio. It measures the short term solvency, that is, its ability to meet short term obligations. The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they come due at that point.
From the calculation, we found that the current ratio for Pace Leisurewear Ltd in the year before last was 1.76:1 and for the last year it was 1.44:1. This ratio indicates that the short-term solvency of the company was getting poorer.
Quick Assets ( liquid or acid test) Ratio
It is the ratio between quick current assets and current liabilities. It shows a firm’s ability to meet current liabilities with its most liquid assets. Companies with the ratio less than 1, are supposed to be in vulnerable condition. Such companies are unable to pay their current liabilities, which show the dependency of current assets on inventory.
In case of this company, it was found that quick assets ratio was getting weaker. It was 0.78:1 in the year before last and 0.47:1 in the last year. It indicates that the company was in difficulty of paying current liabilities. It was even weaker in the last year than the year before last.
Gearing Ratio
The higher the gearing, the higher the dependence on borrowing and long term finance. The lower the gearing ratio, the higher the dependence on equity financing.
Here, in case of this company, the gearing ratio for the last year was 42.3% and 34.4% for the year before last. It shows that the company had a reliance on sources of long term loan.
Conclusion and Recommendation
From the above calculation and interpretation of the ratio and its analysis based on the two years’ financial statement of the Pace Leisurewear Ltd, we came to know that the company was facing mainly a liquidity problem. In order to get rid of such financial problem, assuming myself as a member of Drake Management Consultants, would like to recommend that the company should issue the shares, increase the cash sales rather than credit sales, collect the trade receivables promptly, decrease the long term liabilities and not exceed the limit of overdraft. Beside this, it needs to employ a financial expert and develop an environment of mutual understanding and trust among the shareholders and board of directors.
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