The Role And Importance Of Financial Analysis In Decision Making

Who Can Benefit from Financial Analysis?

Discuss about the Financial Analysis of Melbourne Trading Corporation.

The role and importance of financial analysis and interpretation in decision making cannot be underestimated. In a dynamic business world of today, financial analysis and interpretation are useful to a number of parties to a company. First, financial analysis is useful for financial managers of a company because it provides a framework from which the firm is to achieve a certain desired level of financial performance (Johnson, 1968, pp.78). The financial statement is also useful to both the existing and potential investors. Potential investors have to be sure of where to invest their funds (Subramanyam, 2014, np.). They would, therefore, be forced to consult competent financial analysts and consultants for advice before making the decision of investing in a certain industry or company or not.

 Financial researchers have found out that effective financial statement analysis of a company is not only useful for effective business management decision making by assisting in locating areas for improvement but also giving a ‘‘caveat’’ to potential investors, creditors, customers and the employees of the corporation (Clor-Proell, Proell and Warfield, 2010, np.). Financial analysis also provides a framework for valuation of the financial performance and the price of shares for a company that is quoted on the Australian Stock Exchange (ASX). The nature of financial statements presented by the owner of Melbourne Trading Corporation presents a number of subjects for discussion.

Looking at the financial statements of Melbourne Trading Corporation for the financial periods 2014, 2015 and 2016, there is a lot of issues that can be raised. The best way for analyzing the financial performance trends of a company is trough ratio analysis (Nwaobia, Jayeoba and Ajibade, 2012, pp. 100). Before looking at the detailed analysis of Melbourne Trading Corporation, a shallow overview can be undertaken to find out the changes that might have occurred on the financial statements over the three-year period.

Changes in Sales Value

Looking at the sales figures for Melbourne Trading Corporation for the financial periods, 2014,2015 and 2016, there is an indication that the sales for the company have been increasing at a very slow rate from 2014 to 2016. The sales amount in 2014 was worth 400 000. This figure slightly increased to 405 000 in 2015 and 410 000 in 2016. This slight increase in the sales figure might have been contributed by seasonal factors such as economic stagnation and depression (Park, Ahn, Nam and Jung, 2007, np.). Negative or zero economic growth rate might have hindered the realization of a substantial increase in the sales figure of the company in the subsequent years (Zeng, 2007, pp. 450). Wholesale or retail sales for a company can also be slowed down by factors such as the decrease in the level of real income in the country, higher rates of unemployment, inflation and general economic contraction (Andrikopoulos, 2015, pp.100).

Melbourne Trading Corporation: A Case Study

Changes Cost of Sales

The cost of sales for the company has been increasing tremendously from the year 2014 to 2016. In 2014, the cost of sales was 250, 000. The figure increased slightly to 260 000 in 2015 and increased further to 275 000 in 2016. The increase in the cost of sales between the years might have been contributed by a rise in the price of purchases, carriage in costs or increase in production costs such as direct labour costs, direct materials costs, and overheads (Banker, Byzalov, Ciftci and Mashruwala, 2012, np.).

Changes in Gross Profit

From a mere look at the gross profits for Melbourne Trading Corporation, it is evident that the gross profit figure has been decreasing over the years. In 2014, the gross profit figure was a bit high at 150 000. The figure slightly dropped to 145 000 in 2015 and further to 135 000 in 2016. The main reason behind this decline in gross profits is because of the increase in costs of sales (M.A.Dhandapani and K.Radha, 2011, pp. 370). When the costs of sales amount increase without a corresponding increase in the number of sales, then much of the sales proceeds will be taken up by the costs and thereby eat on the profits margin of the company.

Changes in Amount of Expenses

The expenses for Melbourne Trading Corporation is made up of the selling, administration, finance and interest expense. An overview through the selling expenses shows that the figure has been increasing form the year 2014 to 2016. In 2014, the figure stood at 50 000 before it increased to 55 000 in 2015 and further to 56 650 in 2016. The increase in the sales figure might have been due to an increase in the salaries and wages for the salespersons, promotion costs, carriage outwards costs and any other costs incurred by the sales department in the process of selling the products (Improving Profits – How Expenses Change | AccountingCoach, 2018, np.). When it comes to the administration expenses, the amount increased from the year 2014 from 40 000 to 42 000 and then dropped in 2016 to 39 900. The company might have implemented cost-saving measures in 2016. The finance expenses for Melbourne increased from 2014 to 2016. Finance expenses are costs related to interests and other costs of borrowing money. This shows that the company might have borrowed more funds to use in purchasing more inventory or assets. On the interest expense, the amount was 15,000 in 2014 before it rose to 18,000 in 2015 and 20,000 in 2016. Interest expense represents the interest payable on borrowings. This means that the company spend more funds on the interest of borrowings in the year 2016 than in 2014.

Ratio Analysis

 Statement of Financial Position Overview of Melbourne Trading Corporation

The statement of financial position or a balance sheet of a company shows the assets, Liabilities and the Equity position of a company as at a given date. The statement lists the resources owned by the company, its obligations and other ownership details as at a certain date. The statement of financial position for Melbourne Trading Corporation is made up of the current assets, non-current assets, current liabilities, non-current liabilities and the owners’ equity (BRADBURY and NEWBY, 1989, pp. 35). The Current assets from the company decreased from 93,000 in 2014 to 90,000 in 2015 and remained constant at 90,000 2016. This means that the sum amount of stock receivables and stock on hand was the same in 2015 and 2016. When it comes to non-current assets, the figure was at 90,000 in 2014 and rose to 110,000 in 2015 and further to 212,000 in 2016. This shows that the company purchased more assets as the years progressed. It can be inferred that much of the assets were purchased used debt.

The Current Liabilities for the company was 28,000 in 2014, 42,000 in 2015 and 80,000 in 2016. Out of the 80 000 in 2016, 35 000 was bank overdraft meaning that accruals and accounts payables made up the remaining 45 000. There is an indication that the company was increasingly being financed by short-term debt from the year 2014 to 2016. Non-current liabilities were at 70,000 in 2014 before it rose to 89,500 in 2015 and further to 167,350 in 2016. The figures for non-current liabilities shows that the company acquired a lot of debt from 2014 to 2016. Coming to the Total owners’ equity we can identify that equity for the company was a bit low at 85,000 in 2014 and rose slightly to 68,500 in 2015 before declining to 54,650 in 2016. This means that some shareholders might have converted some of their shares into debt or might have pulled out their investments altogether (Ueda, 2009, np.).

Financial Analysis of Melbourne Trading Corporation

The most effective way of interpreting and analyzing a company’s financial performance is trough ratio analysis. Ratio analysis gives a quantitative measure of a company’s financial statements (Adedeji, 2014, pp. 90). It helps us to evaluate a number of aspects of the company’s financial and operating efficiency. Figure 1 and figure 2 below shows the profitability, solvency and efficiency ratios for Melbourne Trading Corporation.

Conclusion

Figure 1.                             
  Profitability Ratios – Financial Indicators

Financial Ratio	Formulas	2014	2015	2016
Return on owners funds ratio	Net profit÷ Equity	0.4	0.3	0.1
Return on assets ratio	Net Income ÷Total Assets	0.2	0.1	0.01
Gearing ratio	Long-term liabilities ÷Capital employed	0.8	1.3	3.1
Asset turnover rate	Net Sales ÷Total Assets	2.2	2.0	1.4
Fixed asset turnover rate	Net Sales÷ Fixed Assets	4.4	3.7	1.9
Stock turnover	Cost of sales ÷Average Inventory	6.25	5.7	5.5
Debtors turnover ( in days)	(Accounts receivable ÷Credit sales) 360	20.7	26.7	35.1
Profit ratio	Net profit ÷ Net sales	0.09	0.05	0.01
Gross profit ratio	Gross Profit ÷ Net Sales	0.38	0.36	0.32
Cost of goods sold ratio	Cost of sales÷ Sales	0.63	0.64	0.67
Selling expenses ratio	Selling expense ÷Net sales	0.13	0.14	0.14
Interest expense ratio	EBIT÷ Interest Expense	3.33	2.03	0.81
Administration expense ratio	Total sales ÷Administrative expenses	10	9.6	10.3
Finance expense ratio	Finance expense ÷Value of Assets	0.05	0.06	0.05

• It is assumed that all the assets owned by the company were financed with debt
• It is assumed that the sales figures represent the net sales for the company (i.e after deducting any returns inwards)

Figure 2.                                
  Financial Stability- Efficiency Ratios

Item		2014	2015	2016
Working Capital ($)	Current Assets – Current Liabilities	65 000	42 000	10 000
Working capital rate ($)	Current Assets ÷  Current Liabilities	3.3	2.1	1.1
Stock turnover rate( days)	Cost of Sales ÷ Average Inventory	6.25 days	5.7 days	5.5 days
Debtors turnover rate(days)	Net Credit Sales ÷ Average Accounts Receivable	17.4 days	13.5days	10.25 days
Days Sales Outstanding	360 Days ÷ Receivable Turnover	20.7days	26.7 days	35.1days
Days Inventory Outstanding	360 Days ÷ Inventory Turnover	57.6 days	63.2days	65.5 days
Operating cycle (days)	Days Inventory Outstanding + Days Sales Outstanding	78.3 days	89.9 days	100.6 days
Gearing ratio	Long-term Liabilities ÷Capital Employed	0.8	1.3	3.1
Interest coverage rate ($)	EBIT ÷Interest expense	3.3	2.0	1.2

• It is assumed that all sales for the company were made on credit
• It assumed that the Melbourne Trading Corporation operates for a period of 360 days in a year
• It is assumed that the only capital employed is the equity
• It is assumed that the average inventory for the year is equal to the closing inventory (i.e. Opening inventory + Closing Inventory)/ 2.

The most widely used techniques for assessing the financial health of a company is through the use of profitability, solvency and operating efficiency ratios. From the financial ration analysis computed above, there is an indication that the profitability of the company has been falling tremendously from 2014 to 2016. Both the net profit ratio and the gross profit ratio shows that Melbourne’s profitability index has been falling. For instance, the profit ratio in 2014 was 0.09 in 2014 before it fell to 0.05 and eventually 0.01 in 2016. The gross profit ratio has also been falling from 0.38 in 2014 to o.32 in 2016. This downward trend in the profits of the company is worrying because it shows that as the year progresses, the company is slowly losing its financial stability.

Apart from the gross profit and net profit ratios, another interesting aspect of the Melbourne company is the increasing cost of goods sold ratio. In 2014, the ratio was at 0.63 and rose up to 0.64 in 2014 and 0.67 in 2016. This indicates that the costs attached to sales for the company have been increasing at a higher rate as compared to the rate of increase in sales.

According to my view, Melbourne company is not in a stable position financially. Looking at the gearing ratio, I can say that the company is using much of borrowed funds to finance its activities which is a very risky alternative. The gearing ratio for the company was 0.8 in 2014 before it rose to 1.3 in 2015 and 3.1 in 2016. This means that the assets of the company are being financed 3 times by debt and only 1 time by the equity. It is a very unwise decision for a company to use debt finance in sustaining more than half of its assets (Debt-Dependent Effects of Fiscal Expansion, 2016). An adverse situation may occur in such a way that all the creditors demand their funds. This will leave the company without anything because the assets will not be able to meet the money needed to pay back the debt.

The company’s return on equity has been declining tremendously from 2014 to 2016.  The ratio in 2014 was a bit better at 0.4 before it fell to 0.3 in 2015 and to 0.1 in 2016. This shows that the earnings being made by the company are not sufficient enough to pay the shareholders. The returns provided by the company to the shareholders is therefore not satisfactory at all.

Looking at the administration expenses level that is being maintained by Melbourne Trading Corporation, there is an indication that the company has been struggling to keep the expenses level at a minimum. However, this has only been done for the administration expenses. When it comes to the selling expenses, the ratio in 2013 was a bit lower at 0.13 before it rose up to 0.14 in 2015 and 2016. Finance and interest expenses have also been increasing tremendously from 2014 to 2016 showing that the company did little to reduce the expenses for the sake of boosting profitability. The interest cover ratio shows that Melbourne has been losing its significance in terms of its ability to pay off interest expenses using the earnings. The interest cover rate in 2014 was at 3.3 before it dropped to 2.0 in 2015 and rise further t0 1.2 in 2016. It can, therefore, be said that the expenses level has not been kept under control.

Frankly speaking, both the short term and long term debt levels for Melbourne company is at unmanageable level. This is indicated by the high rate of gearing ratio. The Gearing ratio measures the proportion of the company’s borrowed money as compared to equity. A high gearing ratio means that the company is subjected to more financial risks because huge debt can lead to business winding up because of liquidation (Muradoglu, Bakke and Kvernes, 2005). From my analysis, I can say that much of the borrowed funds were used to purchase fixed assets. The same assets have not been adequately used to produce sales.

The operating cycle for a company is the average number of days it takes an entity to effect an outlay of cash so as to produce goods, sell them and receive cash from credit customers for the exchange of goods. The operating cycle for Melbourne has been increasing drastically from 2014 to 2016. In 2014, the cycle was a bit lower at 78.3 days before it rose to 89.9 days in 2015 and 100.6 days in 2016.  A longer operating cycle means that the company’s funds are tied up in inventory for a very long time (Fallah and Hashemi, 2017, pp.44). There are a number of factors that might have caused a longer operating cycle for Melbourne. They include:

The payment for goods supplied period might have been shortened by the suppliers so that the company has to pay for purchases too often.

The amount of inventory being held by the company might be so high so that there is a delay in the conversion of sales to cash.

The credit policy for the company might be lax so that the debtors don’t pay for the goods sold to them on a good time.

Because the operating cycle for Melbourne is too long, it has not assisted the company to boost its liquidity position amid serious high levels of debt.

References

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