FIANACIAL RATIO ANALYSIS

Hence, ratio analysis allows for intra firm evaluation. we. at the. evaluation involving

yourcompany’s effectiveness in today's year with all your company’s effectiveness with

theprevious year. It also allows for inter firm evaluation. we. at the. evaluation of one's

company’sperformance in today's year with all your competitor’s effectiveness in today's

year. Expert assessment, since this can be named, helps you benchmark your effectiveness

with all your mates. Ratios assistance in ascertaining this monetary health and fitness in the

business plus it is futureprospects. These kind of quotients can be classified below various

mind for you to indicate just what theymeasure. There may be a tendency to function quite a

few quotients. Although most of us assume that beingthorough from the working out in

addition to meaning of an number of quotients (Say 20-25) could be best, due to the fact too

much of analysis might lead to paralysis.

Computing RatiosWhen a ratio includes a P&L number both equally from the numerator in

addition to from the denominator or provides abalance page number both equally from the

numerator in addition to from the denominator it really is named a straightratio. Exactly

where it offers this P&L number from the numerator and also the harmony page number with

thedenominator or the total amount page number from the numerator and also the P&L

number with thedenominator it really is named a corner or hybrid ratio. A: Liquidity or

Temporary Solvency RatiosLiquidity identifies this velocity in addition to simplicity along

with which a tool can be converted to money. Liquidity provides a couple of size: ease of

transformation compared to decrease in importance. Don't forget anyasset can be quickly

converted to money in case you slash the retail price. A property property or home valued

atRs twenty five lakhs can be converted to money in 1 day in case you slash the retail price

for you to Rs 5 lakhs! So a water tool is basically a single that is converted to money with no

major decrease in importance. An illiquid tool is actually one that is not en-cashed with no

major slash with value. Present belongings are usually most water. Fixed belongings are

usually minimum water. Real preset belongings likeland in addition to creating in addition to

gear aren’t commonly converted to money in any respect with normalbusiness task. There're

utilised available to create money. Intangibles such astrademark have zero actual lifestyle in

addition to aren’t generally converted to money. Liquidity is actually invaluable. The harder

water a small business is actually, this a smaller amount would be the chance of itfacing

monetary problems. Although too much of liquidity far too is just not good. That’s since

liquidity includes a sale price. Liquid belongings are usually a smaller amount worthwhile to

keep. For that reason there's a trade off concerning theadvantages involving liquidity in

addition to foregone prospective earnings. Liquidity or Temporary solvency quotients supply

information regarding a firm’s liquidity. Theprimary concern would be the firm’s power to

shell out it is expenses in the brief run with no unduestress. Consequently these quotients

target recent belongings in addition to recent liabilities.

“Task A”

Financial performance of Monitor PLC for the last four years can’t be considered up to the

mark by the analysis the ratios of the firm. There are certain areas which are better but on the

cost of others. For the purpose of the analysis of the Monitor PLC, following assumptions are

made;

Product mix of the company remain unchanged

Company does not acquire or merged with any other company

Stock market conditions remain stable in the period of analysis

No significant change occur in the industry structure

Profitability:

Gross profit margin of the company is on declining side while net profit margin is

relatively at stable position with slight increase. By comparing these two ratios, it can be said

that company cost of sales is on higher side and on the other side company slightly reduce its

operating cost. The reason behind the increase in cost of sales can be traced from the analysis

of material, labor, and overhead cost. From the analysis of these, it reveals that there is

significant increase in the materials and labor cost which cause the gross profit margin to

decline from 30% to 24% in the previous four years. Material cost increase from 40% of cost

of sale in 2010 to 48% in 2013. Even in 2013, while comparing these ratios with those of the

competitor and business sector norms, company’s performance is lagging behind. Its gross

profit margin is 24% as compare to 29% and 34% and net profit margin is 3.4% as compare

to 7% and 9% of competitor and sector norm respectively.

2010 2011 2012 20130%

5%

10%

15%

20%

25%

30%

35%

Gross profitNet Profit

On the other side while analyzing the trend of return on employed capital and return

on equity, the opposite direction movement has been observed. Return on employed

capital is on declining side as compare with increasing trend of return on equity. The

reason that can be attributed to such trend is the leverage effect that can be seen in the

gearing ratio which is 35% in 2010 and jumped to 76% in 2013. As compare to

competitor and sector norm, company clearly has shown less performance in 2013 in

the both ratios.

Liquidity:

Liquidity of the firm showed the increasing trend by viewing the current ratio and

quick ratio showing the contradictory behavior. Current ratio increase from 3.4 in 2010 to 3.7

in 2013 and quick ratio decline from 2.30 in 2010 to 1.40 in 2013. This contradictory

behavior indicates that firm invest significant amount in stock which is increasing with the

passage of time. Creation of such bulk of inventory also affect the efficiency of the firm as its

stock turnover in days jumped up to 89 days in 2013from 65 days in 2010.

2010 2011 2012 20130.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

Return on Capital EmployedReturn on Equity

2010 2011 2012 20130.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Current RatioQuick Ratio

Efficiency:

For the efficient management of working capital, firm should try to;

Minimize the stock turnover in days by avoiding the costly stock outs

Minimize the debtors collection period without exerting extra pressure which results

into sales loss

Maximize the creditors payment period without hurting the credit worth

As with the case of Monitor PLC, all of above mentioned three ratios has shown the opposite

trend. Result of which is high and increasing cash operating cycle (95 days in 2010 and 150

days in 2013) that may be the cause of low profitability of the firm. Firm has stuck up huge

amount in the working capital/ cash operating cycle which result into not only the high

opportunity cost but also high inventory handling cost and bad debts. Its cash operating cycle

in 2013 is 150 days as compare to competitor’s 55 days which is about 3 times greater.

2010 2011 2012 20130

20

40

60

80

100

120

140

160

Stock turnover in daysDebtors collection periodCreditors payment periodCash operating cycle

There is a decline in firm’s working capital turnover and fixed asset productivity. Its working

capital turnover decrease from 2.80 in 2010 to 2.30 in 2013 which is also less than its

competitor and business sector norm those are 3.5 and 4.0 respectively. Fixed asset also

decline from 1.95 to 1.39 in the same period and in 2013 the same ratio of the competitor and

sector norm are 2.0 and 2.50 respectively. All of these facts indicate the inefficiency of the

firm not only in the form of poor working capital management but also not utilizing the fixed

assets properly to generate the sales of the firm.

2010 2011 2012 20130

0.5

1

1.5

2

2.5

3

Working capital turnoverFixed asset productivity

Investment:

Monitor PLC’s dividend yield ratio is declining and comes to 2% in 2013 as compare

5.3% in 2009. It is also less than that of the competitor’s 3.15% but higher than sector norm

of 1.60%. Dividend yield ratio is just an indication of the return in the form of dividend not

the representative of the total return of the stock. Even many investors prefer the stock paying

low dividends and offer return in the form of stock appreciation which is a positive aspect of

the analysis of Monitor PLC. The price of its stock increases to €16.20 in 2013 from €11.70

in 2010.

Higher and increasing P/E ratio usually indicates the growth potential of a firm. Apparently

Monitor PLC’s stock seems to be more a growth stock then a value stock while comparing

with its competitor in 2013 as its P/E is 18 as compare to 11 of its competitor. But by keeping

in view the overall analysis of the company and previous years P/E ratios which are around

14, Monitor PLC seems to be overvalued in 2013.

Gearing:

Gearing ratio of the firm increases drastically, from 35% in 2010 to 76% in 2013 that

indicates the strong leverage creation. This heavy increase in long term debt is employed at

fixed assets and working capital investment. Fixed assets investment is justifiable in the

context of growth prospect but employing amount from long term debt to working capital

finance only increases the cost for the business.

Overall financial position of Monitor PLC is neither very good nor very bad. Its return to

shareholders is increasing and also showed satisfactory performance in the market. Liquidity

position of the company is also good as compare to the competitor and business sector norm.

But on the other side, poor working capital management, low profitability, and increasing

cost of sale are major concerns for the firm’s management. There are certain areas like

operating cost structure, cash flows, and assets composition which need to be explored

further in order to get more insight to the company position.

Suggestions/Recommendations:

On the basis of the available information for the Monitor PLC, following are the some

suggestions or recommendations;

Firm should create the close liaison with its suppliers to control the material cost and

negotiate on the payment terms.

Firm should create a better credit policy for the customers and make the collection

system efficient in order to reduce the debtors collection period.

Reconsider the inventory management system and evaluate the feasibility of the JIT

inventory system with the help of long term relationship building with the suppliers.

Firm should maintain the optimal capital structure by also issuing some new stock or

generating more finances internally, as its gearing ratio is increasing which may lead

to the insolvency in the future.

Analyze the composition of fix assets so it can be used optimally in order to generate

the revenue as fix asset productivity declining with the passage of time.

“Task B”

1)

Project X Project Y

Payback Period 1.85 years 2.70 years

NPV €29.92 €21.08

IRR 24.49% 18.78%

2)

On the basis of above three capital project appraisal techniques project X is

recommended for Monitor PLC.

Payback period of Project X is 1.85 years which is less than that of the project

Y’s 2.70 years that’s why project X is acceptable. Because if payback period

is less then firm will be able to cover is initial expenditure in the shorter time

span and cash flows received after payback period will be added to the wealth

of shareholders.

NPV of Project X is €29.92 which is higher than €21.08 of project Y so on the

basis of NPV again project X is more suitable. NPV is net amount that is

added to the shareholders wealth after adjusting the cost of capital. Wealth

maximization is the ultimate objective of the financial management. So in case

of accepting project X wealth of shareholders increases more as compare to

the project Y.

Similarly high IRR of 24.49% for the Project X as compare to 18.78% of

project Y also leads towards the same decision of accepting the Project X.

Every business wants to invest its fund in the opportunity which provides it

the higher returns. From the two alternatives project X provides the higher

return that is the main cause of its acceptance.

3)

Followings are some of the other factors that should be considered before an

investment decision is made;

Risks associated with the realization of projected cash flows associated with

the projects under consideration. For this purpose sensitivity analysis can be

performed.

Rate at which the technological changes took place which obsolete the

existing technology. It is critical for the company like Monitor PLC because

rate of technology change is fast in this industry. This factor becomes more

crucial for software/ IT industry and in this case payback period become the

key capital project appraisal technique.

Consider some of the important macro-economic variables those may impact

on the performance of the projects under consideration.

Competitors’ action or reaction on the important projects implementation and

its impact on the performance of the project.

4)

Optimal investment policy is to undertake the 1.36 projects X. 1.36 is find by;

Number of projects = Available funds/cost of one project

Number of projects = 150,000,000/110,000,000

Number of projects =1.36

The resulting total NPV from this policy will be;

Total NPV = NPV of single project * Number of projects

Total NPV = 29.92 * 1.36

Total NPV = €40.69 millions

5)

If projects are indivisible then company can undertake only one project which is

Project X and search for another suitable capital expenditure project for the remaining

funds or devise some other policy to optimally utilize the surplus fund.

6)

Followings are some of the difficulties and ways to overcome such difficulties

relating to appraising capital investment projects;

One of the theoretical difficulties comes when there is conflict ranking among

different capital project appraising techniques. Such difficulty can be

overcome by analyzing the nature of the project. For example if project is

relating to dynamic industry like software then payback period is preferred

otherwise some other technique can be followed.

Another difficulty is estimation of the life of the project which can be tackled

by careful analysis using the skills of the experienced, qualified, and project

related personnel.

Estimation of the projected cash flows is a very critical difficulty that can be

faced by the appraisers. Because sometimes capital assets are used in such a

mixed way that it is very difficult to find the particular cash flows associated

with that project.

Payback Period:

Project X (€, millions) Project Y (€, millions)Initial Expenditure 110 100

Cash Flows Cumulative CF Cash Flows Cumulative CFYear 1 55 55 30 30Year 2 65 120 35 65Year 3 30 150 50 115Year 4 10 160 30 145Resale value Year 4 10 170 10 155

Payback (X) = 1 + 55/65 Payback (X) = 2 + 35/50

Payback (X) = 1 + 0.85 Payback (X) = 2 + 0.70

Payback (X) = 1.85 years Payback (X) = 2.70 years

NPV (Net Present Value):

Project X (€, millions) Project Y (€, millions)Initial Expenditure 110 100

Cash Flows Present Value Cash Flows Present ValueYear 1 55 50 30 27.27Year 2 65 53.72 35 28.93Year 3 30 22.54 50 37.56Year 4 10 6.83 30 20.49Resale value Year 4 10 6.83 10 6.83Sum of present value 139.92 121.08Net Present Value 139.92 – 110 = 29.92 121.08 – 100 = 21.08

Present value is calculated by using formula;

Present value = future value / (1+r)n

IRR (Internal Rate of Return):

IRR is calculated by using the spreadsheet and financial function “=IRR(Range of Cash flows)”

References :

Abraham, A. (2006). Financial Management in the Nonprofit Sector: A Mission-Based Approach to Ratio Analysis in Membership Organizations. Journal of American Academy of Business Cambridge, 10, 212–217.

Altman, E. (1968). Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance, XXIII, 589–609.

Barnes, P. (1987). The analysis and use of financial ratios: A review article. Journal of Business Finance & Accounting, 14, 449–461.

Beaver, W. (1966). Financial ratios as predictors of failure. Journal of Accounting Research, 4, 71–111

Collier, H. W., Grai, T., Haslitt, S., & Jr., C. B. M. (2010). Using Actual Financial Accounting Information To Conduct Financial Ratio Analysis : The Case Of Mo ... Journal of Business Case Studies, 6, 23–32.

Edmister, R. O. (1972). An Empirical Test of Financial Ratio Analysis for Small Business Failure Prediction. The Journal of Financial and Quantitative Analysis, 7, 1477–1493.

Halim, S. A., Jaafar, M., Osman, O., & Haniff, S. (2012). Financial Ratio Analysis : An Assessment of Malaysian Contracting Firms. UNIVERSITI SAINS MALAYSIA, Journal of, 71–78.

Horrigan, J. (1968). A Short History of Financial Ratio Analysis. The Accounting Review, 43, 284–294.

Horrigan, J. O. (1965). Some Empirical Bases of Financial Ratio Analysis. Accounting Review, vol. 40, 558. 11p

Martikainen, T., Perttunen, J., Yli-Olli, P., & Gunasekaran, A. (1995). Financial ratio distribution irregularities: Implications for ratio classification. European Journal of Operational Research.

Nissim, D., Nissim, D., Penman, S. H., & Penman, S. H. (2001). Ratio Analysis and Equity Valuation: From Research to Practice. Review of Accounting Studies, 6, 109–154. doi:10.1023/A:1011338221623

Patton, J. M. (1982). Ratio Analysis and Efficient Markets in Introductory Financial Accounting. Accounting Review, vol. 57, 627.

Roxas, M. L. (2011). Financial Statement Fraud Detection Using Ratio and Digital Analysis. Journal of Leadership, Accountability and Ethics, 8, 56–66.

Smith, P. (1990). Data envelopment analysis applied to financial statements. Omega. Zeller, T. L., Stanko, B. B., & Cleverley, W. O. (1997). A new perspective on hospital financial ratio analysis. Healthcare Financial Management : Journal of the Healthcare Financial Management Association, 51, 62–66.