Financial Ratio Analysis: A 5Year Trend Analysis for Company X

Introduction

This paper conducts a financial analysis for Company X using trend analysis for

the past 5 years, 2001-5. Key ratios are identified to provide an insight mainly to

employees that are otherwise either disinterested, have no access to the

financial reports or the know-how on how to interpret them. The ratios chosen are

the ones that will best meet this need and are presented simply with graphs for

use and evaluation.

Financial Ratios

Financial ratios help examine various aspects of a company’s financial position,

& performance (McLaney and Atrill 2002) and are used for control and planning

purposes. They are calculated from data in financial statements and provide a

quick and easy means of examining the financial condition of a business. Ratios

are a better analysis and comparison tool vis-à-vis untreated financial statement

figures that can be difficult to interpret accurately (Oldcorn, 1993). Weetman

(2003, p362) agrees, citing that use of ratios is better than absolute values.

However “whilst ratios will tell a story and allow people to question systems, they

do not provide any answers”. Nobes (1999) advocates that ratios are important

as they put changes into context, they are simply more informative and precise

measurement of changes and comparison

According to Biz/Ed Institute of Learning (2006), there are several points to keep

in mind about ratios:

1. Ratios need to be combined with other knowledge of a company's

management and economic circumstances, for them to be more

meaningful

2. There is no single correct value for a ratio and thus ratios being too high,

too low, or just right depends on the perspective of the analyst and

company's competitive strategy.

3. A ratio is meaningful only when it is compared with some standard, such

as an industry trend, ratio trend or a stated management objective.

McLaney and Atrill (2002) advise that there is need to take caution in use and

interpretation of ratios as many limitations exist. For example

1. Financial statements provide summarized, out-of-date information and are

a snapshot of the business at a particular moment in time. This might not

be representative of current and whole years performance.

2. Inflation renders comparison of results over time misleading as financial

figures will not be within the same levels of purchasing power

3. Changing of accounting policies and creative accounting may distort

comparisons from year to year

4. The level of conservatism that each business will adopt when reporting

profit and loss will limit precision.

Company Background and Evaluation of Data used.

Company X is over 20years old, with a joint Directorship and provided

employment at its peak to over 200 employees. The company’s principal activity

is to Manufacture and Sell Computers and related activities (Directors reports

2001-5). Its business strategy is providing high quality products and services

specific to customers needs. The company has authorized 10million shares of

which nearly 5million of these are allotted. Company X is financed from loans,

retained capital, advance bank financing and in 2003 an £800k Directors

injection. The period of analysis reveals financial losses and scaling down of

operations.

Data for this analysis is obtained from the Directors Reports and Financial

Statements between 2001-5 (Appendix 1). There was no access to the 2001

report; hence re-stated figures in the 2002 report were used. The reports have

been audited and are supplied in accordance with the Companies Act 1985.

Company X seems conservative in profit/loss reporting from use of straight-line

depreciation and not writing off intangible assets, both cases that report profit

early. However there does appear to be some creative accounting in 2002

statement where taxation is deferred and there is a once off reporting on doubtful

debts for subsidiaries or affiliated companies. In 2003, the company started

writing off warranty costs at beginning of each year, a change in its accounting

policies.

Some of the relevant data is already pre-calculated in the Directors’ report e.g.

creditor and debtor days and will be used in this analysis as being correct,
However not all data is available and according to Weetman (2003), it can be

difficult to calculate these figures without a full break down of the component

parts of the variable e.g. average stock.

Rational Of Analysis

The ratios that are selected and the use of the resulting information is dependent

on the needs of the analyst or user (Weetman 2003). Employees at Company X

have in the past 3years been resigned to the fact that the company is not

performing well as occasionally reported. Employees rarely have access to the

reports or the knowledge to clearly interpret what they mean. Therefore the

important aspects that employees need to know and corresponding ratios are: To

see

a) the true performance - Performance Ratios

b) if the company has been making profit – Profitability Ratios

c) if resources are optimally utilized – Efficiency Ratios

d) ability to pay short term and long term debt – Liquidity and

Gearing

This analysis can also be used by other stakeholders e.g. managers, suppliers,

customers, investors, lenders etc. See Appendix 2 for Ratio formulas:

Profitability/ Performance Ratios

These ratios will indicate how well a company is being run in terms of using its

assets to make sales, whilst controlling costs and producing profit based on

goods and services sold (Weetman 2003). It shows how well management is

making use of investment in assets and control of costs to maximize profit from

revenue.

2001 2002 2003 2004 2005

Sales Growth % - 4.10 (48.04) (38.81) 7.84

Gross Profit Margin % 17.67 11.67 13.44 24.69 20.71

NET Profit Margin % 3.02 -9.66 -2.30 1.19 3.68
ROCE % 23.94 (113.71) (34.56) 9.98 24.99
ROSF % 15.13 (2,115.8) (42.51) 7.87 24.75
Number of workers 200 196 106 71 65
£410587 £386672 £293926 £203570
Wages 1 4 1 2 £2270046
Total Asset Usage: 3 4 5 4 3
Fixed Asset usage: 23 26 133 360 339
Table 1.

1. Sales Growth

Sales plummeted in 2003 and 2004 suggesting there was a huge decline in

sales activity. The company was not growing its sales nor was it engaging in

any other venture to support this decline. Although there was a 7.84 growth in

2005, the overall growth against the base year 2001 is still a decline.

However whilst there was a decline in sales, the company’s gross margin

analysis showed favourable returns as below.

 Sales Growth

10

-10 2001 2002 2003 2004 2005

%

-30

-50
Year

Sales Growth

1. Gross Profit Margin

Gross profit margin is positive for the period suggesting the company was

making profit on every £1 of turnover realised, which is desirable. However

because this is a sensitive measure, the decline in 2002 to 11.67% meant

significant decrease to the net profit and shows profit reduction. In 2002,

although turnover increased the gross margin decreased because the Cost of

Goods Sold increased dis-proportionally to Turnover (fig 1). The increase to

13.44% in 2003 and thereafter, whilst indicating improved performance, is mainly

as a result of nearly 50% decrease in turnover and thus decrease in size of

business output.
 Profit Margins vs Turnover

30.00 60,000,000
20.00

T/O and GP
Margin %

40,000,000

Value £
10.00
0.00 20,000,000
-10.00
001 200
2
200
3
200
4
200
5
-20.00 2 0
Year

Gross Profit Margin % NET Profit Margin %

T/O Gross profit

Fig 1:

2. Net Profit Margin

This ratio shows the degree of competitiveness in the market, and ability to

control expenses (Weetman, 2003, p366). There is a similar decrease in 2002

and 2003, however this time showing a loss for every £1 of turnover after taking

all costs into consideration. Administration costs (wages) “appear” to be one of

the costs that was not well-controlled vis-à-vis turnover. Fig 2 below shows from

the trendline gradient that turnover was decreasing at a faster rate than the

decrease in administration costs causing a decrease in net profit margin in 2002

to 2003. This then slightly regained in 2004 and marginally in 2005. It appears

the decrease in the number of employees (table 1) through redundancies, as a

company strategy, in 2004 and 2005, meant Company X regained control on its

operating costs in proportion to the turnover.

 Gradient slope Turnover vs Admin Cost

Value- £

y = -9036800x + 56713800

y = -1048100x + 8163300

2001 2002 2003 2004 2005

Year

Turnover Administrative Expense

Linear (Turnover) Linear (Administrative Expense)

Figure 2: Rate of Decrease between Turnover and Administration Cost

3. Return on Shareholders Finance and Capital Employed

The Return on Shareholders Finance/Equity (ROSF) and Return on Capital

Employed (ROCE) showed that the company had difficulties using shareholders

money to generate profit in 2002 and 2003. Therefore there was no profit to

provide wealth to cover their shareholders dividend or cover business growth as

shown by lack of investment in 2003 to 2005. With this, the asset usage ratio

(table 1) should have also declined proportionally but has actually increased

significantly. This is because the company sold most of its fixed assets, a

decrease of 98% of asset value between 2001 and 2005. This decrease in fixed

assets and the corresponding decrease in turnover renders caution in use of the

asset usage ratio, as it’s not indicative of true performance but responsive

strategic action (fig 3).

 Fixed Asset Usage vs Turn Over

2500000 50,000,000

Turnover Value
2000000 40,000,000
Asset Value

1500000 30,000,000
1000000 20,000,000
500000 10,000,000
0 0
2001 2002 2003 2004 2005
Ye ar

Investment Total Fixed Turnover

Fig 3: Fixed Assets vs. Turnover Decline Rate

B. Efficiency Ratios Management Ratios:

These ratios examine efficiency with which various resources are managed. Table 2

below shows extracts from the reports and caution is taken in assessment, as some of the

data is not available.

2001 2002 2003 2004 2005

Sales per employee £226342 £240439 £230994 £211015 £248565

Stock holding Period (Extract
from Report) X X X 31days 29days
Debtors Collection Period
(Extract) X X X 71days 74days
Creditor Collection Period
(Extract) 30days 28days 25days 17days 12days
Table 2: Efficiency Ratios

The sales per employee declined between 2002 and 2004 although both

turnover and number of employee decreased. In 2005 it appears the efficiency

output regained as a result of turnover increasing and employees decreasing.

The company was being more productive in 2005.

The Average Stockholding Days have decreased for the two years (2004-5);

implying stock was being turned over quicker in 2005, showing stockholding

efficiency. This is good especially in the Computer industry where technology

changes fast and stock should be held for just the right period and level. This

also enables the company to convert stock in cash quicker for use when needed.

The Creditor Days have decreased by over 50% between 2001 and 2005 to

12days. Based on performance in 2002/3 and the bad Credit Rating it could be

that creditors are demanding quicker payment, hence have not been efficiently

managed. This situation can present a cashflow problem for the company if not

managed properly.

The Debtor Days have increased between 2004 and 2005 meaning that its

taking 3days days longer for the company to get payment on its sales. This is an

efficiency concern and management needs to negotiate for shorter payment

periods.
 Efficiency Ratios

80 74
Stock holding Period
60 (Extract from Report)
Days

Debtors Collection Period

40 29 (Extract)
20 12 Creditor Collection Period
(Extract)
0
2001 2002 2003 2004 2005
Year

Fig 3: Holding and Collection Days: Focus on 2004-5

From Fig 3, in 2005, 74days to collect payment against 12days to pay creditors

with a 29day stock turnover period is an unmanaged efficiency situation for

Company X. This can lead to cash problems and bankruptcy in the long term for

a company with such turnover and profit levels (see liquidity ratios). Whilst this

has potential problems, employees should not take the efficiency ratios in

isolation and conclude this is poor performance, but indicates that management

need to manage the business better.

C. Liquidity Ratios

Weetman (2003, p367) defines liquidity as having adequate cash in the near

future to cover immediate financial commitments. This involves preserving

adequate but not excessive level of liquidity to ensures the business continues to

survive. Employees are quick to assume that because a company is holding so

much stock or cash then it’s performing well without analysing what obligations

the company has.

 2001 2002 2003 2004 2005
Current Ratio 1.31 1.26 1.39 1.77 1.99
Acid Ratio 0.94 0.9 1.15 1.34 1.56

Table 3.

1. Current and Acid Test Ratios

The Liquidity has increased over the period as indicated by both the current ratio

and acid test ratio. The current ratio has been increasing above one times the

current liabilities, implying the company has always covered its current liabilities.

The more stringent acid test ratio was below one in 2001 and 2002, implying that

the company did not quite cover its current liabilities regardless of good profits in

2001. This could be an indication as to why the creditor days have decreased as

suppliers opt for quicker payment to cover their selves (Table 2 & Fig 4). This

acid test ratio however increased to above one in 2003-5. Overall the company is

in a solid short-term liquidity position.

The acid Ratio is lower than the current ratio as expected, an element common

with manufacturing business. This is due to the fact that they will hold significant

stock for some time. Company Xs rising acid test ratio to 1.56times its current

liabilities means that the company is managing its stockholding well as shown by

the decrease in stockholding period from 31days in 2004 to 29days in 2005

(Table 2). The lower acid ratio values for 2001-2 would suggest that stock was

not being turned over quickly and therefore made a huge component of current
assets, however without information for stockholding period for 2001-3 we can

not affirm this statement.

Liquidity Graph

2.5 20,000,000

2
15,000,000
Current/Acid

CA, Creditors,
1.5
Ratios

10,000,000 stock values

1

0.5 5,000,000

0 0
2001 2002 2003 2004
Current Ratio: Liquidity Ratio Acid Ratio: Liquidity ratio
Year
Stocks Creditors: Falling within one year
Crrent assets

Fig 4:

Whilst from Fig 4 above, the current assets have always been more than the

current liability and Company X appears to be managing its liquidity position,

caution prevails as creditor and debtor days might affect the cash flow. The fall of

creditor days can indicate that suppliers are demanding early payment, whilst the

increase in debtor days means buyers are negotiating longer payment periods. If

this is not managed correctly Company X can have liquidity problems as the

company pays out money quicker than its receiving payments leaving a deficit.

It’s advisable that Company X negotiates for longer creditor days and shorter

debtor days. However with the current marketing strategy with most companies

of buy now pay later schemes (up to 9months), Company X might be doing well

with its 74day collection period. Also alliances with finance companies and banks
that give 80% of sale value on credit sales means the company can avoid

liquidity problems. These are yearly averages in a seasonal industry.

D. Gearing Ratio and Interest cover

The Gearing ratio describes a mixture of loan finance and equity finance. It

measures the extent to which there is financial risk shown in the balance sheet

and P&L account, associated with interest or loan repayment. Thus financial risk

will occur when the company has loan finances which it cannot relinquish when

due for settlement. Shareholders are concerned with this ratio as they have a

claim to any residuals after all financial obligations are met. The interest cover

ratio reflects the extent of cushion or comfort that a company has in meeting its

interest obligations generated from surpluses of its operation. This will also revel

the credit worthiness of the company.

2001 2002 2003 2004 2005

Debt/Equity 12.28 93.51 0.00 0.00 0.00

Interest Cover 4.88 (15.48) (3.86) 4.50 9.88
Table 4: Gearing Ratios

Over the 5 years Company Xs gearing position has fluctuated, in 2001 it does

appear that the company maintained a low debt/equity ratio although the debt

was 12.28 times bigger than the equity financing. With a decent 4.88times

interest cover, the risk was not too big. In 2002 the gearing ratio was high

implying the company was mainly financed by debt at 93.5%, which negatively

affects long-term solvency. The correspondingly low interest cover ratio of –

15.4% implies the company had no cushion to pay for its legal interest payment

obligations and could have gone bankrupt at the time. From the balance sheets
2003-5 it shows that company X had no long-term liability possibly because

lending firms were not extending credit to the company due to the poor credit

record. Instead in 2003, the joint directors injected £800,000 of their own money

as capital. Because there are no long term liabilities, the interest cover has been

steadily rising implying that the profit before interest and tax (PBIT) being made

can cover the interest.

This implies that for equity holders (some employees) the company’s position is

improving and shareholders could get dividends in the near future. This however

is up to the company’s board as the company is still recovering and might need

to retain the profit for growth rather than payout to employees.

Conclusion

Company X appears to have gone through the worst and is in recovery at the

moment. Its change in strategy to find a balance on size of operation appears to

be stabilizing its performance. However because the market is competitive and

Company X is operating at 33% of its previous turnover, there is threat from

bigger players who will keep taking up more market share. It’s recommended that

the company employ strong strategies that increase turn over whilst keeping

costs to a minimum.

References and Bibliography

Biz/Ed Institute of Learning and Research Technology (2006), Financial
Ratio Analysis: Available at
http://www.bized.ac.uk/compfact/ratios/index.htm (Accessed 08 August
2006)

Certified Public Accountant (CPA), Financial Ratios: Available at

http://www.cpaclass.com/fsa/ratio-01a.htm (Accessed 08 August 2006)

McLaney, E and Atrill, P. (2002) Accounting; An Introduction, England:

Prentice Hall

Nobes, C. (1992) Introduction to Financial Accounting, New York:

Routledge

Oldcorn, R (1993) Accounting for Managers, New York: Routledge

Ventureline, Financial Ratio Analysis – Private Held Company: Available at

http://www.ventureline.com/FinAnal.asp (Accessed 08 August 2006)
Weetman, P. (2003) Financial Accounting: An Introduction, London:
Pearson Education limited

Trinity Mirror PLC. Financial Results: Available at:

http://www.trinitymirror.com/ir/results/2004prelims/ (Accessed 14 July
2006)