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Mary Low
Waikato Management School
The University of Waikato
Mary Lo
Business Survival:
There are two key factors for business survival:
Profitability
Solvency
Profitability is important if the business is to
generate revenue (income) in excess of the
expenses incurred in operating that business.
The solvency of a business is important
because it looks at the ability of the business in
meeting its financial obligations.
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statements
to
evaluate
an
Financial performance
Financial position.
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Profitability Ratios
Liquidity or Short-Term Solvency ratios
Asset Management or Activity Ratios
Financial Structure or Capitalisation Ratios
Market Test Ratios
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Profitability Ratios
3 elements of the profitability analysis:
Analysing on sales and trading margin
focus on gross profit
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Profitability Ratios
Return on Assets =
Net Profit
Average Total Assets
Return on Equity =
Net Profit
Average Total Equity
* 100
*100
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The ideal benchmark for the current ratio is $2:$1 where there are two
dollars of current assets (CA) to cover $1 of current liabilities (CL).
The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL
represents liquidity riskiness as there is insufficient current assets to
cover $1 of current liabilities.
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Current Assets
Current Liabilities
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Net Sales
Average Total Assets
Inventory Turnover =
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Equity ratio =
Debt
*100
Total Assets
Equity *100
Total Assets
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Dividends
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Walker Ltd
Statement of Financial Position as at 31 March
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Walker Ltd
Statement of Financial Performance for year ended 31 March
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Walker Ltd
Statement of Cash Flows for the year ended 31 March
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Additional information:
Credit purchases for the year 2006 were $2,142,800.
General prospects for the major industries in which
Walker is involved look good with a forecast glut of oil set
to reduce the cost of production and world demand for
plastic remaining strong.
Benchmarks:
There are no exact benchmarks for Walker Ltd because it
is a diversified company. The following are average
indicators that relate to the plastic retailing and
manufacturing industries for the year 2006.
25%
7%
6 times
0.6 : 1
12%
20%
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Relevant ratios
Important note: The calculations of the ratios in this illustration did not use averages for total assets, equity and
inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.
Profitability
ratios:
Benchmarks
2005
2006
Gross Profit
Margin
Industry
25%
22%
22.7%
Net Profit
Margin
Industry
7%
7.1%
6.1%
Return on
Assets
12%
15.6%
15.5%
Return on
Equity
Industry
20%
32%
26%
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Asset
Management
ratios:
Benchmarks
2005
2006
Inventory
Turnover
Industry
6%
5.8 times
5.58 times
Asset Turnover
Not given
2.2
2.53
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Liquidity
ratios:
Benchmarks
2005
2006
Current Ratio
Ideal standard
2:1
Acceptable
standard
1:1
1.78:1
1.70:1
Quick Ratio
Ideal standard
2:1
Acceptable
standard
1:1
0.85:1
0.69:1
Days Payable
Standard
30 days
Credit
purchases not
available
49.19 days
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Financial
Structure
ratios:
Benchmarks
2005
2006
Debt/Equity
Industry
0.6:1
Standard
benchmark
1:1
1.05: 1
0.67:1
TIE
Standard
benchmark:
Between 3 and 5.
Below 3 risky.
Above 5 very
favourable
10.14 times
39.74 times
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Report
For the investor considering the purchase of shares in
the company, the return they will earn is the key financial
factor but an overall evaluation of the companys
performance and position is also important to get a
better picture of how well the company is actually doing.
ROE in 2006 is 26%. Whether or not this is attractive
depends on the perceived riskiness of this investment
and other alternatives available but this return is certainly
more attractive than current bank interest rates.
ROE has decreased by 4% but the companys ROE at
26% is still better than the industry average of 20%
Riskiness of business is being reduced by the significant
repayment of loan in 2006.
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Profitability
The NP% and ROA ratios show a small downward
trend in % over the 2 year period. ROE% ratio show a
more significant decrease but is still better than the
industry average.
Gross Profit Margin is slightly unfavourable at about
2.3% below the industry benchmark of 25%.
The horizontal analysis information show that Sales
have increased by 20%. However operating costs
have increased by 34%.
Asset Management
IT has gone down slightly from 5.8 to 5.58 times.
IT is still close to the industry benchmark of 6 times.
AT has increased showing more sales being
generated from asset usage
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Liquidity
Current ratios of 1.78:1 (2005) and 1.70: 1 are at
above acceptable levels but below ideal level.
Quick ratios appear more of a concern being below
acceptable levels in both years and even more so in
2006 (0.69:1).
Raises some concerns over the liquidity of the
business and inventory management (although IT
ratio only shows a slight decline in 2006).
Days Payable is a concern as there may be poor debt
payment management.
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Financial Structure
Although slightly higher than D/E industry benchmark
(0.67:1), business has become less risky due to the
significant repayment of loan in 2006.
TIE is extremely good for the business at 39.74 times
(well above 5 the standard benchmark).
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Recommendation
Given:
1) the strong forecast for the industry (ie general
prospects looking good and world demand for
plastic products remaining strong),
2) the sales growth in this business,
3) acceptable ratios as they are quite close to the
industry averages,
4) good cash flows from operating activities and
5) favourable ROE, although it has decreased, it
is still better than the industry average ROE.
=> it is recommended that the investor purchase shares
in the Walker Ltd company.
Mary Lo