Performance Management Assignment - Analysis of Profitability, Liquidity and Efficiency Ratios

This report analyses the profitability, liquidity and efficiency ratios of two companies ABC Ltd and XYZ Ltd. It also calculates the Altman's Z-Score for four companies and evaluates their performance based on the same.

PERFORMANCE
MANAGEMENT
ASSIGNMENT

1
By student name
Professor
University
Date: 25 April 2018.
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Contents
Background and Abstract............................................................................................................................3
Question 1...................................................................................................................................................3
Question 2...................................................................................................................................................6
References...................................................................................................................................................8
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Background and Abstract
A report has been prepared having 2 questions. The 1st question includes the profit and loss account and
the balance sheet based on which the profitability and liquidity ratios have been calculated for the 2
companies ABC Ltd and XYZ Ltd and the performance of the companies have been analysed based on
the same (Boccia & Leonardi, 2016). Furthermore the inventory turnover ratio as well as inventory
turnover period both has been calculated with respect to how fast the companies can replace and sell
the inventory during the period. N the 2nd case study, the Altman’s Z-Score has been calculated using the
given inputs for the 4 given companies and the scores which are less than the Z-score have been
analysed for the respective risk. Furthermore, the performance of the companies has been evaluated
based on the Z-score and area of concern has been mentioned (Alexander, 2016).
Question 1
a. The profitability and the liquidity ratios of both the companies has been shown below for the
year 2016.
1. Profitability ratios
Gross Profit ratio = Gross Profit / Sales ABC Ltd. XYZ Ltd.
Gross Profit 2430 2430
Sales 4,500 3,600
Result 54.0% 67.5%
Net Profit ratio = Net Profit / Sales ABC Ltd. XYZ Ltd.
Net Profit 2166 2170
Sales 4,500 3,600
Result 48.1% 60.3%
Return on capital employed = Net income/total capital ABC Ltd. XYZ Ltd.
Net Profit 2166 2170
Average Capital Employed 2,368.00 2,223.00
Result 91.5% 97.6%
Return on Assets = Net income/total assets ABC Ltd. XYZ Ltd.
Net income 2166 2170
Total Assets 2,557 2,261
Result 84.7% 96.0%
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(Amt in OMR)
Ratio Analysis for the year 2016
2. Liquidity Ratios
Current Ratio = Total current assets/ Total current liabilities ABC Ltd. XYZ Ltd.
Total current assets 399 199
Total current liabilities 189 38
Result 2.11 5.24
Liquid ratio /Quick Ratio = (Total current assets - Inventory - Prepaid
expenses)/ Total current liabilities ABC Ltd. XYZ Ltd.
Total current assets - Inventory - Prepaid expenses 179 39
Total current liabilities 189 38
Result 0.95 1.03
Gearing Ratio = (Total Debt/Total owners' equity) or ((Total assets- total
owners' equity)/total owners' equity) ABC Ltd. XYZ Ltd.
Total Debts 0 0
Total owners' equity 2368 2223
Result 0.00 0.00
Debt Ratio = Total Debt/Total assets ABC Ltd. XYZ Ltd.
Total Debts 0 0
Total Assets 2557 2261
Result 0.00 0.00
Profitability ratios are the measure of how the company has been earning profit and how it been
utilising the capital employed and the assets in generating the sales and overall income for the
company. As such, 4 profitability ratios have been computed namely the gross profit ratio, net profit
ratio, return on capital employed and the return on assets (Bromwich & Scapens, 2016). Gross profit is
the measure of what is the profit generated by company post covering the direct costs and Net profit is
the measure of profit profits generated by company post all the direct and indirect costs. From the
above ratio analysis, we can see that in terms of profitability, the company ABC Ltd. Has earned 54% of
the gross profit and 48.1% as net profit. On the other hand, XYZ Ltd. Has earned gross profit of 67.5%
and net profit of 60.3% as a percentage of the sales (Werner, 2017). This goes on to show that both the
companies are earning healthy profit share but the performance of XYZ in this respect has been much
good as compared to ABC Ltd. Furthermore, in terms of the return on capital employed, the company
ABC has made 91.5% whereas XYZ has made nearly 97.6%. This goes on to show that both the
companies have been on the profit spree and has been giving more than expected returns to the
shareholders. However, in terms of return on assets which shows how the assets have been used to
generate the sales of the company, the performance of both the companies again has been good as ROA
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for ABC and XYZ has been 84.7% and 96% respectively. The profitability ratios computed above shows
that both the companies have been profitable in the year 2016 however ABC Ltd has outclassed XYZ Ltd
and there is always a scope of improvement (Choy, 2018).
On the other hand, liquidity ratios have also been computed and they are the measure of whether the
company would be able to meet the short term as well as long term liabilities. It shows the measure of
liquidity and solvency of the company and if the company will be able to honour the liabilities on time
and will not default in this respect. The current ratio is the measure of the current assets available to
cover off the current liabilities and is at 2.11 times for ABC Ltd and 5.24 times for XYZ Ltd. Similarly, the
quick ratio measures the liquid assets available with the entity to pay off the short term liabilities is at
0.95 times for ABC and 1.03 times for XYZ (Kew & Stredwick, 2017). The ideal industry trend for both of
these ratios is 2 times and 1 time respectively and thus it shows that both the companies are doing
exceptionally well in terms of liquidity but again XYZ has outclassed ABC Ltd. The gearing ratio which is
the measure of debt to equity in the company is zero for both of them and again the debt to total assets
ratio of both the companies is zero since both of them is an all equity company. This shows that both of
them are doing the business mainly with equity capital and thus there is no burden of payment of debt
and interest. It also gives an opportunity to the company to make use of the debt in future at low cost
and thus get the benefit of lower weighted average cost of capital (Fay & Negangard, 2017).
b. The inventory turnover ratio and the inventory turnover period for both the companies has
been shown below.
3. Efficiency Ratios
Inventory Turnover = COGS/Inventory ABC Ltd. XYZ Ltd.
COGS 2070 1170
Inventory 220 160
Result 9.41 7.31
Inventory Turnover Period = 365/Inventory turnover ABC Ltd. XYZ Ltd.
No. of days 365 365
Inventory Turnover 9.41 7.31
Result 38.79 49.91
From the above shown ratio, we can see that ABC Ltd.’s inventory turnover ratio is 9.41 times and that
of XYZ Ltd is 7.31 times, indicating that ABC Ltd is replacing the inventory 9 times in a year whereas
company XYZ is doing so only 7 times in a year. Furthermore, from the inventory days, it can be seen
that the company ABC takes 39 days on an average to sell and replace the inventory whereas XYZ takes
nearly 50 days to clear off the stock (Linden & Freeman, 2017). This only goes off to show that the
inventory cycle of ABC is much less than the XYZ Ltd. The benefit with ABC is that the carrying cost will
be less and the stock will be cleared much early leading to less of stock losses. This shows efficiency of
operations and good internal control practices being enjoyed by the company. Less of inventory days
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indicates that the company has planned it inventory holding well and thus the overhead cost of the
company would be less in such a scenario (Goldmann, 2016).
Question 2
a. The Z-score has been calculated for all the four given companies and has been tabulated below:
Calculation of the Z score for the companies
Company A B C D
Net current assets 5,000 4,500 5,500 15,000
Retained profits 19,000 54,000 54,000 54,000
EBIT 6,500 4,000 -3,500 12,500
MV of shares 9,000 5,250 16,000 254,000
Total Assets 54,000 254,000 204,000 454,000
Total Debt 34,000 24,000 189,000 254,000
Sales 54,000 34,000 254,000 504,000
A = Working Capital/Total Assets 0.09 0.02 0.03 0.03
B = Retained Earnings/Total Assets 0.35 0.21 0.26 0.12
C = Earnings Before Interest & Tax/Total Assets 0.12 0.02 -0.02 0.03
D = Market Value of Equity/Total Liabilities 0.17 0.02 0.08 0.56
E = Sales/Total Assets 1.00 0.13 1.25 1.11
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E 2.10 0.52 1.64 1.74
Based on the above analysis, the companies which are at risk in terms of Z-score are B, C and D as all of
them have the Z score less than 1.8 and it shows that they will be declared bankrupt in the future. The
ranking of the company from high to low can be given as B, C, D and A (Heminway, 2017). Even company
A has a Z score of 2.10 and is thus likely to be declared bankrupt in the future in case the situation arises.
It shows that the creditors as well as the investors need to be worried with respect to the dues of the
company. The main reason for the lower Z score can be lower working capital, adverse current ratio,
more proportion of debt in the capital structure and lower earnings as a percentage of the total assets
of the company (Sithole, et al., 2017).
The Z score is basically a cumulative reflection of 5 ratios. It is a standard score as to how far the
standard deviation is away from its mean (Jefferson, 2017). It shows the deviation of a given data point
i.e., above or below the mean. There are various correlation and it can be zero, positive or negative. In
case the score turns out to be zero, it means the score is near to the mean and is average. Positive score
represents the point which is above in the distribution curve and negative score reflects the point which
is below in the distribution curve. In case the score is between 0-1.8, it indicates the company will be
declared bankrupt in the future, in case the same is lying between 1.8-3, the company is likely to declare
insolvency and in case the Z-score is above 3, the company will not be bankrupt and thus enjoys a good
position in the market and has a sound financial health both in terms of liquidity as well as profitability
(Trieu, 2017).
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b. Based on the Z-score of the companies, the performance of the company can be analysed and
evaluated. There have been five ratios which has been used. The interpretation of the same is as
follows:
1. Working Capital/Total Assets (WC/TA): It shows the ability of company to meet the current
obligations with current assets. It is a measure of financial distress of the firm. All the
companies are struggling in this category however, company A is best amongst the all and
Company B is the worst (Meroño-Cerdán, et al., 2017).
2. Retained Earnings/Total Assets (RE/TA): It shows the leveraging effect of the company as to
how the company is reinvesting its profit. Companies with lower ratio indicate the capital
expenditure is financed through borrowing and with higher ratio, that the same is financed
through retained earnings. Again company A is financed 35% from equity and company D is
financed only 12% out of equity making it the most risky in terms of debts.
3. Earnings before Interest and Tax/Total Assets (EBIT/TA): This shows the return on assets.
Company A is good in this making 12% whereas company C is having negative returns.
4. Market Value of Equity/Total Liabilities (ME/TL): This shows the measure to which the
market value of the company will be impacted in case it goes insolvent. This shows that
company A, B and C are having miniscule market value of equity whereas company D is
having higher market value (Johnson, 2017).
5. Sales/Total Assets (S/TA): This is a measure of how the company handles competition and
how it uses the assets to generate the sales. This shows that company A and D are better off
in utilizing the assets in generating the sales whereas company B has the worst
performance.
Looking at the above parameters and the performance of the companies, it can be told that company A
is best amongst the all and company B has been performing worst amongst the all.
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References
Alexander, F., 2016. The Changing Face of Accountability.
The Journal of Higher Education, 71(4), pp.
411-431.
Boccia, F. & Leonardi, R., 2016. The Challenge of the Digital Economy.
Markets, Taxation and
Appropriate Economic Models, pp. 1-16.
Bromwich, M. & Scapens, R., 2016. Management Accounting Research: 25 years on.
Management
Accounting Research, 31(1), pp. 1-9.
Choy, Y. K., 2018. Cost-benefit Analysis, Values, Wellbeing and Ethics: An Indigenous Worldview Analysis.Ecological Economics, p. 145.
Fay, R. & Negangard, E., 2017. Manual journal entry testing : Data analytics and the risk of fraud.
Journal
of Accounting Education, Volume 38, pp. 37-49.
Goldmann, K., 2016. Financial Liquidity and Profitability Management in Practice of Polish Business.Financial Environment and Business Development, 4(3), pp. 103-112.
Heminway, J., 2017. Shareholder Wealth Maximization as a Function of Statutes, Decisional Law, and
Organic Documents.
SSRN, pp. 1-35.
Jefferson, M., 2017. Energy, Complexity and Wealth Maximization, R. Ayres. Springer, Switzerland.Technological Forecasting and Social Change, pp. 353-354.
Johnson, R., 2017. The Best Strategies for Investing.
In the News, pp. 21-31.
Kew, J. & Stredwick, J., 2017.
Business Environment: Managing in a Strategic Context. second ed.
London: Chartered Institute of Personnel and Development.
Linden, B. & Freeman, R., 2017. Profit and Other Values: Thick Evaluation in Decision Making.
Business
Ethics Quarterly, 27(3), pp. 353-379.
Meroño-Cerdán, A., Lopez-Nicolas, C. & Molina-Castillo, F., 2017. Risk aversion, innovation and
performance in family firms.
Economics of Innovation and new technology, pp. 1-15.
Sithole, S., Chandler, P., Abeysekera, I. & Paas, F., 2017. Benefits of guided self-management of attention
on learning accounting.
Journal of Educational Psychology, 109(2), p. 220.
Trieu, V., 2017. Getting value from Business Intelligence systems: A review and research agenda.Decision Support Systems, 93(1), pp. 111-124.
Werner, M., 2017. Financial process mining - Accounting data structure dependent control flow
inference.
International Journal of Accounting Information Systems, 25(1), pp. 57-80.
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