Financial Ratio Analysis of Two Businesses: A Comparative Study

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Managerial Finance
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Contents
Ans. 1.........................................................................................................................................3
Ans 2..........................................................................................................................................6
Ans 3..........................................................................................................................................9
Ans 4........................................................................................................................................10
Ans 5........................................................................................................................................11
Ans 6........................................................................................................................................13
References................................................................................................................................15
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Ans. 1
a. First of all let’s understand that what financial ratio is. Financial ratios are to be
prepared by using of numerical values from the financial statement. Basically the
motive of financial ratio is to compare the stability, volatility and solvency of the
companies to other companies (Cao, et. al., 2012).
Here the ratio of return on capital employed for business A is 20% and for business B
is 17%. Return on capital employed( ROCE) is a ratio of profitability that is to be used for
measuring that how a company/business efficiently makes profits from its capital
employed and it is done by comparing the net operating profit to capital employed. It also
shows that how the business assets are performing for a long term. So here we can say
that the ROCE of business A is more than business B (My accounting Course, 2019). It
shows that business A generates more dollars of profit by each dollar of capital employed.
It also proves that the business A is efficiently using its capital employed as well as its
financial strategies.
Return on owner’s equity ratio is 30% in business ‘A’ and for business ‘B’ its 18%.
Basically return on owner’s equity shows that how much profit a business has earned
compared to the money a shareholder has invested. It shows that how a business uses its
investment to increase its profit (Cao, et. al., 2012). Hence, business ‘A’ is quite efficient
in terms of investment in comparison with business ‘B’because business A with high
return on equity is successful to generate cash internally (My accounting Course, 2019).
Investors will always prefer to go with the business with high growing returns on equity.
The average settlement period of accounts receivable ratio of business A is 63
whereas its 21 days in the case of business B. The average settlement period ratio shows
the company’s effectiveness of collection of its receivables. This also shows that how a
business handles its credits and when it is to be paid by the clients. So the higher ratio
shows that company is efficiently handling its customers and customers are quickly
paying its debts. Hence business A is good in that and it has high proportion of quality
customers who pays the debts quickly (The Strategic CFO, 2019).
Average settlement period of accounts payable ratio of business A is 50 days and
business B is 45 days. This ratio is also a liquidity ratio which shows that how many
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times a company pays its creditors in an accounting period. The high ratio shows that a
company is efficiently paying its creditors to its vendors/suppliers (Cao, et. al., 2012).
Gross profit percentage ratio determines the relationship between gross profit and net
sales of a company. Here we can see that business A and B both are having equal
percentage of gross profit ratio. It is one of the important aspect for the business because
it shows the overall profit of the business. The larger the profit will be, larger will be its
efficiency to work for a long term (Cao, et. al., 2012).
The last one is inventory turnover period ratio which is 52 days in business A and 25
days in business B. This ratio shows that how effectively the company’s inventories are to
be maintained by comparing cost of goods sold for an average period. It is important to
have high turnover ratio. Investors will prefer to go with the business A because it is
having high inventory turnover ratio which shows that how good it is to invest because
inventory is to be put up as collateral for loans (My accounting Course, 2019).
So we can clearly see that the business approach of Business A is quite efficient in
comparison with business B.
b. As per the given information of ratios of the businesses. I would suggest that business
A should go with personal service and business B should go with competitive price.
The reason is that business A’s ratios shows that a business has been created for a
long term purpose and as efficient as a long term business could be. It has high gross
profit ratio, high return on capital ratio, good in return on owner’s equity ratio. These
high ratio shows that a business is growing well and exist in market where many
investor would want to invest in this business because investors can have faith in the
business that it will give them good return. As we can see that the business A is
having good return and profit, it can go with premium pricing strategies (The
Strategic CFO, 2019). And business B can go with competitive pricing because if it
takes its prices high, investors and banks may not rely on it because its ratios are quite
low if we compare with A. It should put its goods and services prices according to its
competitors so that it can increase its demands and customers as well.
C. Based on the given information business B tends to require more external financing
because business B needs to grow and for that it will need external financing. When we
compare business B with business A we can analyse that it is having good profit but have
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low gross profit, low return on capital employed and low return on equity ratio which
shows that for a long term the business is not going to grow. External financing will help
it to get the funding for building the addition. It will also help to purchase large capital
equipment which it can not afford by its own. It is also good for preserving the own funds
and invest them in a good profit making securities. It will help the business in many way.
I would recommend taking long term debt to business B. Long term debt includes debts
that has to be paid within a year. It is usually use to purchase buildings, equipment, and
assets. It has an advantage that you can pay its debts over an extended period and it helps
you to not to be obliged for paying in month wise and interest on property is tax
deductible. So business B should extend its business and make it more profitable for a
long run (The Strategic CFO, 2019).
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Ans 2.
A.
Profitability ratio:
Profitability ratio shows that how much a company is making profit at the end of the year.
Also how the profit has been utilized in the company.
1. Gross Profit= sales-cost of goods sales
= 370,000-174,000
=196,000
Gross profit ratio= Gross profit/sales*100
=196000/370000*100
=52.97
Liquidity ratio:
Liquidity ratio is used to check the company’s ability to pay its debts and ability to
convert its current assets into cash within a period of time.
Current ratio= Current asset/current liability
=110,000/70000
=1.57
Acid Test ratio=Quick assets/current liability
=current asset- inventory- prepaid expenses/current liability
=110,000-18000-60000/70000
=0.45
Efficiency ratio: Efficiency ratio determines that how well a company manages its assets and
liabilities.
Accounts Receivable turnover=Revenue/average accounts receivable
=370,000/40,750
=9.07%
Average number of days receivable outstanding=365/accounts receivable turnover
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=365/9.07
=40.24 days
Inventory turnover=cost of goods sold/average inventory
=174,000/17000
=10.23
Average number of days inventory in stock=365/inventory turnover
=365/10.23
=35.67 days
Working capital turnover ratio=Sales/Average working capital
=sales/current asset-current liability
=370,000/81,333-54,666
=13.87
Total asset turnover=Sales/average total assets
=370,000/243,500
=1.51
Capital Structure ratio: It is also known as leverage ratio and concern with long term
financing and used to check the business financial position.
Current asset turnover ratio=cost of sales/current assets
=174,000/110,000
=1.58
Owned capital turnover ratio=cost of sales/shareholders fund
=174,000/140,000
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=1.24
Ratio of tangible assets to total debts=tangible assets/total debts
=total assets- intangible assets/total debts
=320,000/62000
=5.16
B. Based on the ratios the strength of the business are:
Profitability- In terms of gross profit the business is quite efficient. The gross profit ratio is
52% which quite more in comparison with previous years. So in terms of profitability
company is performing well (Berger & Bouwman, 2017).
Solvency-As per the solvency of the business concern, it is better than the previous years.
Solvency basically shows that company’s liability should not exceed to company’s current
asset. For long term growth and expansion of business the solvency of the company should be
good. Here we can see that the company’s current ratio and acid test ratio are comparatively
good which shows the better solvency of the business.
The weaknesses are:
Based on the ratio analysis some of the business weaknesses are:
Liquidity- As per the current asset turnover ratio business liquidity is not so good.
Reliability- For investment purpose companies is not so good. It is important to have better
owner’s equity ratio so that investors can invest and get good return.
C.On the basis of above information we can only identify some of the ratios which are not
enough for analysing the company’s efficiency in terms of profitability, stability and
solvency.
As per my view EPS is one of the important aspect to analyse the company’s growth and that
too for a long term. EPS(Earning per share) determines share price of the company which
helps to decide the value in the market. It determines that how much money a business makes
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for each share of its stock. The higher will be the EPS the higher the investor will invest in
your company. It basically shows the worth of your company (Berger & Bouwman, 2017).
EPS is calculated by:
Net income-preffered dividend/End of period common share o/s
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Ans 3.
A. Bonanza’s source of financing in the financial market over the last four years is the
issuance of debt and the amount is 9700.
=1500+100+4000+4100
=9700
B. The major activities of Discount Bonanza’s are from operating activities over the last
four years.
=20,700+20,600+18,400+15,000
=74,400
C . The three important perspectives by which a financial statement can be viewed or
analysed are:
1. Balance Sheet
2. Income statement/Profit and loss statement
3. Cash flow statement
All the three aspects are important for analysing the company’s growth and profitability
and each one has its own place and importance. Like the income statement tells that how
much money a company is making during the year and the balance sheet of a company
focus on the capital of a company and cash flow statement shows the inflow and outflow
of cash on daily basis and also tells us that how much money is being invested in which
area (Efinancemanagement, 2019).
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Ans 4.
a. Here, years to retirement= 50
Years of retirement=25
Annual income required=30,000
Annual interest rate=8%
=30,000*1.08^25
=205,200
The couple will have to save 205,200 each year.
b. If the couple will have to spend 60,000
=65371+205200
=270,571 The couple will have to save this.
C. The time value of money determines the intrinsic value of future. It helps to find the
present value of the future price and also helps to determine the future value of the
present value (Berger & Bouwman, 2017). Basically through Time value of money
we can find out the worth of the future value.
The formula is:
FV=PV*(1+Interest rate)^n
Where,
FV=Future value of money
PV=Present value of money
I= Interest rate
N=Number of compounding periods annually
T=Number of years
Importance of time value of money:
The time value of money determines the time is actually money. The value of the money we
are having now will not be the same in future (Berger & Bouwman, 2017). It is very
important concept for the investors. By knowing how to measure and calculate the future and
present value we can determine the worth of investment that would be offered in different
times.
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Ans 5.
Here,
Index fund investment=17,500
Years =7
Earning=9.5%
Annual cost of university education=25,000
Expected increase in annual tuition costs=4%
a. Four year tuition costs=7 to 10
Years FV Tuition Cost
7 25000(1.04)^7 32898.29
8 25000(1.04)^8 34214.23
9 25000(1.04)^9 35582.80
10 25000(1.10)^10 37006.11
Discount rate=6%
P.V=32898.29+34214.23(1.06)^1+35562.80(1.06)^2+37006.11(1.06)^3
=127915.48
b. Future value of the index mutual fund at t=7
P.V of index fund investment=PV=7500
Return on fund=9.5%
FV of investment=FV
=7500*(1.095)^7
=14,156.64
c. T=7
Pv of tuition costs-fv of investment
=86,124.36-14,156.64
=71,967.72
d. I=11%
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