Essay On Financial Ratio Analysis And Horizontal Vs Vertical Analysis For CCL's Financial Statements.

Benefits of Financial Ratio Analysis

1. a. Identify and discuss the benefits and limitations of Ratio analysis.

Benefits.

1. Planning and Forecasting.

Computing ratios of relevant financial statistics from the previous few years can reveal trends in costs, sales, profits, and other facts. This ratio-based trend analysis could be helpful in forecasting and planning future business actions.

2. Budgeting is the evaluation of future actions based on previous experiences. Accounting ratios are helpful in the estimation of budgeted numbers. A sales budget, for example, could be created using data from previous sales.

3. Operating Efficiency Evaluation.

Ratio analysis determines the degree of efficiency in the management and usage of a company's assets. The operational efficiency is indicated by various activity ratios. A company's health is determined by the sales revenues generated by its assets.

 Limitations.

1. Financial Statement Limitations.

Ratios are determined based on the information disclosed in financial statements. Financial accounts, on the other hand, have a number of flaws that can impair the quality of ratio analysis.

2. Historical Information.

Financial statements contain information from the past. They do not reflect the present situation. As a result, it is unhelpful for forecasting the future.

3. Quantitative Analysis.

Ratios are solely used for quantitative analysis, and qualitative aspects are not taken into account while calculating ratios. When current assets comprise a big inventory of mostly outdated items, a high current ratio may not always indicate a strong liquid position.

b. In your own words explain the difference between Horizontal analysis and Vertical analysis.

Horizontal analysis is the process of calculating the absolute and relative deviations for each line item in a financial statement over two or more periods. Where as vertical analysis is a proportionate review of the financial statement in which each item in each part is calculated as a percentage of the whole.

Horizontal analysis illustrates an item's increase or decrease in value. Vertical analysis assists predicting and estimating the relevant proportion of an item to the common item in a financial statement.

The goal of horizontal analysis is to determine the trend and changes in a given item over time. Vertical analysis goal is to establish the percentage of items to the single accounting year's common item.

 The main difference between the two is that vertical analysis focuses on the connections between numbers in a given reporting period, whereas horizontal analysis covers numerous reporting periods.

2. You have been provided with a summary of the Profit & Loss data and Balance Sheet data for the past three years for Cooks & Cleans Limited (CCL).  

CCL are a home handy service that are called into people’s homes to cook and clean for them. CCL uses their own ingredients and cleaning equipment which is managed under a Periodic Inventory System.

In the past three years CCL have invested significant funds into marketing both in print and online to increase their customer base and therefore boost income.  They are wanting to employ more staff to ensure they are able to meet the demand when the expected demand for their services increase.

Cooks & Cleans Limited
Profit and Loss Statement
	20X7	20X6	20X5
Sales income
Cooking & Cleaning Income	187,718	188,189	177,743
Total Income
Less Cost of Goods Sold
Opening Inventory	628	562	210
Purchases – Ingredients & Cleaning Supplies	10,895	20,365	15,585
Less Closing Inventory	(345)	(628)	(562)
Cost of Goods Sold	11,178	20,299	15,233
Gross profit	176,540	167,890	162,510
Other Income
Interest income	472	588	510
Dividend income	6,900	4,890	5,970
Total Income	183,912	173,368	168,990
Expenses
General administration expenses	2,036	1,850	1,069
Advertising	17,890	16,400	10,540
Wages	128,280	115,450	113,600
Printing, postage & stationery	263	204	198
Telephone	2,388	1,788	1,512
Rent	13,520	13,000	11,960
Vehicle expenses	4,978	3,669	3,458
Total Expenses	169,355	152,361	142,337
Net Profit Before Tax	14,557	21,007	26,653
Less Taxation Expense (30%)	4,367	6,302	7,996
Net Profit After Tax	10,190	14,705	18,657
Cooks & Cleans Limited
Balance Sheet
	20X7	20X6	20X5
Current Assets
Cash	1,807	2,050	2,063
Accounts receivable	6,578	3,604	2,613
Inventory	345	628	562
Total Current Assets	8,730	6,282	5,238
Non-current Assets
Property, plant and equipment	12,917	13,460	12,790
Term Deposit	30,000	30,000	30,000
Total Non-current Assets	42,917	43,460	42,790
TOTAL ASSETS	51,647	49,742	48,028
Current Liabilities
Accounts payable	1,616	1318	1,142
Accrued expenses	380	314	298
Tax payable	4,367	6,302	7,996
Total Current Liabilities	6,363	7,934	9,436
Non-current Liabilities
Rolling overdraft	2,090	2,100	2,500
Finance Lease - Vehicle	13,150	13,300	13,500
Total Non-current Liabilities	15,240	15,400	16,000
TOTAL LIABILITIES	21,603	23,334	25,436
NET ASSETS	30,044	26,408	22,592
Equity
Opening balance	26,408	22,592	14,500
Funds introduced	-	-	-
Profit / Loss	10,190	14,705	18,657
Drawings	(6,554)	(10,889)	(10,565)
Closing Equity	30,044	26,408	22,592

Using the Horizontal analysis approach, you are required to analyse the data and then highlight three areas that the owners need to look into in more detail. You must also provide a brief explanation to support each of the three areas you highlight need to be investigated.

1.	Gross profit increases: The absolute percentage change in gross profit in 20X7 was higher than in 20X6, indicating that the firm has continued to grow over the previous two years. In the year 20X7, gross profit grows owing to cost-cutting in the procurement of Ingredients and Cleaning Supplies, as well as a reduction in the cost of goods sold.
2.	Increase in wages: In 20X7, the absolute percentage change in wages increased to 11.11%, up from 1.36% in 20X6. From the year 20X5 until the year 20X7, wages have been steadily rising. Wage increases have an effect on net profit before taxes. The owner must investigate the wage costs and must deduct the abnormal wages from the wages.
3.	In 20X7, the absolute percentage change in account receivable was raised to 82.52%, compared to 37.93% in 20X6. In 20X7, account receivables have increased by over 45%. From the year 20X5 through the year 20X7, it has been consistently growing. The owner should investigate the account receivable. Cash collection has fallen from 11.85 percent in 20X7 as a result of this. In terms of collecting money from a debtor, the efficiency is poor.

Limitations of Financial Ratio Analysis

Using the financial information provided for Cooks & Cleans Limited, you are now required to use ratios to analyse the Financial Statements.  

You may find it useful to know the following 20X4 Balance sheet figures:

• Total Assets - 44,880
• Accounts Receivable – 2,745

CCL has also given a further break-down of their sales:

Sales Breakdown
	20X7	20X6	20X5
Cash Cooking & Cleaning Income	120,140	148,669	151,083
Credit Cooking & Cleaning Income	67,578	39,520	26,660
Total Cooking & Cleaning Income	187,718	188,189	177,743

Using the following table, you MUST state the formula and provide the ratio calculations for 20X5, 20X6 and 20X7. Your final answer should be stated in the green box. In the grey box you MUST provide an evaluation and recommendation based on your findings: 

Ratio	Formula	20X7	20X6	20X5
Gross profit margin	Gross Profit	176,540	167,890	162,510
	Sales	187,718	188,189	177,743
		94%	89%	91%

The gross profit margin has gone down by 2% from 20X5 to 20X6 but picked up again from 20X6 to 20X7 by 5% considering the sales in 20X7 was a bit down than 20X6 but the COGS was way down in 20X7 than in 20X6. It is recommended to keep control over the COGS every year as this help improve the gross profit margin.

Ratio	Formula	20X7	20X6	20X5
Net profit margin	Net Profit Before Tax	14,557	21,007	26,653
	Sales	187,718	188,189	177,743
		8%	11%	15%

The net profit has been declining from 20X5 to 20X6 to 20X7 due to increasing expenses (overheads) from one year to another particularly wages and advertising. Net profit is the positive cash flow remaining in the company after accounting for all the costs and expenses. Therefore, it is recommended that the company should control it operating expenses and accurately pass it on to the customers without jeopardising its market share in the industry.  

Ratio	Formula	20X7	20X6	20X5
Current ratio	Current Assets	8,730	6,282	5,238
	Current Liabilities	6,363	7,934	9,436
		1.37	.79	.56

A good current ratio will depend on the company’s industry and historical performance. As a general rule, a current ratio below 1.00 could indicate that a company might struggle to meet it short term obligation. A ratio of 1.5 or greater would generally indicate good liquidity.

It is recommended that the company must try to increase its current assets and decrease its current liabilities to achieve the required level of liquidity and remain solvent.

Ratio	Formula	20X7		20X6	20X5
Working capital	Current Assets – Current Liabilities	8,730-6,363		6,282-7,934	5,238-9,436
		2,367		-1,652	-4,198

The working capital formula above indicates that the company had a liquidity problem in 20X5 and 20X6 but improved its liquidity position in 20X7,

The company needs to ensure that it has enough liquidity to pay its debts as and when they fall due. As a result, the company must ensure that its current assets exceeds it current liabilities at any point of time.

Ratio	Formula	20X7	20X6	20X5
Accounts receivable turnover	Net Credit Sales	67,578	39,520	26,660
	Average AR (((OB+CB)/2))	(3,604+6578)/2	(2,613+3,604)/2	(2,745+2,613)/2
		13.27	12.71	9.95

The higher the accounts receivables turnover rate the better as it means that the company collects its debts from its customers on time which increases the cash flow that will allow the company to pay its debts quicker.

It is vital that the company has a firm payment term policy in place with all the customers and collects it debts on time so the company can have enough cash to pay its liabilities as and when they fall due. No point of a company that makes lots of profit without converting this profit into cash on time.

Ratio	Formula	20X7	20X6	20X5
Debtor days	365	365	365	365
	Receivable turnover ratio	13.27	12.71	9.95
		28	29	37

In 20X5 the average customer took approximately 37 days to pay their debt where it took about 29 days in 20X6 and 28 days in 20X7 which indicates that the company improved its debt collect process over the 3 years.

It is recommended that the company maintains its average collect days around 30 days in order to maintain enough cash in the business and avoid being insolvent.