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## 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 When current assets comprise a big inventory of mostly outdated items, a high current ratio may not always indicate a strong liquid position.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.

Cite This Work

My Assignment Help. (2022). Essay On Financial Ratio Analysis And Horizontal Vs Vertical Analysis For CCL's Financial Statements.. Retrieved from https://myassignmenthelp.com/free-samples/abka189-financial-statement-analysis/the-limitations-of-ratio-analysis-file-A1DF096.html.

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[Accessed 21 February 2024].

My Assignment Help. 'Essay On Financial Ratio Analysis And Horizontal Vs Vertical Analysis For CCL's Financial Statements.' (My Assignment Help, 2022) <https://myassignmenthelp.com/free-samples/abka189-financial-statement-analysis/the-limitations-of-ratio-analysis-file-A1DF096.html> accessed 21 February 2024.

My Assignment Help. Essay On Financial Ratio Analysis And Horizontal Vs Vertical Analysis For CCL's Financial Statements. [Internet]. My Assignment Help. 2022 [cited 21 February 2024]. Available from: https://myassignmenthelp.com/free-samples/abka189-financial-statement-analysis/the-limitations-of-ratio-analysis-file-A1DF096.html.

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