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 When current assets comprise a big inventory of mostly outdated items, a high current ratio may not always indicate a strong liquid position.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

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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.

"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.

My Assignment Help (2022) Essay On Financial Ratio Analysis And Horizontal Vs Vertical Analysis For CCL's Financial Statements. [Online]. Available from: 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.' (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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