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1. Identify and discuss the benefits and limitations of Ratio Analysis.

 Ratio analysis is one of the techniques for analysing the financial data presented in the financial reports of the company. The financial ratio analysis is helpful in planning and forecasting through trend analysis; determining the efficiency of business operations; estimation of budgets using past performance; comparing the company’s performance with that of the competitors or industry average; determining the long-term solvency and liquidity of the firm; and providing important information to the users regarding the financial performance of the company. Despite having several advantages, the ratio analysis also have certain limitations. One of the major limitations is that the information provided by the analysis is historic. The ratio analysis also fails to measure the human element in relation with the company. It does not consider external factors such as global recession while providing information. While comparing the financial ratios of past years, the changes in accounting policies are also ignored. The ratio analysis is conducted using the financial statements, now if the company reports manipulated statements, then the true condition of the company could not be known.
1. In your own words explain the difference between Horizontal Analysis and Vertical Analysis.
 One of the major difference between the horizontal analysis and vertical analysis is that the former analysis involves comparison of amounts in financial statements line by line over a certain period of time for making related decisions whereas the latter analysis involves comparison of each element in the statements by listing them as a percentage of another item from the same statement. Horizontal analysis is conducted to compare the line items to calculate the changes over time whereas the purpose of vertical analysis is to compare the changes in terms of percentages. The vertical analysis is more useful in comparing the company’s result with another companies, probably a competitor, whereas the horizontal analysis is useful in comparing the past performance of the company.

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 (12.5%) 1,820 2626 3332 Net Profit After Tax 12,737 18,381 23,321 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 1820 2626 3332 Total Current Liabilities 3,816 4,258 4,772 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 19,056 19,658 20,772 NET ASSETS 32,591 30,084 27,256 Equity Opening balance 30,084 27,256 14,500 Funds introduced - - - Profit / Loss 12,737 18,381 23,321 Drawings (10,232) (15,553) (10,565) CLOSING EQUITY 32,589 30,084 27,256

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 that need to be investigated.

 1 Accounts receivable The horizontal analysis reveals that the accounts receivable has just increased by 37.93% during the period from 20X5 to 20X6. However, it has increased largely by 82.52% during the period from 20X6 to 20X7. It shows that the company has failed to recover the amount from its customers efficiently. Therefore, the owners need to improve its collection techniques. 2 Operating expenses, particularly vehicle and telephone expense The company’s net profit has reduced by 30.71% and 21.18% in the year 20X6 and 20X7. The revenue of the firm does not change much in comparison with the previous year. The decline in net profit is mainly due to the increase in operating expenses. However, the company has managed to reduced the increased percentage of 73.06% increase in general administrative expenses during 20X6 to 10.05% increase in 20X7. Similarly, the percentage increase in advertising and rent expenses is less than that of previous year. The company need to focus on reducing the telephone and vehicle expenses to earn higher profit. 3 Sales Revenue Sales revenue is one of the most important elements for any firm. The company had been able to increase the revenue by 5.88% during the year 20X6. However, it has reduced by 0.25% in 20X7. The percentage is quite low, but the company is expected to increase its revenue with every passing year. The advertising expenses has been increased by 9.09%, which was 55.60% increase during 20X6. It means that the company is not focusing on advertising for actuating large amount of sales. Thus, the owners should think of increasing advertisement and thereby attract new customers to increase the sales revenue.

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 176540 167890 162510 Net Sales Revenue 187718 188189 177743 94.05% 89.21% 91.43% Evaluation and Recommendation: Gross profit indicates the amount of revenue left after meeting the direct expenses to cover the operating expenses of the firm. The company’s gross profit has increased from 91.43% in 20X5 to 94.05% in 20X7. It means that the company has managed to reduce its direct costs slightly and increase the gross profit of the firm. The owners can further reduce the direct costs and iprove gross profit ratio by procuring raw materials and supplies from alternative suppliers at reduced costs for bulk purchases
 Ratio Formula 20X7 20X6 20X5 Net profit margin Net profit after tax 12737 18381 23321 Net Sales Revenue 187718 188189 177743 6.79% 9.77% 13.12% Evaluation and Recommendation: The net profit margin indicates the ability of the firm to convert the revenue of the firm to the actual profit. The net profit margin of the company has been declining continuously from 13.12% in 20X5 to 9.77% in 20X6 and to 6.79% in 20X7. This is mainly due to increase in operating expenses and decline in sales revenue of the firm. It is recommended for the owners to focus on reducing the operating expenses such as vehicle, telephone and wages expenses to earn higher profit for the company
 Ratio Formula 20X7 20X6 20X5 Current ratio Total Current Assets 8730 6282 5238 Total Current Liabilities 3816 4258 4772 2.29 1.48 1.10 Evaluation and Recommendation: The current ratio indicates the ability of the company to pay the short term obligations using the current assets of the firm. The current ratio of Cooks & Clean Limited is good as it is above 1. It means that the company could pay its current liabilities using the current assets easily. The current ratio has increased from 1.48 in 20X6 to 2.29 in 20X7. It shows that the company is not utilizing the current assets to the fullest.
 Ratio Formula 20X7 20X6 20X5 Working capital Current Assets – Current Liabilities 8730-3816 6282 – 4258 5238 – 4772 4914 2024 466 Evaluation and Recommendation: Working capital represents the excess of current assets over current liabilities. The working capital ratio of less than 1 indicates that the company will face financial troubles in future. The working capital ratio is also known as current ratio. The working capital ratio of greater than 2 indicates idle funds that are underutilized. The working capital ratio for the year 20X5 and 20X6 can be considered as balanced ratio. It is recommended for the company to find additional bank finance and invest in advertising or other operational areas so that the profitability as well as the liquidity position of the company is improved. The working capital of the company has largely increased from 466 in 20X5 to 4914 in 20X7
 Ratio 20X7 20X6 20X5 Accounts receivable turnover 67578 39520 26660 (6578+3604)/2 (3604+2613)/2 (2613+2745)/2 13.3 times 12.7 times 10.0 times Evaluation and Recommendation: The accounts receivable turnover ratio is measured by dividing the net credit sales by the average accounts receivable. The main purpose of calculating this ratio is to quantify the effectiveness of company in collecting the money owed by the customers. The accounts receivable turnover has increased from 10.0 times in 20X5 to 13.3 times in 20X7. However, this needs to be improved further through cash discounts and giving regular reminders to pay their debt to the customers.
 Ratio Formula 20X7 20X6 20X5 Debtor days (Average Accounts Receivable) (6578+3604)/2)*365 (6578+3604)/2)*365 (6578+3604)/2)*365 Annual Sales 187718 188189 177743 9.90 days 6.03 days 5.50 days Evaluation and Recommendation: The debtor days represents the number of days taken by the company to collect debt from their customers. The average debtor days was 9.90 days, 6.03 days and 5.50 days for the year 20X5, 20X6 and 20X7 respectively. This indicates that the number of days are increasing which means that the company is taking more time for recovering its debt. However, the company can improve its collection days by making easy to pay invoices, offering several payment options such as credit cards and bank transfers.
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