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(a) Calculate the following six ratios for both companies, clearly showing the ratio formula and figures used:
(i) Current ratio
(ii) Quick ratio (acid test ratio)
(iii) Receivables collection period
(iv) Return on capital employed
(v) Gross profit percentage
(vi) Net profit percentage

(b) Using the ratios calculated in part (a) prepare a report for the investor providing comments on the performance and position of Wallace and Gromit. You are required to critically evaluate the advantages and limitations of using ratio analysis in part (a) as an analytical technique in assessing the performance of firms.

(c) Critically discuss what further information might be useful to the potential investor before they decide in which company to invest.


(d) Gromit is planning an expansion of their production facilities which will cost £2.5million. Critically discuss how this might be financed and how potential problems can affect financial ratios associated with the methods you have chosen.

Current ratio of Gromit and Wallace for the year 2017

Six financial ratios have been taken into consideration for both Wallace and Gromit and their detailed calculations are depicted as follows:

Particulars

Details

Wallace

Gromit

Current Assets

A

303

274

Current Liabilities

B

70

151

Current Ratio

A/B

4.33

1.81

Table 1: Current ratio of Gromit and Wallace for the year 2017

(Source: As created by author)

Particulars

Details

Wallace

Gromit

Current Assets

A

303

274

Inventory

B

138

167

Current Liabilities

C

70

151

Quick ratio

(A-C)/B

2.36

0.71

Table 2: Quick ratio of Gromit and Wallace for the year 2017

(Source: As created by author)

Particulars

Details

Wallace

Gromit

Revenue

A

596

678

Receivables

B

69

98

Receivables collection period (in days)

365/(A/B)

42

53

Table 3: Receivables collection period (in days) of Gromit and Wallace for the year 2017

(Source: As created by author)

In this case, it is noteworthy that the total receivables for the prior year have not been provided for both the organisations. Hence, the average receivables could not be used for ascertaining the receivables collection period (in days) due to which the total receivables are considered for calculating the same.

Particulars

Details

Wallace

Gromit

Operating Profit

A

113

51

Total Assets

B

610

1200

Current Liabilities

C

70

151

Return on capital employed

A/(B-C)

20.93%

4.86%

Table 4: Return on capital employed of Gromit and Wallace for the year 2017

(Source: As created by author)

Particulars

Details

Wallace

Gromit

Revenue

A

596

678

Gross Profit

B

202

152

Gross profit percentage

B/A

33.89%

22.42%

Table 5: Gross profit percentage of Gromit and Wallace for the year 2017

(Source: As created by author)

Particulars

Details

Wallace

Gromit

Revenue

A

596

678

Net Profit

B

99

24

Net profit percentage

B/A

16.61%

3.54%

Table 6: Net profit percentage of Gromit and Wallace for the year 2017

(Source: As created by author)

Date: 27/03/2018

To,

The Investor,

Subject: Financial performance and position of Gromit and Wallace

The above calculations primarily help in representing the financial position and performance of Gromit and Wallace for the year 2017. The current ratio calculated signifies that the ability of Wallace is greater compared to Gromit to settle its existing debts and dues because of available greater short-term asset base. In this regard, Baños-Caballero, García-Teruel, & Martínez-Solano (2014) stated that the standard current ratio in the business sector is 2. Any figure above this benchmark indicates that the firm has kept the assets idle and there is no effective use of cash for enhancing the current business operations. For Wallace, the situation is similar, since the current assets are kept idle, which has hindered its revenue earning capacity. The similar scenario could be observed in case of Gromit as well; however, the ratio is much lower in contrast to Wallace. In addition, Gromit has the capability of disclosing short-term obligations and dues with its short-term assets.

The quick ratio signifies the liquidity position of a firm, which is obtained by comparing cash and other liquid assets against the short-term liabilities (Barman & Sengupta, 2017). For both the companies, the ratio is well above the ideal benchmark of 1. This implies that the organisations are highly capable to transform their short-term assets into cash for accomplishing the existing dues and obligations; however, the utilisation is not made properly. In case of Wallace, the primary reason identified behind such situation is the excess amount of idle cash kept at bank (Barr, 2018). On the contrary, Gromit has enabled greater extension of debtor terms due to which the cash base of the organisation could not be enhanced. Hence, from the liquidity perspective, the asset base for both the organisations has been adequate; however, effective use is not made for investing in business operations and capital projects (Cavusgil et al., 2014).

Quick ratio of Gromit and Wallace for the year 2017

According to Finkler et al., (2016), receivables collection period in terms of days could be utilised for evaluating the time that the customers have taken in repaying the debt amount owed to the firm. The provided table states that Wallace is collecting amount at a faster rate in contrast to Gromit from its customers. This is because Wallace intends to increase its cash base, which could be used further in carrying out the daily business operations (Gitman, Juchau & Flanagan, 2015). Hence, from the efficiency perspective, Wallace is enjoying competitive supremacy over Gromit because of the effectiveness of the management in dealing with the debtors.

As pointed out by Enekwe (2015), return on capital employed signifies the capability of an organisation for obtaining revenues from amount invested in the overall business operations. In case of Gromit, the ratio obtained is 4.86%, while the same for Wallace is obtained as 20.93%. The probable reason behind such greater ratio for Wallace is the rising market demand because of the greater service quality delivered to its customers. Thus, Wallace provides greater returns compared to the rate of borrowing and thus, it enjoys sustainable competitive supremacy over Gromit.

As commented by Enqvist, Graham & Nikkinen (2014), the gross profit percentage measures the profit level of a firm by contrasting gross income with sales revenue via sale of inventory or merchandise. A greater ratio is always favourable, as it signifies the capability of the organisation for covering its operating costs, interest expense and income tax with considerable amount of cash in hand or at bank. In the provided case, the gross profit percentage for Gromit is 22.42%, while Wallace has a percentage of 33.89%. Even though Gromit has generated more revenues than Wallace, the latter has bought raw materials and other consumables at a lower price in contrast to Gromit. Hence, the profit level of Wallace has increased and thus, its ability to clear its operating costs with the gross income is increased accordingly (Evans & Mathur, 2014).

In the words of McKinney (2015), net profit percentage denotes the portion of sales, which is left over after all the pertinent expenditures are adjusted in an organisation. The table above clearly inherits that the percentage in case of Wallace is 16.61%, while the percentage for Gromit is obtained as 3.54%. The strategy of product differentiation is the primary factor, which has helped Wallace in maintaining effective competitive edge in the operating market. Hence, from the perspective of profitability, Wallace is maintaining competitive position compared to Gromit because of the selection of effective suppliers and rightful demand projections.

Receivables collection period (in days) of Gromit and Wallace for the year 2017

Based on the evaluation of the above-stated ratios, it could be inferred that Wallace has performed better and it is in a better position in contrast to Gromit in the market. The sole exception has been observed in the liquidity position of both the organisations, as the short-term assets are not used efficiently resulting in greater amount of idle cash. Hence, depending on the financial analysis, it is recommended to invest in the stock of Wallace. This is because there is greater stability and growth of the organisation compared to those of Gromit. However, before undertaking the final investment decisions, certain other influential dynamics need to be taken into account and they are elaborated in details in the later sections of the report.

Different information would be useful for the investor for evaluation purpose before final investment decision is undertaken in any one of the two provided organisations. These factors primarily comprise of the following:

It is necessary for the potential investor in creating an expansion strategy before investment is made in only one firm. The reason is that any variation in market index has either positive or negative impact on a specific stock movement (Rahman, Yaacob & Radzi, 2015). Henceforth, if the investor undertakes the decision of investing in the stock of Wallace depending on its better financial performance, a negative market index movement might minimise the overall return on investment. In addition, it is desirable for the investor to maintain knowledge of other shares in the index for expanding the strategy depending on macroeconomic and market conditions.

As laid out by Rashid et al., (2015), assessing the performance of a firm in the share market is crucial from the perspective of an investor in order to determine the rate of return, which could be accomplished from each share bought. This could be carried out by considering the past data of the two provided companies, which would reveal the movements of share price over the specific timeframe. In addition, the return that the stock is expected to provide would be considered for contrasting the stock performance with the overall index. In addition, both market risk and stock risk are needed to be calculated for ascertaining the feasible and worst likely outcomes for the investor.

However, before undertaking any investment decision, the investor’s nature has a crucial role to play. A risk-prone investor might tend to invest in shares providing higher returns, while a risk-averse investor would invest in shares providing constant and timely returns with minimised risk. Hence, the investor is needed to assess the stock performance of both the organisations against the index before investing in shares in any one of them.

Return on capital employed of Gromit and Wallace for the year 2017

Before investment decision is made, the prospective investor might think of approaching three to five customers that have consumed the products of Gromit and Wallace. As a result, the investor would be able to gain an insight of the presence of a particular substitute in the market (Robinson et al., 2015). Moreover, if assumption is made that the investor would invest in the stock of Wallace, it is necessary to seek feedback from the customers about their attitudes at the time Gromit minimises its pricing structure. As a result, the loyalty base of the former would be increased.

Assumption is made that the investor does not have any prior knowledge of the share market and thus, assistance is required in order to make investment decision. Therefore, if the investor seeks advice from an investment banker or industry professional, it would be useful for obtaining pertinent information regarding the current market conditions (Titman, Keown, & Martin, 2017). If the investor has lack of contacts, social media sites such as LinkedIn would enable the investor to find the answers of those questions, which are not provided initially.

Gromit could use the following techniques of diversifying its production facilities and the issues related to each of these methods are elucidated briefly as follows:

In this case, assumption has been made that the credit position of Gromit is strong and hence, it could avail the alternative of raising conventional bank loans in order to raise funds for the facility of production. Debt funding enables a firm to conduct its pre-determined plan without any kind of interference from the equity stockholders (Vogel, 2014). However, if the overall amount is financed through debt, the overall liability burden of Gromit might increase largely in future. As a result, the cash reserves of the organisation would be minimised, while the interest payments would rise accordingly. Thus, the organisation might experience a fall in it short-term asset base.

It is observed that the investors are highly beneficial in expanding the business operations, as they could offer various insights and experience (Zainudin & Hashim, 2016). If the production facility requires expansion, Gromit needs to arrange £2.5 million. This amount could be raised from the investors, which is highly significant for implementing the strategic plan. However, compromise of excess equity for obtaining funds might pose problems for the concerned organisation, since the investors might demand certain stuffs in contradiction to the expansion plan, as set by the organisation

Gross profit percentage of Gromit and Wallace for the year 2017

After careful dissection of the above two sources of finance, it is advised to Gromit to obtain £1.5 million via debt and the leftover amount from the investors. This is because the optimum capital structure of the organisation would be maintained, which is 0.5 for most of the business sectors operating in the global market.

References:

Baños-Caballero, S., García-Teruel, P. J., & Martínez-Solano, P. (2014). Working capital management, corporate performance, and financial constraints. Journal of Business Research, 67(3), 332-338.

Barman, A. N., & Sengupta, P. P. (2017). Determinants of profitability in Indian telecom industry using financial ratio analysis. International Journal of Research in Management & Social Science, 25.

Barr, M. J. (2018). Budgets and financial management in higher education. John Wiley & Sons.

Cavusgil, S. T., Knight, G., Riesenberger, J. R., Rammal, H. G., & Rose, E. L. (2014). International business. Pearson Australia.

Enekwe, C. I. (2015). The relationship between financial ratio analysis and corporate profitability: a study of selected quoted oil and gas companies in Nigeria. European Journal of Accounting, Auditing and Finance Research, 3(2), 17-34.

Enqvist, J., Graham, M., & Nikkinen, J. (2014). The impact of working capital management on firm profitability in different business cycles: Evidence from Finland. Research in International Business and Finance, 32, 36-49.

Evans, J. R., & Mathur, A. (2014). Retailing and the period leading up to the Great Recession: a model and a 25-year financial ratio analysis of US retailing. The International Review of Retail, Distribution and Consumer Research, 24(1), 30-58.

Finkler, S. A., Smith, D. L., Calabrese, T. D., & Purtell, R. M. (2016). Financial management for public, health, and not-for-profit organizations. CQ Press.

Gitman, L. J., Juchau, R., & Flanagan, J. (2015). Principles of managerial finance. Pearson Higher Education AU.

McKinney, J. B. (2015). Effective financial management in public and nonprofit agencies. ABC-CLIO.

Rahman, N. A., Yaacob, Z., & Radzi, R. M. (2015). Determinants of effective financial risk management in small business: A theoretical framework. International Foundation for Research and Development (IFRD), 89.

Rashid, N. M., Norfadzilah, N. M., Noor, R. M., Mastuki, N. A., & Bardai, B. (2015). Longitudinal Study of Corporate Tax Planning: Analysis on Companies' Tax Expense and Financial Ratios. Pertanika Journal of Social Sciences & Humanities, 23.

Robinson, T. R., Henry, E., Pirie, W. L., & Broihahn, M. A. (2015). International financial statement analysis. John Wiley & Sons.

Titman, S., Keown, A. J., & Martin, J. D. (2017). Financial management: Principles and applications. Pearson.

Vogel, H. L. (2014). Entertainment industry economics: A guide for financial analysis. Cambridge University Press.

Zainudin, E. F., & Hashim, H. A. (2016). Detecting fraudulent financial reporting using financial ratio. Journal of Financial Reporting and Accounting, 14(2), 266-278.

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