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An investor is considering the purchase of shares in either Wallace or Gromit. Both companies are in the same business sector and their accounts are shown below:

(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.

## Ratio analysis – evaluating the relationship between the items included in the financial statement

(a)

Computation of ratios

 Ratio Formula Wallace Gromit Current ratio Current assets/ current liabilities 4.33 1.81 Quick ratio (Current assets-inventory)/ current liabilities 2.36 0.71 Receivables collection period Receivables/sales * 365 42.26 52.76 Return on capital employed Earnings before interest and tax/Capital employed 0.21 0.05 Gross profit percentage Gross profit/Sales * 100 33.89 22.42 Net profit percentage Net profit/sales * 100 16.61 3.54

b.Ratio analysis – ratio analyses are used for evaluating the relationship between the items included in the financial statement. It is further used for identifying the trends over the specific period of time for any company or comparing it with any other company in the same industry. Ratio analysis focuses on the 4 major aspects of the business – liquidity, solvency, efficiency and profitability. Investors and managers use various tools for stating the financial performance of the company and whether the company is a good consideration for the purpose of investment.

• Financial position analysis – ratio analysis is the analytical procedure that helps in analysing the company’s financial position
• Performance comparison – it assists in comparing the performances of the company with the previous years and with the industry peers and helps in ascertaining the financial statement.
• Operating measurement efficiency – it assists the organization to evaluate the efficiency and assists in identifying and monitoring the issues.
• Inter firm comparison – ratio analysis process assists in comparing the business performance with other firms. Best way to compare the firms is comparing relevant ratios of the company with average industry ratios.

Limitation of ratio analysis

• Historical information – it provides the historical information and makes the comparison with past data. However, it has no impact on the company’s current situation.
• Lack of comparison standard – there is lack of the standard comparison and no fixed standardized ratios are there for analysing the current situation. Further, it explains the relationship among past information. However, the users are more concerned regarding the present performance and future potentials.
• Window dressing – it states the arrangement that present the financial statement in the way in which it shows better position as compared to the actual position. This technique is generally used by the finance managers and companies for manipulating the financial reports and statement to state more favourable result.
• Quantitative analysis – under the ratio analysis only the quantitative ratios are considered. On the other hand, the qualitative ratios are simply ignored under the procedure.

Analysis of the calculated ratio

Current ratio– the current ratio falls under the category of liquidity ratio and are used for measuring the ability of the company to pay back the liabilities when they become due. Payments towards the current liabilities are paid with the available current assets like inventories, account receivables, marketable securities and cash. Therefore the current ratio can be used for making rough estimation regarding the financial health of the company. Basically the current ratio is the comparison of short term assets with the short term liabilities. Creditors and the potential investors use current ratios for measuring the liquidity position of the company for paying off the short term obligations. If the company has high current ratio like more than 1, they are considered to have good liquidity position. On the contrary, if the current ratio is less than 1, the company is regarded as inefficient in terms of liquidity. From the available data of Wallace and Gromit it is found that the current ratio of Wallace is 4.33 whereas the same for Gromit is 1.81. Therefore, it is clearly evidential that the current ratio of Wallace is significantly better as compared to Gromit. Hence, the liquidity position of Wallace is significantly better as compared to Gromit.

Quick ratio– it measures the ability of the company to meet the short-term obligations. It is also used to measure the liquidity position of the company. When the quick assets are computed the inventories and prepaid expenses are not taken into consideration as these assets take more time to convert into cash. Quick ratio of 1: 1 is considered good for any company. It states that the company has quick assets of \$ 1 available for each dollar of quick liability. It is observed from the given financial information and calculation that the quick ratio of Wallace is 2.36 whereas the same for Gromit is 0.71 only. Therefore, it is clearly evidential that the quick ratio of Wallace is significantly better as compared to Gromit. Hence, the liquidity position of Wallace is significantly better as compared to Gromit.

Receivables collection period– it compares the company’s outstanding receivables with the total sales. The comparison is then used to analyse the time period customers take for make the payment to the dues. Low figure for receivables collection period is considered good as it signifies that the company is able to collect its outstanding dues on time. This ratio is most useful when it is compared with the standard number of days that are allowed to the customers for making the payment. Generally, 40 days will look better until the management realizes that the actual allowed period is only 15 days. It can also be compared with the standard in the industry or with the average ratio of top companies in the industry for judging the collection ability of the company. It is observed from the available information and calculation that the receivables collection period for Wallace is 42.26 days whereas the collection period for Gromit is 52.76 days. Therefore, it can be stated that the Wallace is more efficient in collecting their dues as compared to Gromit.

Return on capital employed– it is a profitability ratio that evaluates the company’s efficiency regarding generating of profit from the employed capital through comparing the net operating profit or the profit before tax and interest with the employed capital. Capital employed refers to the amount of total assets reduced by the amount of current liabilities. High ratio for return on capital employed signifies that the larger amount of profits can be re-invested in the business for the benefits of the shareholders. A ratio of 0.20 indicates that for each invested dollar in capital employed the company is able to earn 20 cents profits. Generally the potential investors interested in high return on capital employed. For instance, if the borrowing rate for the company is 20% and the return that the company is earning is only 15% it will signify that the company is losing money. It can be observed that the return on capital employed of Wallace is 0.21 whereas the same for Gromit is only 0.05. Therefore, it can be stated that return earning capability from the employed capital of Wallace is significantly better as compared to Gromit.

Gross profit percentage– it is the calculation that reveals the percentage of sales including the cost that directly attributable to sales of goods or the services rendered for generating sales. This margin is monitored closely over the time to analyse the earning capability of the company out of the sales made by it. It is the 1st benchmark for the business model. Business that fails to achieve the required rate of gross profit margin fails to go further as the business model will not considered as economically viable. It can be observed that the gross profit margin of Wallace is 33.89% whereas the same for Gromit is only 22.42%. Therefore, it can be stated that profit earning capability of Wallace is significantly better as compared to Gromit.

## Limitation of ratio analysis

Net profit margin– it is the revenue percentage left with the company after meeting all the expenses like interest, operating expenses, taxes and dividends on preferred stock from the sales revenue. It states the profit that can be extracted from the business from total sales. This margin is monitored closely over the time to analyse the earning capability of the company out of the sales made by it. It is the 1st benchmark for the business model. It can be observed that the net profit margin of Wallace is 16.61% whereas the same for Gromit is only 3.54%. Therefore, it can be stated that profit earning capability of Wallace is significantly better as compared to Gromit

c.Further information required by the potential investor before investment

Before making the final decision regarding investment apart from the above information the potential investors require further information as follows –

• Sales – the company may have amazing service or product but the ultimate question is whether the people are ready to buy the product or not. The investor must establish the track record for sales before making any final decision. The investor shall also be informed regarding the rate of sales growth. If the sales growth rate shows an upward trend then the company can be considered for investment
• Cash flow – in any business cash is the dominating item. Even the strong 5 year plan will not be able to maintain the sustainability if the employees leave owing to non-payment of wages or the production unit stops owing to non-payment of dues. Investors look for the cash balance of the company and its regularity to assure them that the company will be able to face unexpected situations and are able to capitalize new opportunities. Free cash flow that is the amount left with the company after meeting all the expenses is also analysed to evaluate the sustainability.
• Debt – debt scares the investors for mainly 2 reasons. 1stis that if the company goes into liquidation the debt holders will get priority in getting their dues over the equity holders. 2nd is that high level of debt needs high amount of repayment and that will eat up the business cash. It further signifies that the company will have fewer amounts of available cash to meet unforeseen events.
• Break – even point – investor may accept the losses over short-term period. However, over the long – term period they want profit and return on the investment. Break-even point is the particular sales point that covers the expenses and start earning profits after that point of sales. Further, other assumption like economies of scale, minimization of marketing expenses and improvement of production efficiency can be built based on the break-even point.

After accumulating all the above mentioned information the potential investor can make his final decision regarding investment in the company.

d.Gromit is planning the expansion of production facilities for which it requires £ 2500,000. It can be observed from the balance sheet of the company that out of total assets of £ 1200,000, an amount of £ 239,000 is financed through debt and the rest £ 969,000 is financed through equity. Therefore, only 19.25% is financed through debt and 80.75% is financed through equity. Adding up £ 2500,000 will make total assets of £ 3700,000. If the entire amount is raised through debt it will make total debt of (£ 2500,000 + £ 239,000) = £ 2739,000. Therefore, debt will be 74.03% which is quite high. Therefore, the company is suggested to raise 50% that is £ 1250,000 through debt and 50% that is £ 1250,000 through equity. The new fund raising will have an impact on the debt equity ratio and the capital employed amount of the company in the following ways –

 Additional amount £             25,00,000.00 Debt - 60% £             12,50,000.00 Equity - 40% £             12,50,000.00 Revised amount of total asset £                37,00,000.00 Revised amount of debt £                14,89,000.00 Revised amount of equity £                22,19,000.00

Debt equity ratio = Total debt / shareholder’s equity

 Previous debt equity ratio 23.84% New debt equity ratio 67.10%

Further, the previous capital employed of the company was = £ 1200 – (120+1+30) = £ 1049 million and new capital employed amount will be = £ 2700 – (120+1+30) = £ 2549 million.

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