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Limitation of financial analysis

The financial analysis means taking into account the financial information of the company made available in the market and then anticipating the future viability of the company with the help of this financial information. Financial analysis is an important tool to in analysis the strength and weakness of the company. The financial statement of the company contains information about the company’s business operation and their future plan. These financial statements contain too much information and can be only understood by a professional accountant or person with such similar qualities. There are many users of the financial information of company such as investors, creditors, vendors, etc. The financial analysis simplifies the data into a simpler form which can be understood by the general public. For example, the investor is interested in the profit making capacity of the company because the sole purpose of their investment is to make money from their investment, so they should be checking the profitability ratio such as return on investment, gross profit ratio etc (N). The different users of the financial statement do not have to analysis whole of the financial statement, but with the help of financial analysis, they are given the information they are looking for.

The financial statement used in financial analysis and interpretation itself posse some inherent limitation. These limitations become the limitation of financial analysis. The financial analysis is simply based on the mathematical calculation and the past performance of the company. The future uncertainties cannot be anticipated by the financial analysis. Therefore the threats and opportunities present in the market that are yet to occur are not taken into consideration by financial analysis. The financial statement of the different companies are prepared on the basis of different accounting policies can give the different financial position of the company. For example, one company is preparing accounts on the basis of accrual basis and other is preparing the accounts on a cash basis of revenue recognition. Now both of the company is showing the result on basis of different accounting policies and these cannot be compared with each other with the financial analysis.

 Year 2011 2012 2013 Growth in Sales 17.52% 20.46% 17.21% Growth in Profit 43.82% 41.72% 39.59% Return on Equity 20.95% 25.23% 26.92%

In the above table, the three profitability ratios are taken that is most relevant in the point of view of financial analysis.

Growth in sales ratio: the growth in sale ratio indicates the percentage growth in sales in the present year with respect to the previous year. The growth in the sales indicates an increase in current profit compared to the previous year. The growth percentage is measured by the company to compare the actual performance with the budgeted performance planned in the beginning of the year. Higher the turnover of the business indicates healthy functioning of the business organization and stability in the future years.

The formula for calculating growth sales ratio :

 Sales Growth %           = Change in Sales \$ Last Year’s Sales \$

Gross profit ratio: the main motive of every organization behind its existence in earning some profit. Every business organization competes in the market with their new strategies to earn more profit every year. The dividend paid to the shareholders of the company comes from the profit earned by the company in the financial year. The financial position of the company in the market is determined by the profit earned by the company and the future of the company is estimated on the basis of its profit earning capacity. The company should earn a reasonable amount of profit to cover its variable and fixed overheads in order to survive in the market, the profit earned over and above the fixed and variable overheads is distributed in shareholders and kept for future development of the company after paying taxes.

## Profitability

 Gross profit %: Gross profit Sales

Return on equity ratio: the equity shareholder is the owner of the company. The equity shareholder of a big company can in thousands. The shareholder invests in a company in order to earn some return over and above the money invested in the company. The general public will invest in that company in the market which is giving more return on the money invested by the investors in the company. The return on equity shows the return earned in percentage over the money invested. For example, if the return on equity of a company is 19% and the share of the company is \$100 then the investor is earning \$19 every year from the company and can get the \$100 whenever the share is sold in the open market. The general public will obviously invest in the company which will have a higher return on equity ratio.

 Return on equity% Net Profit after Tax Average equity

Growth in Sales ratio: the Alpaca Products Ltd has a sale growth ratio of 17.52% in 2011 which then increased to 20.46% in 2012 and then suddenly it gets decreased to 17.21%. The Alpaca Products limited achieved a higher growth rate in sales in the year 2012 as compared to previous year than it gets decreased in the year 2013 to 17.21%.

The sales of the Alpaca Products Ltd has shown increasing trend in all the three years it means it sales is increasing with every year. If the sales growth shows negative result than it implies that the sales of the current year are decreased from the last year. But it can be noted that the sales growth in the year 2013 is comparatively lower than 2012, this is because the cash sales increased but the credit sale of the year 2013 is lower than 2012. Collectively the result shows 17.21% growth in sales which is good for the company.

Gross profit ratio: the Alpaca Products Ltd shows a declining trend in the growth profit percentage over the three years. The gross profit is the operating profit of the company. The gross profit of the year 2011 is 43.82% which is decreased to 41.72% in 2012 then again decreased to 39.59% in 2013.

The Alpaca Products Ltd is showing a declining trend in the gross profit percentage over the period of three years which is not a good sign. The sales growth is continuously increasing every year but despite this fact, the gross profit is decreasing every year. This is due to increase in the expenditure is more than the increase in sales. The declining trend of the gross profit should be stopped for the future benefit of the company which can be achieved by cost control.

Return on equity ratio: the return on the equity of the Alpaca Products Ltd is showing a continuous rising trend over the years.

Explanation: the return on equity is increasing every year due to increasing trend of net profit. The net profit is continuously showing an increasing trend over the years. This increasing trend of return on equity attracts more investors and help in increasing the market value of the shares of the company.

## Liquidity and asset utilization

 Year 2011 2012 2013 Inventory Turnover 5.31 times 6.49 times 7.97 times Age of Debtors 47 days 58 days 67 days Current ratio 2.04:1 1.62:1 1.20:1

The inventory ratio is another tool financial analyzing and interpretation the inventory turnover ratio tells us about the number of times an inventory is changed in the given financial year (MyAccountingCourse). The inventory turnover ratio calculates the number of times a company has sold its average inventory during the year. The company should not purchase a large amount of inventory at once because it can increase the storage cost of the inventory which will increase the cost of production, and if the inventory is purchased in small quantity than there can be a shortage of inventory for fulfilling the order. The inventory turnover ratio helps in avoiding both the situation. The efficiency of the company’s operation is largely depending on inventory management.

 Inventory Turnover: Cost of Goods Sold Average Inventory

The age of Debtors ratio is also known as debtor’s turnover ratio. Large companies often conduct the sale operation on credit basis. It will be impossible to execute such big contracts of sale and purchase on a cash basis, therefore credit purchase and selling are done by the companies (Karmakar). The age of debtors means the average number of days taken by the debtors of the company is paying the amount due to the company. The age of debtors can be different for a different client. Less the age of debtors more profitable for the company, the amount received from debtors quickly can be easily put to some other use.

 Age of Debtors: Average Accounts Receivable x 365 Credit Sales

The current ratio is a liquidity ratio that gives the idea about the company’s capacity to pay its current and long term obligation out of its current assets such as cash, inventories, and marketable securities. The current ratio is calculated by dividing current assets by current liabilities (Investopedia). The Higher current ratio of a company indicates e higher capacity of the company to pay its obligations. The composition of the current assets is also an important factor. The current asset

 Current ratio: Current Assets Current Liabilities

Financial Analysis of the Alpaca Products Ltd on the basis of the following Liquidity ratio :

Inventory Turnover ratio: The inventory turnover ratio of the Alpaca Products Ltd is 5.31 in the year 2011 than it increased to 6.49 and further it increased to 7.97. There has been a continuous increasing trend throughout the period of analyzing.

The inventory turnover ratio in 2011 is 5.31 which means it has sold its average inventory 5.31 times during the year 2011. It is showing an increasing trend which is a good sign for Alpaca Products Ltd. The inventory turnover shows the effectiveness of inventory management. The inventory turnover increased because of sales increased over the year but the average inventory remains the same. The inventory turnover indicates in a low cost of production and increases profit in the future.

Age of Debtors: the age of debtors of Alpaca Products Ltd in the year 2011 is 47 then it decreased to 58 in 2012 and again it decreased to 67 in 2013.

The age of debtors is showing growth in the past three years which is bad from the point of view of Alpaca Products Ltd. The debtors of the Alpaca Products Ltd are taking more time to pay the money. This should be decreased for the benefit of the company. This can be the reason for declining credit sales in the year 2013. The debtors should be charged interest for late payment of the money due.

## Financial Analysis of the Alpaca Products Ltd

Current ratio: the current ratio of the Alpaca Products Ltd is 2.04: 1 in 2011 than it decreased to 1.62: 1 in 2012 then again it is decreased to 1.20: 1 in 2013. The current ratio is showing a declining trend in its past few years.

The Alpaca Products Ltd is showing a declining trend in the current ratio which is bad for the company. It means the liquidity of the company is affected seriously. This decreasing trend of current ratio is because the current assets remain same during the three years but the current liabilities are increased in that period. The capability of Alpaca Products Ltd paying its obligation is getting lower year by year.

 Year 2011 2012 2013 Interest Cover 32.22 times 22.16 times 14.85 times Debt Ratio 20.80% 25.00% 30.77%

Interest coverage ratio is used by the company to find out the capacity of paying the interest on its debts. The earning is divided by the total interest to be paid in the current financial year. This shows that how much time the company can pay its current interest liabilities (Answers). This interest cover ratio is an important tool for determining the solvency of the company. Various stakeholders of the company use this interest cover ratio in the different decision-making process.

The formula for calculating Interest Cover :

 Interest Cover: Net Profit Before Interest & Tax Interest

A company is financed by both the equity share capital and debenture capital. The capital of the company should be comprised of the mixture of these two financing option. The debt ratio provides information about the percentage of debenture capital in the total capital of the company (Investopedia, Debt Ratio). It takes into account both the short term as well as long term debentures. The financial leverage of the company is measured by this ratio. It can also be said that it will give an idea about the extent of the company’s asset that is financed by the debenture capital.

 Debt percentage: Liabilities Assets

Financial Analysis of the Alpaca Products Ltd on the basis of the following Financial Structure Ratio :

Interest cover: the interest cover ratio of Alpaca Products Ltd is 32.22 times in 2011 which decreased to 22.16 in 2012 than again decreased to 14.85. This means that the interest paying capacity of the company is declining every year.

Explanation

The Alpaca Products Ltd is showing a continuous decrease in the interest cover ratio over the period of last three year. The reason for such declining trend is increasing in the loan amount every year which gives rise to more interest every year. The decreasing trend of interest coverage is not good for Alpaca Products Ltd.

Debt Ratio: the debt ratio of the Alpaca Products Ltd is 20.80% for the year 2011 which increased to 25.00% in 2012 which again increased to 30.77% in the year 2013. This indicates that the composition outside borrowing is increasing every year. The loan of the Alpaca Products Ltd is 250,000 in 2011 which increased to 300,000 in 2012 then increased to 450,000 in the year 2013.

Explanation

The increase in the debt ratio shows the increased in the outside borrowing in the total capital of the company. It means a lot of assets are financed by outside borrowing which is very risky for Alpaca Products Ltd.

Based on the above evaluation of Alpaca Products Ltd’s financial, liquidity and profitability ratio the main and the most important problem areas are gross profit ratio and the current ratio. These are showing a continuous declining trend over the period of three years.

The Alpaca Products Ltd is showing a continuous decrease in the gross profit ratio over the last three preceding years. The main cause of such declining trend in the gross profit ratio is due to continuous increase in the cost of production and another administrative cost. The sale of the company is also increasing over the period but the expenses are increasing at a comp[aratively higher rate. Gross profit ratio shows the profitability percentage of the company, therefore, such declining trend should be stopped soon. The Alpaca Products Ltd should concentrate on the areas where the unnecessary expenses are incurred which are bringing down the rate of gross profit. If the cost cannot be cut down and the cost is of fixed nature which is increased than either the sales quantity should be increased more or the sale price per unit should be increased without affecting the demand for the product of Alpaca Products Ltd.

The current ratio shows the capability of the company to pay its obligation in time. The Alpaca Products Ltd showing a continuous decreasing trend in this ratio also which is a bad sign for the growth of the company. The current ratio is declining in the case of Alpaca Products Ltd due to the continuous increase of current liability over the year. On the other hand, the current asset of the company did not show any viable growth during these years. The growth of current ratio at this pace can be dangerous for the liquidity of the company.The current liabilities of the Alpaca Products Ltd is increasing at a very high rate which should be controlled by the management. Bank overdraft if showing the highest growth rate and this should be controlled by the company. On the other hand, the total current assets remain intact over the periods. Current assets define the liquidity of the company. Therefore with the growth of the company, the current assets should be increased over the time.

Based on the above evaluation the Alpaca Products Ltd is showing huge growth in the sales. This is mandatory for every company to increase the sale every year. The growth rate in the year 2013 has declined compared to 2012 but the then also it has achieved 17.21% growth which is good enough.

The Alpaca Products Ltd has is showing high growth in cash sales than credit sales. The credit sale even declined in the year 2013 but the overall sale growth rate remains considerably good. The demand for the product should be increased in the market by Alpaca Products Ltd by making additional expenses on the advertisement. Increasing sale will give higher profit in a future year.

Investopedia. (n.d.). Current Ratio. Retrieved august 6, 2017, from Investopedia: https://www.investopedia.com/terms/c/currentratio.asp

Investopedia. (n.d.). Debt Ratio. Retrieved August 6, 2017, from Investopedia: https://www.investopedia.com/terms/d/debtratio.asp

Karmakar, R. (n.d.). Average Age of Debtors: Formulas and Calculations. Retrieved August 6, 2017, from YourArticleLibrary: https://www.yourarticlelibrary.com/accounting/debtors/average-age-of-debtors-formulas-and-calculations/65647/

MyAccountingCourse. (n.d.). Inventory Turnover Ratio. Retrieved August 6, 2017, from MyAccountingCourse: https://www.myaccountingcourse.com/financial-ratios/inventory-turnover-ratio

N, S. (n.d.). Analysis and Interpretation of Financial Statements. Retrieved August 6, 2017, from economicsdiscussion: https://www.economicsdiscussion.net/accounting/analysis-and-interpretation-of-financial-statements/2202

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My Assignment Help. (2022). Understanding Financial Analysis And Interpretation Is Crucial For Writing An Essay. (70 Characters). Retrieved from https://myassignmenthelp.com/free-samples/acct222-management-accounting/accounting-principles-management-file-A92191.html.

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My Assignment Help (2022) Understanding Financial Analysis And Interpretation Is Crucial For Writing An Essay. (70 Characters) [Online]. Available from: https://myassignmenthelp.com/free-samples/acct222-management-accounting/accounting-principles-management-file-A92191.html
[Accessed 04 August 2024].

My Assignment Help. 'Understanding Financial Analysis And Interpretation Is Crucial For Writing An Essay. (70 Characters)' (My Assignment Help, 2022) <https://myassignmenthelp.com/free-samples/acct222-management-accounting/accounting-principles-management-file-A92191.html> accessed 04 August 2024.

My Assignment Help. Understanding Financial Analysis And Interpretation Is Crucial For Writing An Essay. (70 Characters) [Internet]. My Assignment Help. 2022 [cited 04 August 2024]. Available from: https://myassignmenthelp.com/free-samples/acct222-management-accounting/accounting-principles-management-file-A92191.html.

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