Analyse the financial performance of the two companies based on your calculations, identifying and discussing the purposes of calculating those ratios and the weaknesses of ratios analysis?
Accounting is a method of recording transactions which are financial in nature sorting, summarizing and representing those transactions and prepare a report. It also gives important information to the management which needs to be considered while taking the decision. On the hand financial statement is the statement which is prepare to know the current financial condition of the company and it helps to forecast future plans and policies. Several tools are used for analyzing financial data like cash flow statement, profit and loss account, Balance sheet, Ratio analysis etc. the information generated from these statements help in doing the SWOT analysis of the company and the internal performance can be analyzed. In this research study two companies Next Plc and Debenhams PLC are taken into consideration and an analysis has been made on the basis of different financial ratios.
Next plc is the oldest company in the group of plc and it was started its business in the year 1982. From the introduction of the company they presented their own collections of women wears and different accessories. This brand supplies its home ware and official clothing to the London Olympic and Paralympic games in 2012. They provide the outfit in the opening and closing ceremonies. Recently the company is proving services to almost 4 million consumers and most of their business is done through online (Anon, 2015).
Debenhams Company was established in year 1813 when William Debenham invested in the firm created by William Clark. This is one of the international multi brand store. This company operates almost 240 stores across 27 countries in the world. They have to compete in the retail sectors with some of its strong competitors like Tesco, Sainsbury’s, Wal-Mart etc. They provide an exclusive collection of their own brand to worldwide customers (Anon, 2015).
The performance analysis of any firm can be done through the help of different analytical tools as already stated. Ratio analysis is the most commonly used tool among all. So in this study for analyzing the performance ratios are used as decision making parameters (Campilho and Kamel, 2012).
The profitability can be measured by the use of profitability ratios. The word profitability implies the capacity of a company to generate positive return for the shareholders which can be distributed as dividend and some portion can be retained for future expansion purpose. It is the ultimate result of the management decisions and policies. For a company’s survival and expansion long term profitability is necessary. The profitability can be indicated by many ratios like Net Profit ratio, Gross Profit Ratio, operating profit ratio etc (Drury, 2012) ; (Collings, 2015).
Gross profit ratio is the ratio which is calculated by taking net sales revenue into consideration. It reveals the percentage of gross profit achieved by a company on its net sales. The profit generated from the direct trading activity is known as the Gross profit of the company. It is the primary measurement of the profitability as there are some other factors which may have some influence on the profit. Higher gross profit ratio leads to high profitability. From the financials of both the companies it is found that the ratio of gross profit in next plc is increasing trend and 33.2% in year 2014, it represents a very good percentage on the revenue of the company. On the other hand it is very low in case of Debenhams as it is only 12% in 2014 and the most important point is that it is continuously decreasing. The main reason is may be due to the excessive cost of sales with respect to revenue earned (Robinson, 2012)..
Operating profit of a company indicates the profit which is derived from the gross profit after deducting the operating expenses for the year. This approach is suitable than the gross profit approach as the financials are more accurate. In Next plc this ratio is satisfactory and increased in 2013 but in 2014 it is reduced by some fraction. Though the fraction amount is not too high but the company has to make an investigation on this for getting a better result. Debenhams has too low operating profit percentage. The main reason is lower gross profit and operational inefficiency.
The most commonly used ratio for measuring the profitability is the net profit ratio. Net profit is the profit which is available after meeting all the direct and indirect expenses. A part of the net profit is distributed as dividend to the shareholders. Debenhams Company has a deteriorating net profit ratio. It is only 3% in the financial year 2014 and the situation is very unsatisfactory. The next plc company is in good state as they have almost 14% net profit for the year 2014. The way their net profit is increasing it shows that they are in the growing stage.
Liquidity ratio indicates the liquidity position of a firm. Liquidity means the ability to pay cash and cash equivalents when it is required. Liquidity is necessary for smooth running of a business. Poor liquidity position hampers the credit policy of the firm as they may not be able to pay their creditors due in time. On the other side the firm may able to capture new market opportunities if its liquidity position is high. Current ratio and quick ratio are the two important ratios measures the liquidity position.
Current ratio is the ratio between the current assets and current liabilities. Both current assets and liabilities are the main factors of working capital, so it is known as the working capital ratio. The company will be better position if the ratio is high. Ideal form of this ratio is 2:1 i.e. if a firm has rupee 1 as current liability then it should have the current assets of rupees 2. In next plc the current asset ratio is more than 1 but not as much as it should be. It is also in the increasing trend from which it may be predicted that very soon they may reach to the ideal form. In case of current ratio also the Debenham Company produces a negative image as the current ratio fall below 1. It means the company has more current liabilities to pay than its available current assets (Collis, Holt and Hussey, 2012).
Quick ratio as the name indicates is the proportion between the quick assets and quick liabilities. Items which are not easily converted into liquid cash are deducted from the current assets and liabilities in order to get quick assets and quick liabilities. Inventories and prepaid expenses are deducted from the current assets and bank overdraft is deducted from the current liability as these items are not very liquid. Next plc has moderate quick ratio which is also more than 1. In Debenham the quick ratio is too low almost 0.22. This clearly indicates that the company is suffering by liquidity crunch (Alan Russell, R. Langemeier and C. Briggeman, 2013.
Efficiency is the factor which is measured when the actual performance is more than the standard. For this it is necessary to set some standard which should be treated as performance indicator. Some ratios measuring the efficiency are interest coverage, receivable turnover, inventory turnover etc.
Receivable collection period is the time lag which is allowed to the debtors for paying off their dues. It can be calculated by the receivable collection ratio with the total number of days/ months in a year. If the ratio is high then it indicates that the company is able to collect its due on time and it implies the frequency of the collection. Here in Next plc company the receivable collection ratio is 4 which means amount are collected from the debtors 4 times in a year with a time interval of 78 days in 2014. If we concentrate on this ratio for the past three years then we find that the company loosens its credit policy as the collection interval is increased from 73 days in 2013 to 78 days. In Debenham from the debtors are 11 days it means very frequently they have collected their dues so that they can cope up with the liquidity problem they are facing.
Asset turnover ratio measures the utilization of the assets in the firm’s operation for generating the sales revenue. If the management is efficient enough to handle its operation with the help of its available assets then this ratio will be high. Both next plc and Debenham have more than 1 asset turnover ratio. But in case of Next plc it is getting reduced subsequently whereas in Debenham it is in a stable position (Foroughi, 2012)..
Inventory represents the raw materials consumed for a particular year and the left over portion. It is an important element of current asset. In most of the business a large amount is blocked in the inventory so the inventory should be managed properly. Like other turnover ratios it also measured the frequency of inventory cleared during a particular period. While we are taking this ratio as performance indicator we found that both companies have a moderate inventory policy and there is less chance of overstocking or under stocking of inventories.
Opposite of the receivable collection period is the payable collection period. it is the time lag within which a firm can pay its due to suppliers. If the time allowed by the supplier is high then it has both positive and negative impact on the company. It is positive because the company is not required to pay the amount at a time, but negative because it creates financial burden on the company and if the company is not financially viable then it may hampers the performance. The payable collection period of Debenham is mentionable here as they paid their dues with a time interval of 95 days. The company collects from the debtors within 11 days of sales but make payment to the creditors after 95 days which creates a possibility of enhancing the liquidity position as more liquid cash are now available to them.
Gearing ratios deal about the capital structure of company. For operating a business efficiently long term capital is needed which is collected from different sets of investors. It involves some fixed charges also which the firm has to pay in return of the debt. Gearing ratio shows the ability of maintaining the cost of capital of the company.
Financial gearing ratio which is also recognized as debt equity ratio is the proportion of debt capital on owned capital. For maintaining a high debt capital the company also has to incur high fixed obligation. 1:1 is considered as the benchmark for this ratio. Financial gearing ratio is very high in case of next plc and it is enhanced in 2014 compared to 2012 shows that they are more dependent on the debt capital and they may want to take the benefit of trading on equity. But in case of Debenham though it was more than one in 2012 but it reduces as they become more dependent on equity capital.
The ratio between total equity and total assets is nothing but the equity gearing ratio. For acquiring the assets of the business a part of the owner capital should be used up. In this ratio this measurement is made. The inefficient performance is followed by a low equity gearing but when it is high then it can be said that the firm is performing well (S and Suresh Kumar, 2013).
The financial stability can be calculated through the interest coverage ratio. It is the amount of the net profit earned by a company to cover its fixed interest obligation. If the interest coverage is high then it gives assurance to the investors and they will be satisfied by knowing the fact that the company can pay off their interest in time. By the ratio analysis of both the companies it is visible that next plc has a better position in paying off their interest than the Debenhams plc. The later company’s ratio is falling from 14 to 9, so they are not in a position to deal with the debt capital. It will be too risky for them.
1. Financial ratios are clues. So it cannot be considered as the single most factors for making any conclusion (Seal, Garrison and Noreen, 2012)..
2. Ratios are prepared by individual professionals. So can never be free from biased.
3. The data used for ratios are historical data and with the help of the ratios sometimes we predict the future, but it is not always true that the past and present will be same.
4. Comparison of the ratios will only be meaningful if uniformity is maintained in the accounting methods.
5. Inflation has an effect on the ratio which may not indicate actual figures. For example if the rate of inflation is 100 percent then the predicted amount of sales will be doubled from the previous year which may not an exact figure.
6. The interpretation of the ratio is quite complex task only by watching the results. For example the good current ratio is indicated as 2:1, but it may be the fact that the company sold its inventories in order to increase the csh balance for the current year.
7. Ratios are totally depends upon the strategies of different firms. If a comparison is made between two firms who are operating different lines of activity then the comparison does not give a satisfactory result.
From the above calculations following are the recommendations
1. The Debensham plc should concentrate on increasing of its revenue because they have to incur a huge amount of direct and indirect cost but their revenue is not up to the mark compared with this (Karelskaya and Zuga, 2012); (Kieso, Weygandt and Warfield, 2012).
2. All the ratios of Debensham indicate unsatisfactory conditions except the debtors and creditors collection period so the company should undergo by a proper investigation in order to find out their deficiencies.
3. The overall financial performance though well in case of Next plc but their equity gearing ratio is too low. So they should try to find out new investment opportunities which will enhance their return as well as increase the asset base (Kusano, 2012)..
4. The two companies are reputed companies in this sector but they need to gain the competitive advantage by their efficient performance. Especially Debenham company should try to utilize its core competencies and inner strength in order to maintain their position in the competitive market.
From the different accounting data ratios are calculated and it establishes a logical relationship among them (Goodhart, 2013) : (Jury, 2012).
The conclusion can be made as-
1. Debenham Company has a good receivable and payable management policy.
2. The overall condition of the Debenham is deteriorating as all the ratios are below the standard.
3. The quick ratio of both companies are very low because they have blocked a large amount in inventories they have bank overdraft balances which is also a financial burden.
4. The liquidity, solvency and profitability position of the Next Plc is better than the other one.
So from the total discussion made it can be concluded that Next plc is a consistent performer in the market but the Debenham is gradually losing their position, So they need to focus more on their activities. Lastly it should be remembered that ratio is one of the tools of performance analysis but it is not the only tool, so the other factors should also be considered before giving any final decision (Llewelyn, 2012); (Marilena and Alice, 2012)..
Alan Russell, L., R. Langemeier, M. and C. Briggeman, B. (2013). The impact of liquidity and solvency on cost efficiency. AgriculturalFINANCE Review, 73(3), pp.413-425.
Campilho, A. and Kamel, M. (2012). Image analysis and recognition. Berlin: Springer.
Collings, S. (2015). Interpretation and Application of UK GAAP. Hoboken: Wiley.
Collis, J., Holt, A. and Hussey, R. (2012). Business accounting. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.
Drury, C. (2012). Management and cost accounting. Andover: Cengage Learning.
Foroughi, K. (2012). Market-consistent valuations and Solvency II: Implications of the recent financial crisis. Br. Actuar. J., 17(01), pp.18-65.
Goodhart, C. (2013). Ratio controls need reconsideration. Journal of Financial Stability, 9(3), pp.445-450.
Jury, T. (2012). Cash Flow Analysis and Forecasting. Hoboken: Wiley.
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Anon, (2015). [online] Available at: https://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/.../2013/ar2013.pdf [Accessed 15 Jul. 2015].
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