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Review the financial information for Watley's Furniture.

Ratio analysis is a useful tool for businesses to analyse financial performance and to develop plans for future business improvements.

Using the above information for Watley’s, carry out ratio analysis for liquidity, activity, profitability and gearing.

Using the ratios calculated in part 1, carry out critical analysis for each of the 4 pairs of ratios in turn. Your answer should explain what can be gleaned from the ratios, and also what Watley’s should do differently in order to improve their future financial performance.

Computation of Key Financial Ratios

Computation of Key Financial Ratios

The financial performance of a business can be determined effectively with the help of key financial ratios of the business. The main purpose of this assessment is to compute key financial ratios for Watley’s and also determine the performance of the business during the period. Ratio analysis can be defined as estimates which can be used by business for understanding the financial performance of a business. Ratio analysis allows the business to analyze different areas of performance of a business such as liquidity, solvency, gearing and efficiency of a business (Carraher and Van Auken 2013). The computation of key financial ratios of a business is shown in the table below:

 Watley’s Particulars 2014 2015 in (£000s) in (£000s) Sales revenue A 3290 3520 Net Profit B 400 300 Total Current Assets C 300 480 Total Current Liabilities D 270 210 Inventories E 90 140 Total Assets F 1550 1630 Receivables G 160 260 Total Liabilities H 470 410 Net Profit Margin J=B/A 12.16% 8.52% Current Ratio K=C/D 1.11 2.29 Average Receivable Turnover N=A/G 20.56 13.54 Debt Ratio O=H/F 0.30 0.25

Figure 1: (Table showing computation of Key Financial Ratios of Watley’s)

Source: (Created by the Author)

The above table shows computation of key financial ratios of Watley’s and the same can be used by the business in analyzing the performance of the business. The ratios which are shown in the table above comprises of Net profit margin, Current ratio, Average Receivable turnover ratio and Debt ratio of a business (Delen, Kuzey and Uyar 2013). The ratios of the business effectively show the performance of the business for two years which are 2014 and 2015. The table which is shown above considers key financial information which is related to the business for the year and on the basis of such information the ratios which are shown in the above table is computed.

Analysis of Key Ratios

The main purpose of this part is to analyze the ratios which are computed in figure 1 shown above and also interpret the financial performance of the business on the basis of the ratios which are computed in the above figure. Ratio analysis is an important tool which helps businesses to not only measure the performance of the business in different areas but also has a significant role in decision making process (Weygandt, Kimmel and Kieso 2015). As the ratios cover specific areas of liquidity, solvency, gearing and efficiency. The ratios which are shown in the above table covers different area for performance of the business.

The net profit of the business is shown to be 12.16% for the year 2014 and the same is shown to be 8.52% in 2015. The net profit ratio of the business is considered to be an important financial indictor of business and investors are always looking for a positive net profit margin and also looking for growth in net profit margin of the business. The net profit of Watley’s is shown to have decreased in comparison to previous years estimate which is calculated in the above table. This is not a good sign for the business and the management of the company needs to effectively formulate a strategy which can improve the profitability of the business (Tayeh, Al-Jarrah and Tarhini 2015). The profitability of the business is considered by potential investors before they take any decisions regarding investments in a business. The fall in the net profit of the business can be attributed to the fall in the sales which is achieved by the business during the period. The income statement of the business shows that the main source of revenue for the business is through sales and the same is shown to be £ 3,520,000 for the year 2015 and the same has decreased significantly from the estimate which is shown in 2014. Another reason for fall in the profitability of the business can also be due to high costs of production incurred by the business which would result in fall in the net profits and thereby result in the fall in the net profit margin of the business (Geng, Bose and Chen 2015). In general circumstances, the higher the net profit margin for a business, the more favorable is the results which is achieved by the business and the management of Watley’s need to form strategies in order to improve the sales and costs structure of the business.

Analysis of Key Ratios

The current ratio which is shown in the above table is associated with the liquidity of the business and is considered to be one of the important indicators for overall performance of the business. The current ratio of the business is shown to be 1.11 in 2014 and the same has increased in 2015 and shown to be 2.29. This shows that the liquidity position of the business has improved significantly in comparison to previous year analysis. The liquidity position of a business is considered to be an important aspect of a business and the operations which are carried out on the basis of the liquidity of the business (Gitman, Juchau and Flanagan 2015). The current ratio of a business is shown to have increased in the current year and this also suggest that the business can effectively meet the current obligations of the business. The ratio also shows the ability of the business to raise funds for any projects or operations of the business and maintain the operations of the business. In general terms, the current ratio of a business considers the current assets and current liabilities of the business and if the current assets of the business are more than the current liabilities of the business, the liquidity position of the business is shown to be favorable. An ideal estimate for current ratio should be 2:1 and the estimate which is computed for 2015 is shown to be 2.29 which confirms the fact that the current ratio of the business is ideal in all respect. Therefore, the liquidity position of Watley’s is shown to be favorable for the business.

The average receivable turnover ratio of the business is covered under efficiency ratio of a business and the same is shown to have decreased slightly in comparison to the estimates which are shown for previous year. The efficiency of the business is shown to have reduced significantly in comparison to previous year. The average turnover ratio of the business is shown to be 20.56 in the year 2014 and the same is shown to be 13.54 in 2015. The management of the company needs to effectively formulate strategies which can help the business to improve the efficiency structure of the business (Bentley et al. 2013). The average receivable turnover ratio is associated with the collections from the debtors of the business and the same is shown to have fallen. This also shows that there has been change in the debtor’s policy of the business and the efficiency of the business is affected due to such a situation. There is scope of bringing about improvement in the efficiency structure of the business which would help the business to generate more profitability in the business.

The debt ratio of a business shows the gearing aspect in the business and the use of debt capital in the capital structure if a business. Any increase in the debt ratio of the business suggest that the management of the business is incorporating more of debt capital in the capital structure of the business. The debt of the business is shown to have reduced slightly in comparison to the estimate which is shown for previous year. The debt ratio for the year 2015 is shown to be 0.25 which has slightly decreased from the estimate which is shown for 2014. This suggest that the management of the business has effectively repaid a portion of debt of the business. This also signifies that the business is trying to make changes in the capital structure of the business and also at the same time also reduce the risks of the business.

The management of the business needs to improve the profitability of the business which can be done by either increasing the sales of the business or reducing the overall costs of the business. The sales of the business are shown to have fallen significantly in comparison to previous year estimate and the management should formulate a plan to increase the sales of the business and thereby also generate higher revenues for the business (Storey et al. 2016). The liquidity position of the business is shown to be appropriate and the same suggest that the management can undertake any projects which requires appropriate amount of funds and it also suggest that the management is effectively able to handle all current obligations of the business (Ehrhardt and Brigham 2016). The efficiency of the business has fallen slightly as shown in the table above and the management needs to formulate strategy in order to improve the efficiency of the business. This can be achieved by implementing proper supervision and control in the business.

The management needs to take appropriate steps to set up a proper internal control system in the business so that the operational structure of the business can be improved and also bring about efficiency in the operations. The gearing ratio of the business is shown by debt ratio which is shown to have reduce in 2015 which suggest that the management is making changes to the capital structure of the business and repaying a portion of debt capital of the business.

References

Bentley, K.A., Omer, T.C. and Sharp, N.Y., 2013. Business strategy, financial reporting irregularities, and audit effort. Contemporary Accounting Research, 30(2), pp.780-817.

Carraher, S. and Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336.

Delen, D., Kuzey, C. and Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), pp.3970-3983.

Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach. Cengage learning.

Geng, R., Bose, I. and Chen, X., 2015. Prediction of financial distress: An empirical study of listed Chinese companies using data mining. European Journal of Operational Research, 241(1), pp.236-247.

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

Storey, D.J., Keasey, K., Watson, R. and Wynarczyk, P., 2016. The performance of small firms: Profits, jobs and failures. Routledge.

Tayeh, M., Al-Jarrah, I.M. and Tarhini, A., 2015. Accounting vs. market-based measures of firm performance related to information technology investments. International Review of Social Sciences and Humanities, 9(1), pp.129-145.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.

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