This report provides an analysis and evaluation of the profitability, liquidity, efficiency and financial stability of Nicholson Plc. The ratio analysis method is used to analyse the financial performance of the company. All the computations can be found in the appendix. Furthermore, investment appraisal tools is discussed to select best and profitable project of investment by evaluating viability of the project. The result shows that all ratios are effective except liquidity and leverage ratios. The report also investigates the significances and limitations of the ratio analysis method.
Introduction To Decision making for Organization
Accounting is the scientific and systematic process of entering monetary data of the business in the books. Financial information recorded into the books is very significant in decision making for the association (Interpreting financial statements. 2007). The present research report is about Nicholson Plc which is building and home improvement merchant, trading in the highly competitive building and construction sector of UK with 87 stores. The corporation desire to expand its operations in Western Europe. Hence, Ruch and Ruch which is consultancy firm is selected to evaluate business performance.
The research report will include business performance assessment with the help of ratios. It also discusses significances and limitations of ratio method. Investment appraisal techniques will be also explained in this study. Finally, the various options of short term internal funding will be evaluated for the entity.
1 Business performance analysis
Ratio analysis is one of the better method of assessment of financial performance and position of the company (Key Performance Indicators. 2014). Furthermore, it is the quantitative analysis of data contained in the financial statement (balance sheet and income statement) of the corporation. It is helpful way of comparing performance of the business with existing years performance or other entity's performance of same industry. Decisions related to expansion and investment is made on the basis of financial health of the firm, and thus ratios can be computed for this purpose. Generally, here is four types of ratios such as profitability, liquidity, efficiency and solvency, through which profitability, liquidity, efficiency and capability of the business can be assessed easily, in order to make effective decisions for the company (Management accounting. 2014). Following table shows the various kinds of ratios of Nicholson Plc.
Take help from this sample
These are the ratios which computed to identify the capability of the company to generate profits from its business operations. Followings are the key profitability ratios of Nicholson.
Gross profit margin: Gross profit percentage can be explained as the financial metric utilized to analyse company's financial health by revealing the proportion of money left over form revenues after accounting for the cost of goods sold. Furthermore, this serves as the source for paying extra costs and future savings (Method of costing. 2014). The gross profit margin of Nicholson has increased by approximately 8.6, which shows that entity is able in generating gross profits from its business operations. It means company is selling its products at a higher profit percentage and they are well capable of paying their operating expenses. The condition represents that profitability of the business in the year 2014 is higher than year 2013. In the year 2013 gross profit percentages of firm was 10.08, that was less with compare to year 2014.
Operating profit margin: This is also very significant percentage utilized to measure entity's pricing strategy and operating efficiency. Furthermore, the operating earning ratio is a measurement of what proportion of enterprise's revenue is left over after paying for variable costs of business i.e. wages, raw material etc (What is ratio analysis. 2014). Thus, it is stated that healthy operating profit ratio is needed for the organization to be capable for paying for its fixed expenditures like interest on debt etc. After evaluating above table, it has been found that operating margin in the year 2014 is increasing with very high rate, it shows that business is making sufficient money from its existing operations in order to pay its variable costs as well as fixed costs. It is a sign of stability within the operations for the organization.
Net profit margin: It can be simply defined as the percentage which represents that how much of every dollar earned by the company is translated into profits. This is only the profitability ratio through which accurate earning capacity of the association can be measured for making effective and best investment and expansion decisions. On the basis of above table it can be said that earning capacity of the year 2013 was negative but the company is generating sufficient positive net profits in the year 2014, which is 3.04% (Vrentzou, 2011).
Furthermore, it has been seem that there is very high level of differences between gross and net profit margin, which states that management is not able in controlling its operational expenditures.
Efficiency is needed in managing the affairs of the business.
The ability and capability of company to use its resources (human, financial and other) in efficient manner can be assessed by using efficiency ratios. The key ratios which show efficiency are as below.
Total assets turnover ratio: This can be defined as the amount of revenues of sales earned per dollar of assets. This is the major indicator of the efficiency with which a firm is deploying its assets. Efficiency and effectiveness of management team of the business can be also measured by this ratio. Normally, if the level of total assets turnover ratios is higher, then the entity is efficient. In the present case of Nicholson Plc., this ratio is 0.72 in the year 2014 which is less than year 2013. The level of this ratio is very low in both the financial years, which states that company is not utilizing its assets efficiently in generating sales (Vij, 2008). The ratio is low because they might be facing issues related to production and management. This situation is not favourable for company's investors and creditors.
Inventory turnover ratio: This is ratio representing how many times the entity's stock is sold and replaced over a time. Furthermore, it can be said that this ratio indicates the process of the inventory within the associations. It means how many times raw materials of the business is converted into finished goods during the particular financial year. By evaluating the above table, it has been found that this ratio of year 2014 is lower than year 2013.
However, the present level of this ratio in both the year is lower than standard of the industry. This indicates that company is doing overspending through purchasing too much inventory and wasting resources by keeping non-saleable stock.
(Barth, Beaver and Landsman, 2001).
These are the ratios which calculated to find of firm's capacity to pay its short term obligations with the help of available current assets. The major liquidity ratios are as below.
Current ratio: It is very significant ratio through which ability of business to pay its short term obligations can be measured easily for making effective decision. Various stakeholders of the company such as suppliers, banks, creditors etc. are interested in knowing liquidity conditions of the company and hence, current ratio shows this situation to all these parties. It can be easily calculated by dividing current assets with current liabilities of the business for particular financial year (Coombs, Hobbs and Jenkins, 2005). In the present case of Nicholson, current ratio is not steady and this indicates that it is facing problems in paying its current liabilities.
Quick or acid test ratio: This is also represents liquidity condition of the business but there is one major difference between current and quick ration. Acid test ratio shows very short term ability to pay its current obligations. Hence, the amount of inventory is not included in the current assets, in this kind of condition. Furthermore, this measures the dollar amount of liquid assets available for every dollar of current liabilities. By evaluating above table of calculation, it can be stated that the quick ratio of the Nicholson in the year 2014 is 0.41 which is lower than previous year (Deegan and Unerman, 2006). This indicates that company is not able in paying its very short term debts. Generally the ideal quick ratio is 1:1 and is considered to be a minimum safe limit. Hence this is a good sign for suppliers as they can get their money from the organization quickly.
The long term capability of the association to pay its long term liabilities can be analysed by using solvency ratios. The main gearing ratio of Nicholson is as below.
Debt to equity ratio: It is a measure of firm's financial leverage computed by dividing its total liabilities by stockholders' equity or total capital. It indicates what proportion of equity and debt the company is using to finance its assets. There is not big major differences between debt equity ratio of year 2013 and 2014. However, the company is not able in maintaining this ratio with standard which is 2 (Gordon, 2008). This represents that company is not capable in paying its long term liabilities with the help of shareholder's equity. Steady debt to equity ratio is needed to maintain a healthy business.
2 Advantages and limitations of ratio analysis
Advantages of ratio analysis
The key significances of financial ratio analysis method can be discussed as below.
Comparison: Ratio evaluation is the best method through which performance of particular company can be compared with the performance of other companies or same industry. In addition to this, it is the simple way of comparing performance of the entity of particular year with existing years to make effective managerial decisions.
Helpful of managers: Ratios provide significant information to the managers, through which they can make effective decisions for the business. This is also helpful in financial forecasting and planning (Hines, 2002). By evaluating the ratios, managers can control the business activities to reduce costs and improve quality and profitability of the entity.
Helpful for stakeholders: Shareholder, suppliers, creditors, government etc. can make effective decisions regarding business performance and future. For example, shareholders can use financial data such as price to earning ratio for making effective investments or disinvestment decisions regarding particular business unit.
Limitations of ratio analysis
The key limitations of financial ratio analysis method can be discussed as below.
Ratio evaluation explains relationships between past information while stakeholders are more concerned about current and future information (Hussey and Ong, 2005).
Different firms operate in various sectors every having different surrounding situations like regulation, market structure, etc. These elements are so important that a comparison of two entities from different sectors might be misleading.
Inflation may have seriously contorted a firm,s financial statements such as balance sheet. In this condition, earnings will also be influenced. Hence, the ratio evaluation of one organization over time or a comparative assessment of entities of different ages must be interpreted with judgement (Jara, Ebrero and Zapata, 2011).
3 Investment appraisal techniques
In the current scenario Nicholson desire to expand its business operations in Western European markets. In this kind of condition, company can use capital budgeting tools such as payback period, accounting rate of return and net present value etc. These techniques are used to evaluate the viability and feasibility of the financial project. On the basis of given information and calculations, the
Western European market project of the company can be evaluated easily as below.
Payback period method
It can be defined as the length of time needed to recover cost of an investment. Thus, it can be stated that the payback period of a given investment is very significant determinant of whether to undertake the position, as longer payback periods are typically not desirable for investment positions (Neale and McElroy, 2004). As per the given information, it has been found that pay back period of Western project is 4 years and 5 months approximately. This is very good for the business to invest in the given option. However, in this high competitive and rapidly changing era of world economy 4 years are very big time period. The environmental and economic changes may influence the profitability of the project during this time period.
Accounting rate of return method
In simple language, it can be defined as the amount of profit or return which the company estimates from its investment project. In the given scenario, Nicholson will earn 9.2% return from its Western project (Method of costing. 2014). This is sufficient amount of profit but the company can earn more than this by investing several other available project. In the current economic conditions, this is very low amount of return.
Net present value method
This is the scientific way of calculation of future amount of cash flows. NPV is used to evaluate profitability of an investment. High level of NPV represents that company should accept the project. In the given case, the value of NPV is 3 which is positive for the organization. However, in this rapidly changing conditions, there are ranges of other profitable alternative opportunities in the market in which company can invest to get higher return (Key Performance Indicators. 2014).
On the basis of above evaluation it can be said that all the investment appraisal techniques are providing positive information regarding the current investment options. Hence, the company can easily invest in the project. However, the NPV, ARR and payback period of Western project in not good for the present competitive and fast changing business environment. The company can search ranges of other investment alternative through which they can earn higher amount of return in very short time period (Barth, Beaver and Landsman, 2001).
4 Sources of finance
Internal sources of short term finance
Retained earning: It can be defined as the percentage of net earnings which are not paid out as dividends, but retained by the association to be reinvested in its core business. In addition to this, it is the profit kept in the company rather than paid out to shareholders as a dividend. This is very easy and good method of raising funds for further investment. The main advantage of this is that company does not need to pay any direct financial cost to use this money (Coombs, Hobbs and Jenkins, 2005). The major limitation of it is that there may be opportunity loss in this case.
Sales revenues: In the given case study, Nicholson is generating sufficient amount of sales from its business operations. Hence, the entity can utilize this amount of money for further expansion and development, and generally, in this case firms also does not require to pay any financial costs.
Sales of unproductive assets: Each and every business has huge amount of assets in the business and there may be several unproductive equipments of the associations (Deegan and Unerman, 2006). Managers can sale these assets to generate funds for development and expansions. The major limitation of this is that amount of assets will be decreased. However, firm can use its unproductive assets to generate profits and incomes.
As per the above evaluation it can be recommended to boar of directors of Nicholson that they should use retained profits as a short term internal sources of funding. The entity has retained earning of ₤ 109 M in year 2014, and hence, they do not require to pay any costs to use this amount (Hines, 2002).
The study designed herewith emphasizes on assessment the case for Nicholson Plc by calculating and evaluating financial performance of the corporations by using profitability, liquidity, efficiency and solvency ratios. It has been found that the entity is generating huge amount of sales revenues and profits from business operations and financial performance of the entity is better in the year 2014 with compare to year 2013. Furthermore, company has big amount of retained earning, and thus management can use its retained profits as a short term source of funding, for fulfilling short term fund needs.
- Coombs, H., Hobbs, D., and Jenkins, E., 2005. Management Accounting: Principles and Applications. SAGE.
- Deegan, C. and Unerman, J., 2006. Financial accounting theory. Maidenhead: McGraw-Hill Education.
- Gordon, A. E., 2008. Sustainability in global financial reporting and innovation in institutions. Accounting Research Journal.
- Hines, R. D., 2002. Financial accounting: in communicating reality, we construct reality. Accounting, organizations and society.
- Neale, B. and McElroy, T., 2004. Business Finance- A Value Based Approach. 1st ed. Financial Times/Prentice Hall.
- Vij, 2008. Management accounting. Macmillan.
- Vrentzou, E., 2011. The effects of International Financial Reporting Standards on the notes of auditors. Managerial Finance.
- Method of costing. 2014. [Online]. Available at: <http://www.svtuition.org/2012/09/method-of-costing.html> [Assessed on 7th April 2015].
- What is ratio analysis. 2014. [Online]. Available through: <http://www.wisegeek.com/what-is-ratio-analysis.htm> [Accessed on 7th April 2015].