Financial Performance and Discussion of Ratio Analysis

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Monitor PLC has posted an increase in sales from $16 million in 2008 to $19.8 million in 2011. This boasts of a 7.4 percent increase on an average in sales in 4 years. Profit after taxes also showed a significant increase of 8.5 percent on an average for 4 years. The ratio analysis provided for 2008 through 2011 demonstrates that the gross profit margin of the company has declined. This indicates that the company’s costs are exceeding its earnings and it is unable to manage its inventory costs. The gross profit margin of Monitor PLC is 24 percent in 2011 while the industry norm is 34 percent and that of similar-sized companies is 29 percent. Evidently, its gross profit margin is lesser than industry-standard or companies of similar size. Though the company has shown an increase in net profit margin, indicating a higher profit, but at the cost of higher inventory cost as stock turnover days has increased from 65 days in 2008 to 89 days in 2011. This is a clear indication of increasing inefficiency.

In terms of investment, the company’s return on equity has been increasing from 3 percent in 2008 to 5 percent in 2011 indicating a greater return on shareholder’s money. The average share prices of the company have increased indicating a better sentiment towards the company stocks in the market. The price of the shares went up from $14.62 in 2008 to $17.80 in 2011 on an average. The price per earnings ratio also showed an increase, as there was greater profit associated with the share earnings. The P/E ratio of the company also showed an increase indicating a positive sentiment among investors who are expecting the share prices of the company to increase in the future, as the company is expected to do better. The P/E ratio of Monitor PLC is higher than that of the industry and that of same-sized companies. The return on equity is less than the industry standard. This shows that the sentiment towards the company’s performance among investors is high and positive as they expect the company to perform better. The dividend yield of Monitor PLC in 2011 has been better than the industry standard which is at 1.6 percent and that of Monitor is 2 percent. However, the actual performance of the company has been below the industry standard.

The liquidity of the firm can be ascertained using two ratios – current ratio and working capital turnover. The current ratio is the ratio of a current asset to current liabilities. Monitor PLC’s current ratio increased from 2008 through 2011 from 3.4 to 3.7 indicating that the company’s debt giving capability over the next business cycle increased. Further, the working capital turnover of the company also declined from 2.8 to 2.3 in 2008 and 2011 respectively. The company enjoyed a positive working capital indicating its current assets were greater than its current liabilities, which allowed the company to pay off its short-term debts. This demonstrates the underlying operating efficiency of the company. Therefore, as the company is operating efficiently it is showing a decline in working capital turnover indicating that less of the investor’s money is tied up in inventory.

The company is operating efficiently as its working capital is declining to indicate less of its money is tied up in investment. Further, the return on capital employed is declining continuously in four years showing that there is a decrease in the capital being used in the operations. The time taken for return on the capital is declining indicating an increasing efficiency of the company.

The gearing ratio indicates the long-term debt capitalization of the company. as Monitor PLC showed an incredibly higher gearing ratio over the 4-year period, this indicates that the risk of leveraging money increased incredibly for the company. Therefore, in case of a business downturn, the company will be more susceptible to risks as the debts are to be cleared for the company even though its sales fall. However, when the sales are expected to grow high leverage may give a boost to growth.

Based on the analysis of the ratios for Monitor PLC it can be deduced that the company needs to concentrate on decreasing its gearing ratio as this shows a very high-risk element. Though the company is growing, a downward spiraling business cycle can become a problem for the company. The liquidity situation of the company is good, therefore, no issues are observed in the area. The company is operating efficiently as the current, quick ratio, and working capital turnover indicate so.

Banks do a thorough check-up of the financial health of organizations before lending out or providing overdrafts to companies. The reason for such a stance is apparent – to ascertain the financial health and efficiency of the company and to check if their investment would not be blocked in an inefficient operation. Usually, banks use financial ratio analysis to ascertain the financial performance and health of companies. This paper ascertains the importance of using financial ratio analysis in ascertaining the operating performance of a company and tries to point out if there is an alternative method available for the same.

There is a divide in the opinion of academicians and practitioners in terms of the effective usability of financial ratios as a predictor of the performance of businesses (Altman, 1968). A simple rule of thumb such as ratios cannot be used, according to academicians, as a viable method of comparison between two companies. One empirical research in the 1930s showed that ratios of firms performing well showed significant differences from that of an ill-performing firm (Altman, 1968). Empirical research conducted to see the usefulness of ratios in predicting failure of firms showed that ratios were not a great predictor of financial failures of firms as the empirical research failed to predict the illness of the failed firms (Beaver, 1966). Ratios of the firms that have stable performance are stable while that of failing firms shows declining ratios as they approach closure. Banks using ratio analysis as a measure of creditworthiness of firms may not be able to gauge their proper health solely through ratios (Beaver, 1966). Therefore, a note of caution must be kept in mind as the financial ratio is used. First, all ratios are not good predictors. For instance, cash flow and debt ratios are said to have good predictive power however liquid asset ratios weak in making predictions (Beaver, 1966). Second, financial ratios may not have similar success in predicting successful and failing firms (Beaver, 1966; Horrigan, 1965; Horrigan, 1968). However, there are a set of financial ratios that are specifically designed to predict bankruptcy such as the likelihood ratio (Beaver, 1966). Multivariate discriminate analysis of ratios is found to be a more effective method of consumer loan evaluation for banks (Altman, 1968)

The usefulness of using financial ratio analysis is evident as numerous banks use this as credible data for financial analysis of other firms. Literature on financial analysis provides immense importance on the usefulness of the tool for users (O’Connor, 1973). This analysis is useful in understanding the performance of the company over a period. This allows analyzers to understand the effect of changing numbers through simplified ratios and allows comparison with competitors or industry standards. This provides a relative understanding of the firms’ performance rather than absolute numbers. Further, it allows comparison of a company with its competitor that may be very large. Ratios allow the comparison of a company with its much larger competitor. Given its practical usefulness, empirical research has been conducted to ascertain the predictability of financial ratios (Chen & Shimerda, 1981). Further ratios can also be used for predicting the future profitability of firms (Whittington, 1980).

One drawback of using a financial ratio is that it is considered to be a somewhat inefficient method of predicting financial difficulty (Horrigan, 1965). Some academicians believe the financial ratios are not good predictors of firm performance, especially when the performance of the firm is in the downturn (O’Connor, 1973) while others believe that such a belief may not be completely warranted (Abdel-khalik, 1974). Therefore, ratios are not always considered to be a full-proof measure of financial performance. Some could be computer-run software that analyzes the whole of financial data without considering their ratios (Altman, 1968). Multivariate analysis may be adopted as an alternative method of financial performance predictor instead of financial ratio analysis (Altman, 1968). Therefore, banks may consider using the discriminate or probabilistic model for the prediction of the financial performance of firms instead of ratio analysis.

References

Abdel-Khaliq, A.R., 1974. On the Usefulness of Financial Ratio: A Comment. The Accounting Review, pp.547-50.

Altman, E.I., 1968. Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy. The Journal of Finance, 23(4), pp.589-609.

Beaver, W.H., 1966. Financial Ratio as Predictor of Failure. Journal of Accounting Research, 4, Empirical Research in Accounting: Selected Studies, pp.71-111.

Chen, K.H. & Shimerda, T.A., 1981. An Empirical Analysis of Useful Financial Ratios. Financial Management, pp.51-60.

Horrigan, J.O., 1965. Some Empirical Basis of Financial Ratio Analysis. The Accounting Review, pp.558-68.

Horrigan, J.O., 1968. A Short History of Financial Ratios. The Accounting Review, pp.284-94.

O’Connor, M.C., 1973. On the USefulness of Financial Ratios to Investors in Common Stock. Te Accounting Review, pp.339-52.

Whittington, G., 1980. Some Basic Properties of Accounting Ratios. Journal of Busienss Finance & Accounting, 7(2), pp.219-32.

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