Ratio analysis is a method that is mostly adopted when analyzing the performance of most organizations. The importance of ratios is justified by the kind of uses of ratios in trend analysis, cross sectional analysis and industrial analysis as per Atrill, P. and McLaney, E. (2008). Trend analysis involve the analysis of business performance over time, cross-sectional analysis is the comparison to a firms performance with those of competitors while industrial analysis entails the comparison of the firms performance with that of the average industries.
Black, G. (2005) suggest that there are different forms of ratios i.e. liquidity ratios, profitability ratios, gearing ratios, asset utilization ratios and market valuation ratios. Ratios are preferred in the analysis because of the diverse indications from each particular kind of ratios. The liquidity ratios have been calculated to show the ability of the two companies to meet their financial obligation as they fall due to i.e. payment and redeeming of debts. An organization that does not take into account this ratios are likely to face liquidation problems.
Griffiths, I., (1995) argues that profitability ratios are also needed to show the returns in capital and funds that the company has employed. The profits of a company will be important as it will reveal the shareholders wealth maximization. Businesses that make perennial losses will have hardships in operations and in cash flows. This may in turn affect the ability of the business to meet its financial obligation and influence the valuation of the business shares.
The gearing ratio which is also termed as the capital structure ratios indicate the extent to which the company has borrowed the fixed charge capital to finance its operation. The ratios may be subjected to government regulations as they may lead to high risk of creditors’ money. The asset utilization ratios are calculated to determine how efficient and effective the company will utilize its assets with a bid to earn revenue. If the assets are not well utilized, there will be unnecessary costs incurred and the cash flow generated will decline. Finally, the valuation ratios are important for valuation of the firm.
They are majorly employed when the business wants to sell shares, enter into a merger or when there is need to determine the value of the firm. Ratios are also preferred because of the simplicity with which the ratios can be analyzed and understood by others who are not financial experts. This makes ratios be prioritized when making presentations to the shareholders and stakeholders who lack the expert knowledge.
Findings and recommendations
The first kind of analysis that is done is to find the trend analysis of the performance of Morrison limited. The performance of the year 2008 and 2009 is considered to help reveal the changes in the performance. To begin with, the profitability ratios show that there is no improved performance in the gross profit margin for the two years as the rates are at about 6.3%. The net profit margin is 3.16% in 2009 and 4.27% in 2008 showing a decline in the net earnings realized.
This will be attributed to increased operating costs e.g. administrative expenses and the tax liability. The rate of capital employed was 9.6% in 2008 and 7.4% in 2009. It therefore implies that the additional capital that has been acquired has not impacted much on the company’s earnings. The increased cash flow from £118 to £327 may be attributed to the increased turnover and the prompt payments from debtors of the company.
A look at the liquidity ratios reveals that there is an improvement in the current ratio from 0.52 in 2009 from 0.49 in 2008. The current assets have therefore increased compared to the changes in the current liabilities. The increase in stock from £442 to £494 also justifies the improvement of the ratio. There is as well an improvement in the quick ratio from 0.25 in 2008 to 0.28 in 2009 indicating the firms improved ability to discharge its financial obligation as they fall due.
Moreover, the increase in operating costs and the decline in the income revenues has led to the general fall in the income between the two yeas. With the reduced earnings after tax from £554 to £460 in 2008 and 2009 respectively, the earnings per share have declined from £20.67 to £17.16. The decline in the EPS may have an impact adversely on the market price of then shares of the company.
The chairman attributes the fall in EPS to the abnormal taxes that were charged in the previous periods. Gowthorpe, C., (2005) says that in as much as there had been merger improvement in the financial performance in the previous periods, the management needs to come up with sound strategies that will lead to large increase in profits and reductions in the operating expenses. Tax laws and policies must also be keenly monitored in the today’s running of the organization.
As the chief executive officer notes the improvement in the performance in 2010 being attributed to the increased market share, there is need for the company to ensure that the products of the company are widened and expansions critically examined to ensure costs are minimized. The payments of directors and auditors should also be done in a way that they do not impact negatively on the performance of the company.
Another analysis that has been conducted is the cross sectional analysis of the performance of Morrison and Tesco’s performance in the year 2009. A cross sectional analysis is the comparison of a company’s performance to those of other firms in the industry. The performance of competitors should be thoroughly scanned as the firms compete for the same market share and action of one firm will bear an impact on the performance in the industry. In this comparison, the ratios have been analyzed on the basis of the respective ratio type. Ratios are therefore first classified before an actual comparison is made.
The first kind of ratios that we will look into is the liquidity ratios. It will be noted that a look at this ratio shows that the performance of Tesco is better compared to that of Morrison. The current ratio of Morrison is 0.527 compared to that of Tesco of 0.756. Again, both the quick ratio and the net working capital ratio also prove the outcome. It therefore means that Tesco limited can discharge its obligation better that Morrison. The management of Morrison should strategies on the means of improving on the management of working capital since working capital is important in the generation of revenue. If not properly managed the income of the company will be below par that of the competitors.
On the contrary, the gearing level of Tesco is higher compared to that of Morrison. Gearing level affects the costs of capital and increases the level of liquidation risk. With the high level of gearing, the interest cover of Tesco is 6.7 compared to that of Morrison of 11.1. This is attributed to the high cost of finance paid to the lenders of finance. The high gearing level also explains the high return level as the cost of debt is always a tax deductible. There is also need for Morrison to seek for more debt financing to assist in the expansion strategies to meet the expanding market.
A further comparison of ratios is conducted on the profitability ratios. Profitability ratios are ratios that show the rate of return on the assets and the owner’s funds. According to these ratios, the performance of Tesco is slightly higher than that of Morrison. It therefore explains the reason why the cash flows of Tesco is higher. The gross profit margin of Morrison is 6.28% compared to 7.8% of Tesco. Again, the operating cost margin is 1.7% and 1.8% for Morrison and Tesco respectively. This slim difference in the operating cost margin will be as result of the high cost of debt.16.7% versues10.2%for Tesco and Morrison respectively is as a result of the high risk made by the former company.
The asset utilization ratio indicates that the assets of Morrison are better put into utilization compared to that of Tesco. With the high utilization level, Morrison ltd is able to increase their returns despite the little capital that is invested. The total asset utilization ratio is 1.8 for Morrison compared to 1.2 for Tesco. The high stock turnover further reduces the gap of performance. Finally, Tesco ltd has a high earning per share ratio compared to those of Morrison. This is due to the fact that the two companies have different level of gearing with Morrison having high equity finance (Dyson, J.R., 2001).
Other information that is useful in the analysis of the firm’s performance is by comparison of actual performance to the strategies of the organization. The strategies will influence and determine the activities that the business will embark. If the strategic objectives are not well implemented, then there will be adverse deviation in performance. We can therefore conclude that Morrison retailer’s performance is on track because of the increasing market share growth together with the good performance in the industry that makes them win awards. The business must also operate within there set core values of leadership, performance, employees relations among others.
Limitation of the analysis
In as much as ratio analysis is used in the evaluation of the performance of businesses, it suffers several drawbacks. First, in ratio analysis only the financial aspect of the business is used. It therefore becomes a non comprehensive means of evaluation. In this regard, the management should consider the use of other techniques like the balanced scorecard that captures both financial and non financial aspects of the business. There is therefore need to look into the aspects of motivation, quality of management, supplier’s needs and the employee’s needs.
The second drawback that this method suffers is the fact that ratios don’t take into consideration the time value of money. In addition, ratios fail to show the absolute value of the transactions that are made. This may therefore lead to a wrong representation of the exact financial performance of the business. Ratios should thus be used not singly but in conjunction with other methods for evaluation.
In undertaking the cross sectional comparison, ratios brings a complication when different accounting policies are used (Chadwick, L., 1996). Different firms often adopt different accounting policies when making there financial returns. Inter alia factors that limit ratio analysis is the failure of ratios to consider the size of the firm and contains the errors made when making the financial statements.itb ids therefore important for the analysis to integrate the use of charts, graphs that may show the performance better. Performance appraisal must as well be undertaken within some duration for earlier correction of errors.
Atrill, P. and McLaney, E. (2008) Accounting and Finance for Non-Specialists. 6th edn. London: Prentice Hall Financial Times.
Black, G. (2005) Introduction to Accounting and Finance. London: Prentice Hall Financial Times.
Chadwick, L. (1996) The Essence of Financial Accounting. 2nd edn. Hertfordshire: Prentice Hall.
Dyson, J.R. (2001) Accounting for Non-Accounting Students. 5th end. London: Prentice Hall Financial Times.
Gowthorpe, C., (2005) Business Accounting and Finance for non-specialists. 2nd edition. London: Thomson Learning.
Griffiths, I., (1995) New Creative Accounting: how to make profits what you want them to be. London: Routledge.