Executive summary
Stakeholders always rely on financial ratios to make a financial decision in relation to an organisation under consideration. Various stakeholders are always interested in various accounting ratios. Investors are interested in all the ratios while long-term debt provider is interested in the gearing ratios. Other suppliers are interested in liquidity, profitability and operational ratios.
The government and other stakeholders are also interested in the ratios for various decisions making. However, ratios have a limitation of window tracing i.e. the management may prepare the account in a manner that looks attractive.
As regards the companies under consideration based on the financial ratios, airport hotels performed better as compared to seaside hotels in some areas. While seaside hotels performed better in terms of profitability and capital structure.
Lastly, this recommendation has its own limitations given the fact some information was not provided which will have given us information as to which accounting practices are adopted by the companies and the future prospects of the industry.
Introduction
Financial statements analysis is used by many people in determining whether they should transact with accompany or not. In this case, this report is to recommend which stock between seaside hotel and airport hotel is good for investment. However, in normal circumstances, there are two types of users’ i.e. internal and external users. Internal uses include the management and the employees while external users include shareholders, creditors, government and agencies, suppliers, customers and environmentalists. These groups use this information in decision making, they also monitor the performance of a company for future transactions while others use the ratio to assist them to interpret contracts and agreements which they have with the company (Saunders, 1997).
The emphasis of this report is for the specific use of financial statements users with respect to investors and prospective investors. Investors use financial statements to facilitate them to make decisions on whether to hold or sell the shares, which company to invest in? When to buy the shares of a company and how much of the shares should be purchased. However, in this case it will be which company to invest in because we have one year’s financial statement for the company (Atril and McLaney, 2002).
Ratio Analysis
Table 1. Ratio Definition Seaside Hotel Airport Hotel
Liquidity ratios measure the firms’ ability to meet short-term obligations without technical default (Davis and Peles, 1993). In this case, there are two or three ratios under consideration in this category for the two companies. These include current ratio and acid test ratios. Looking at the two companies, both companies have sound liquidity because the acid test ratio for the seaside hotel is 1.1:1 and the current ratio is 3:1 which healthy financial position is. The airport hotel has a current ratio of 2:1 and an acid test ratio of 1:1. In my opinion, the two companies have good liquidity but both of them have a problem of holding a large stock in store. They should think of reducing the stock they are holding because it appears stock is the largest element of working capital. Especially Seaside has a poor stock management policy because it appears that the stock is more than two times the current assets. In this case, all the two companies have the ability and capability to meet short-term obligations (Atril and McLaney, 2002).
Solvency ratio
Solvency ratios are those ratios that measure the company’s long-term ability to meet long-term obligations. Seaside hotel gearing ratio is 34.62 while airport it is 43.75% it means that 34.62% of the total assets of the company are financed by debt in the case of a seaside hotel, while it is 43.75% on the side of an airport hotel. However, looking at the debt to equity ratio you find those airport hotels by keeping a low long-term debt of 0.11:1 while the seaside hotel had 0.18: 1. Still, in my opinion, the two companies have kept a low debt in their capital structure therefore there is not much risk for any investor investing in this company. However, the interest earned ratio should bring out the riskiness associated with this company. To begin with, interest coverage ratios shows how a company has its interest covered by the profits generated. The interest cover for the seaside is timed 11:2 while for the airport is 24.92. It means that the airport hotel has enough profits that will cover the interest more than a seaside hotel. It shows that seaside hotel is a high financial risk company while airport hotel has an overall sound financial situation (Larson D. Wild & Chippetta, 1996).
Operational ratios
These ratios show the performance of the company management in using the assets of the company wisely. The ratios under consideration, in this case, include turnover of funds, fixed assets usage, working capital usage, stock turnover, debt collection and creditors’ payments (Atril and McLaney, 2002).
Seaside hotel performs poorly in this category because the turnover of funds is lower than an airport hotel. Turnover of funds is times 1.61 for the seaside and 2.42 for the airport. In fixed assets usage and working capital usage airport hotel performs excellent because working capital is 4.04:1 while at the seaside they have turned 2.69:1. Fixed assets usage is 6.06: 1 for the airport and 4.03: 1 for the seaside hotel. In the usage of assets, the airport hotel is more efficient in generating revenue while the seaside hotel utilises the assets poorly (Henderson, Peirson, and Herbohn, 2008).
From this analysis, one can be able to understand the pricing strategy of the company. In credit management, the airport hotel appears to be performing better at to seaside however this conclusion is subjective because they appear to hold the creditor money for a long period and this may destroy their creditworthiness. The company takes 61days to collect funds from creditors while the seaside takes 50 days meaning the seaside takes a longer period to convert sales into cash. In the creditors’ payment, they take a longer period to settle their accounts of 129 days as compared to 96 days of the seaside. In converting inventory into sales, airport hotel performs better as compared to the seaside by converting stock into sales in 122 days while the seaside takes 183 days (Larson D. Wild & Chippetta,1996).
Overall when looking at cash circle airport hotel performs better although it has some risks associated with holding creditors’ funds for a longer period.
Profitability ratio
Profitability ratios measure how a company manages its operation and how efficient it is in generating a return from the assets provided. Profitability ratios that are used in this case, include gross profit margin, net profit margin, return on capital employed and return on equity (Henderson, S., Peirson, G. and Herbohn, K., 2008).
The gross profit margin does not take into account expenses and income taxes. While net profit margin takes into account expense but does not take into account interest and tax. The gross profit margin does not provide clear information about the company’s profitability. However net profit margin provides this information. Therefore, the net profit margin for airport hotels is 6.17% which is a poor performance as compared to the seaside which has 6.25%. The seaside hotel has a gross profit margin of 40.44%, which is better than 38.11 % of an airport hotel. However, looking at return on capital employed you find those airport hotels as compared to the seaside hotel by having a rate of 14.9% as compared to the rate of 10.08% of the seaside hotel (Davis, and Peles 1993).
Return on equity also depicts the same, where airport hotel generates a rate of 33.33% and seaside a rate of 9.41%. Return on equity measures how stockholders of a company are rewarded during the year. It breaks down the return on equity into three parts, operating efficiency, asset use efficiency and financial leverage (Larson D. Wild & Chippetta, 1996).
Market ratios
Market ratios or valuation ratios are used to compare the valuation of more than one stock of different companies within the historical context. The main aim is to measure the value of the business as well as the potential benefits of owning shares in the companies (Atril, and McLaney, 2002).
A Price-earnings ratio shows how much an investor is willing to pay for each dollar of earnings made by a specific company. In this case, the earning ratio of the airport is 30 while the earning ratio of the seaside hotel is 30. It means that investors of airport hotels are willing to pay 30 for every dollar seaside makes in profits while it is 20 for the seaside hotel. The dividend cover shows how the dividend is covered by the profits generated by the company. The dividend cover for the seaside hotel is 1.33 to 1 and for the airport hotel is 3:1. In this case, the airport hotel performed excellently. The dividend yield is poor in an airport hotel where it is 1.1 % and the seaside is 3.75%. The seaside hotel has low earnings per share. Overall, the seaside hotel has a high performance as compared to an airport hotel in terms of the market (Davis, H.Z,. and Peles Y.C. ,1993).
The limitation associated with ratio analysis
Ratio analysis has various limitations which are inherent in ratios. One of the limitations of ratio analysis is the fact that ratio analysis is based on historical data, therefore using them to make future decisions will not be based on reality because of changes in economic factors in the world today.
Another limitation of ratio analysis it does not use all information, especially the accounting methods of inflation and depreciation so that adjustments will be made to have a more accurate and reliable financial ratio. Accounting ratios in such a situation cannot be reliable for comparison purposes because various companies use different accounting policies and conventions. For example, a company may use the straight-line method in the evaluation of assets or first in first out in accounting for inventory while the other uses net realisable value in accounting for inventory therefore comparing the ratios will not be prudent because of the different accounting policies adapted (Larson D. Wild & Chippetta,1996).
Accounting financial statements may be prepared by the management using creative techniques in order to show good performance and if this information is used including calculating ratios for decision making it can be misleading.
Financial ratios cannot be relied upon not only because of outdated information but because the ratios alone cannot stand as a definite measure of performance. They require some qualitative and quantitative analysis for them to have some measure. The idea of using the historical cost accounting method also produces information that is actually outdated and not suitable for decision-making for a company in business (Godfrey, Hodgson, Holmes, and Tarca, 2006).
Financial statements are usually prepared in a summarised manner from records of the whole years there is some information which is relevant which may not be shown in some financial statement report, if this information is provided the decision-maker may change his mind relating to the performance of the company otherwise financial ratios are always as a result of summarised report which is not a true result. Again, it cannot be easy to interpret ratios as good or bad such as a high current ratio may be viewed as a good ratio by the short-term fund’s providers but on the side of the shareholder, it is money being held without being in use (Atril and McLaney, 2002).
Financial ratios usually do not take into consideration the effects of inflation and technological changes that always are a day-to-day occurrence. When there is a change in accounting policy as well as accounting standards the ratios do not take care of these facts (Saunders, 1997).
While comparing results of different companies the risk of one company to another especially unsystematic risk is not taken care of. Different firms have different risks. Therefore, ratios fail to take into consideration these facts thus rendering them useless (Larson D. Wild & Chippetta,1996).
Recommendation and conclusion
From the above analysis, I conclude that airport hotel performs well in almost all sections of ratio analysis. The company management should sacrifice short-term gains for long-term gains for all companies for them to remain profitable (Larson, Kermit, Wild, & Chippetta, 1996). I, therefore, recommend that investments should be made in airport hotels because the management appears to be whole round although not profitable as a seaside hotel. If it is an investor is not willing to take an active role in the management of the company then he should invest in a seaside hotel.
References
- Atril, P.F. and McLaney, E. J. (2002). Management accounting for non-specialists, 3rd edn (financial times prentice Hall).
- Davis, H.Z,. and Peles Y.C. ,(1993) measuring equilibrating forces of financial ratios , the accounting review.
- Eisen, P. ;(2003;) Accounting the Easy Way; Barron’s Educational Series
- Godfrey, J., Hodgson, A., Holmes, S. and Tarca, A., (2006), Accounting Theory, 6th edition, Milton: John Wiley and Sons
- Henderson, S., Peirson, G. and Herbohn, K., (2008); Issues in Financial Accounting, 13th edition, Frenchs Forest: Pearson Education Australia.
- Larson D, Kermit, Wild, J. john & Chippetta Barbara;(1996); fundamentals of accounting principle; London; Irwin.
- Saunders, A. (1997); Financial institution management: a modern prospective 2nd ed. (Chicago, IL: Richard D Irwin).