Introduction
In order to determine the risk associated with each company before granting a loan, it is imperative to conduct a vertical analysis. Gilbertson and Lehman (2013) noted that vertical analysis could be used to determine the financial risk associated with a firm by showing the items in the income statement as a percentage of a based figure. In this analysis, the sales figure is the base used to conduct the analysis. The sales figure is used as the main base to convert all the figures in the income statement as a percentage of sales as shown below.
Profit margin
Gross profit/sales.
Return on equity.
Discussion
From the vertical analysis in the table above, Apple a Day is more efficient than Healthy Edibles. Apple a Day has a low cost of goods sold which is an indicator that the company is more effective than Healthy Edibles. The total cost of goods sold represents 36 percent of total sales compared to 40 percent in Healthy Edibles. This shows that management in Apple a Day has been able to minimize the cost of goods sold through efficient operational management. Apple a Day’s operational efficiency has helped the company to minimize operating expenses by 6.7 percent compared to its main competitor. However, both companies have the same return on equity and gross margin ratio. The gross profit margin and return on equity are similar in both companies at 0.13 and 0.3 respectively.
Healthy Edibles is highly geared compared to Apple a Day because it has a high-interest expense. When a company borrows fixed return capital, it has to pay interest expenses. Therefore, a high-interest expense is an indicator that the company has borrowed fixed return capital compared to Apple a day. Therefore, it is imperative for the bank to consider the financial risk associated with fixed return capital before granting the loan. It is in the best interest of the bank to ensure their clients will be able to pay the loan effectively. Moreover, the bank must consider the ability of the company to make profits. This means that the bank will consider the operation efficiency of the enterprise. Although Healthy Edibles is highly geared, it has diversified its business in real estate properties. A significant amount of Healthy Edibles profit was obtained from the sale of real estate property. This is a clear indication the company has diversified its operation which reduces business risk. However, the high fixed return capital might increase the financial risk of the company.
Apple a Day has a low financial risk compared to Healthy Edibles. Although Healthy Edibles has reported more profits, it has high financial costs which is an indicator that the company is highly geared. Banks always consider the cash cycle from purchases of inventory to the collection of money from the debtor. The main concern for the bank is whether the client’s business will generate adequate returns to repay the loan. Thus, operational efficiency becomes imperative because it determines the ability of a company to generate sufficient cash to repay the loan (Gibson, 2013). Cash flow analysis helps the bank to understand how the company reduces operational expenditures in order to increase profits. Operational efficiency is important to a bank because it gives an overview of the business market demand, business cycle, and management competence. Therefore, the bank should consider the loan application of Apple a Day because it has an efficient business cycle. Moreover, the company is not highly geared which reduces business risk.
The strategy employed by both companies to award managers bonuses is inappropriate. When managers know their bonuses will be based on the achievement of a specified profit margin, there is a high probability they will interfere with books of accounts. Window dressing is a common practice in accounting where managers change figures in financial statements in order to earn bonuses. When bonuses are based on the return on equity, window dressing becomes a common practice because stakeholders cannot be able to trace the amount of profit reported by the company. According to Warren, Reeve and Duchac (2012), managers who prefer a return on equity performance measure are more likely to have lower managerial ownership. In most cases, managers prefer a return on equity compensation when the company is highly geared because it will appear they are performing better compared to average performance in the industry.
Conclusion
In summary, Apple a Day has outperformed Healthy Edibles. Moreover, the company is more profitable and has a low-risk profile. Therefore, lenders should consider the loan application of Apple a day. Healthy Edibles is highly geared which increases the risk that the company will not be able to repay the loan effectively.
References
Gibson, C. (2013). Financial reporting & analysis: using financial accounting information. Mason, Ohio: South-Western.
Gilbertson, C. & Lehman, M. (2013). Century 21 accounting. Mason, Ohio Andover: South-Western Cengage Learning distributor.
Warren, C., Reeve, J. & Duchac, J. (2012). Financial accounting. Mason, OH: South-Western Cengage Learning.