Financial statement analysis is one of the tools businesses use to analyze their financial statements and make informed decisions on future growth. The external users and stakeholders use the financial information from the analyzed statements to evaluate these companies’ overall health and assess their investments’ value (Titman et al., 2018). The most common methods include horizontal analysis and the use of financial ratios. ABC Company Limited has conducted its analysis using the ratios and presented its statements for proper decision-making. Therefore, this paper analyzes the information presented from these financial ratios, compares the company’s performance with the industrial averages, and recommends whether the acquisition would benefit the management.
Company Financial Analysis
Liquidity ratios assess the ability of a company to pay its short-term financial obligations (Kliestik et al., 2020). In addition, these ratios help the management determine whether the firm could use its current assets to pay off the current liabilities. The common liquidity ratios include the current ratio and quick ratio. From the liquidity ratios calculated, ABC company recorded an increase in its current and quick ratios during the three years. The current ratios were 0.85, 0.88 and 0.97 in 2013, 2014 and 2015 respectively while the quick ratio was 0.22, 0.24 and 0.28 in 2013, 2014 and 2015 respectively.
Based on the current ratios, it is clear that the company cannot use its current assets to finance its short-term financial obligations since all the current ratios for the three years were below 1.0. Besides, the quick ratio, which also falls below 1.0, indicated that the firm could not handle the assets in paying its liabilities when due. The current and quick ratio of ABC Company Limited was below 1.0, indicating that the company risked paying off its liabilities from sources other than the assets since the available assets were not easily liquifiable.
The activity ratios measure how effective and efficient the company’s operations are (Jana, 2019). These ratios evaluate a firm’s ability to use its assets effectively and compare one firm’s performance against the other or the same organization across different years of operations. The activity ratios include: inventory turnover, accounts receivable turnover, total assets turnover, and average collection period. From the activity ratios of ABC Company Limited, the inventory turnover had increased from 2013 to 2015 to 7.97, 7.98, and 8.09, respectively. The accounts receivable turnover decreased between 2013 to 2014 from 72.83 times to 71.33 times before increasing from 2014 to 2015 with values of 71.33 times to 71.65 times, respectively.
Based on the firm’s activity ratios, the inventory turnover indicated that the firm was able to replace its inventories at a slow rate in the year. The inventory turnover ratio indicates that ABC Company Limited restocked slowly and could not achieve its goals as desired. The accounts receivable of the firm also showed that there was laxity in the collection of debts owed to facilitate its projects; hence the company risked generally operating due to large volumes of debts owed outside. The total assets turnover ratio increased over the three years, indicating low consumption of the firm’s assets for three years. Finally, the average collection period increased over the three years, indicating that the company had most of its dues increasing, making it difficult to achieve its objectives.
Financing ratios compare the firm’s debts to its assets and equity (Sikidar & Gautam, 2019). The most common financing ratios include; the debt ratio, debt to equity ratio, and times interest earned ratio. From the financing ratios computed, ABC Company Limited decreased its debt ratio, debt to equity ratio, and times interest earned ratio over the three years. The debt ratio declined from 67.29%, 62.03% and 60.04% from 2013, 2014 and 2015 respectively. The debt-to-equity ratios were 205.74%, 163.36%, and 150.27% in 2013, 2014, and 2015. The time’s interest earned ratios were 15.61, 11.46, and 10.98 across the three years.
From the financing ratios presented from the ABC company limited statements, the decline in debt ratio over the three years showed that the company implemented policies to reduce its dependency on debt financing for its operations. The high debt ratios reflect that most of the firm’s activities were financed by debts rather than assets. In addition, the debt-to-equity ratio was high during the three years, which indicated that ABC Company Limited depended on capital management to ensure that most of its projects were attained. The time’s interest earned ratio declined over the three years, which indicated that the company did not implement policies to ensure that it generated enough interest to finance its internal activities.
Market Value Ratios
The market value ratios measure the value of stock prices and compare their market prices against their competitors (Jana, 2019). The most common market value ratios include earnings per share (EPS) and price-earnings ratio. From the market ratios presented, the company’s EPS were 1.58, 1.15, and 1.16 in 2013, 2014, and 2015 respectively, while the price-earnings (PE) across the three years were 5.37, 7.79, and 8.59 from 2013, 2014, and 2015 respectively. Based on the market value ratios presented in the financial statements, the decline in earnings per share over the three years showed that ABC Company’s share value experienced a fall in the market due to the instability of its operating activities. The low EPS value indicated that the firm’s shares in the market could not trade competitively with other companies’ shares, and its value had deteriorated over time. In addition, the price-earnings ratio of 5.0 to 8.60 shows a low value of this company’s share price due to its non-performance in the industry.
These ratios determine the ability of the company to generate profits concerning their specific items (Titman et al., 2018). The most common profitability ratios include gross margin, net profit margin, operating profit margin, ROA, ROE, and ROI. From the profitability ratios, ABC Company had a decline in gross margin from 26.26%, 24.82%, and 24.83% in 2013, 2014, and 2015 respectively. The operating profit margin declined from 7.25%, 5.64%, and 5.59% in 2013, 2014, and 2015. The net profit margin was 4.67%, 3.39%, and 3.36% across the three years.
Based on the company’s profitability ratios, there was a general decline in most of the ratios over the three years. For instance, the gross margin declined, indicating a reduction in the gross profit from the company’s revenues. The decline in most profitability ratios could be linked to poor sales patterns and the inability to collect debts frequently. In addition, the low profitability ratios indicated that the company had high spending on costs and other expenses rather than the generation of revenues due to poor transaction history in the three years.
Analytical Study Reporting
There is a need to consider the growth value associated with the acquisition plans—the ability of ABC company to generate financial growth returns in terms of profitability and liquidity ratios. In addition, the finance department is concerned with the costs associated with purchasing the new company.
The sales department needs to consider the underlying market value of the ABC company shares, all its outstanding shares, and the possibility of generating more proceeds once the company is purchased. In addition, there is a need to consider the company’s financial position against its competitors based on the activity and market value ratios.
The marketing department must consider the market’s responsiveness and the previous customers’ ability to shift their focus on the new company once the acquisition process is completed. In addition, the goodwill for the previous company is also vital since the revenue generation would depend on how well the products would be sold in the new market.
The human resource department should consider the level of turnover from the previous company and how well they can improve the employee’s welfare in their purchase plans. In addition, the human resource department should understand the contents of the agreement between the two companies to ensure that they are collaborating with the new company management.
The legal department should understand and evaluate whether the preferential creditors and other potential previous company stakeholders are managed effectively before signing the new acquisition plans. In addition, there is a need to assess the legal issues related to the acquisition to reduce the potential issues that would arise later.
The trend of ABC Company Financial Performance
From the company performance trend, the liquidity ratios increased over the three years with an increase in its current and quick ratios from 2013, 2014, and 2015 respectively. In addition, activity, market value, and financing ratios also increased their values across the three years. However, the company’s profitability ratios declined over the three years. Based on these trends witnessed in ABC Company Limited’s performance, it is clear that it could not use the available resources to finance its activities and pay its financial obligations. The low liquidity ratios of below 1.0 as attained in the company indicated that the firm could not use its assets to finance its debts effectively.
In addition, the firm’s low market value and financing ratios indicated non-performance of its shares in the market; hence their price values declined. The figures for financing activities show that the company mainly depended on its debt financing to sustain its operations. Finally, the activity ratios over the three years indicated that there were no appropriate policies and plan to ensure that the company’s debts were quickly recovered within a short period to ensure consistency and sustainability of the firm’s activities.
Comparison of ABC Company Performance and Industry Average
The ABC Company Limited’s profitability ratios were lower than the industrial average from the three years of comparisons. In addition, the firm’s return on equity, assets, and return on investment was higher than the industry averages. At the same time, the current and quick ratios were lower, indicating that the company’s liquidity ratios were lower than the industry average. The efficiency of ABC Company was higher than the industry average across the three years.
Based on the comparisons above, it is clear that most of the ratios of ABC Company Limited performed lowly compared to the industry average. The profitability ratios, for instance, were lower than the industry averages indicating that the company’s profits were minimal and had higher costs than its revenues. The efficiency of the ABC Company, however, performed slightly higher than the industry average, indicating that it focused on achieving returns from assets, investments, and equity (Sikidar & Gautam, 2019). The company’s activity and liquidity ratios were lower than the industry averages, indicating that there were no sustainable assets to assist in paying off its debts within the shortest period in the financial years.
Pros and Cons of ABC Company
ABC Company Limited has its pros on the ROE, ROA, and ROI values, while it has cons in managing its debts, ability to convert its assets to cash, and slow management of its receivables and inventories. The firm performs slightly high in its efficiency ratios, which include the returns on asset, equity, and investment returns, which have been reflected in the ratios it presented during the three years. This efficient performance, therefore, is the critical strength of ABC Company as it focuses on ensuring that it maintains high-efficiency ratios at the expense of its available resources. However, the firm has severe challenges in ensuring that the available assets manage the available projects, and it has recorded high debt ratios, which show that most of its operations depend on the financing of debt and equity. Therefore, the company needed a sustainable plan to cushion its activities from the financing challenges and external sourcing of debts to ensure that the operations were achieved within the financial periods.
Conclusion and Recommendations
The management should not consider investing and acquiring ABC Company Limited based on the financial ratios. The liquidity ratios of ABC are underperforming; hence, the company cannot easily convert its assets to meet its short-term financial obligations. The market values and activity ratios are also low, indicating that the assets available in the firm cannot be utilized efficiently to generate revenue. Finally, ABC company’s financing ratios are high, showing that it depended on debts to finance its projects.
Jana, G. (2019). Cost and management accounting-1 (Rev. ed. ). New Central Book Agency.
Kliestik, T., Valaskova, K., Lazaroiu, G., Kovacova, M., & Vrbka, J. (2020). Remaining financially healthy and competitive: The role of financial predictors. Journal of Competitiveness, 1, 74-92. doi:10.7441/joc.2020.01.05.
Sikidar, S., & Gautam, H. (2019). Financial statement analysis. New Central Book Agency.
Titman, S., Keown, A., & Martin, J. (2018). Financial management: Principles and applications (13th ed.). Pearson.
Table 1: ABC Company Limited Ratios
|Accounts Receivables Turnover||71.65||71.33||72.83||71.94|
|Total Asset Turnover||2.38||2.33||2.35||2.35|
|Average Collection Period||5.09||5.12||5.01||5.07|
|Times Interest Earned Ratio||10.98||11.46||15.61||12.69|
|Earnings per Share (EPS)||1.16||1.15||1.58||1.30|
|Price Earnings (PE)||8.59||7.79||5.37||7.25|
|Return on Equity (ROE)||20.03%||20.80%||33.52%||24.78%|
|Return on Assets (ROA)||8.00%||7.90%||10.96%||8.95%|
|Net Profit Margin||3.36%||3.39%||4.67%||3.81%|
|Operating Profit Margin||5.59%||5.64%||7.25%||6.16%|
|Return On Investment (ROI)||19.01%||21.12%||33.72%||24.61%|
Table 2: Ratio Comparisons
|ABC company||Industry Average|
|Operating Profit Margin||6.16%||12.04%|
|Net Profit Margin||3.81%||6.01%|
|Earnings per Share||1.30||1.49|
|Return on Equity||24.78%||12.40%|
|Return on Assets||8.95%||5.61%|
|Return on Investment||24.61%||14.42%|
|Total Asset Turnover||2.35||0.55|
|Accounts Receivable Turnover||71.94||44.98|