Financial Ratio Analysis

Financial Ratio Analysis

a) Explain how the selected ratios in the table have been calculated and identify the financial classification to which they belong.
i. Gross profit margin
Gross profit margin is classified under the profitability ratio of the financial classification (Hart, 2011). It is calculated by subtracting the cost of sales of all goods sold from the total revenue generated from the sale of the goods the dividing the quotient by the total revenue as in the formula below;
Gross profit margin = {Revenue – Cost of goods sold} ÷ Total Revenue
ii. Current ratio
It is calculated by dividing the current assets by current liabilities and classified under the liquidity ratio of financial ratio classification (Hollad et al. 2005). The formula for calculating current ratio is as shown below;
Current Ratio= {Current assets ÷ Current liabilities}
iii. Acid test ratio
It is calculated by dividing the sum of cash, account receivables and short-term investments by current liabilities (Kieso et al., 2012). The acid ratio test falls under the liquidity ratio of financial classification. The formula for calculating the acid test ratio is as below;
Acid test ratio = {Cash+ Account receivables + Short-term investments} ÷ Current liabilities

iv. Average Settlement Period for trade receivables
It falls under the activity ratio classification of financial ratios. It is calculated by dividing the average balance of account receivables by the net credit sales for a given duration of time and the multiplying the answer by the number of days in that period such as (Kieso et al., 2012);
Average collection period = {Days × Average amount of account receivables} ÷ Credit sales (Total amount of net sales during the period)
v. Average inventories turn over
It is calculated by dividing the cost of all the goods sold in a certain duration of time then multiplying the quotient the number of days. It falls under the activity ratio financial ratio. The formula is as shown below;
Average inventories turn over = {Average inventory ÷ Cost of goods sold} × 365 days
vi. Interest cover ratio
It is calculated by dividing the total earnings before the interests and taxes and dividing it by the expenses on interest (Hollad et al., 2012). It falls under the financial ratio classification of the coverage ratios. The formula for its calculation is;
Interest cover ratio = {Earnings before interest and taxes ÷ Interest expenses}
vii. Price/ earnings ratio
It falls under the profitability ratio of financial ratio classification and calculated by dividing the price per share by the earning per share (Hollad et al., 2012). The formula is as shown below;
Price/Earnings ratio = {price per share ÷ Earning per share}

b) Comment on how Dixon’s overall performance compares to the average for its industry, pointing out any significant features, assumptions, and limitations of the information used to analyze the company’s performance.
Dixon Retail PLC has performed dismally in the years of 2013 and 2014 as compared to the industry average. For the gross profit margin, Dixon had a poor performance for both 2013 and 2014 since the best gross profit margin for the two years was 7.47% which is far below the industry average gross profit margin of 15%. This is because of the bigger the gross profit margin percentage, the more the company will retain on each dollar of sales to service other cost obligations. The assumption that might have been applied in analyzing the company’s performance using this approach is that the company has calculated the percentage margin and the percentage markup which are not shown before arriving at the gross profit margin. The limitation of this approach is that is widely misunderstood since it does not include all the cost such as the administrative costs but the production costs alone.
The current ratio for the company is also weak as compared to the industry value. This is because the company had the ability to pay its liability 0.93 times using its current assets in 2014 an improvement from the 0.89 times in 2013 which is still below the industry average of 2.05 times. The assumption that accompanies with the use of the current ratio to analyze the company’s performance is that the company’s inventories will be liquefied at the present value in the balance sheet are common in this approach of performance analysis. Another assumption for this approach of business performance evaluation is that a debtor will pay his or her debts in time. The limitation of this approach is that there can be overvaluation of the current assets as well as the current liabilities. Also, this approach may suffer from a wrong recording of the values of the current assets as well as the omission of liabilities. The other limitation of this approach is that there may be a crude ratio whereby only the money value of current assets and liabilities is measured instead of the quality of the current assets.
The acid test rate for the company in the two years is also reduced as it is below the standard of 1.1 of the industry average. Despite an improvement from 2013, the acid test rate is still poor. The measure of a company’s performance by use of this approach has some assumptions since the acid ratio of the company may be high than the required meaning that there are large amounts of account receivables that the company may be having at hand. This approach also suffers from the shortcomings that may arise from the current ratio. The limitation that faces this method is that since it involves a number dividing the other to come up with the value of a company that has a fixed inventory that is simple to liquidate, then it is not favored by the value as it eliminates key sources of asset valuation.
The average settlement for the trade receivables for Dixon the year 2013 and 2014 is poor because the mean time taken by the business to get the payments owed in the form of account receivables has gone far above the industry average of 10. This is despite the decrease from 16.84 days in 2013 to 14.45 days in 2014. On the average inventories turnover period, Dixon company has a poor performance as it has a greater duration which its managers manages the company’s stocks to generate income from them. In the year 2014, there was a decline in the period needed to 43.17days from 49.56days in the year 2013 though it is still above the average industry number.
The company also had a poor interest cover rate as it pays bigger interest on its debts in the year 2014 as compared to 2013 when it slightly paid a small interest of the ratio 5.27 which is still greater than the average industry value of 4.60. When the company pays higher interests to its debts, it makes small profits as compared when it pays little benefits on the same. When this approach is used to analyze the performance of a company, it is assumed that the number of the account manipulated in either of the two numbers involved is made in the process of working out the interest coverage ratio.
Dixon’s price/ earnings rate was good in both years as it was above the average industry value of 10 times. This means that the level of the stock prices compared to the level of the corporate profits was great, and the company was enjoying a bigger profit on the price of a single share above the industry levels. The limitation with this approach of analyzing the performance of a company is that it doesn’t consider the virtue of inflation. Secondly, it also ignores the effect of the company’s debts, and it confuses the investors in the small capital stock markets. The approach also assumes that the investors are willing to buy the shares at high prices since they believe that the stock has a significant potential for growth.
c) Using the ratio analysis in part (a) and (b), explain how the following shareholders might be affected by Dixon’s performance.
i. Current and potential shareholders
The low gross profit margin of the company below the average industry will lead to low retain of each dollar of sale. Thus the shareholders will have low returns on their investment than if the gross profit would be higher. Also, the current ratio of the company is below the average industries 2.05 times at 1.93 times in the year 2014. This means that the firm’s insolvency is questionable and this may affect the potential shareholders who may only be willing to invest in a company that is stable. The little solvency and short-term liquidity of the enterprise also scare away potential shareholders since the company has a solvency ratio of less than 1.

ii. Lenders such as banks
Banks and other lending institutions will be reluctant to lend short-term loans to Dixon’s since the company has a low current ratio in both years. However, when compared to the previous year 2013 banks would be more willing to lend in 2014 since the current ratio had increased. Due to its high-interest cover rate in 2014, banks would be more ready to give the company as it will reap more profits from it. Also, the small acid test ratio in both years would not encourage banks to lend money to the company as the company seems solvent and has more liabilities than current assets.
iii. Suppliers
Suppliers will be able to supply more products to the company since it has an excellent price/earnings ratio that will help the company to ask for more products from the suppliers since the level of stock prices to the level of corporate profits is high and they are receiving high profits. Also, vendors will be willing to supply products to the company since the average inventory turnover period is short thus maximizing on their supplies to the enterprise. Dixon’s company will also be asking for more supplies frequently regularly as the stock is going over a short period.
iv. Customers
As a result of the high settlement period on trade receivables, customers will be attracted to buy from the company since in the case of debt; they will have a longer period of 14.45 days in 2014 to pay their debts as compared to other businesses in the industry that range from ten days. Also, the low earning per share that has been used to find the high price/ earnings ratio will attract customers to acquire the goods at considerably low prices as compared to other retailers in the industry.

Hart-Fanta, L. (2011). Accounting demystified.
International Conference on Plasma Source Mass Spectrometry, Holland, G., & Bandura, D. (2005). Plasma source mass spectrometry: Current trends and future developments. Cambridge: Royal Society of Chemistry
Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2012). Intermediate accounting.

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