CASE STUDY-Ratio analysis You have been approached by a shareholder in XYZ plc t

Question

CASE STUDY-Ratio analysis You have been approached by a shareholder in XYZ plc to provide himher with a thorough evaluation of the company: XYZ plc. The shareholder is going to a shareholders meeting with the company's directors in two weeks time. The information provided by the shareholder is limited to the attached set of financial statements. Using this information you are required to write a report to the shareholder that analyses the financial statements In particular the shareholder would like you to: 1 Explain the analysis technique- ratio analysis 2 Highlight the limitations of ratio analysis 3. Analyse the company in terms of its solvencyliquidity Analyse the company in terms of its working capital management 5 Analyse the company in terms of its financial performance; and 6. Analyse the company in terms of its investment potential

Explanation / Answer

1. The analysis technique of ratio analysis is based on the interpretation and analysis of financial statements of a company. A ratio is an arithmetical relationship between two figures. Financial ratio analysis is a comprehensive study of ratios between different items or group of items in financial statements of a company.

2. Financial ratios and its use have its own share of limitations. First of all ratio analysis becomes distorted due to seasonal factors. Secondly financial ratios lose their significance during times of inflation as inflation distorts a company’s balance sheet. Thirdly different accounting practices can distort meaningful comparisons. For instance use of LIFO versus FIFO may produce different current ratios.

3. Liquidity ratio = current ratio = current assets/current liabilities

We can see that the company’s current ratio declined in 20x1. This means that the company’s ability to meet its current liabilities has reduced. Thus the short term solvency of the company has declined and in fact has fallen below 1. This means that their current liability in 20x1 has exceeded its current assets.

4. Working capital management ratio = inventory turnover ratio, collection ratio etc.

Inventory turnover = cost of goods sold/inventory

We can see that the speed with which the inventory was moving through the company declined in 20x1 compared to last year, indicating a fall in working capital management efficiency.

Collection period = debtors/daily sales

The average collection period has fallen and this augurs well for the company.

5. Financial performance ratios = gross profit margin, net profit margin, and ROE

We can see that the financial performance of the company has increased.

6. Here we will use the P/E ratio. Price = 8 pounds as at the end of 20x1. No. of shares = 100,000. Profit = 828,000. Thus EPS = 828,000/100,000 = 8.28

P/E = 8/8.28 = 0.97

For 20x0 P/E = 2/(188,000/100,000) = 1.06

Thus P/E ratio of the company is quite low and if the future growth prospects are good then the company presents upside potential.

20x1 20x0 Total current assets 1,676.00 1,952.00 Total current liabilities 1,831.00 1,344.00 Current ratio = current assets/current liabilities 0.92 1.45

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