Economic and Financial Analysis

ACCOUNTING RATIOS AND THEIR IMPORTANCE IN BUSINESS

Accounting ratios are the techniques of financial analysis which is used by an organisation or its stakeholders for the purpose of measure the profitability, efficiency, liquidity and other attributes of an organisation (Ramesh, Berger and Loo, 2012). The concept of accounting ratios is based on the principle of determining the relationship between two elements of financial ratios which can interpret the efficiency of the operations of a business. There are various accounting ratios and are classified on the basis of liquidity, efficiency, profitability, turnover and earnings ratios. Despite of the variation in size and structure, this metric can be used by every organisation with minimum skills and time.

Accounting ratios plays an important role in business as these ratios provides the proof to investors and financial statements about effective profitability and productivity of an organisation by which company can procure funds and loans for their operations (Deitiana, 2013). These ratios also provide a basis for quick decision making as by this, management of the company can decide which projects are profitable for them and which are not. Few other importance of ratio analysis includes effective development of financial plans, budgets and trend analysis. Take Free Examples of Assignments Now!

CALCULATION OF FIVE RATIOS

Return on capital employed

This ratio is a part of profitability ratio analysis which can be calculated analysing the dominant relationship between operational profit earned by an organisation and capital which is employed in that organisation (Singh, Kumar and Colombage, 2017). This ratio measures the capability of a business of generating the profits against the capital employed in the regular course of business. It is an important for an organisation to have rising ROCE ratio as it indicates the improving and growing ability of an organisation of turning their capital into profits (Croce, 2017).

In the present case scenario of Mother Care company, it is important to compute and evaluate return on capital employed ratio as it can help its investors to get a general idea about how capable the company is to effectively utilise the capital which gathered by them by shareholders and investors. Decision making is the most important significance of this ratio as by this investor can ascertain whether it is viable to invest in the company. ROCE ratio also work as a basis of comparative analysis as it is considered that enhancing ROCE overtime is an indicator high profitability (Kansal, Joshi and Batra, 2014). ROCE ratio for Mother Care company is calculated and interpreted below for three years:

Mother Care is a large scale organisation which is listed at the London Stock Exchange due to which the annual reports of this company are easily accessible. ROCE is a ratio metric which can be computed using Income statement and Balance sheet. From the above numerical analysis, it can be evidently said that the performance of Mother Care company is continuously degrading as the ROCE of all three years is continuously decreasing. As it can be seen above, ROCE in 2017 is computed as 24.76 million pounds which decreased in 2018 as (525) million pounds which even further decreased in 2018 as (1046) million pounds (Annual report of Mother Care. 2017-2018, 2018).

This ratio is clearly showing the decreasing trend which is probably caused by the high current liabilities of the company which they are unable to pay off from their low earned revenues. High current liabilities has resulted into low capital employed and ultimately lead to decreasing ROCE. This ratio will affect the brand equity of Mother Care as investors will less prefer to consider this company for their investments.Need Online Assignment Help  UK? Contact Our Experts.

Net profit margin

This ratio is also a part of profitability ratios which represents the relationship between net profit which an organisation earns in an accounting year and total revenue which is gained by the same organisation (Rehman, 2013). This ratio shows the capability of an organisation of earning profit after paying off all the expenses and taxes (Bond, Bugeja and Czernkowski, 2012). The most essential significance of this ratio for the case of Mother Care is that it is the indicator of financial health of the company.

(All amount in million pounds)

From the above ratio analysis, it is evident that the net profitability of this company is continuously degrading. As it can be seen from above table, net profit margin for the year 2017 is computed as 1.22% which decreased to -13.10% in 2018 and further decreased in -18.17%. Such degrading ratio of this company is caused by the high operational expenditures which management of the company has to pay for continuous operations. Other cause of this degrading ratio is the high taxation which this company has to pay. This is the adverse situation which Mother Care company is facing from their desired situation and this will affect the low satisfaction of their investors. Dividend to investors and shareholders are distributed from the attributable profit but in this situation, there is no attributable profits due to which no dividend will be distributed to investors and it will affect their satisfaction level.

Current ratio

Current ratio is a financial metric which lays under the segment of liquidity ratio. This ratio is used by the management of an organisation and stakeholders of the organisation for analysing the liquidity of the business operations (Ahrendsen and Katchova, 2012). This ratio is calculated by the analysing the relationship between short term assets and short term obligations of a company. This ratio is important for a business as it provides the evidence for effective working capital of an organisation.

Significance of this ratio includes that this metric provides gauge the short term accounting strength of an organisation. In the industry in which Mother Care company works, the idea current ratio is considered to be as 2:1. This ratio means that every organisation must have two parts of current assets to pay off one part of current liabilities.

(All amount in million pounds)

From the above ratio analysis table, it can be clearly analysed that current ratio of this company is continuously degrading. Mother Care is currently at a position where they are facing the issue of low liquidity as they do not have adequate funds to fulfil their financial obligations. The current ratio for the year of 2017 is computed as 1.3:1 which decreased in 2018 as 1.12:1 which further decreased to 0.9:1 in 2019. This degrading current ratio situation has been raised in the company due to high current obligations and low current assets.

Not even in one year, Mother Care has been experienced to come even close to their ideal ratio which can affect their credibility in market. This company can even face the situation when no investor will agree to invest in their company without any eligible return evidence.

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Average Receivable days/ Debtors collection period

In financial terms it is defined as the average time taken to collect all the payments due to debtors. This is one of the tool which helps business organisation to evaluate their efficiency for collecting any amount due to debtors (Mathuva, 2015). In each industry an average collection period is set as standard and this needs to be achieve to work as financial viable unit. Higher rate of efficiency minimises time taken to collect all the debts form debtors. In general terms a period of 30 days is considered to be one of the moderate debt collection period. Small debtor’s collection period provides good financial availability to businesses and this helps in improving financial credibility of business. Debtors collection period is improved through keeping continuous watch on collection period and making strict collection guidelines. To calculate debtor’s collection period following formula is applied-

Debtors Collection Period= Trade Receivables / Credit sales * 365

In order to calculate debtor’s collection only sales made on credit basis is considered because such credit sales will arise debtors for business. It is termed as important ratio because it helps in improving cash flow of business and reduces risk of bed debts by collecting all the dues on time (Olson and Groves, 2012).

Financial statements of Mother Care organisation are analysed and for this past three years’ data is evaluated. In the year 2017 the organisation possesses debtor collection period of approx. 37 days. In the year 2018 days of debt collection has increased to 40.5 days and represents poor financial performance. In the year 2019 there is a great improvement is recorded in the debt collection period and 32.6 days were taken on an average to collect the debt. This represents that in the recent financial year organisation has increased its efficiency and generate good amount of cash flow to maintain effective financial position. This will be served as an important information for investors to make investing decision in Mother care organisation.

Average Payable days/ Creditors collection period

It is a term which indicates the average time taken by business organisations to pay off their current liabilities. It is one of the important financial tool helps business organisation in order to access their average payment period. This tool helps business organisation to gain good market image by paying all the due amount in the prescribed payment period. Analysing the creditors collection is important because it helps in accessing future financial requirement to pay various current liabilities generated in the day-to-day operations of business organisation. Calculating the financial requirement helps in making all the arrangements on time and stable financial position will be achieved by business organisation (Han and Jang, 2013). Calculation of creditors collection period is as follows-

Creditors collection period= Trade Payables / Credit Purchases * 365

Purchases made in credit basis will be considered in order to calculate average payable days of the business. Higher credit collection will be more preferable for business as it will provide long time to pay due funds to creditors and funds can be utilised in other investments to generate good amount of returns.

(All amount in million pounds)

Financial statements of Mother care organisation are evaluated for calculating average payable duration and it is identified that in all the three years the time duration is very high. In the year 2017, 2018 and 2019 the trade payable period is 939 days, 381.5 days and 487 days. These are more than a year or 2 years and termed as a poor performance of business. Because trade payables are current liabilities which needs to be paid in a year (Annual report of Mother Care. 2018-2019, 2019). Time taken more than a year to pay current liability by Mother care organisation will become unfavourable. When investors will consider this ratio then results will be negative and their decision for making investment in the business may get change. In long run this will also hamper brand image of organisation as no creditor will provide goods and services on credit to such organisation.

CONCLUSION

From the above conducted analysis on Mother Care, it has been analysed that this company is not in an effective situation as their operations and management are falling apart due to which various branches of this company has been shut down. Various ratios of this company are calculated and evaluate in the above report from which it has been observed that this company is not earning viable profits and revenues due to which they are unable to pay of their debts. It is also found that, this company is even unable to earn profits as they have to expend heavily on operational expenses and taxes.

From the findings gathered from Mother Care financial ratios, it has been concluded that there is a decreasing trend in this company as all the ratios and profits are degrading. Due to these findings, it is concluded that, for investors it is not the best time to invest in this company.

For the purpose of Mother Care, three strategic decisions are suggested to this company which can help this company to earn reliable profits and grow in marketplace. These decisions are that this company should seek help from government so that their tax liability can be evaded. Another decision is that; this company should follow the debt equity ratio of 2:1 by which they can operate on one part of their capital and two parts on acquired capital. Third strategic decision suggested to the company is that management of the company should focus on generating other revenue streams.

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