Methods to Evaluate the Performance and Financial Strength of a Company

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You as a financial consultant have been asked to evaluate the performance and financial strength of Deluxe Trading Co for the two years. For performance evaluation the industry averages of different accounting ratios are also available:

Solved Example:

The following information relates to Deluxe Trading Co for the years ended 30 June 2015 and 30 June 2016.

financial-strength-of-deluxe-trading-co

Required:

Evaluate the performance and financial strength of Deluxe Trading Co. on:

(a) Inter-period basis over the financial two financial years.

(b) Inter-firm basis by comparison with the industry average.

(a) Evaluation of Deluxe Trading on an Inter-Period Basis:

The net profit ratio or net profit margin has fallen by approximately 3% (11.3% – 8.1%). This may be due to increase in operating expenses and cost of purchases without a corresponding increase in selling price or sale volume. This can also be seen in worsened cash flow to sale ratio from 13.3% to 8.46% in the period.

The return on shareholders’ equity has deteriorated by 1.9%. This is a very important ratio because it measures the overall profitability of the business. Deluxe trading has done well in both years and, despite the fall, has shown a generally good performance in terms of profitability.

Inventory turnover ratio has increased from 6 times in 2015 to 8 times in 2016., indicating faster turnover of inventory into sales. Under general trading conditions, an increased turnover rate suggests higher level of trading activities which is a good sign for the business.

The average debt collection period has fallen from 36 days to 29 days. This means that in general, Deluxe trading is tightening the credit granted to trade receivables. This ratio is a measure of company’s credit control efficiency. The working capital cycle of Deluxe remained at consistent level in the last two two years.

Current ratio has improved over the year. In 2015 it has $1.62 current assets to meet every $1 of current liabilities, an indication that the company is fairly solvent.

The acid test ratio or liquid ratio has also improved over the year, indicating that the company has more liquid resources to meet its current liabilities. Though improved, it is still not too satisfactory in terms of liquidity in the short term.

The operating cash flow ratio for Deluxe Co. has fallen from 72.4% to 63.1% in 2015. This decrease in ratio could be an indication of financial distress in the future as it means that the company has generated less cash over the year than it needs to pay off short term liabilities as at the year end.

(b) Evaluation of Deluxe Trading Performance Against the Industry Average:

The net profit margin and cash flow to sales ratio achieved by Deluxe in 2015 was higher by 2% and 3% respectively than the average of the industry. However, when other similar businesses in the industry were able to achieve improved performance of 10.6% in 2016 as compared to 9.4% in 2015 (an improvement of 1.2%), the net profit margin of Deluxe fell to 8.1% (almost 2.5% below the industry’s average). In addition cash flow to sales also worsened from 13.3% to 8.46% in the period when industry showed an improvement of 1.1%. On a relative basis, Deluxe did not perform too well in 2016 when there was improved operating performance shown by companies in the same industry. The return on shareholders’ equity is also slightly lower when compared with the industry’s average. This may be due to the slight fall in the net profit earned in 2016.

Comparing its rate of inventory turnover, Deluxe is ahead of the industry’s average in 2016, indicating that sales were accelerated and increased. It was in line with the industry’s average in 2015.

On the question of granting credit period to customers, it appears that Deluxe is giving slightly extended credit compared with those in the industry. The average debt collection was 36 days in 2015, when the industry’s average was only 27 days. Although in 2016, Deluxe’s average debt collection period was reduced to 29 days, it is still longer than the industry’s average of 28 days. The short cycle in comparison to industry average indicates that Deluxe is well managing its working capital and lower value of working capital to be financed from other sources.

In terms of liquidity as measured by the current ratio and acid test ratio, Deluxe improved its general image in that both its ratios were fairly close to the industry’s average in 2016. However, the same cannot be said for 2015.

The operating cash flow ratio for Deluxe Co. was lot better than industry average in 2015, however, in 2016 it showed a decline may be to decrease in operating cash flows as evidenced from decrease in cash flow to sales ratio. Moreover company was unable to improve with industry average in 2016.

Generally Deluxe Trading has performed satisfactorily over the two years in comparison on other similar businesses in the industry. The liquidity has much improved but profitability has weakened.