Financial Management & Control Individual Assignment

Gearing

The gearing ratios help evaluating the solvency position of the company. These ratios calculate the firm’s capability to tend to its debt obligations. This is to say that the ratios help in evaluating whether the company would be capable in repaying the debt obligations and still remain profitable (Brooks, 2015). The two ratios calculated to evaluate the gearing position of the company are the Debt to Equity Ratio and the Interest Coverage Ratio.

The company’s debt equity ratio has reduced from 0.59 to 0.39. This indicates that a substantial portion of debt must have been repaid in the financial year 2016. A lower debt to equity ratio reduces the solvency risk to the organisation. However, on the downside, this also implies, the dilution of the shareholders’ earnings.

The interest coverage ratio of the company, on the other hand has deteriorated in 2016. The ratio fell from 2.28 times to 1.91. This may be attributed to the fall in the company’s profitability. This fall however raises concern over the capability of the company to meet its compulsory debt obligation. However, since the ratio is more than 1, the solvency position of the company can still be said to be stable. It can be said that the company is in no immediate risk of going insolvent.

Asset utilization

The asset utilisation ratios represent the manner in which company applies its short-term resources to generate operational revenues. These ratios combine an element of income statement with balance sheet. Asset turnover ratio signifies how company has applied its assets to generate revenues for the period. The asset turnover ratio of the company has not changed in the past years. This implies that company has adopted a stable policy for asset management. However, this also signifies that sales revenues per unit of asset is not growing which is an area of concern for the company. Inventory turnover ratio is the number of times inventory is rotated in the business in relation to its revenues. The ratio shows favourable results for the company at 12.26 in the year 2015 and 12.31 in the year 2016. While the assets are utilised adequately by the company, the outcomes in terms of sales revenues have declined during the period.

The ratios categorised under investor potential are generally used by investors to check the feasibility of investment alternatives. These ratios cover value generated by the firm towards its shareholders. Earnings per share (EPS) is the value per share earned by the company from application of investments of the shareholders (Delen, et al., 2013). EPS of the company is a major concerning issue for the company as it reflects on the future capital inflow of the company. EPS of the company is critical and it has further decremented from £0.08 to £0.05 per share in the past year. The ratio indicate that company is not generating sufficient value to the shareholders. Dividend pay-out ratio is the percentage earnings distributed by the company to its shareholders. In 2015, the dividend pay-out ratio was 51.40% which means that company distributes almost half of its net earnings for the year and retains the remaining in the business for future growth. In 2016, the ratio took a drastic change with a pay-out of 87.69% which means that company is distributing a substantial proportion of its earnings to its shareholders and retains only a small portion in the business. Company is following a fixed dividend plan which can be perceived as a suitable investment alternative for a potential investor. Despite a display of constant dividend to its investors, lower retention ratio is hampering the growth of company which has been indicated by the profitability ratios.

Limitations of Ratio analysis

Despite being a handy tool for analysis, fundamental ratio lacks capability to be considered a decision-making tool. It provides an overview of the financial performance of the company to the users of financial statements but it is not a managerial decision-making tool (Delen, et al., 2013). A major limitation of ratios is that they are a quantitative tool and lacks qualitative characteristics. Managerial decisions cannot be taken only on the basis of quantitative figures. These ratios derived should be corroborated with other information presented in the notes to financial statements.

One major setback on basing the managerial decisions solely on the ratio analysis is that the ratios are calculated on the historic information. The inherent limitation of accounting is that it uses historic information to take decisions regarding the future. This limitation is also inherited by the ratio analysis technique as the ratios are also based on historic information. Being based on the historic accounting information, the ratios cannot be said to be the true indicators of the future business scenario (Nair, 2018).

The ratio, even after being calculated are extremely difficult to be used as the means to making business decisions. This is because in order to understand the implications of the calculated ratios it is important for the user of financial information to have a certain degree of expertise. It is extremely difficult for the users with little to no knowledge of accounting to understand what a ratio truly implies in context of the position and performance of the entity. Even for the experts it is sometimes difficult to derive the utility out of the calculated ratios as there are no set standards and regarding the ideal ratios and the same are only derived based on a few rules of thumb (Brooks, 2015).

In addition to the above information the financial decisions cannot be based solely on the calculated ratios as the ratios are often used as a means to window dress the accounting information. While the ratios signify a different scenario, the actual position might vary in accordance with the non-financial measures (Wahlen, et al., 2014). Hence, substantial reliance on ratios might mislead the users as well as management with regard actual position of the company. That is to say that ratios may easily be used as a tool to mislead the stakeholders to believe a better business scenario than the ground reality. It is also at times used by the management to mislead the potential investors regarding the performance of the business. Standalone value of ratio does not lead to adequate decisions. These must be substantiated with other financial as well as non-financial tools check their validity.

Conclusion

On the basis of ratio analysis, it can be established that the performance of the company has declined during the year. Fundamental ratios have indicated that all the ratios are impacted due to fall in sales revenues during the year. While the board is recommended to take measured to generate growth in sales revenues by effective utilisation of available resources. However, the management is advised not to take decisions on the basis of ratio analysis due to various limitations of the tool. It is not an absolute measure of firm’s position but it can be used in unison with other tools to gain more clarity over financial position to formulate relevant strategic policies.