Working Capital Ratios

Working Capital Ratios

I] INTRODUCTION

Working Capital Ratios provide a quick and relatively simple means of assessing the financial health of a company. By calculating these ratios, it is possible to build up an overall picture of the financial position and performance of a company. This view has been supported by McLaney E. et al, (1990).

Using ratios financial statements can be analyzed and interpreted, which is of interest to a vast number of stakeholders such as shareholders, customers, employees, lenders, suppliers, government agencies and also importantly to future investors. (Woods. F et al, 2008)

The ratios help identify irregularities and anomalies in a business and point out areas of exploration for the determination of its existing and expectation. Thus, they facilitate in highlighting the financial sturdiness and fragility, however they cannot by themselves explain why those exist and can only be revealed by conducting a detailed investigation. (McLaney E., et al., 1990 and Elliot B., et al., 2008)

The ratios that have to be calculated for Upholland Ltd can be categorized into the following headings relating to exacting characteristics

i) Profitability: This measure primarily indicates business in terms of profit achieved. It is also used to assess other aspects like the managerial performance, its investment potential and its comparative performance to its competitors.

ii) Liquidity: This measures the extent to which resources can be turned into currency to meet maturing obligations. In short, it is the estimation of the amount of hard cash accessible.

iii) Efficiency: This ratio measures the competence with which the assets of a company are utilized and are also known as activity ratios. (McLaney E., et al., 1990 and Woods. F et al, 2008)

II] LIMITATIONS:

Before we venture to the calculations and analysis of the ratios for Upholland Ltd, let us first highlight the limitations of the data provided which would affect the interpretation

1) Simply determining a ratio will not assist us in understanding the performance or position of a company. It is only after evaluation with some set standards, that this data can be deduced and estimated. The relative performance analysis of Upholland Ltd should have been gauged by comparison of the financial statements with either

a) Past periods of Upholland Ltd

b) Similar business for the same or past periods, or

c) Planned performance for the business (Mc Laney, 2010)

However, as this data is not given, the ratios cannot be analyzed accurately.

2) Although ratios can be calculated, the industry sector is not mentioned for the given company Upholland Ltd and hence no meaningful comparisons can be done.

3) The products and services offered by Upholland Ltd are also not mentioned, and hence we cannot analyze the market norms and trends observed for similar businesses to give appropriate suggestions.

Due to the above mentioned limitations, the analysis will not be able to give a complete picture of the company and give suitable suggestions to the management to improve its performance in the coming year.

III] FINDINGS AND ANALYSIS:

The appendix contains all the calculations for the ratios.

i) Profitability ratios

a) Gross Profit Margin: The gross profit margin (GPM) ratio processes the quantity of profit the company has produced with respect to the quantity of sales that it has made for the same period according to Dyson J. (2007)

* According to calculations, the gross profit margin is 8 %. This means for sale of every 100 £, Upholland Ltd makes a gross profit margin of 8 % before overheads and taxes. The low profit margin indicates that the company is facing a lot of competition.

* The gross profit margin of every entity is a function of two policies namely selling price policy and Purchasing policy. Hence, by amending either of the 2 policies the GPM can be increased.

* GPM can be increased by either of the following two ways. Firstly, the company can increase the Selling price of their products, however as in this case the competitiveness is high, thus it is not a viable option for the company. Secondly, the company can reduce its operating expenses (operating expenses are defined as any expenses sustained by an entity during its everyday operations, which are obliquely linked to production) that can be categorized as Administration expenses, selling expenses and Distribution expenses.

* Thus the management needs to look into the operating expenses and determine how to effectively reduce it to increase GPM. (http://bizfinance.about.com/od/financialratios/f/Gross_Profit_Margin.htm)

b) Return on Capital Employed (ROCE): ROCE is a elementary measurement of an entity's performance. It conveys the association of the profit produced to the capital employed in the entity. (McLaney E., et al., 1990, p.238)

* According to calculations, ROCE is 13 %. This means for sale of every 100 £ of capital employed, Upholland Ltd makes a return of 13 % before the deduction of overheads and taxes.

* Usually, if the ROCE is higher, higher is the profit and consequently it means that the assets of the company have been efficiently used.

* As ROCE is considered the primary measure of profitability, it measures how much profit the ordinary shareholders will receive in proportion to their investment in the business. As ROCE of this company is low, which is 13 %, the dividends that are distributed to the shareholders is also low. Thus, the dividend cover is also low. Hence, the overall profitability and efficiency of the company is low.

* The management has to investigate the reasons for this decline in profitability and efficiency. One of the ways to increase ROCE could probably be by cutting costs and minimizing initial capital expenditure so as to increase its profit margin ratio. Another way could be by increasing the mark-up of the products without adversely affecting sales revenue. (http://www.intergraph.com/assets/pdf/PPM-US-0001C-ENG_screen.pdf)

(McLaney E., et al., 1990, p.238)

ii) Efficiency ratio

a) Debtor's ratio: This ratio computes the average period, the credit customers take to reimburse the amounts that they are indebted to the company. It may be employed