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Introduction
According to Weston, J., (1990) financial ratios are normally calculated by all business organizations that are in need of determining the performance of the business. With the help of ratios a business is able to make appropriate and viable decisions that will determine the going concern of the organization. There are four types of ratios i.e. the profitability ratios, liquidity ratios, gearing ratios and asset utilization ratio/efficiency ratios. Profitability ratios help in the determination of the measure of the returns of the business over time, liquidity ratios help in determining the ability of a business to meet its financial obligation as they fall due while gearing ratios are important in the determination of the financing of the business through debt and equity financing. Finally, the asset utilization ratios are calculated with the objective of determining the efficient use of the business property in achieving organizations goals.
Financial Ratios
From the calculation of the liquidity ratios, it is worth noting that Cuero limited is in hard financial crisis as its liquidity position has declined. In as much as the current ratio of the company has stagnated at 1.16 the acid test ratio has declined from 0.68 in 2009 to 0.59 in 2010.this implies that Cuero ltd will not be in a position to discharge its obligation as they fall due. From the acid test ratio it can be noted that the sales level has reduced thereby impacting on the increased stock. The company should therefore take measures to increase its sales and reduce its liabilities. Promotional strategies should be undertaken and buyers should be offered fair credit terms to improve sales to credit worthy customers. The reduction in sales also explains the reason for the decline in cash ratio from 0.03 in 2009 to 0.01 in 2010.If action is not taken immediately then the going concern of Cuero ltd is in jeopardy.
Houston, F., Brigham, E. F., (2009) argue that, “The profitability ratios can be analyzed in two perspectives; profitability in relation to sales and profitability in relation to investment.” Taking a look at profitability in relation to sales, it is observed that there is a decline in the gross profit margin from 0.49 to 0.45. This is attributed to the decline in turnover during the period. Again, the net profit margin has declined from 0.03 in 2009 to 0.002 in 2010. This could be as a result of the failure to reduce the expenses with the reduction in turnover. On the other hand the profitability in relation to investment also indicates a non satisfactory performance of the company. The return on investment has declined from 2% to 1% due to the under utilization of the assets of Cuero ltd. the return on equity has also reduced from 6% to 4% meaning that the shareholders value on investment has been reduced. Lastly, the return on capital employed declined from 3% to 2% implicating that the capital of the company has not been efficiently used in production or that the capital assets are used for other purposes not leading to the realization of the objective of the company.
Moreover, the efficiency ratio that reveals the level of asset utilization has been computed. From the computation of the inventory turnover, it is realized that the rate of turnover has declined from 2.625 to 2.098 demonstrating a longer duration of holding stock. Bodie, Z., Alex, K. and Alan, J. M (2004) suggest that, the fixed asset turnover has realized a mild improvement of 0.01 which might not be significant in the performance of the business. Cuero ltd must therefore put their investment assets in proper utilization and emphasis given on the motivation of the staff to ensure proper handling of the firm’s assets. Retrenchment of some staff members might have led to demoralization. The constant change of the business ownership could be responsible form poor management of the organization.
Lastly, Cuero ltd is highly geared. The debt equity ratio has increased from 1.15 to 1.37 resulting in threat to business going concern. The increased rates in gearing explains the increased interest expense
Advantages of ratios
Ratios can be used to monitor the performance of a business over a period of time thereby helping in taking corrective measures. Williams, J. R., Susan F., Mark, S. Bettner, J., and Carcello, V. (2008), say that, “Secondly, with the help of ratios an industrial analysis can be conducted to compare the performance of the business to that of the industry and with other companies in the industry”. The liquidity ratios help in the determination of the going concern of the business, profitability ratios are important in the determining the performance of the business over time and the gearing ratios reveal the extent of debt financing for the company. Efficiency ratios also portray the efficiency of asset utilization of the company i.e. whether the company’s property is used in the proper manner.
Disadvantages of ratios
In as much as ratios are important in the determination of the performance of the business, it suffers some drawbacks. First, ratios don’t take into consideration the time value of money i.e. any consideration given to the inflation. Ratios as well fail to consider the absolute values but the relative comparison of values. Moreover, different companies apply different accounting conventions hence limiting the comparison possibility. Finally ratios only consider the financial aspects of the business only and not the management strength.
References
Bodie, Z., Alex, K. and Alan, J. M., 2004. Essentials of Investments, 5th ed. McGraw-Hill Irwin.
Houston, F., Brigham, E. F. 2009. Fundamentals of Financial Management. Cincinnati, Ohio: South-Western College Pub. p. 90.
Weston, J., 1990. Essentials of Managerial Finance. Hinsdale: Dryden Press. p. 295.
Williams, J. R., Susan F., Mark, S. Bettner, J., and Carcello, V. 2008. Financial & Managerial Accounting. McGraw-Hill Irwin. pp. 266.
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