This part will include the financial analysis about the two companies which are Alpha and Gamma. It will cover the four areas such as liquidity, asset utilization, debt utilization and profitability. Also, the report will include a suggestion for improvement for each area.
Current ratio measure the firm’s ability to pay short term liability with the current assets. This ratio is important portion of liquidity because short term liability is due within one year, so the firm have a short time in order to increase funds to pay for liability. However, if the current ratio was below 1, it means that the firm is not good in financial health. Alpha’s current ratio is 1.36 which is higher than Gamma and its means that they can pay their obligation.
Quick ratio which also known as acid test ratio, measures company’s ability to pay current liability when it’s come due with quick assets. The quick assets are the current assets that can be changed to cash in short period or 90 days. However, Alpha Company has quick ratio with 1.04 and Gamma with 0.60, which means that Alpha is doing better. Also, they can pay off all the current liability with the quick assets. On the other hand, Gamma has quick ratio less than 1, which means that they can’t pay back the current liabilities. So, Gamma Company should look at their sale and inventory if they heavily rely on it.
2. Asset Utilization:
Receivable turnover ratio:
Receivable turnover ratio used to quantify the company’s effectiveness in extending credit and in gathering debts on that credit. It’s also about how much money is expected from the customer. Moreover, higher ratio is more favorable, and Gamma has higher ratio than Alpha, which means that they are collecting the receivables frequently throughout the year and they have high portion of customers that pay off the debt quickly. However, Alpha Company has low ratio which means that they are not effective in collecting the receivables. Therefore, Alpha Company can increase their ratio by selling the inventories quicker. Furthermore, they should manage their inventory because the more inventory can be turned the higher the profit they will gain. Also, they should change the credit term, business offers and time frame that is given to the customers to pay bill to improve this ratio.
Average collection period:
Average collection period measures how many days the company take to change their receivable into cash and it’s about how long it takes to receive payments. According to companies, Alpha Company is less effective than Gamma Company, where Gamma’s collection period is 63 days and Alpha’s collection period is 257, which is 4 times greater than Gamma. Therefore, to improve the average collection period, Alpha should reduce the credit sales or the amount of average debtor, and sell the inventories quicker and increase the receivable turnover ratio to do better in this ratio.
Inventory turnover ratio:
Inventory turnover ratio measures how many times the inventory of the firm is sold and replaced over the period of time. And how the company can control their merchandise efficiently. Alpha Company has inventory ratio with 2.84 which is lower than Gamma Company, which means that Gamma is effective and selling their inventory quicker than Alpha. Consequently, to increase this ratio, Alpha should increase the demand of the product and focus on the merchandise that sells consistently to get a high ratio and do better than Gamma.
Fixed assets turnover ratio:
Fixed assets turnover ratio measure the operating performance and it’s about how the company is able to generate net sales from fixed assets. In this ratio. Alpha company has a high ratio than Gamma, which means that the company has more effectively used investment in fixed assets to generate the revenue.
Total asset turnover ratio:
Total asset turnover ratio or efficiency ratio measures the company’s ability to generate sales from the assets and the high the ratio is favorable. Gamma Company has high ratio than Alpha which means that they are using their assets more efficiently than Alpha. As a result, to increase this ratio Alpha should increase their sales, don’t purchase the inventory if they don’t need and don’t let their assets to build up.
3. Debt Utilization:
Debt to total assets ratio:
Debt to total assets ratio measures the debt level as a percentage, it shows the company’s ability to pay off liabilities with assets. In this ratio the both companies have almost the same result, which is Alpha with 0.50 and Gamma with 0.51, and this means that they have little of financial risk and have a problem to pay back the loans. So, to improve the debt to total assets ratio, the companies should focus on increasing the sales, sell the assets and lease them and issue shares to rise their cash flow.
Times interest earned ratio:
Times interest earned ratio measures the firm’s ability to meet debt obligation and how much interest the company is earned. The high ratio is more favorable, so Alpha Company has 8.80 which is higher than Gamma, and this means that the company can pay additional interest expense and their income is 8 times greater than annual interest expense.
Fixed charge coverage ratio:
Fixed charge coverage ratio measure the company’s ability to meet fixed charge such as lease expense or interest expense. High fixed charge coverage ratio indicates that the company can use their debt easily. And again Alpha is doing better than Gamma in this ratio, which means that the company is able to make fixed payment.
Profit margin ratio:
Profit margin ratio measures how efficient is the firm managed their forecast profit based on sales. In this ratio Gamma has 0.12 and Alpha has 0.09, which means that Gamma Company is doing better than Alpha. Therefore, Alpha Company can increase their profit margin ratio by increasing their sales and gross margin and lower the prices.
Return on assets:
Return on assets ratio measures how the firm is efficient in using their assets to generate profit, and the higher the ratio is more favorable. So, Gamma Company has 0.10 which is higher than Alpha who has 0.05, and this means that Gamma is selling their assets efficiently. Therefore, Alpha can increase their return on assets ratio by decreasing their assets cost and expenses and increasing their revenue.
Return on equity:
Return on equity ratio measures the efficiency of the company in using the money from shareholders to generate profit. And again Gamma Company has a higher return on equity ratio than Alpha Company. However, to increase their return on equity ratio, Alpha Company should increase their sales, low the taxes and improve the revenue performance.
This part will include how the increase or decrease of 10% of operating costs can affect the business and it performance. Also, a recommendation for which proposal should be adopted and the reasons of choosing the proposal in order to convince Kay Marsh.
c. What would happen if operating costs were 10% higher than expected?
Operating costs is an element of operating income and it’s usually reflected on a firm’s income statement. As a general rule, any increases in business expenses directly affect the profit and decrease it. Therefore, an increase of 10% in operating cost, increases the expenses and decrease the profit of the business. Also, it decreases the sales and the internal rate of return (IRR), which reduces the company’s productivity. Furthermore, increase in operating cost effects on payback period, because it increases the days where it will affect the company because they can’t get their money earlier and they can’t pay their loan quickly. For example, in proposal A the net present value was 52872.62 and when the operating cost increases by 10% the net present value decreased to 45000.79. However, increase of 10% in operating cost it’s not good for any business because it effects on their profit, so if the company want to increase their profit they should decrease the expenses and sell more.
d. What would happen if operating costs were 10% lower than expected?
Reducing the operating costs can be a smart way to run a lean and efficient business, as decreasing it will decrease the expenses and increase the profit. Therefore, lowering 10% of operating cost will reduce the expenses and increase their profit. Also, it will increase the sales and the internal rate of return (IRR) so the company will get more revenue and will help them to improve their performance and grow faster. Moreover, decreasing the operating costs will also decrease the payback period which will let the company to get their money quicker and pay their loans. However, reducing the operating costs usually increase the short term profit and hurt the company’s earnings in long term. For instance, in proposal C the net present value was 76644.5 and when the operating cost decrease by 10% the net present value become 86801.7. However, if the firm cut their advertising costs their short term profit will improve, as they will spend less money on the operating costs. The best course of action is to keep the operating cost as much as lower to increase the profits and maintain the ability to increase the sales.
Proposal C Proposal D
Payback Period 4 Years 2 Years
Net Present Value 76,644.5 52,872.62
For this report I recommend the CEO, Kay Marsh to choose proposal D and C for many reasons. Firstly, proposal C, this proposal have the highest cash flow and net present value than other proposals as a positive NPV is acceptable. Therefore, a positive cash flow and NPV indicates that it’s a profitable company, discount the future earning by present value. Also, NPV of proposal C is greater because the present value of cash flow is higher than the present value of outflows, and this means that cash flow is higher than the initial cost and this will generate money on investments. Moreover, the payback period of proposal C is 4 years, and this means that the company will get their money back from the investment after 4 years and then if they have loan they can pay it. Basically, less year of payback is better because the company can take advantage of it and get their money as soon as possible.
Secondly, proposal D, this proposal has the second highest cash flow and net present value, which is a positive and that’s means the company is profitable and the long term cash inflows exceeds the long term outflows. Moreover, proposal D have the best payback period comparing with the other proposals, where all other proposals have payback in year 4, which means that the company will get their money late and then they can cover their initial investments. But, proposal D have a short time of payback period which is 2 years and this means that the company will get their money quicker and they can pay their loans faster and they can cover their initial investments.
However, there are some other recommendations for other proposals to improve their performance, such as decrease their operating cost and other expense to improve their payback period, as it can get the company it money back if the period is short, it can improve the company liquidity position and it can reduce the risk of the loss that is caused by changing economic condition. Also, add a value for the firm to increases the net present value as the NPV is the time value of money and it’s the idea that the future money has less value that the present available capital. Furthermore, improve the shareholders wealth as the financial management goal is to increase the shareholders wealth. As an overall, proposal C and D can be adopted by CEO, as the reasons mentioned before and they have a positive cash flow, net present value and payback period.