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Gorgeous Limited is a fashion retailer and it is now seeking to expand its business and product range by acquiring another firm, Accessorize, which operates in the designer segment of the fashion retail industry. This report covers the financial analysis of Accessorize Limited with a view to establish its profitability, asset turnover, and solvency situation over the period from 2010 to 2012. Ratio analysis shows that the company’s profitability was on a declining trend during the period. It also portrays unfavorable trend in asset turnover and liquidity ratios. However, the levels of all the ratios (profitability, liquidity, and asset turnover) are not below the industry standards. Inefficiency of Accessorize’s management is the most probable reason behind the unfavorable ratio trend and this situation could be changed through better management of the firm. Therefore, Gorgeous Limited could increase its market value by acquiring this company and turning it around. Besides, the suppliers of Gorgeous have promised to offer the company significant discounts if it goes ahead with the acquisition. However, Gorgeous limited should also consider qualitative factors in addition to financial statement analysis before deciding whether it should acquire Accessorize.
Financial Analysis

Profitability Analysis

  1. Net profit margin= (Operating profit after tax/net sales) x 100

Net Profit Margin for Accessorize

Year

 

Gross profit margin

2012

($253/$5180)x100

4.88%

2011

($269/$5520)x100

4.87%

2010

($386/$5398)x100

7.15%

  1. Return on assets= (Operating profit after tax/Net assets)x100

Accessorize’s Return on Assets

Year

 

Return on Assets

2012

($253/$847)x100

29.87%

2011

($269/$837)x100

32.14%

2010

($386/$838)x100

46.06%

Liquidity Ratios

  1. Current Ratio = Current Assets/ Current Liabilities

Accessorize’s Current Assets

Year

 

Current Ratio

2012

(46+86+478/302)

2.02

2011

(61+75+470/317)

1.91

2010

(75+67+407/260)

2.11

  1. Quick Ratio= (Current assets-Inventory)/ Current Liabilities

Accessorize’s Quick Ratio

Year

 

Quick Ratio

2012

(46+86/302)

0.44

2011

(61+75/317

0.43

2010

(75+67/260)

0.55

Asset Turnover Ratios

  1. Inventory turnover=Cost of goods sold/Average inventory

Accessorize’s Inventory Turnover

Year

 

Inventory Turnover

2012

{3620/{0.5(478+470)}

7.64

2011

{3712/{0.5(470+407)}

8.47

2010

 

 

  1. Receivables turnover= Net credit sales/Average inventory

Accessorize’s Receivables turnover

Year

 

Receivables Turnover

2012

(15%x5180)/(86+75)

4.83

2011

(15%x5520)/(75+67)

5.83

Financial Stability Ratios

  1. Equity Ratio = (Shareholders’ equity/Total assets)x100

Accessorize’s equity ratio = ($847/$1345) x 100 = 62.97%

  1. Debt Ratio= (Non-Current Liabilities/Total Assets)x100

Accessorize Debt Ratio= ($498/$1345) x 100= 37.03%

Financial Analysis

Profitability Ratios

Net profit margin is expressed as net profit as a percentage of revenue (Cynthia 2010). The ratio is mostly used for internal comparison purposes. The ratio measures the amount of contribution to profits by each dollar earned by the company. A low net profit margin implies a low margin of safety, that is, high risk that a decrease in sales will cause a net loss for the company. A high net profit margin, on the other hand, indicates a high margin of safety which means that it would take a large decline in sales for a company to register a net loss.

Net profit margin is a good indicator of a firm’s pricing strategy, cost structure, and efficiency in production (Cynthia 2010). Difference in strategies and product mix is the main cause of variance in profit margin among different firms. More efficient companies control their costs better and, hence, they have favorable net profit margins.

The net profit margin of Accessorize decreased from 7.15% in 2010 to 4.88 in 2012. This shows that the company has either adopted poor pricing policies or become inefficient in the management of its costs. Therefore, before acquiring this company, there is a need to investigate its pricing strategies, cost structure, and efficiency of its production systems. If the decrease in net profit margin has resulted from managerial inefficiency, Gorgeous can turn this situation around through better management.

The return on assets (ROA) indicates how profitable a firm’s assets are in producing revenue. The ratio is calculated by dividing net income with the total assets of a company. Specifically, the ratio tells us how many dollars of revenue each dollar of asset is generating. The ratio is usually used to compare rival companies in the same industry. ROA indicates the efficiency of management in utilizing assets for the generation of profits. A company with a lower ROA in relation to other companies or the industry’s average shows that the management is less efficient in employing assets to generate earnings. In contrast, a firm registering higher ROA than competitor companies or the industry’s average indicates superior management.

The return on assets of Accessorize’s has been on a declining trend as shown by the financial statements presented. As shown by the ratio analysis, the ratio was 46.06% in 2010, 32.14%, and 29.87%. The decline may be an indication that Accessorize is not being managed efficiently and, as a result, it is generating fewer dollars for every dollar of assets held by the company.

Liquidity Ratios

The current ratio relates the current assets of a company to its current liabilities. It indicates the liquidity of a company as well as its financial strength. The ratio shows the amount of a company’s assets that are likely to be converted to cash within one year and, therefore, provide cash for meeting current liabilities. Essentially, it portrays the ability of a company to meet creditors’ demand when they fall due and how it varies from industry to industry. When the current assets of a firm are more than its current liabilities, its current ratio is below 1 meaning that the company may experience difficulties meeting short-term obligations. Conversely, if the current ratio is very high (above 1) this could be indicating that the company is not efficient in using its current assets or in working capital management. Thus, a company should strive to achieve an optimal current ratio.

The current ratio of Accessorize has been around 2 between 2010 and 2012. This could indicate that the company has not been very efficient in employing its current assets for generation of earnings.

Quick ratio is similar to the current ratio except that inventories are not included in the calculation as inventories are considered as illiquid assets. Based on quick ratio, it is evident that Accessorize has not been generating enough cash to meet its short-term obligations.

Asset Turnover

Asset turnover indicates the rate at which a company’s current assets are being converted into cash. There are two key asset turnover ratios namely inventory and accounts receivables turnover. Inventory turnover shows the number of times a company replenishes its entire stock of inventories over a given period of time. In contrast, receivables turnover indicates the number of times a company collects its entire receivables over a given period of time. The inventory turnover times for Accessorize are above 7 which are quite impressive but its receivables turnover times need to be enhanced. This situation could have arisen as a result of the company having loose credit policies.

Financial Stability Ratios

Financial stability ratios indicate whether a company is solvent or not (Hemant 2010). There are two major ratios used to indicate a company’s solvency: equity and debt ratios. The equity ratio of Accessorize is 67% while its ratio stands at 33%. The two ratios show that the firm is fully solvent.

Recommendation

Analysis of Accessorize’s profitability shows that the firm is a profitable company and this profitability is likely to be sustained into the future. However, the company’s profitability has declined in comparison to its earnings in 2010. This decline in profitability is most likely due to the change in the company’s management that occurred in the beginning of 2011 when Malcolm’s daughter Ivy left the company. If this is the reason behind the decline in profitability, it is possible for Gorgeous Limited to turn the company around through better management.

The liquidity ratios of the company show that the company has not been very efficient in managing its working capital (Dutton 2007). Specifically, most of the firm’s current assets are inventories indicating that it may not be generating adequate cash to cover its maturing obligations. Therefore, Gorgeous Limited should investigate Accessorize’s credit policies and its efficiency in managing working capital to see if improvements can be made so that its current ratio goes beyond 1. The poor management of Accessorize working capital is also depicted by the firm’s asset turnover ratios. As regards financial stability, the company is in good health as portrayed by its debt and equity ratios.

On the whole, it appears that Accessorize is a valuable venture if the management of Gorgeous Limited will be able to improve the firm’s management. The best option is to go ahead and acquire the company at the stated price.

Shortcomings of Financial Statement Analysis

Although financial statement analysis yields very important information that can be used for making decisions regarding whether to acquire another company or not, this approach has various shortcomings and, therefore, it should not serve as the only basis for making business acquisition decisions. To start with, a company’s financial position is influenced by various factors including economic, social, and financial factors. However, it is only financial factors that are considered in the preparation of financial statements. The economic and social factors such as the effects of recession and changes in consumer trends and preferences, respectively, are not captured by financial statements although they influence the financial position of a business significantly. As a result, financial statement analysis should be accompanied by an investigation of the economic and social conditions under which a business has been operating so as to form an accurate view of the financial performance and position of a business.

Secondly, the profitability of a business as revealed by its income statement and the financial position as shown by its balance sheet are basically short-term in the sense that they may not depict the future financial position of the related company with a hundred percent accuracy (Lev 2001). The financial position of a business is always subjected to change depending on the prevailing circumstances and predicting the future circumstances with certainty is obviously impossible.

Thirdly, financial statements capture quantitative factors only leaving out qualitative factors which also affect the financial performance of a firm (Lev 2001). Such qualitative factors include prestige and reputation of a business, quality of management, skill level of employees, etc. Thus, when conducting a financial statement analysis it is also important to consider qualitative factors which are usually not captured by financial statements.

Fourthly, financial statements are normally prepared on the basis of historical costs. This means that the impact of inflation is ignored in preparing the statements, although this effect is material (Lev 2001). Items such as liabilities are recorded in terms of the amounts they were initially contracted for. Similarly, fixed assets are measured and recorded based on the amounts they were exchanged for at the time of acquisition. The assumption of constant purchasing power in preparation of financial statements leads to distortion of the financial information expressed by these statements.

In addition, financial statements have a lot of items whose values depend on the discretion of the accountants who prepare them. Examples of these items are provisions for depreciation and doubtful debts, valuation of inventory, etc. Human judgment is subjective and prone to error and, as a result, financial statements are not always an accurate representation of the financial position and performance of a business.

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