Accounting for Decision Making
This paper seeks to analyze and discuss the financial statements of Pratt Ltd. (or Pratt) and Dana Ltd (or Dana), which are leading manufacturers and marketers of apparel, home furnishings and camping goods, in terms of analyzing their financial ratios and industry averages. The result of the analysis would be used for giving advice to a potential shareholder on what would be his or her best course of action with respect to that company’s shares. 2. Analysis and Discussion
The following summary is of financial ratios are extracted from the financial statements of Pratt and Dana and industry data to facilitate analysis in terms of profitability, liquidity and solvency (Helfert, 1994) of the company Pratt profitability is slightly lower than Dana. Based on net profit margin for year 2008. Pratt had 11. 68% as compared with Dana’s 13. 49% for the same year. The same behavior may be observed in terms of gross profit margin, where Pratt reflected 33. 36% as against Dana’s 37. 02%. Thus it may be safely declared that Dana is more profitable than Pratt.
For purposes of comparing the company’s gross profit margin and net profit margin of the two companies against the industry averages of 35. 10% and 12. 65% respectively, Dana fared definitely better than Pratt under both ratios. The return of asset (ROA) for Pratt reflects 56. 76% for the years 2008, although higher than industry average of 54. 39%, proved still lower compared with Dana which reflected ROA of 57. 75%. The results of these ratios got further confirmed in terms of return of equity (ROE) where Pratt showed 78.
35% for the years 2008 which is still lower than that of Dana At 79. 87%. Both companies exceeded however industry averages. While ROA measures how efficient management of company is in terms of assets employed in business, ROE measures how much management is compensating resources invested by stockholders. By comparing the two ratios, it would seem that the management of both companies did show leverage in using company’s assets since ROE’s are higher than ROA for both companies with management of Dana Ltd showing better performance than Pratt.
As a general rule every business should have profitability as its primary goal in all of its business ventures for without which the business will not survive in the long run, thus the need to measure current and past profitability to project future profitability. Basically profitability measures only income and expenses. A company as a rule should have higher income than expenses. Relating the two accounts may not be as simple as being defined as expenses could some exceed income.
Before comparing the two accounts, it must be made clear that income is money generated from the activities of the business but said activities had cost and they are called expenses. To incur expenses entail use by business entity of assets. These assets may come from the investment of the owners or from the assets provided by the company creditors. Profitability therefore reflects measurement in the income statement with the desired effect of having more revenues over expenses. The said accounting information could however be further manipulated by converting them into ratios as used in this paper.
Closely related with profitability is efficiency in operation where this time, Pratt reflected better result than Dana in terms of better inventory turnover, faster collection period below its normal credit terms and better payment period also below normal credit terms. In fact even in compared with industry average, Pratt is more efficient than Dana. Efficiency needs to be translated however into profitability hence, Dana may still be considered more preferred than Pratt. 2. 2 Liquidity
A company’s liquidity shows its to meet currently maturing obligations and the same could be measured by the quick ratios and current ratios. Pratt’s quick ratio, computed by dividing quick assets by the total current liabilities, showed 0. 60 for the year 2008 as against the Dana’s quick ratios of 0. 64 for the year. Similar behavior may be observed in the current ratios of the two companies as Pratt still showed a slightly lower ratio of 1. 5 as compared with Dana at 1. 7. Compared with industry averages, it appears that it is only in term of current ratio that Dana has exceeded the said average.
Comparing quick ratio from current ratio, the formers assumes a better measure of liquidity since the same excludes inventory in the composition of the quick assets. It may be observed however that the results of the profitability analysis appear to create some consistency in the resulting liquidity ratios of the Pratt and Dana. Generally, for a company to have good liquidity, the ratio of current or quick assets to current liabilities should be at least one since this would mean that a company must be able to match 1 dollar from it current assets to every dollar of its currently maturing obligations.
Failure of a company to do this could result to bankruptcy and may force the company to stop operation. This takes on the premise that the salaries of its employees every payday cannot wait longer as people need to have their living expense. The ready quick assets a typical company need match maturing obligations include cash, marketable securities, short term investments, accounts receivable and notes receivable. To make quick assets into current assets, other current assets would have to be added including inventory and prepaid expenses.
Given the theoretical know how to be applied in the case of the Pratt and Dana, quick ratios for both companies in 2008 showed less than 1. 0, hence indicative of less than industry average liquidity which happened to be also 1. 0 The said ratio normally carries a lower figure than that of the current ratio, as confirmed in this analysis. The lower liquidity of Pratt as compared with Dana may be expected due to the latter’s greater profitability compared with the former as earlier analyzed. This could be an indication that Dana had indeed improved its liquidity better because of better profits.
2. 3 Financial Stability – Short Term and Long Term In finance, financial stability or solvency like liquidity has also something to do with the ability of an enterprise to pay its debts with available funds like cash. Such is presumed to exist but this time it differs from liquidity since solvency relates to long term health that may speak for the financial stability of the company to survive short term problems due to more than sufficient investment from stockholders (Meigs and Meigs, 1995) to match long term debt of the company together with currently maturing obligation.
It differs also from profitability, as the latter refers to the ability of a company to earn a profit. A business therefore may show a profitable result of its operation without being solvent as in the case when companies are on the stage of expanding rapidly in the early part of business. On the other hand, solvency can exist apart from profitability when companies attempt to sacrifice early losses to build market share.
Ideally however, a company should be profitable, liquid and solvent since a business may stop operation from bankruptcy when it loses money due to unprofitability. Solvency may be expressed using debt to equity ratio (Bernstein, 1993). In applying the knowledge, debt to equity ratio in 2008 for Pratt is at 81% for the year 2008 while Dana has reflected debt to equity ratio of 76% for the same year. The ratios are better this time for the company if they are lower. Hence in 2008 Pratt has shown poorer solvency than that of Dana because of higher ratios.
The behavior in the solvency ratios appear to confirm the behavior of liquidity that was earlier described as Pratt has shown lower profitability and liquidity in 2008. This is on the premise that profitability contributes to liquidity and solvency. Compared with industry average, both companies debt to equity ratios are inferior, however in terms of times interest earned, Dana Ltd again came out better than Pratt. Nevertheless, debt to asset ratios of the two companies fared better than industry average but Dana still came out better than Pratt.
It must be pointed out that debt equity ratios and debt asset ratios measure long-term financial stability while the times interest earned gauges the companies’ short term stability. Limitation The analysis made for both companies did not consider the time value of money as profitability; liquidity and financial stability speak about the past of the companies. Although the past may predict about the future, there is no sure guarantee that what happened in the past will necessarily happen in the future.
3. Recommendation Given the higher profitability, higher liquidity and better solvency of Dana compared with Pratt and even with industry averages in terms of some given ratios, investing in the stock of the former is a better option. Dana’s gross profit margin, net profit margin, current ratio and debt to asset ratios are better than that of Pratt and even against industry averages, thus in making an investment decision, all fingers point to Dana over that of Pratt.
Although efficiency ratios appear higher for Pratt than Dana, what is controlling is profitability, thus the recommendation stays for Dana. With the limitation of the study mentioned above, this paper still maintains the same recommendation. References: Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia Case Study (n. d. ) – Pratt Ltd. and Dana Ltd. Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Sydney, Australia Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK