Financial Health of a Business Organization Research Paper

1. Financial Ratios

Financial ratios are an essential tool used in determining the financial health of a business organization. They are computed using numerical values from financial statements of the company. They are mainly applied in accounting when evaluating the economic status of a business organization either to examine financial trends or to compare financials condition of different firms operating in the same industry. Ratios are used by various stakeholders such as managers, investors, and creditors to understand company profitability, liquidity and even efficiency (Groppelli and Ehsan 2000). These kinds of information are used for making investment decisions. Profitability ratios are used to determine the ability of a business organization to generate profits to its owners while liquidity ratios are calculated to assess the firm's ability to meet its financial obligations when they become due. Also efficiency ratios are also very important in evaluating the strength of the company to convert finished goods into sales and also how often the company can pay its creditors or receive its account receivables.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

2. Methodology

In this project, ratio analysis is used to assess the financial health of two different companies. Financial information of each company is obtained from the annual financial report of each company. From the financial statements such as balance sheet and income statement, numerical values are used to compute different ratios such as profitability, liquidity and efficiency ratios. The results obtained are used to compare the financial health of various companies under analysis (Groppelli and Ehsan 2000). The results are tabulated, and formulas used when calculating different ratios are indicated. It is crucial to use ratio analysis because it has the potential of assessing financial trends and compare financials condition of different firms operating in the same industry

3. Brief Summary of Both Companies

NESTLE is a viral company that producing different products including chocolate, coffee, bottled water, powdered milk and other products required for daily home use. This company can market its products by targeting all its customers without considering their ages. It is a profit making company and provides satisfactory rewards to its shareholders making it a company worth investing in. This can be understood through assessing its financial reports for five years (Groppelli and Ehsan 2000). The business is managed correctly throughout its operating life cycle making it maintain its value to date.

ENGRO FOODS is also a significant company in food processing industry. It was started in 2005 to produce milk products. It produces 300000 liters of milk per day and offers significant employment opportunities to 750 people. ENGRO FOODS enters the market to pursue growth opportunities and to promote CSR programs and cooperate with the local people to encourage integrated farming and livestock development (Houston and Brigham, 2009).

4. Financial Ratios Theory with Ratios Formula

There are different ratios that are essential in this project. They include profitability ratios liquidity ratios and efficiency ratios.

4.1 Profitability Ratios

Profitability ratios show the ability of a business organization to generate profit. It includes a gross profit margin, operating profit margin, and return on assets and return on equity.

Gross Margin

This is a ratio which shows how much a business cost to produce the product. It is computed using the formula below (Houston and Brigham, 2009)

Gross Margin = Gross Profit/Net Sales * 100

Operating Margin

This is a ratio that shows how much the business incurs to produce products within one financial year. It is computed as shown below:

Operating Margin = Operating Profit / Net Sales * 100

Return on Assets

It is a ratio that shows the amount of revenue earned by using the company assets. It is determined by dividing net income by total company assets as shown below.

Return on Assets = Net Income / Assets * 100

4.2 Liquidity Ratio

These are ratios that show the ability of a business organization to meet its financial obligations when they become due. They include current ratio and acid test ratio.

Current ratio

It is used to measure present assets against existing liabilities. It is essential in determining how the business can meet its short-term financial obligations by liquidating its current assets. It is calculated as shown below

Current ratio = current assets/current liabilities

Acid test ratio

It is a critical ratio than the current ratio (Houston and Brigham, 2009). It is used to compare cash, short-term marketable securities and debtors to current liabilities. It is calculated using the formula below

Acid test ratio = Current assets- inventories/ current liabilities

4.3 Efficiency ratio

It is also called activity ratios, and it used to measure how the company utilizes its resources to produce earnings. It usually focuses on how often the company collects cash from debtors and makes payment to its creditors. These ratios are important for the management and other external investors who are concerned about the company profitability.

Inventory turnover

This is a critical ratio which measures how quickly the company converts its stock into sales. It is calculated using the formula below

Inventory turnover= CostofsalesAveragestocksDebtor's turnover

This is used to measure the ability of the company to convert its account receivable into cash. It is determined using the formula below

Debtors turnover= CreditsalesAveragedebtorsCreditors Turnover

This ratio measures how often the company pays its creditors. It is calculated by the formula below

Creditorsturnover= CreditpurchasesAveragecreditors5. Ratios Calculations with Analysis

Profitability ratios of NESTLE company

NESTLE company is more profitable than ENGRO FOODS. Its gross profit margin is higher than the gross profit margin of ENGRO FOODS since its sales revenues can cover its cost of sales with a larger percentage. It also has higher net operating margins as indicated in the table above. This shows that it uses less operating cost than ENGRO FOODS and this result in a higher operating profit margin as its gross profit margin can greatly cover operating expenses.

Profitability ratios of ENGRO FOODS

It also has a more significant net profit margin as compared to that of ENGRO FOODS. This is because it utilizes its assets, capital employed and equity capital to generate income. ENGRO FOODS does not use its assets properly and this result in a lower return on asset, equity and capital employed.

Liquidity Ratio for NESTLE company

In the contrary to profitability ratio ENGRO FOODS has a higher liquidity ratio than Nestle. Its current ratio is more than 1 while than of Nestle is less than 1. It therefore it can meet its financial obligations more efficiently than Nestle company despite being less profitable.

Liquidity Ratio for ENGRO FOODS

Furthermore the company holds more cash without investing in long term assets than Nestle and this makes it less profitable because long term assets generates additional income to the business.

Efficiency ratios for NESTLE company

Furthermore ENGRO FOODS is more efficient than Nestle because it pays its creditors within a shorter period than Nestle. It only takes between 35 days to 45 days to pay creditors while Nestle takes at least 115 days. Its days of inventory are also shorter than that of Nestle as it takes only 49-73 days to convert its stock into sales.

The inventory turnover ranges between 4 to 9.5 while that of Nestle ranges from 5.5. Its ability to convert stock into sales is higher and this is important in revenue generation. It also has a higher asset turnover throughout the recent five years of operations. Although it is more efficient it generates a very small amount of profit at the end of each financial year.

Efficiency ratios for ENGRO FOODS

6. Summary of the Ratios Result

This is a very important report that compares NESTLE company and ENGRO FOODS. All these companies operate in milk processing product industry. Financial ratios are used as a tool for comparing their financial performance. The result of the analysis shows that NESTLE company is more profitable than ENGRO FOODS because it has a higher profit margins although it is less liquid. The liquidity position of NESTLE company is less than 1 while of ENGRO FOODS is more than 1. This shows that it has the ability to meet its financial obligations than Nestle Company. Nestle has the ability to utilize its assets, equity capital and capital employed than ENGRO FOODS and that makes it able to generate a higher profit margin at the end of every financial year.

References

Groppelli A and Ehsan N (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433.

Houston, J and.Brigham, F. (2009).Fundamentals of Financial Management. [Cincinnati, Ohio]: South-Western College Pub. p. 90.