Accounting Sample

Comparison of the performance of Diamond Ltd. and Pearl Ltd.


Diamond CompanyPear Company

Return on capital employed 12.95% 10.87%
Net profit margin 2.9% 2.3%
Volume of trade
Current ratio 2:1 2:1
Acid test ratio 1.37 1.42
Gross profit margin 24.46% 30%
Debtors collection period 40 Days 40 Days
Creditors payment period 33 Days 37.79 Days
Inventory turnover 2.8 times 85.31 times
Gearing 0.39 0.36
Net dividend
Dividend cover 5 times 4.07 times
Interest cover 32.8 times 37.67 times
Earnings per share 0.08 per share 0.069 per share

Interpretation


Liquidity ratios

The following liquidity ratios have been calculated in order to show the position of the company in terms of meeting its obligations to other parties. The obligations can be long-term or short term.

A. Current Ratio
For both companies, the current ratio was equal i.e. 2 implying that they both have $2 of their current assets to enable them meet $1.00 of their obligations or Current liability for the year. There is no difference between the two companies because the current assets are twice as much as the current liabilities in each of the two companies

B. Acid Test Ratio
The acid test ratio for Diamond was 1.37 compared to Pearl which had 1.42. This means that diamond has $1.37 of quick assets to meet $1.00 of its obligations. Pearl on the other hand has $1.42 of quick assets to meet $1.00 of its obligations. The possible reason for the difference is that Diamond might be carrying a lot of inventory which is moving slowly or its inventory has become obsolete with time. Pearl has fewer inventories as it is able to sell it as quickly as possible.

Efficiency ratios

A. Debtors collection period
Both companies have an equal debtors’ collection period of 40 days. Both companies take approximately 40 days to receive cash payment from their accounts receivable or credit sales.

B. Creditors payment period
Diamond pays creditors faster than pearl by a difference of 4 days mainly because it is more liquid. This is not good for Diamond as it does not extend the period to use the cash for operations.

C. Inventory Turnover ratio
Diamond has a 2.8 times inventory turnover compared to 85.31 times in Pearl. Diamond therefore uses 2.8 times of suppliers’ money in funding its sales while Pearl only uses 85.3 times suppliers’ money in funding its sales (Welch 2012). Pearl has a higher ratio because most of its working capital is financed by the suppliers than that of Diamond.

D. Return on Capital Employed
Diamond Company is able to generate a 12.95% return on its investments in capital provided by the owners compared to Pearl that generates a return of 10.87% on capital. The difference exists because it incurs less costs and expenses than Pearl.

E. Gearing Ratio
Diamond has a 0.39 gearing ratio compared to that of Pearl which is 0.36. Diamond is therefore highly geared than Pearl which could possibly arise because Diamond mainly finances most of its business operations from the fixed debt compared to that of Pearl

F. Interest Cover
Diamond can cover its interest 32.8 times compared to Pearl which can cover about 37.67 times using its profits. The difference might be as a result of Diamond paying a higher interest on fixed debts than Pearl.

Profitability ratios

A. Gross profit margin
Diamond has a 24.46% of its profits to cover all its overhead, other expenses on goods to be sold compared to Pearl that has only a 30% cover. Pearl, which has a higher gross profit margin, therefore has ability of making reasonable profits because it can cover its costs well enough thanDiamond. The difference could have been due to huge costs incurred for the production of Jewelry in Diamond than that of Pearl.

B. Net profit margin
Diamond Company makes $ 2.9 for every $1.00 of sales while Pear makes $ 2.3 for every $1.00 of its sales. Diamond is able to withstand falling prices/sales or any rising costs in future than Pearl Company. The possible reason for the lower profit margin in Pearl may be due to very high competition and high costs incurred by the company.

Shareholder Ratios

A. Dividend Cover
Diamond has a higher dividend cover of 5 times compared to Pearl which has a 4.07 times. It implies that Diamond has high earnings to pay for its dividends than that of Pearl. The possible reason for the difference could be that Diamond has higher earnings compared to that of Pearl and therefore has a high dividend cover ratio.

B. b) Earning per share (EPS)
Diamond has a higher EPS of 0.08 than that of Pearl which is 0.69 per share. It means that the shareholders of Diamond will be paid a higher dividend per share than those of Pearl. The difference between the two companies is because of high earnings difference between them for the period

Comparison to Industry


Interpretation


Liquidity ratios

A. Current Ratio
For both companies, the current ratio was equal i.e. 2 . This ratio is good because it is higher than that of the industry. The company can pay for its obligations comfortably.

B. Acid Test Ratio
The acid test ratio for Diamond was 1.37 and Pearl had 1.42. This means that they both have a higher ratio as the industry ratio is 1.27. Their quick assets can conveniently meet their obligations.

Efficiency ratios

A. Debtors collection period
Both companies have debtors’ collection period of 40 days which is higher than 30 days of industry. Both companies take an extra 10 days to receive cash payment from their accounts receivable or credit sales compared to other firms in the industry

B. Creditors payment period
Both companies have a lower payment period compared to 49 days, which puts them at bad position, they should extend their credit period.

C. Inventory Turnover ratio
Diamond has a cycle of 2.8 times and Pearl has 85.31 times. Diamond‘s 2.8 times of suppliers’ money in funding its sales is way below the industrial average of 4 cycles. However Pearl has a higher ratio than industrial average which puts in a good position

D. Return on Capital Employed
Diamond generates a 12.95% return on its investments and Pearl generates a return of 10.87% on capital. Both of them fall way below the industrial average of 18.50 %. This is not good performance, they should improve

E. Gearing Ratio
Diamond has a 0.39 gearing and Pearl which is 0.36. Both companies are higher than the 32.5% in the industry. They should lower their ratio as it may become very difficult to pay the obligations and instead increase their equity capital

F. Interest Cover
Diamond can cover its interest 32.8 times and Pearl is 37.67 times using its profits. This is higher than industrial average of 15%, which means both companies are at a better position

G. g) Volume of trade
Diamond has a lower sales volume of 1.3 to cover cost of goods sold compared to Pearl with 1.4. The difference is because Diamond has higher cost of sales than Pearl.

Profitability ratios

A. Gross profit margin
Diamond has a gross profit margin of 24.46% and Pearl has 30%, implying that it is less than the industrial average 35.23%. Both companies are way below the industrial average; however, Diamond has to work hard to improve its margin to meet the industrial average

B. Net profit margin
Diamond has a 2.9% while Pear has 2.3%.Both companies should improve their profitability margin as it is way below the industrial average of 15%. Otherwise, they may have problems in case of high competition and high costs incurred by the company in future

Shareholder Ratios

A. Dividend Cover
Diamond has a higher dividend cover of 5 times compared to Pearl which has a 4.07 times. However, they both do not meet the industrial average of 6 times. They should improve their cover to attract many investors and shareholders

B. b) Earning per share (EPS)
Diamond has a higher EPS of 0.08 than that of Pearl which is 0.069 per share. However, the industrial average is £0.20 implying that both companies are way below the industrial average ratio. They should improve their Earning per share (EPS) as it puts them in a poor position and shareholders may not be confident in investing in the two companies.

Usefulness of accounting ratio analysis

Ratio analysis facilitates understanding of the performance of a company from one period to another. For example, the profitability ratio calculated can be compared from one yea to another and if the profitability ratio is increasing from one period to another, it indicates improved performance.

Investment decisions by the shareholders are based on the shareholders ratios. For example, if the EPS is higher in one company than another, then an investor will prefer to invest his funds in the company with a higher EPS. They therefore expect high cash dividend at the end of the period. The lenders and creditors are interested in the liquidity ratios of the company and therefore can only lend to companies with a high liquidity ratio. High liquidity implies that it has sufficient cash to meet its both short term and long term obligations.

Ratio analysis can also be used to compare the performance of one company to another over the same period of time as long as they both belong to the same industry. This analysis can be used to understand how the competitors are performing to enable a company change its competition strategies.

It can also show the efficiency of the operations of a given company. Efficiency can be measured through the use of inventory turnover, the creditors’ payment period and debtors’ payment period (Bhatia 2011). This enables the management to assess its efficiency and make appropriate changes in its policies and operations to ensure profitability of the company is improved.

Limitations of Ratio analysis

Despite the usefulness of ratio analysis, it has been reported to be having various limitations it does not use qualitative data. Ratio analysis is more about computation of figures and therefore can only work with quantitative data. It does not measure other factors like employees’ morale and motivation which is crucial in determination of the performance of any company. This becomes a limitation as it assumes that performance is only measured quantitatively.

The ratios computed can be interpreted differently by different users. There is no specific standard of interpretation and therefore may cause confusion or lead to wrong interpretation of the results obtained. The ratios can only be compared to companies that belong to the same industry. For example, a bank can only be compared to another bank. In case the companies belong to different industries, ratio analysis cannot be used; instead, other measures of performance are to be used.

The accounting method should be similar and consistent throughout the period for the companies being compared. For example, if one company is using the straight line method of depreciation, it should apply it fro on period to another to ensure accuracy of measurement. The other company that it is compared to should also be using the same method of depreciation. Ratio analysis therefore cannot be applied in companies with inconsistent method of accounting.

Due to the limitation mentioned, one should evaluate the motivation of employees and the reputation of the company which will be crucial in assessing performance.

Recommendations to Dragons’ Ken Ltd. Co


Based on the computed ratios above and their interpretation, it is better for you to invest shares in Diamond Company instead of Pearl. Diamond is likely to pay a higher dividend due to its high earnings compared to Pearl.This will enable the company to have a share of the huge dividends paid by the company. However, it should be noted that, there should be a portfolio of investment in different companies from different industries. Do not invest all your money in both companies if you decide to invest in the Jewelry industry, instead, consider investing in a different industry to reduce the risks of one industry failing which may lead to huge loss of your investment.

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