The Predicted Future Success Or Failure Of Northern

Published Date: 02 Nov 2017

This report is based upon the comparative performance of Northern Housing Limited’s Profitability, Liquidity and Return on Investment using the company’s most recent financial statements covering the last two years of operations as per the attached as well as a review of the internal and the external factors affecting its financial performance and share price. Northern Housing is into real estate, building executive residential housing.

Profitability.

Profitability may be explained as the amount of income left after a company has settled or made provision for the settlement of all its liabilities and commitments. It can also be said as a measure of the company’s ability to earn income or revenue in excess of its operating costs. Among the ratios use are as follows.

Return on Capital employed

The absolute figure of profit achieved, is not in itself, significant since the size of the business earning that profit may vary greatly. It is significant to consider the size of the profit figure relative to the size of the business; size being expressed in terms of the quantity of capital employed.

The return on capital employed (ROCE) is the ratio which measures this relationship. It is the key ratio in assessing financial achievement. It reflects the earning power of the business operations and it’s the primary ratio because it is often the most important measure of profitability

Gross Profit percentage

This is the margin that the enterprise makes on its sales. Normally, this ratio is

expected to remain reasonably constant. The gross profit percentage may change over various accounting periods due to a change in some other factors such as price changes, increase in competition, changes in sales, changes in purchase cost as well as changes in production cost .

When gross profit percentage is low, it is an indication of poor performance but may be due to expansion cost (e.g. launching of a new product) or trying to increase market share

High profit percentages on the other hand are a sign of good management enven though it can attract other to join and compete for a share of the company’s profit.

Generally, industries with high volumes of sales and quick turnover rates like food retailing are able to support and sustain low margins while manufacturing industries with high operating overheads would normally have higher margins

Liquidity

Liquidity which refers to short term solvency, measure the ability of an entity to meet its current liabilities as and when they fall due. The following ratios have been considered:

Current ratio – this shows the ability or capability of the company to meet it’s pressing or short term liabilities as and when they fall due. It is a reflection of whether the entity is in a position to meet its liabilities as they fall due. A high current ratio shows that short term creditors can feel reasonably sure of receiving payment on due date. According to Chasteen et al, 1995 "Analysts view a low current ratio with concern because short term cash flow problems could force a company into bankruptcy. On the other hand, a current ratio that is too high may indicate poor management of liquid resources. Excessive current assets might be better used to pay dividends, to retire long-term debt, or as investment capital. The current ratio is assessed in line the policy of the company, as well as industry and general economic conditions" (Chasteen et al, 1995). Northern ratio under this indicates that, its current assets which when realized, can meet its liabilities 1.86 times and 1.12 times in 20x0 and 20x1 respectively

Traditionally, a current ratio of 2 or higher was regarded as appropriate for most companies to maintain credit worthiness. However in recent times, a figure of 1.5 may be regarded as the norm. Northern Housing Limited liquidity current Position is not encouraging, though it is worth nothing that the year 20x0 was better than the year 20x1. The situation has worsened in the year 20x1 because it reported 1.12 which is far below the norm.

One problem with the current ratio is hat current assets have varying degrees of liquidity. This is often avoided by computing liquidity ratio that more consider degree of current assets than the current ratio.

Acid Test – This is also known as Quick ratio because by eliminating inventories from the current assets, it provides quick test of whether the company has sufficient resources in terms of receivables and cash to settle its liabilities.

The acid test ratio of 1.10:1 in 20x0 is comparable to the norm of 1:1 but in 20x1 a ratio of 0.5:1 has gone below the recent practices, for the quick ratio norm ranges from 1 to 0.7.

The implication is that the current liabilities cannot be met from the current assets if inventories are excluded. This has to be improved, else creditors can mount external pressures on Northern limited’s liquidity if they all demand immediate payment of the amount due them. As a major part of the current liabilities in 20x1 is the bank overdraft of £875,000 meaning the company is obviously depending on the Bank Continuing support with short term funding. It would be useful if terms of bank funding and the projected cash flow requirements for future funding are established.

Debtors’ collection period - This measures how long; on the average it takes the company to collect its debts. In general, when debt kept too long before payment is made then it is prone to be irrecoverable. It is also advisable to have a shorter debtor’s collection period than the creditor’s payment period.

Debtor’s collection period of Northern limited has increase from 66days to 79 days of 20x1 over that of 20x0. This indicates inadequate credit control procedures of Northern limited.

Creditors collection period – This measures the average time taken to pay creditors. This is very short unless there is a good reason for this rapid payment should be extended. Too long a payment period may be an indication that the company’s has cash flow problems.

Powel (2000) submits that there are a few cautions when interpreting this ratio. On the surface, an increase in this period is a good thing; the company has increased its usage of this free source of finance. However, it may be not having been a conscious policy to extend the average period of credit taken; it may be a necessary due to a cash flow problem. Perhaps the company does not have the available funds to settle its debt on time. The company’s cash flow statement should be analyzed in conjunction with this ratio.

In addition, deliberately extending the credit period may not be without cost. The company may have to forgo discounts for early settlement; if the credit period is extended too far, the supplier may refuse to supply; or the supplier may impose penalties such as demanding that the company pay a deposit up front before any supplies are made, or insisting on cash-on-delivery.

Creditor’s collection period of Northern limited has increased from78days to 105days, this may seem favourable, however it may tarnish its reputation with its suppliers in future and they may feel reluctant to grant credit to the company if the trend persist.

It’s obvious that Northern limited has cash flow problems since it is recently depending on overdraft facility. This problem must be rectified in order to restore a well relationship between its supplies.

Stock turnover – this is a measure of stock activity during the period. It shows how quickly inventory is sold. A steadily declining indicates a decline in operating efficiency, poor marketing or an obsolete stock. Low stock turnover ratio may indicate slow-moving sales or too much stock on hand, with related increases in cost of holding stocks. Again, the amount of time it takes to turn over stock is a good indicator of a company’s cash inflow prospects. High stock turnover may indicate that there are problems with stock outs, leading to peeved customers. Such problems may necessitate an increase in stock levels. Northern Limited recorded average stock turnover of 4 times in 20x0 and a slight decline of 3.9 times in 20x1. This implies that on the average Northern sells its finished stocks and get them replaced about 4 times in a year.

An alternative is to express this in reference to the number of days, weeks or months it has to take for finished stocks to be sold and replaced. Northern yearly stock turnover indicate 89days in 20x0 and increased to 92 days. The increasing number of days implies that the inventory is turning over less quickly. This may be regarded as a poor sign because:

It may show poor stock control and associate costs of holding and insurance.

It may reflect poor or lack of demand for the products

It may also lead to deterioration in stocks

There may be spoilage, obsolescence and write offs

On the other hand, it may not necessarily be bad or poor where

Northern has increased stock levels to avoid shortages

Northern limited wants to take advantage of increase in price levels or

Buying in large volumes to benefit from discounts or price fluctuations.

Return on investment

This is a measure of the earnings per every pound of investment made. It shows how effective management has utilized the resources of the company to generate income. Among the ratios considered are as follows:

Return on Total assets – this shows the productivity of total assets and the higher the figures the better the performance is perceived. Northern Limited return on total assets show that its management has not being able to utilize its assets well in generating returns for the company because there was a consistent decline in the return on total assets from 8.3% to 6.6%.

Return on Net Assets – this shows how efficient management were in turning much of the company’s sales into profit on overall net assets. The higher the ratio the better. Northern limited recorded a decline in the return on net assets from 10.3% to 9.4%. This also shows that management performance of the company in this respect is on the declined.

Asset turnover – total assets this shows the efficiency of assets utilization in generating sales. Northern recorded a marginal increased in Asset turnover in the year 20x1 over the year 20x0 of 1:5 times in net assets turnover and 0.78 times in total assets turnover.

This means that every pound

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