Introduction – Background Overview on Organisation Chosen The organisation chosen in this paper entails John Lewis Partnership. This is a well established firm, which is ranked as one of the top ten retail business in the United Kingdom. During the year under review, 2008, John Lewis had 69 department stores and 187 Waitrose supermarkets (John Lewis 2009, p 1). Financial Analysis The financial analysis of the aforesaid organisations will be classified in three main categories, which encompass the following: financial performance, financial position and financial stability.
This will be followed by a discussion of the weaknesses in ratio analysis and a recommendation of the most optimal company to invest in. Financial Performance of Company Chosen An increasing trend in the return on capital employed is portrayed for John Lewis. This implies that the level of efficiency of management in resource utilisation improved. A high and increasing return on capital employed is always desirable because it acts as a margin of safety during adverse industrial and economic periods (Randall 1999, p 463).
For instance, presently in England there is a severe economic recession, which is affected negatively the sales revenue of a number of retail companies. A high and increasing return on capital employed ratio, like the one at hand can safeguard the going concern of the company from such adverse economic conditions. Positive factors are also pinpointed for the operating profit margin, which is also increasing. This ratio indicates the operating profit generated out of every ? 100 of sales (McKenzie 2003, p 353).
Such increasing trend also substantiates the return on capital employed commented above. Reasons behind a rise in operating profit are better cost efficiency and/or a more favourable sales mix. The first reason outlines more effectiveness in management to utilise resources, which is a central element of the return on capital employed. The return on assets ratio, which outlines the ability of management to generate sales out of the assets employed is also shedding positive lights upon John Lewis (Randall 1999, p 467).
Indeed, an increase in such ratio is portrayed, which highlights better utilisation of resources to generate sales, which is the main element of income generation in the income statement. Therefore in view of the above ratios, one can contend that the profitability of John Lewis is improving during the time frame considered. Financial Position of Company at Hand The current ratio, which outlines the ability of current assets to cover current liabilities, has remained stable for John Lewis.
However, the acid test ratio, which denotes the capability of the most liquid assets to cover the current liabilities decreased for the organisation (McKenzie 2003, p 205-206). This implies that the management of liquid assets is deteriorating. These ratios portray the liquidity of the company in generic terms. In order to identify the reasons behind such decrease one has to apply other ratios specific on certain items present under the current assets and/or current liabilities. An important variable present for organisations engaged in the retail industry, like the one examined, is inventory.
Such firms tend to keep high stock of finished goods in order to hinder lost sales, which leads to money tied up in stock and greater risk of stock obsolescence especially for clothing and perishable goods. In this respect it is plausible to apply the days of inventory ratio. This ratio indicates the period (in days) taken for an organisation to sell its stock (Investopedia 2009). A decrease in such ratio is taking place for the firm. This indicates that management is more effective in stock management. Therefore one can state that stock is not the reason behind the working capital problems noted above.
Cash and cash equivalents are a vital element in a company that has to be considered in a financial analysis. In the absence of cash an organisation will perish in a few days. In this respect the cash debt coverage ratio is computed, which outlines the ability of operating cash flow to cover debt (Boise State University). An increase in the cash debt coverage ratio is noted for the organisation, which highlights an improvement in the aforesaid capability. Financial Stability of Firm Selected John Lewis is a high-geared company as indicated by the gearing ratio.
This is normally an adverse argument towards the financial stability of the organisation, because the higher the gearing ratio, the greater the amounts of debts. Such medium of finance necessitates higher financial commitments like interest and debt capital repayments (Pike et al. 1999, p 558). Therefore, if high, the risk of instability is greater during adverse trading conditions. The interest cover ratio, which portrays the ability of operating profits to cover interest expenditure increased for John Lewis (Randall 1999, p 472).
Therefore as regards John Lewis, despite it is a high geared organisation the financial stability is improving in light of a greater profit potential to cover long-term debt commitments, which are a central issue as noted in the previous paragraph. Limitations of Accounting Ratios The forthcoming conclusion in this paper is highly dependent on the accounting ratios computed. Thus it is important to outline the limitations of accounting ratios in order to comprehend the potential that such technique holds.
One of side stems the weaknesses of accounting ratios, which basically encompass neglection of qualitative characteristics and of economic factors present in the external environment like inflation (Weetman 2003, p 374). Another important aspect that affects ratio analysis is the one concerning the limitations of financial statement information, which is the basic medium on which vertical analysis is conducted. The lack of information present in such financial reports is one of the main reasons of such disadvantage.
A typical case in point is the limitation outlined in accounting policies in a section above. The latter category of limitations of vertical analysis arises from the additional information demanded by external users. In order to identify such factors, apart from attaining a list of these external users, it is also necessary to enter in substantial detail on the information needs of such parties. For instance, lenders like banks a good understanding of the grading provided to the financial health of the company at hand and security measures required ought to be outlined (Pike et al. 1999, p 558-559, 507).
In addition, lenders normally request additional information through other reports like business plans. In this respect, an examination of the key features of such reports is critical. Concluding Remark – Optimality of Organisation to Invest In In the financial analysis outlined above, John Lewis outlined strengths in both profitability and financial stability. The only financial weaknesses portrayed by John Lewis are in the liquidity section namely the quick ratio. Therefore overall the financial health of the organization is sound and is a good investment for equity investors.
In financial analysis there are two more important elements that one has to take into account. These encompass qualitative variables and investors attitude towards risk. In every business environment there are qualitative features that also hold importance in investment decisions. For instance, United Kingdom is presently passing through a severe economic recession that may increase the investment risk especially in the retail industry. John Lewis may commence experiencing sharp falls in sales revenue, which may lead to profitability, liquidity and stability problems.
Therefore the financial analyst together with the investor has to take into account such elements before taking a decision. The points noted above, both financial and qualitative also are closely entwined with the investor’s attitude towards risk. A risk-averse investor, which is an individual that is normally not willing to take risks, will probably decline the aforesaid investment decision even though the financial health of the company is good. This is due to the fact that the recession element noted above will increase the investment risk.
On the contrary a risk taker, which is an individual often, inclined to take additional risks, will probably invest in John Lewis despite the environmental risk noted above (Pike et al. 1999, p 234). Therefore in financial analysis one cannot be certain upon the investment decision since it is based upon personal features of the investor. The main role of financial analysis, which is central to this paper, is therefore to aid in the decision-making process by providing financial information pertinent to the investment decision.