All the firms under consideration are presently low-geared companies, as portrayed by the gearing ratio computed in this assignment. Gearing is a capital structure ratio that shows the proportion of equity to debt finance. Since the companies are presently low-geared, this means that the financial obligations like interest commitments are low, because debt finance is low. Therefore the higher the gearing ratio the greater the risks stemming from higher interest commitments, which an organisation may not meet during adverse trading conditions.
With only this ratio we cannot attain substantial evidence on the financial position of the organisations. Other stability ratios like for example interest cover should be applied to shed light on such matter. However, this accounting ratio provides good financial information on the funding decisions of the corporations. Since the firms are low-geared they can finance envisaged projects through debt finance. Debt finance is frequently desirable due to certain benefits like tax advantage. The interest payments stemming from debt finance are deductible from taxable profits leading to a lower tax charge.
This is not the case for dividend payments arising from equity. However, management should take particular on the amount of debt used, especially in light of the financial commitments arising from such finance medium. 1. 2. 4 Investment in Tesco PLC and J. Sainsbury PLC The earnings per share ratio again favours Tesco PLC since the ratio of this company is higher than the other firm, even though the increase of J. Sainsbury PLC was greater. This investment ratio amalgamates the profitability and the capital structure of the organisation.
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It portrays the total return per share value the shareholder will attain from the investment in light of the total earning made by the organisation. Since both firms are low-geared companies as noted in the previous sub-section, the earning per share will tend to be lower than high-geared corporations. This stems from the fact that the number of ordinary shares, which is the figure that divides the profits generated would be higher. The Price-Earnings Ratio is an investment ratio that outlines the confidence of the market in the organisation.
Such confidence is basically based on the envisaged capability to make future profits. For instance, the fall in the price-earnings ratio of both firms indicates that the capital market is expecting the future profits of both organisations to decline. Investors however, portray greater confidence in Tesco PLC in light of a higher ratio. 1. 3 Limitations of Ratio Analysis The first important weakness that comes to mind is the fact that accounting ratios fail to consider the qualitative characteristics inherent in the corporations and the external environment in which they operate (Petroff 2001).
Such qualitative elements, like organisation reputation and market reputation hold a substantial influence on the financial health of the firm. For instance, the companies operate in a very competitive environment in which a proactive approach is needed to client’s tastes. Such approach is not outlined through the financial analysis conducted in this dissertation. In addition, the ratios determined in this assignment are based on historical data, which may not be a mirror of the future. Thus the ratio analysis may not actually reflect what the companies would perform in the forthcoming years, since they are based on such figures.
This can be promulgated with the argument normally contended by critics of such accounting measurement bases that it fails to reveal management stewardship. Such critics challenge that this valuation scheme fails to provide detailed analysis of how successfully executive management administered the resources of the corporation. For example let us hypothetically presume that two companies started trading in a similar industry. Company A invested ? 3,000 in a particular good, while Company B spent the same amount of money in another commodity.
Let us further presume that during the accounting period under consideration no company sold any of the commodities purchased. At the end of this time frame, the good held by Company A increased by 7%, while that of Company B by 9%. This highlights that the management of Company B was more effective in the investment decision and added additional value to the company. Since under historical cost accounting, everything is measured at either historical cost or depreciated historical cost, such improved performance would not be reflected.
It is also important noting that ratio analysis fails to consider economic elements like inflation, which also influence financially the firms considered. Ratios are also static figures and only indication of a problem. Additional analysis is necessary to identify the financial strengths and weaknesses of the company. Another important element, which outlines the limitations of ratio analysis are the deficiencies present in the financial statements. In financial statements a number of items tend to be aggregated under one figure. For example, in the profit and loss account of Tesco PLC, the Administrative Expenses of ?
907 million in 2007 include all expenses relevant to such nature. It includes a combination of office overheads, directors’ remuneration and even depreciation. This refrains the financial analyst from making a valuable distinction between value adding and non-value adding activities. In addition, the aggregation of all the departments operating in the company in one account prevents the evaluation of the financial performance of each department. Certain products marketed by the companies considered are subject to seasonal variations during an accounting period. Such movements in sales may affect the liquidity of the firms.
The financial statements do not to provide information on such aspect, which may be significant mainly for organisations that have a very rigid working capital and cash flow. Financial statements also do not present financial information on a number intangible assets held by the company. For example, internally generated goodwill is not shown in the financial statements. Such item is unquestionably of high value to the organisation and its ommittance limits the value of financial information provided. 1. 4 Concluding Remark – Most Prominent Organisation in Financial Terms
The accounting ratios computed reveal that Tesco PLC is financially well especially on the aspects of profitability and financial stability. However the financial position is presently weak in relation to J. Sainsbury PLC. Yet since such deterioration is arising from material investment, which may in the long-term be beneficial to the company, Tesco PLC seems the most viable equity investment. The equity investors are also favouring Tesco PLC as revealed in sub-section 1. 2. 4, thus leading this company to be the most optimal investment decision on such facet.
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