Financial and Operational Analysis
Competition Bikes Incorporation is a manufacturer of sports cycles and is a famous brand among professional cyclists. This report presents a financial and operational analysis for Competitors Bikes Incorporation for the past three financial years, which include year 6, 7 and 8. The financial analysis presented in this report includes horizontal and vertical analysis of the three years’ income statement and balance sheet of Competition Bikes Incorporation, trend analysis of sales including sales forecasting for the next three years and ratio analysis. In the ratio analysis of the company, comparative analysis has been conducted by keeping in view the ratios for Competitor Bikes Incorporation’s major competitor “Two Wheel Racing”. On the other hand, the operational analysis includes analysis of working capital of the company, evaluation of internal control of the company with respect to the purchasing department and its operations and evaluation of Competition Bikes Incorporation’s compliance with the requirements of Sarbanes Oxley Act. Each of these analysis and evaluations are presented in sequential manner in the following sections.
Horizontal Analysis of Competition Bikes Incorporation’s Financial Statements
Keeping in view the horizontal analysis for Competition Bikes Incorporation for the last three years, it is observed that the company has managed to increase its sales in 7th year in comparison with 6th year, i.e. from $ 4,485,000 in 6th year to $ 5,980,000 in 7th year, which represents an increase in sales by $ 1,495,000. At one hand, sales revenue for the company has increased considerably, but on the other hand cost of sales also increased significantly as there were increased units sold by the company. However, it can be noted that the increase in cost of sales for the company from 6th year to 7th year is lower than the increase in the sales revenue for the company. Apart from this, there is also a significant increase in the selling expenditures of the company, due to increase in advertisement expenses. In addition, due to increase in research and development activities of the company, the general and administrative expenses also increased in year 7. Lastly, it is also pertinent to note that the net income of the company increased by a significant percent in the year 7 due to comparatively lower percentage of the operating costs to gross profits and also due to decrease in the interest and tax expenditures. The horizontal analysis for year 8 shows contrasting findings as to the findings obtained for year 7. The sales revenue for the company declined in year 8 in comparison with the increase in year 7, and as a result there is a corresponding decline shown in cost of goods sold, gross profit and selling expenses for the company in year 8. However, the general and administrative expenses showed slight increase in year 8 (Brigham & Houston, 1998; Noreen, Brewer, & Garrison, 2011).
As far as balance sheet items are concerned, from year 6 to 7, the current assets increased from year 6 to year 7 by 31.5 %. Among this increase, the most significant increase was noted in the accounts receivables of the company, which can be attributed to increased sales volume. From year 7 to 8, the increase in current assets fell by 50 percent and as a result the increase remained to 16.5 %. However, it can be observed that the cash and cash equivalent increased significantly, i.e. by 348.2 % in year 8. On the other hand, non-current assets of the company, which include property and equipment, showed no increase at all in any item from year 6 to 7 and also from year 7 to 8, except from the accumulated depreciation. The rise in accumulated depreciation is due to the annual depreciation expense which is accumulated in the balance sheet of the company (Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010).
The liabilities and equity section of the balance sheet shows increase current liabilities of Competition Bike Incorporation by 122.4 % in year 7 as compared to year 6, primarily due to considerable increase in the accounts and notes payable, whereas the current liabilities increased in year 8 as compared to year 7 only by 28.5 %. The long term liabilities section has shown consistent decrease in the mortgage payables and other long term liabilities of the company. This trend has been similar in the past three years for the Competition Bike Incorporation. On the other hand, equity portion of the balance sheet shows no significant change in the comparative proportion of the items included therein, apart from the slight changes noted in the retained earnings of the company in year 8 and 7 (Jiambalvo, 2010; Noreen, Brewer, & Garrison, 2011; Arnold & Kumar, 2008).
Vertical Analysis of Competition Bikes Incorporation’s Financial Statements
In order to conduct a vertical analysis of financial statements, each item in the income statement is expressed as a percentage of net sales, and in case of balance sheet’s vertical analysis, each item pertaining to assets side of the balance sheet is expressed as a percentage of total assets and each item pertaining to equity and liabilities is expressed as a percentage of total equity and liabilities of the company (Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010; Brigham & Houston, 1998). Keeping in view the vertical analysis of Competition Bikes Incorporation, there is no significant change noted in the cost of goods sold, gross profit, selling expenses and general and administrative expenses of the company as a percentage of net sales for the three years under consideration. The items falling under the general and administrative expenses head, however, have shown slight changes in their respective proportions to sales during the three years under consideration. As for instance, there are changes observed on a consistent basis in the admin salaries, compensation of executives, utilities expenses, depreciation expenses and other general and admin expenditures of the company during the course of past three years. Considering these changes, it can be stated that from year 6 to 7, there is a downward trend which implies decline in the proportion of expenses incurred under general and administrative expenditures head, and from year 7 to 8 the trend is an increasing one, which implies that there has been a proportionate increase in these expenditures. These observations in turn imply that year 7 has been the most efficient year for Competition Bikes Incorporation as far as management of expenditures is concerned. Similarly, the net profits of the company have also been highest in proportion to sales in year 7 as compared to year 6 and 8 (Needles & Powers, 2010; Noreen, Brewer, & Garrison, 2011; Brigham & Houston, 1998).
As far as balance sheet is concerned, there has been a gradual increase in the current assets’ proportion to total assets, due to increase in cash reserves and accounts receivable. On the other hand, there is a contrasting finding for non-current assets, as there proportion has declined with respect to total assets due to depreciation of assets. Similar trends can be noted for current and non-current liabilities respectively. As far as equity is concerned, there has been slight increase in the total equity of the company in relation to total equity and liabilities. This increase can be attributed to increase in retained earnings of the company (Brigham & Houston, 1998; Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010).
Trend Analysis of Competition Bikes Incorporation
Trend analysis is carried out by considering the percentages of trends relating to certain variables or financial performance indicators. The significance of trend analysis is that it is helpful in conducting a comparative analysis of financial information pertaining to a long period, which may include a number of financial years. The trend analysis shows changes in a financial performance indicators or any other variable over a given period of time under consideration. The trend analysis is also considered as a forecasting tool with respect to a number of variables. In order to conduct trend analysis, one has to select a year amongst the given years as the base year and compare the information pertaining to other years with respect to that base year. The values in base year are given 100 % and any favorable or unfavorable changes in the values of other years are expressed in percentages relative to the base year’s values and percentages (Needles & Powers, 2010; Noreen, Brewer, & Garrison, 2011).
As far as the information relating to net sales of the company is concerned, a comprehensive trend analysis has been carried out. The trend analysis carried out has been conducted while taking into account net sales amount for the 6th year as base figure. In this manner, the analysis conducted reveals that net sales for the company have increased considerably, i.e. by 33 % in the 7th year, whereas in 8th year the increase has been 13.3 % relative to the net sales for 6th year. This in turn implies that the increase in net sales or growth of sales on annual basis in comparison with year 6 has been 33 % and 13 % for year 7 and year 8 respectively. In addition to this, the forecasted sales growth rates have also been determined for year 9, 10 and 11. These forecasted sales growth rates have been determined by keeping year 8’s sales figures as base figures. In this way, the forecasted sales growth rates have been determined to be 3.2 % 4.4 % and 4.2 % for year 9, year 10 and year 11 respectively. Although there are varying growth rates for each of the forecasted years, but it can be stated that there is an increasing pattern noted for net sale of the company in the years to come, while keeping year 8 as the base year. The analysis of sales trends during the past three years, however, show that there has been no consistency in growth of sales and there has been a significant decline noted in year 8 in this regard. Having said this, it is recommended that management shall strive for lowering down the manufacturing costs and other costs associated with selling products, which in turn will result in increase in profits. In this manner, it will be possible for the company to maintain consistency in its profits’ growth (Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010; Arnold & Kumar, 2008).
Ratio Analysis of Competition Bikes Incorporation
Having reviewed the financial statements through horizontal and vertical analysis, this section turns to ratio analysis of the information presented in the financial statements of Competition Bike Incorporation. From the horizontal and vertical analysis, it has been concluded that the financial performance has been on a declining side for Competition Bike Incorporation. The ratios calculated for the company are also presenting a similar analysis. The current ratio and acid test ratio for the company show a declining trend, i.e. 5.79 in 7th year and 5.25 in 8th year for current ratio and 4.41 in 7th year and 4.14 in 8th year for acid test ratio. The comparison of these values with Two Wheel Racing’s current and acid test ratios 4.20 and 3.20 respectively shows that Competition Bikes Incorporation is still better off than its competitor. The primary reason behind this decline in liquidity position of Competition Bikes Incorporation is that the current assets of the company increased by 16.5 % whereas current liabilities increased by 28.5 % in 8th year. These considerable changes in the proportions of current assets and liabilities have caused the liquidity position of the company to deteriorate (Needles & Powers, 2010; Noreen, Brewer, & Garrison, 2011).
The next ratio determined is average collection period, which has remained same in year 8 as it was in year 7, i.e. 43.8; however, it is pertinent to note that this ratio for Competition Bikes Incorporation is considerably higher than the competitor’s ratio, which is 32.5. This difference shows that the competitor Two Wheel Racing is able to collect its amounts receivable more swiftly than Competitor Bikes Incorporation, thus implying that Two Wheel Racing is more efficient in its receivable collection than Competition Bikes Incorporation (Needles & Powers, 2010).
The debt ratio of the company has declined in year 8 as compared to year 7’s debt ratio; however it is worth noting that this ratio is considerably higher than that of Two Wheel Racing’s debt ratio of 38.0 % (Needles & Powers, 2010; Noreen, Brewer, & Garrison, 2011).
The profitability ratios on the other hand, which include gross profit margin, operating profit margin, net profit margin, earnings per share, return on total assets and return on common equity are signifying significantly lower results for Competition Bikes Incorporation as compared to its competitor. One main finding, which has also been noted in the horizontal analysis, is that the performance of the company has declined in year 8, particularly profitability. The primary reason behind the decrease in profitability is a significant decrease in the sales revenue, i.e. 15 %. Although there has also been a similar decline in the cost of sales for the company, but the decline in sales has been such that it has resulted in a significant decline in company’s profitability ratios. It is due to this reason that all profitability ratios have shown a declining trend. Moreover, notwithstanding insignificant decreases in total assets and common equity of the company, returns on total assets and common equity and earnings per share have declined due to decline in net profits in year 8. Similarly, price earnings ratio also declined due to decline in the stock prices of the company, which is also lower than the competitor’s ratio (Noreen, Brewer, & Garrison, 2011).
Lastly, the times interest earned ratio for the company decreased significantly. As can be noted in the income statement of Competition Bikes Incorporation, the net interest expense has decreased from year 6 to year 8, but at the same time declining trend in net profits has resulted in a decrease in the times interest earned ratio for the company. This decline is representative of the fact that the ability of Competition Bikes Incorporation to cover its interest expenses through net profits is on a declining trend (Jiambalvo, 2010; Noreen, Brewer, & Garrison, 2011).
Analysis of Competition Bikes Incorporation’s Working Capital
The working capital of a business enterprise is an important area of concern for different stakeholders of the business (Needles & Powers, 2010). Effectiveness and efficiency in relation to working capital is always considered as a promising and favorable sign by the stakeholders and therefore give the business a better standing in the market. Normally, working capital is determined by subtracting current liabilities of a business from its current assets (Noreen, Brewer, & Garrison, 2011). As far as working capital of Competition Bikes Incorporation is concerned, there is a consistent increase noted in the working capital from year 6 to year 8. The working capital for Competition Bikes Incorporation for year 6, 7 and 8 has been $ 924,223, $ 1,119,344 and $ 1,275,631 respectively.
As has been noted earlier in the liquidity ratios, Competition Bikes Incorporation’s liquidity position declined in year 8 due to the fact that there has been a significant rise in current liabilities as compared to increase in current assets of the company. On the contrary, however, working capital has been observed to be on a rising trend. But it is important to determine what factors are leading to the increase in working capital. The primary factors which can be viewed as contributing in the increase in working capital available for use by the company include accounts receivables and cash reserves of the company. Since the sales volume has increased considerably as compared to year 6, therefore there is a significant increase in receivables of the company. On the other hand, cash has also increased as per the financial statements of the company primarily due to the increase in sales revenue and also due to increase in current liabilities, as indicated by increase in accounts payable. Having considered these areas, it can be stated that Competition Bikes Incorporation can use its excess cash reserves to pay off its payables and can become entitled to the discounts offered to it by creditors. Moreover, it can also be observed that the cash reserves of the company have grown considerably by the end of 8th year due to significant increase in its accounts payable, which are reflective of the fact that the company is not giving particular attention towards the payment of accounts payable. It is also worth noting here that there has been a significant rise in the net sales of the company in year 7 as compared to year 6, but it is suggestive of the fact that the company has not opted to pay off its accounts payable. This in turn implies that the working capital of Competition Bikes Incorporation is not being managed in an efficient manner, because the company is not able to pay its current liabilities on a timely basis because of inefficient recovery of amounts owed to it by its debtors (Arnold & Kumar, 2008).
In order to use working capital which is in excess of the needs of the company, there are a number of options. Some of these options are listed as under:
- The foremost opportunity is to pay off any bills of the company which are still pending and decrease the overall amount of current liabilities.
- The company can make use of excess working capital by investing it in short term investments and earn a steady income in return.
- The company can make use of excess working capital by purchasing more inventory and stocks.
- The company can pay off short term loans and their associated borrowing costs.
- Even if there are no short term borrowings to be paid off by the company and there are no opportunities for making short term investments, the company can still make use of its excess working capital to pay its expenses in advance or look forward towards the expansion of its operations.
By capitalizing on these opportunities, a company can improve its working capital management and in turn influence its profitability and overall efficiency in relation to operations in a favorable manner (Arnold & Kumar, 2008; Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010).
Evaluation of Competition Bikes Incorporation’s Internal Control
As far as the purchasing system of Competition Bikes Incorporation is concerned, it is an integral part of the internal control system of the company. The purchases of raw material are made on the basis of estimates made by management regarding the potential use and demand of the raw material in production. At present, the review of internal control procedures pertaining to purchase department of the company are indicative of the fact that there are no specific separation of responsibilities among purchase department staff and as a result all steps involved in carrying out a purchase are under the authority of a single employee. This lack of segregation in duties may result in significant losses for the company as it entices the related staff members to embezzle with resources, order unwanted stocks, put resources purchased to personal use, misappropriate records and cash, etc. In addition to this, there is no statement of the fact that there is any system in place for ensuring inventory count and management, which in turn poses risks of inventory items being misappropriated by the purchase department staff members (Jiambalvo, 2010; Noreen, Brewer, & Garrison, 2011).
Moreover, as has been noted in the previous section, which pertains to analysis of working capital of Competition Bikes Incorporation, the company has not been efficient enough in maintaining an effective working capital level. This observation is also evident from the fact that there is a significant portion of raw materials included in the current assets of the company, which is obviously reflecting inefficient and risky act by the management. Since there are continuous advancements in production processes and material needs, there is always a chance that materials considered necessary today may become completely irrelevant tomorrow, thus resulting in a loss for companies which hold large quantities of raw materials. Based on these observations, it is suggested that the management shall look into this matter and consider making budgets for raw material requirements for small periods, so that any risks associated with holding large quantities of inventory can be mitigated in this way (Noreen, Brewer, & Garrison, 2011; Jiambalvo, 2010).
It is also pertinent to mention here, however, that even if budgets are made on sound basis, maintaining small quantities of raw material are still full of risk; for example, a client places an order with the company for a large quantity of bikes and the company has its usual stock levels, the gap between stock levels and order size may result in the inability of company to meet order requirements and thus lose a profitable order. Keeping in view these difficulties associated with inventory management, it is pertinent that an optimum level of stock is determined and maintained at all times by the company. In this regard, it is suggested that the company shall consider maintaining minimum levels of stock which can be determined by considering the quantity of raw material or inventory required and the time it takes for suppliers to deliver the materials. In this way, the company will be able to have an idea of how long it takes for it to prepare for taking a large order, and whether it can actually be able to take that order or not (Brigham & Houston, 1998; Noreen, Brewer, & Garrison, 2011; Needles & Powers, 2010).
Therefore, in short, for the purpose of ensuring that internal control system is effective, the management of the company shall make sure that responsibilities are segregated among employees and no one person is serving as a sole authority in any position. In this way internal control’s effectiveness can be ensured, which results in detection and prevention of fraudulent activities. Moreover, it is also important that the internal audit department of the company oversees the activities of purchase department and ensure that there is an appropriate manner in which transactions are approved and authorized before being processed (Jiambalvo, 2010; Arnold & Kumar, 2008).
Evaluation of Competition Bikes Incorporation’s Compliance with Sarbanes Oxley Act
With the introduction of Sarbanes Oxley Act and its underlying requirements in the United States back in the year 2002, there have been significant changes noted in the manner in which business operations are conducted, which are aimed at maintaining a socially responsible corporate image of the businesses and ensuring compliance and adherence to the ethical values of the society. This is because businesses that are unable to meet the ethical requirements are bound to suffer losses in the days to come.
As per the regulations included in the Sarbanes Oxley Act 2002, every publicly traded business entity is bound to comply with the requirements of the Act. Since Competition Bikes Incorporation’s stocks are traded on a stock exchange that implies that the company is a public company and is therefore obliged to comply with the requirements of the Act (Rockness & Rockness, 2005).
Competition Bikes Incorporation shall introduce ways and plans to overcome the issues related to its internal control. At present, the company does not have an effective internal control established for monitoring purchasing activities, receivable and payable operations. For bringing improvements in relation to these activities, it is pertinent that the company introduces measures and policies for the concerned staff members. In this regard there are certain measures which the management can take to make sure that activities are monitored and overseen in an effective and efficient manner. These measures may include:
- Segregation of Responsibilities of Employees: This will ensure that no unauthorized or fraudulent activity is being carried out;
- Authorization and Approval: This will prove to be deterrence against theft, fraud and will improve the management of inventory items; and
- Accountability and Security: This will ensure that there misappropriation of assets and misuse by employees, and also it will also ensure proper record keeping of the assets and related operations and information.
Competition Bikes Incorporation can improve its compliance with the regulations of Sarbanes Oxley Act by introducing enhanced participation and oversight from the board of directors and the committees established for overseeing the compliance and auditing matters relating to the company. If Competition Bikes Incorporation’s management manages to establish compliance with the provisions and regulations identified under the Sarbanes Oxley Act 2002, the profitability and market prices of its stocks are expected to improve due to more confidence gained by investors due to quality financial reporting by the company and compliance with legal and regulatory requirements and frameworks (Rockness & Rockness, 2005).
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