ACC 2501 : Financial Accounting : Financial Statements of the Business

In general, profitability ratios help in the measurement of the efficiency of the businesses for turning business activities into profit. Profit margins help in assessing the company’s ability in turning revenues into profit. More specifically, gross profit margin helps in analyzing the ability of the companies for making money using their products and services when the cost of goods sold are taken out (Lartey, Antwi & Boadi, 2013). At the same time, net profit ratio helps in measuring the ability of the companies in making profit. Return on assets helps in the measurement of the ability of the companies in using the assets for producing net income. These asset scan be cash and cash equivalent along with physical items with intangible value such as plant and machinery, building and others. A high return on assets is favorable for the companies. Return on equity assists the companies in comparing the net incomes to the shareholders’ equity. The analysis of this ratio helps in the measurement of the efficiency of the companies in using their investments for earning profit. Thus, a high return on equity implies that the company is optimizing the investment of the shareholders that leads to the increase in value of ownership in the company (Ehiedu, 2014).

Calculation of Return on Assets (ROA) and Return on Equity (ROE)

Liquidity Ratios

Liquidity is regarded as the capability of the business organizations in meeting their short-term financial obligations. Effective measurement of liquidity ratios helps the management of the companies in taking proactive actions in order to avoid the burden of debts and expenses. In order to generate profit, it is needed for the businesses to bring in more than sufficient revenue so that it can cover the fixed as well as variable costs (Delen, Kuzey & Uyar, 2013). High liquidity indicates that the company has a strong cash and current account position for covering the short-term debt obligations. Current ratio is a major tool for the companies as this helps the companies in measuring their current assets to the current liabilities. Current assets include cash and accounts that can easily be converted into cash. Current ratio assists in measuring the company’s ability in covering the short-term debts. Another major liquidity ratio is Quick or Acid Test ratio and this ratio helps the companies in determining the short-term financial security of the businesses (Babalola & Abiola, 2013). This ratio helps in measuring the capacity of business in paying off current debt with other assets. It also shows the businesses the need of inventory for creating sales and generating revenues.

Calculation of Current Ratio and Quick or Acid Test Ratio

Debt Ratios

Debts ratios assist the business organizations in measuring the extent to which the business organizations use debt for funding their business operations along with the ability of the business organizations to pay these debts. Thus, the investors consider debt ratios of great importance as their investments in the companies can become in great risk in case the level of debt is too high. At the same time, the lenders use these rations for the determination of the extent to which the loans can be at risk (Makori & Jagongo, 2013). Two major debt ratios are Debt ratio and Deb to Equity ratio. The calculation of debt ratio is done by dividing total debt by total assets. A high debt ratio indicates that the company is using term debts for primary financing of their assets more willingly than equity and it is a risky technique. The calculation of debt to equity ratio is done by dividing total debts by total equity. This ratio helps in measuring the fact that if the financing is coming from a term debts. Investors and lenders prefer to have the presence of large equity stake in the business (Komala & Nugroho, 2013).

Calculation of Debt Ratio and Debt to Equity Ratio

Comparison of the Ratios of Wesfarmers and Woolworths

The following discussion shows the comparison of the financial rations of both Wesfarmers and Woolworths to reach to the investment decision:

Profitability Ratios: Two main rations under profitability are Return on Assets (ROA) and Return on Equity (ROE). ROA is a major probability ratio that helps in measuring the efficiency of the business organizations in managing their assets in producing profit during the year. Thus, a higher ROA is preferable for the companies. As per Table 1, Wesfarmers has higher ROA than Woolworths; that is 7.10 percent as compared to 6.87 percent. It shows the superiority of Wesfarmers over Woolworths in ROA. On the other hand, ROE is another major profitability ratio that measures the capability of the companies in generating profit from the investment of the shareholders. The investors want to see higher ROE from the business. According to Table 1, the ROE of Woolworths is higher than the ROE of Wesfarmers; that is 16.13 percent as compared to 12 percent. Thus, from this perspective, Woolworths is preferable for the investors (Edwards, 2013).

Liquidity Ratios: Two considered ratios under profitability are Current ratio and Quick or Acid Test Ratio. Current ratio is an important liquidity ratio that shows the ability of the companies in paying off its short-term liabilities with current assets. Investors favor a higher current ratio that a lower one as it indicates towards the ability of the company in making current debt payment more easily. Table 2 shows that Wesfarmers has stronger current ratio than Woolworths as Wesfarmers has 0.93 and Woolworths has 0.79 as their current ration. It indicates that Wesfarmers has stronger liquidity position than Woolworths based on current ratio. At the same time, Quick or Acid Test Ratio helps in measuring the ability of the companies in paying off their short-term liabilities with quick assets. Table 2 shows that Woolworths has slightly higher quick ratio than Wesfarmers, both the companies can be considered as having almost same quick ratio (Weil, Schipper & Francis, 2013).

Debt Ratios: In this context, two considered ratios are Debt ratio and Debt to Equity ratio. Debt ratio shows the ability of the companies to pay off their liabilities with the assets. In addition, it helps in measuring the total liabilities of the companies as a percentage of total assets; and a lower debt ratio is preferable to the investors. As per Table 3, Wesfarmers has lower debt ratio than Woolworths; that is 0.40 as compared to 0.57. It implies that Wesfarmers use fewer debts for their business and relies more on the issue of equity shares. This is preferable for the investors. On the other hand, the debt to equity ratio helps in showing the percentage of company financing coming from creditor ad investors. A higher debt to equity ratio shows the use of banks loans by the companies rather than equity shares. Table 3 shows that Woolworths has higher debt to equity ratio than Wesfarmers; that is 1.32 as compared to 0.68. It implies that Woolworths is highly leveraged than Wesfarmers that makes Woolworths more risky (Beatty & Liao, 2014).

Recommendation: The above discussion indicates towards the fact that both Wesfarmers and Woolworths have certain financial strengths and weaknesses. When considering the profitability position, Wesfarmers has higher ROA where Woolworths has higher ROE. While considering liquidity position, the superiority of Wesfarmers can be seen as it has higher current ratio along with almost same quick ratio. Lastly, in case of debt position, Wesfarmers has superiority over Woolworths as the they have financed their business with more equity than loans that makes their business less risky. Thus, on the basis of the above discussion, it is recommended to the investors to buy the shares of Wesfarmers instead of Woolworths.

Performance Measurement compared to the Industry

The following table shows the performance of Wesfarmers and Woolworths as compared to the industry average:

It can be seen from the above table that the financial ratios of both Wesfarmers and Woolworths have difference with the industry average and they are explained below:

ROA: According to the above table, the ROA of both Wesfarmers and Woolworths is below the industry average and it implies that both these companies are underperforming as compared to the whole retail supermarket industry. However, it can be seen that there is not huge difference of the ROA of these companies with the industry average (Henderson et al., 2015).

ROE: The above table shows that both Wesfarmers and Woolworths have higher ROE than the industry average and it implies that these two companies are efficient in using their equity investments for gaining higher return than the other companies in the industry (Warren & Jones, 2018).

Current Ratio: As per the industry average, companies should have twice the current assets of the current liabilities. However, results show that both Wesfarmers and Woolworths have lower current ratios than the industry and it implies that these companies do not have the required current assets to pay off their current business obligations (Narayanaswamy, 2017).

Quick Ratio: As per the above table, the quick ratios of both Wesfarmers and Woolworths are significantly lower than the industry average and it indicates towards the shortage of cash base of these two companies to pay off their short-term business obligations (Trucco, 2015).

Debt Ratio: As per the above table, the industry average for this ratio is high that is not good for the businesses. It can be seen that both Wesfarmers and Woolworths have lower debt ratio and it implies that they will not have any problem to repay their loans (Deegan & Ward, 2013).

Debt to Equity Ratio: The above able shows that the industry average for this ratio is high that indicates the large use of bank loans for business financing. Wesfarmers has lower debt to equity ratio that indicates towards the use of equity financing by the company. However, more than 1 debt to equity ratio of Woolworths shows the use of debt financing by the entity (Henderson et al., 2015).

Conclusion:

The above discussion involves in the analysis of the financial ratios of Wesfarmers and Woolworths. It can be observed from the above discussion that both of these two companies have mixed financial performance; that means both these companies have performed good as well as bad in certain areas. For example, Wesfarmers has better ROA where Woolworths has better ROE. However, the above discussion indicates towards the fact the Wesfarmers has the edge over Woolworths as Wesfarmers has performed well in maximum areas. After that, while compared the ratios of Wesfarmers and Woolworths with the industry average, it can be observed that in some areas, these two companies have performed well than the industry while in some areas, they have performed worse. For example, the performance of the debt structure of these two companies is better than the performance of the industry.

References:

Babalola, Y. A., & Abiola, F. R. (2013). Financial ratio analysis of firms: A tool for decision making. International journal of management sciences, 1(4), 132-137.

Beatty, A., & Liao, S. (2014). Financial accounting in the banking industry: A review of the empirical literature. Journal of Accounting and Economics, 58(2-3), 339-383.

Deegan, C., & Ward, A. M. (2013). Financial accounting and reporting: an international approach. Delen, D., Kuzey, C., & Uyar, A. (2013). Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), 3970-3983.

Edwards, J. R. (2013). A History of Financial Accounting (RLE Accounting). Routledge.

Ehiedu, V. C. (2014). The impact of liquidity on profitability of some selected companies: the financial statement analysis (FSA) approach. Research Journal of Finance and Accounting, 5(5), 81-90.

Henderson, S., Peirson, G., Herbohn, K., & Howieson, B. (2015). Issues in financial accounting. Pearson Higher Education AU.

Komala, L. A. P., & Nugroho, P. I. (2013). The Effects of Profitability Ratio, Liquidity, and Debt towards Investment Return. Journal of Business and Economics, 4(11), 1176-1186.

Lartey, V. C., Antwi, S., & Boadi, E. K. (2013). The relationship between liquidity and profitability of listed banks in Ghana. International Journal of Business and Social Science, 4(3).

Makori, D. M., & Jagongo, A. (2013). Working capital management and firm profitability: Empirical evidence from manufacturing and construction firms listed on Nairobi securities exchange, Kenya. International Journal of Accounting and Taxation, 1(1), 1-14.

Narayanaswamy, R. (2017). Financial Accounting: A Managerial Perspective. PHI Learning Pvt. Ltd..

Trucco, S. (2015). Financial Accounting and Alignment to Management Accounting in the Italian Context. In Financial Accounting (pp. 83-132). Springer, Cham.

Warren, C., & Jones, J. (2018). Corporate financial accounting. Cengage Learning.

Weil, R. L., Schipper, K., & Francis, J. (2013). Financial accounting: an introduction to concepts, methods and uses. Cengage Learning.

Wesfarmers (2018). 2017 Annual Report. Retrieved 25 August 2018, from https://www.wesfarmers.com.au/docs/default-source/default-document-library/2017-annual-report.pdf?sfvrsn=0

Woolworths Group (2018). 2017 ANNUAL REPORT. Retrieved 25 August 2018, from https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf