Assessing the Expansion Opportunity using Financial Ratios

To assess whether the business should proceed with the expansion, we need to consider how the expansion will affect its financial ratios. We'll focus on the impact on profitability and solvency.

Profitability Analysis: The current profit margin is 10%. The projected annual profit increase is £30,000. We can calculate the new profit margin after the expansion:

New Profit Margin = (Current Profit Margin + (Projected Annual Profit Increase / Total Revenue))

Without knowing the current total revenue, we can't calculate the exact new profit margin. However, we can assume that the expansion will increase revenue. If the expansion is successful, the profit margin should increase. A higher profit margin is always desirable.

Solvency Analysis: The current debt-to-equity ratio is 0.6. This means that for every £1 of equity, the business has £0.6 of debt. The expansion requires a £200,000 investment. We need to consider how this investment will affect the debt-to-equity ratio. If the business finances the expansion with debt, the debt-to-equity ratio will increase. If it finances the expansion with equity, the debt-to-equity ratio will remain the same. The impact on the debt-to-equity ratio depends on the financing method.

Decision:

Based on the information provided, it's difficult to definitively say whether the business should proceed with the expansion. However, the projected annual profit increase of £30,000 is a positive indicator. To make a more informed decision, the business needs to:

• Estimate the total revenue increase resulting from the expansion.
• Determine how the expansion will be financed (debt or equity).
• Calculate the new debt-to-equity ratio after the expansion.
• Compare the new profit margin and debt-to-equity ratio to industry averages.

If the expansion is financed with equity and the new profit margin is higher than the industry average, and the debt-to-equity ratio remains manageable, then the business should proceed with the expansion. If the expansion is financed with debt and the debt-to-equity ratio becomes too high, or the profit margin does not improve, then the business should not proceed.

Ratio Calculations and Discussion

Alpha Ltd Ratios:

• Current Ratio: Current Assets / Current Liabilities = (Total Assets - Total Liabilities) / Total Liabilities = (£500,000 - £300,000) / £300,000 = 2. This indicates that Alpha Ltd has £2 of current assets for every £1 of current liabilities, suggesting good short-term liquidity.
• Debt to Equity Ratio: Total Liabilities / Shareholders' Equity = £300,000 / £200,000 = 1.5. This means that for every £1 of equity, Alpha Ltd has £1.5 of debt. This is a moderate level of debt.

Beta Co Ratios:

• Current Ratio: Current Assets / Current Liabilities = (Total Assets - Total Liabilities) / Total Liabilities = (£800,000 - £400,000) / £400,000 = 2. Similar to Alpha Ltd, Beta Co also has a current ratio of 2, indicating good short-term liquidity.
• Debt to Equity Ratio: Total Liabilities / Shareholders' Equity = £400,000 / £400,000 = 1. This means that Beta Co has £1 of debt for every £1 of equity. This indicates a lower level of financial risk compared to Alpha Ltd.

Implications:

Both Alpha Ltd and Beta Co have a current ratio of 2, suggesting they are both in a good position to meet their short-term obligations. However, Beta Co has a lower debt-to-equity ratio (1) compared to Alpha Ltd (1.5). This suggests that Beta Co is less reliant on borrowing and therefore has a stronger financial position and lower financial risk. While Alpha Ltd has a higher debt level, its strong liquidity provides a buffer. Overall, Beta Co appears to be the more financially stable company based on these ratios.

When comparing the financial statements of different companies, several problems can arise due to variations in accounting practices and business circumstances. Here are three key problems:

• Different Accounting Policies: Companies may use different accounting policies, even when reporting the same type of transaction. This can significantly affect the reported figures.

  Example: One company might use the FIFO (First-In, First-Out) method for valuing inventory, while another uses the weighted average method. This difference will lead to different cost of goods sold and ultimately different profit figures.

• Different Industries: Companies operate in different industries, which inherently have different financial characteristics. Comparing a high-growth technology company with a mature utility company is difficult.

  Example: A technology company might have high revenue growth but low profit margins, while a utility company might have stable, low profit margins. Direct comparison of profit figures would be misleading.

• Different Size and Scale: The size and scale of a company can influence its financial ratios. Larger companies may have different capital structures and operating efficiencies than smaller companies.

  Example: A large company might have a higher debt-to-equity ratio due to its larger borrowing needs for expansion, while a smaller company might have a lower ratio because it relies more on owner's equity. Comparing these ratios directly without considering the company size is problematic.