Accounting – 6.3 Inter-firm comparison | e-Consult
6.3 Inter-firm comparison (1 questions)
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.