Strengths and weaknesses of Rolls Royce - Essay Example

Contents Introduction 2 Financial Ratios 2 Analysis of the Financial Ratio 3 Gross Profit Margin 3 Operating Profit Margin 3 Net Profit Margin 4 Return on Ordinary Shareholders Funds 4 Gearing Ratio 4 Interest Cover Ratio 4 Earnings Per Share 5 Price-Earnings Ratio 5 Strengths 5 Weakness 6 Conclusion 7 References 8 Introduction Rolls Royce has been a pioneer in the motor car market for over 100 years. It continues to set the standard for motor cars in the industry. This paper identifies the strengths and weaknesses of Rolls Royce based on its various financial ratios. In order to do this, first the financial ratios of the company are analysed. Financial Ratios Profitability Ratios Gross Profit Margin (%) Operating Profit Margin (%) Net Profit Margin (Before Tax) (%) Net Profit Margin (After Tax) (%) Return on Ordinary Shareholder Funds (%) 2010 19.85 10.19 6.33 4.90 13.66 2009 20.27 11.27 28.39 21.29 58.62 2008 19.50 9.41 -20.83 -14.81 -52.70 2007 19.26 6.91 9.86 8.07 16.96 2006 22.76 9.67 19.44 13.89 36.57 Financial Gearing Ratios Gearing Ratio (%) Interest Cover Ratio 2010 82.55 1.28 2009 83.55 2.39 2008 77.26 0.27 2007 81.97 1.03 2006 84.17 1.39 Investment Ratios Earnings Per Share (p) Price/Earnings (P/E) Ratio 2010 29.2 0.04 2009 120.38 0.15 2008 -73.63 -0.09 2007 33.67 0.04 2006 57.32 0.07 Analysis of the Financial Ratio Financial ratios help to analyse the financial health of a company. Following is the analysis of the financial ratio of Rolls Royce: Gross Profit Margin Gross profit margin is an indicator of how %age of a sales dollar is left after the payment for the goods has been made. It is the actual mark-up on the goods sold. It is better for the company if it has a higher gross profit margin. Rolls Royce gross profit margin has been stable for the past 5 years. There hasn’t been much change in the gross profit margin of the company. This means that with respect to each unit of the product the margin has been consistent and hence the company has been effectively maintaining the process of manufacturing of goods (Pinson, 2008). Operating Profit Margin Operating profit margin indicates the profit margin after payment is made for goods as well as its fixed expenses and other variables. This again has been stable for Rolls Royce with no sharp changes. This means that company understands its business very well and is very effective in managing it. The company has knows how to efficiently manage the various processes of its business (Pinson, 2008). Net Profit Margin Net Profit margin is the actual measure of a company’s financial success. Net profit margin indicates how profitable the company is. Therefore, higher the net profit margin more profitable the company is (Brigham & Houston, 2009). Rolls Royce’s performance with respect to net profit margin has been very inconsistent over the past 5 years. There have been drastic differences in the net profit margin ratio of the company. Company has had a peak of 21.29% while a low of -14.81%. In 2010 net profit margin was 4.90%. This inconsistency irrespective of stable gross profit margin and operating profit margin is a concern for the company. Return on Ordinary Shareholders Funds Return on shareholders’ funds indicates the net income that an investor would get for their equity. This is another area of concern as the performance has been very inconsistent. In 2010 it has dropped to 13.66% from 58.62% in 2009. Gearing Ratio Gearing ratio compares the borrowed funds to that of owner’s equity. It is a measure of financial leverage. It is indicates how much of the business activities is funded by the shareholders funds to that of creditor’s funds (Ramsden, 1998). Higher the gearing ratio more vulnerable to company is to financial downturns. The gearing ratio of the company has been consistently high for the past 5 years and in 2010 was 82.55%. This is not good for the company as irrespective of the sales, the company has to continue paying towards its debts. Interest Cover Ratio Interest cover ratio indicates how difficult or easy it is for a company to pay interests towards its debt. Higher the ratio better the company is and lower the ratio the company paying interest is a burden to the company. 1.5 Or lower interest cover ratio mean that a company is finding it very difficult to meets its interest expenses (Peterson & Fabozz, 1999). In this case, the Rolls Royce’s interest cover ratio has been consistently under 1.5 and this is trouble. The company’s ability to pay off the interests is questionable. Earnings Per Share Earnings per share (EPS) are an indicator of a company’s profitability. EPS is the profit that each outstanding share gets (Parrino & Kidwell, 2009). The earnings per share have been inconsistent and indicate that the company has been not able to produce the same results using the same amount of equity. Price-Earnings Ratio Price earnings ratio is a valuation ratio that compares a company’s share price (current) to its earnings per share. This indicates how the company might perform in the future. Higher the price-earnings ratio means that a higher earnings growth can be expected and vice versa (Parrino & Kidwell, 2009). Rolls Royce’s earnings ratio is very low which means that its performance is not expected to improve. Strengths The only strength that company has demonstrated is with respect to its expertise in manufacturing of the goods. This is because the company’s gross profit margin and operating profit margin have been stable for the past 5 years. The company understand the process of manufacturing its products and has effectively used it to ensure that the operating costs have remained constant. This is shows the company’s expertise in the industry. It pays the appropriate value for the goods and services that go into the manufacturing of its goods. That is, it effectively manages the operating activities and is capable of achieving breakeven ad registering profits. Weakness The overall performance of the company has not been very good. The company’s sales have been on the decline as the net profit margin has been declining irrespective of gross profit margin and net profit margin remaining stable. The company has not been able to generate enough sales or is lagging in manufacturing the required number of goods. More importantly it is not able to manage its other activities that are contributing to lesser net profit margin. Return on Ordinary Shareholders Funds has not been consistent over the last five years. There have been peaks and lows in the span of 5 years. 2008 hit a low with -52.70% while 2009 saw a high 58.62%. In 2010 it again dropped to 13.66%. This is a major drawback for the company as the inconsistency in Return on Ordinary Shareholders Funds will negatively affect the shareholder’s confidence. As the shareholders lose confidence in the company, it will be very hard for the company to raise investments and attract new shareholders. This can affect the financial health of the company as it can affect the cash flow. There can be various reasons for the decline on return on ordinary shareholders’ funds such as recession, overall industry performance, etc., but investors do not look into these reasons and to them this is an indicator of company’ profitability. Decline in profitability rings an alarm for the investors. It is very much necessary for the company to attain a stable Return on Ordinary Shareholders Funds ratio. Small variations can be understood but in this case, the performance is very inconsistent and hence is a matter of concern for the management. Another major weakness of the company is its dependency on borrowed funds. Company’s gearing ratio indicates that in the last 5 years the company has been heavily dependent on the funds from outside sources to run the business rather than funds from shareholder equity. This is a major concern as irrespective of the sales and profits the company makes, it has to pay for its debts. This was company will find it very difficult to meet ends and carry out day to day operations. Also the company’s interest cover ratio has been less than 1.5 for 5 years (except for 2009). This is alarming as the Rolls Royce’s ability to pay interests for its outstanding debts is questionable. It has not been able to pay the interests that it has to efficiently. This will not just affect shareholder confidence but also affects the sources of investment in the form of loans. The cash flow will be negatively affected and the company will find it very difficult to keep the business activities going on as usual. Conclusion From the analysis of the financial ratios of Rolls Royce it is evident that company is financial health is not good and drastic steps need to be taken to revive its conditions. One of the major drawbacks of the company is the borrowed funds and its ability to pay for the services of these borrowed funds. Even though the company has expertise and the knowledge to effective manage its operational activities and satisfy its customers, it is not been able to generate the sales and funding needed to improve its financial health. References Brigham, E.F. & Houston, J.H. (2009). Fundamentals of Financial Management. OH: Cengage Learning. Parrino, R. & Kidwell, D.S. (2009). Fundamentals of Corporate Finance. PA: John Wiley and Sons. Peterson, P.P. & Fabozz, F.J. (1999). Analysis of financial statements. PA: John Wiley and Sons. Pinson, L. (2008). Anatomy of a business plan: the step-by-step guide to building your business and securing your companys future. CA: Aka associates Ramsden, P. (1998). The essentials of management ratios. VT: Gower Publishing, Ltd., Read More