Financial Performance Analysis of Fuller Smith and Turner Plc Group - Essay Example

?Question No Financial Performance Analysis of Fuller Smith and Turner Plc Group Ratio analysis is a very accurate and reliable tool when it comes to analyzing the financial outlook of an entity. The primary reason to conduct a ratio analysis is to quantify the results of the operations of a company and compare them with that of the prior year(s) in order to assess different aspects of the financial feasibility. The ratios can be divided into various categories such as profitability, gearing and liquidity, each focusing on a different area of the financial outlook of the organization and highlighting the company’s performance. These analysis form an integral part of the financial statement analysis, especially from the investors point of view, who always strive to invest in countries having strengthen and stabilizing financial ratios and representing an upward trend. It is of great significance that the ratios must be benchmarked against a standard in order for them to possess a meaning. Keeping that into account, the comparison is usually conducted between companies portraying same business and financial risks, between industries and between different time periods of the same company. The company under consideration is Fuller Smith and Turner Plc Group and in this report analysis of the financial performance of the company over two years has been conducted in order to draw attention to various financial trends and significant changes over the period. The analysis is divided into three main categorize namely Profitability, Liquidity and Gearing. Profitability ratios identify how efficiently and effectively a company is utilizing its resources and how successful it has been in generating a desired rate of return for its shareholders and investors. Liquidity ratios measure the ability of the company to quickly convert its asset into liquid cash to settle its short term liabilities. Whereas, the Gearing ratios identifies the extent to which the company is financed through debt and to what degree the operations are being conducted from the finance raised through raising equity capital or otherwise. Profitability Ratios   2010 2009   Profitability Ratios Gross profit margin 67.85% 67.48% Net profit margin 14.14% 9.90% ROCE 15.54% 10.56% Gross profit margin is an analyzing tool which assists in identifying how effectively and efficiently the company is utilizing its raw materials [1], variable cost related to labor and fixed costs such as rent and depreciation of property plant and equipment. The ratio is calculated by dividing the sales revenue by the gross profit for the year. If we analyze the gross profit margin of financial year 2010 we can only see a marginal increase in the ratio as compared to the financial year 2009. During 2010 the revenue of Fuller Smith and Turner Plc has increased by 8.428% but connectively has also increased by 7.174% thus resulting in only marginal increase in the gross profit margin. Maintenance of gross profit ratio is quite commendable as the companies usually are not able to maintain such ratio due to price fluctuation in the raw materials and other factors related to production cost. Increase in revenue can be described due to several factors such as increase in per unit sales price, increase in customer base and increase in overall sales volume due to higher demand in the market. Net profit margin, on the other hand analyzes the profitability of the company before deducting the taxation and finance charges from the earnings [2]. The ratio is calculated by dividing the profit before interest and tax with the sales revenue of the current financial period. The ratio highlights how well the company is managing its selling and administrative expenses it also highlights the other income generated by the company during the course of its operations. The net profit margin of the company has shown considerable improvement as it has increased by 4.24% during the current financial year. The distribution and other administrative expenses of the company was higher during the current year by 1.89% (? 2.30 million) but the major impact that caused the increase in the net profit margin is the increase in the sales revenue. Other income amounting to ? 1.1 million also incrementally increased the net profit margin which arose due to the disposal of property assets by the company. The net profit margin of the company for the financial year would have been higher but to the impairment loss recorded by the company on its property, plant and equipment amounting to ? 8.4 million, the ratio showed a downward trend. Return on capital employed (ROCE) is, according to the analyst, is considered to be the most significant ratio in order to evaluate a company’s performance from an investor’s point of view. ROCE measures a company’s ability to earn a return on all of the capital that is being employed by the company [3]. The ratio is calculated as net income upon total capital employed, which is the sum of debt and equity financings. The ROCE has also shown improvement from the previous financial year which is a sign of improvement and sound financial outlook. It can be translated as a fact that the company is effectively and prudently utilizing its capital and offering return to its investors that are adequate and attractive at the same time. Liquidity and efficiency Ratios 2010 2009 Liquidity Current ratio 0.20 0.49 Acid test ratio 0.14 0.36 Debtors turnover period 14.6 13.13 The liquidity ratio measures the company’s ability to pay its short term liabilities. The ratio illustrates that how quickly a company can convert its assets into cash and cash equivalent in order to pay off its short term liabilities [3]. The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The strengthened the current ratio the more ability the company has to pay its debts and short term obligations over the next 12 months. An overall analysis of the ratio would portray that in all the years the company had enough assets to pay off its obligations and debts. The current ratio of the company has taken a downward plunge during the current financial year and has almost decreased by 60%. This is a negative sign as far as the financial outlook of the company is concerned. On further analysis it shows that although the total current assets have increased by 8.26% during the current year, due to the increase inventories and cash and cash equivalent, the current liabilities have increased incredibly. The drastic increase in the current liabilities balance is due to the change in the borrowings closing balance which have increased by 9.25 times. This could also be due to the fact that the long term portion of borrowing, which in the prior year was classified as long term, has now been classified as current liability. The acid test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance. . Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. The acid test ratio has followed the same trend as the current ratio. Receivable turnover represents how quickly the cash is received from the debtors. The ratio is calculated by dividing the revenue generated from the sales by the receivable balance as mentioned in the balance sheet of the company. The formula calculates the number of times the debtors are turned over during a year. The higher the value the more efficient the management is or it could also mean that the debts are more liquid. This ratio has shown marginal increase during the current financial year. Analyzing the movement in this ratio, it can be noticed that the revenue for the company has increased during the current financial year, but the receivable balance has decreased. This can be further interpreted as the fact that the company actively monitored its cash collection procedure and was able to reduce its closing receivable balance. It is better to keep the current assets in the most liquid form which is cash and cash equivalent. Gearing Ratios 2010 2009 Gearing Ratios Equity ratio 0.50 0.52 Debt ratio 0.50 0.48 Debt : equity ratio 0.5 : 0.5 0.52 : 0.48 Borrowing ratio 0.38 0.69 The gearing ratios and indicate the level of risk taken by a company as a result of its capital structure [4]. These ratios are a great source of determining the level of financial risk to which the company is exposed and thus helps in reducing it to the optimum [4]. The equity ratio indicates how much of the entity’s assets are financed through the finances generated through the revenue generated from the operations of the entity and raising financing through equity issue rather than acquiring debts or other financial institution. The equity ratio of the company has decreased marginally which is due to the increase in the total liabilities of the company during the year. The major impact caused by the increased in the total liabilities of the company was due to the increase in the borrowing of the company which increased almost 9.25 times as mentioned earlier. This means that previously ?100 worth of assets of the entity was financed by 52% equity and 48% debt, but now since the borrowing of the company has increased, the ratio has been changed to 50% debt and 50% equity. 50% debt ratio is considered high as the company is significantly exposed to financial risk. Financial risk can be defined as the risk that the company will not be able to pay off its long term debts both interest payments and principal if it becomes bankrupt. Another ratio to assess the financial leverage of the company is by calculating the borrowing ratio of the company. The ratio is calculated by dividing all the short term and long term borrowing of the company in the form of overdraft, long term loan and finances etc., with the shareholder’s equity. The borrowing ratio presents similar trends as the debt ratio, and also due to the fact that the ratio uses the same dependents. Question 2 - Financial Appraisal of different investment projects As mentioned in the case, Pacioli Accounting Software Systems Limited has short listed three tax accounting software system for procurement, the following investment analysis evaluate the financial feasibility of the three investment decisions Answer to requirement a (i) and a (ii) Analysis through Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability Indexation (PI) Net Cash Flow Net Cash Flow Net Cash Flow Software Programme Initial Outlay Year 1 Year 2 Year 3 ? Tax Wizard (60,000) 25,000 30,000 32,000 Discounting Factor @ 10% 1.000 0.909 0.826 0.751 Present Value (60,000) 22,725 24,780 24,032 Net Present Value (i) 11,537 IRR (ii) 20% Profitability Indexation (i) 1.19 Net Cash Flow Net Cash Flow Net Cash Flow Software Programme Initial Outlay Year 1 Year 2 Year 3 ? Tax Easy (120,000) 50,000 70,000 40,000 Discounting Factor @ 10% 1.000 0.909 0.826 0.751 Present Value (120,000) 45,450 57,820 30,040 Net Present Value (i) 13,310 IRR (ii) 16% Profitability Indexation (i) 1.11 Net Cash Flow Net Cash Flow Net Cash Flow Software Programme Initial Outlay Year 1 Year 2 Year 3 ? Tax Angel (180,000) 95,000 80,000 58,000 Discounting Factor @ 10% 1.000 0.909 0.826 0.751 Present Value (180,000) 86,355 66,080 43,558 Net Present Value (i) 15,993 IRR (ii) 15% Profitability Indexation (i) 1.09 Answer to requirement a( iii) Payback Period Analysis Tax Wizard Year Cash Flow ? Cumulative ? Outflow (60,000.000) Year 1 25,000 25,000 Year 2 30,000 55,000 Year 3 32,000 87,000 Payback Period Between Year 2 & 3 Difference in Cumulative Cash Flow 32,000 Fraction of the year 0.16 Payback period 2.16 Tax Easy Year Cash Flow ? Cumulative ? Outflow (120,000) Year 1 50,000 50,000 Year 2 70,000 120,000 Year 3 40,000 160,000 Payback Period At 2.000 Tax Angel Year Cash Flow ? Cumulative ? Outflow (180,000) Year 1 95,000 95,000 Year 2 80,000 175,000 Year 3 58,000 233,000 Payback Period Between Year 2 & 3 Difference in Cumulative Cash Flow 58,000 Fraction of the year 0.09 Payback period 2.09 Answer to requirement b The method used in the investment appraisal is determining the Net Present Value (NPV) of each proposal. According to this method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate in the economy. As mentioned in the case study, the directors of Pacioli expect the cost of capital to be 10% which is used as the discount rate in calculating the NPV of each project. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the investment. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture an investment where as the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Payback period is another method utilized in investment appraisal which calculates the time taken by the investment to generate enough cash inflows to recover the initial cost of the investment. The following table summarizes different attributes of the investment appraisal for the three investment decisions Software Programme NPV IRR PI Payback Period (years) Tax Wizard 11,537 20% 1.192 2.156 Tax Easy 13,310 16% 1.111 2.000 Tax Angel 15,993 15% 1.089 2.086 Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. A good financial analysis is based on the tradeoff between these two methods. However, practically the IRR method is used widely in investment appraisal decision. The prime reason behind selecting the IRR method of appraisal is it is comparatively straight forward and can be used without having a prior experience in capital budgeting. NPV method has certain drawbacks and limitations. Different projects must be assessed at different discount rates because the risk for each project is generally different. The reliability of the NPV based investment appraisal can be as reliable as the discount rate itself. However, in practice, it is very unrealistic to determine different discount rate for different investment proposals. Whereas, IRR uses a single discount rate to evaluate every investment, due to which it is used extensively among the financial analysts. With certain disadvantages, the NPV method comes with several attributes which makes it superior to the IRR method. IRR method of appraisal is for evaluating the financial result of an investment over a short period of time. Moreover, IRR is also ineffective for investments proposals which are a mixture of positive and negative cash flow. For these types of investments, the IRR can be more than one. Another factor which makes the NPV method more reliable than the IRR method is the fact that the discount rate changes several time over the period. The IRR method does not incorporate this fact into calculation, and thus is not suitable for long term investment appraisal. In NPV method the discount rate is known and is singular which makes it easier to evaluate the feasibility of the investment. An investment with a negative value represent an unattractive investment where as a positive value represents otherwise. In IRR method, the rate must be compared to a specified risk rate in order to declare the investment proposal effective or ineffective. In the absence of the predetermined risk rate, the IRR method is of no use. Based on the discussed fact, NPV method of appraising investment is more practical and precise. As per the above superiority of NPV technique over the other investment appraisal techniques, Pacioli should select Tax Angel as it has the highest NPV of ?15,993. Question 3 - Behavioral aspects of accounting control systems In organizations, planning and control is considered to be the most crucial part of the day to day operations. The primary purpose of the financial controls installed and operated by the management accountants is to supply managers with relevant information which is up to date and sufficiently accurate which allows the manager with such information from which they can take relevant and important decisions. The information should be such that the managers are able to take appropriate and well-informed decisions. When we analyze the financial reporting procedures of the entity it comes to our notice that it involves people the information is generated by the people and is ultimately used by the people. A further analysis tells us the fact that accounting controls are actually the cost and revenue management through the management of the people. Based on this fact it is of prime importance that the organizations put significance to the individual’s behavior when it comes to financial control system. The most important behavioral aspect of individuals is seen in the process of budgeting. Budgeting can be defined as a process in which the management accounts, based on past experiences and patterns, try to predict and forecast future trend of cost, revenue, collection, cash inflows and outflows. Budgeting can be regarded as one of the most significant aspect of standard operating procedures of any organization as the resources are allocated on its basis. The involvement of human’s behavior is quite crucial in budgeting and controlling process. Some managers tend to set budgets which are easily achievable as they belong to that particular traits of individuals who avoids challenges and are complacent with their current status and current position. They do not crave higher designation or perks which they might achieve on achieving higher sales, for example, or reduction in cost during the period. Growth in sales and reduction in cost requires are aspects which require significant efforts and excessive beforehand planning which the sort of managers discussed in the above might be reluctant to undertake. In contrast, there might be a manager who is willing to take such risks and thus would be present such budget which is proactive, rather than reactive, and shows a less vigilance. Such managers prepare budgets which will bring benefit to the firm in terms of increase in the growth rate of sales, cost reduction or cost control, prudent and apt allocation of resources and undertakes new investment opportunities. The involvement of top management is very crucial in the preparation of these budgets. Budgeting and controlling activity can be both top down and bottom up. Budgets can be set by the executives of any organization. For example in a banking company, the head of customer and retail banking might mention in the upcoming budget for the financial year that he expects that staff during the current year will raise deposits from customers amounting to $ 1,000,000. The head of consumer departs might have set this budget based on his own calculation or based on the set of information which he might have extracted from various serious. If the president of the bank wants to see an increase in the profit before tax of $10,000 and currently the bank is offering interest at 9% on the deposits, whereas charging interest at 10%, he must have communicated this to the head of retail banking that we need to raise the deposit balance by at least a million dollar this year. However, if in the same bank the budgets are set bottom up the situation would have been different. In such condition, the staff members would have an idea that based on the amount of resources they have, each branch manager of the bank will raise deposits amounting to $100,000. Now this estimation and forecast is based on a totally different criteria and situation as compared to the previous example. This is due to a different position and different set of information that the branch manager is currently exposed to. The above examples elaborates that how behavioral aspect affects budgeting and control. No matter how much the organization tries to implement financial reporting and financial controlling standards, the aspect of human behavioral always tries to deviate such controls from the established standards. References [1] Richard Loth “Profitability Indicator Ratios: Profit Margin Analysis.” investopedia.com. Investopedia, n.d. Web. 4 May 2011. [2] Rosemary Peavler “Use profitability ratios in financial ratio analysis”Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. . 4 May 2011. [3] Jim Mueller “Diving into financial liquidity” investopedia.com. Investopedia, n.d. Web. 25 March 2011. [4] “Gearing ratios” qfinance.com. Bloomsbury information limited, n.d. Web. 25 March 2011. [5] “Equity Financing.” investopedia.com. Investopedia, n.d. Web. 26 March 2011. [6] Pierre Vernimmen “Corporate Finance – theory and practice” John Wiley & Sons Ltd. Volume 10 [7] Rosemary Peavler “Debt and Equity Financing.” Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 26 March 2011. [8] Linda Grayson “Internal rate of return: An inside Look” investopedia.com. Investopedia, n.d. Web. 18 Dec. 2010. [9] “Net Present Value - NPV” investopedia.com. Investopedia, n.d. Web. 18 Dec. 2010. [10] Elazar Berkovitch “Why the NPV Criterion does not maximize NPV” rfs.oxfordjournals.org Oxford Journals n.d. Web. 19 Dec. 2010. [11] Randika Lalith Abeysinghe “Nature and introduction of investment decision” ezinearticles.com Ezine articles n.d. Web. 19 Dec. 2010. [12] “What influences investment decision” saching.com saching.com n.d. Web. 19 Dec. 2010. [13] “Which is a better measure for capital budgeting, IRR or NPV.” investopedia.com. Investopedia, n.d. Web. 19 Dec. 2010. [14] “Capital Budgeting and pros and cons of IRR and NPV” financialmodelingguide.com Financial Modelling Guide, n.d. Web. 19 Dec. 2010. [15] Mark Cook “Approaches to investment appraisal” findarticles.com CBS Business Network, n.d. Web. 19 Dec. 2010. [16] Mark Cook “Approaches to investment appraisal” findarticles.com CBS Business Network, n.d. Web. 19 Dec. 2010. [17] Frank Smith “Investment appraisal and capital budgeting: NPV and IRR” suite101.com Suite 101, n.d. Web. 19 Dec. 2010. Read More