Liquidity Ratios - Marks & Spencer Plc - Essay Example

?Contents Liquidity ratios 2 Current ratio 2 Quick ratio 2 Leverage against KPI 3 Solvency ratio 3 Debt to equity ratio 4 Solvency against KPI 5 Working capital management 5 Working capital turnover 5 Networking capital ratio 5 Working capital management against KPI 6 Profitability ratios 6 Gross profit ratio 6 Return on capital employed (ROCE) 6 Profitability against KPI 7 Asset efficiency ratios 8 Asset efficiency against KPI 9 Uses of KPIs in assessing organization performance 9 Advantages and limitations of the analysis techniques 9 Liquidity ratios Current ratio Current ratio = current assets/ current liabilities Current ratio is the simplest measure of a company’s liquidity. The current ratios for both 2011 and 2012 are less than 1, which is financially unfavourable since it means that the company is likely to experience difficulties paying its short-term dues. Furthermore, this current ratio is less than the industry average, which suggests that the company is having serious liquidity problems in comparison with related companies. The management of the company may want to contemplate a change of strategy, for example by reducing its current liabilities, to avoid landing into financial problems. The ratio has declined from 0.74 in 2011 to 0.73 in 2012, which could be attributable to leaner working capital cycle or deteriorating liquidity position (Bodie, Alex, and Alan, 2004; Damodaran, 2002). 2011 2012 Industry Current Asset 1,641.7 1,460.1 Current Liabilities 2,210.2 2,005.4 0.74 0.73 1.44 Quick ratio Quick ratio = [cash and equivalents + short-term investments + accounts receivable]/current liabilities 2011 2012 Industry Cash and equivalents 470.2 196.1 Short-term investments 18.4 67.0 Accounts receivable 250.3 253.0 Total Current liabilities 2,210.2 2,005.4 Quick ratio 0.334 0.257 0.82 Unlike the current ratio, this ratio is more conservative because it does not include inventory from the current assets. This ratio further shows that Mark & Spenser is likely to have problems meeting its short-term obligations with its most liquid assets, especially considering the ratio is significantly below the industry average (M&S, 2012; Weston, 1990; Houston and Brigham, 2009). Leverage against KPI As discussed, the company’s leverage is unfavourable, but with the continuing efforts to build the company to become more international.ly focussed, with the sales expected to increase by 5.8% by 2013, the increased revenue can be used to offset the excessive shot-term debt. This will lead into a more balanced liquidity position, hence freeing the company from the risk of bankruptcy (Weygandt et al., 1996; HayGroup, 2006). Solvency ratio Solvency Ratio = [After Tax Net Profit + Depreciation]/ [Long Term Labialise + Short-Term Liabilities] 2011 ?m 2012 ?m After Tax Net Profit 782.7 371.4 Depreciation 467.5 479.7 Total 1250.2 851.1 Long-Term Liabilities 2,456.5 2,489.1 Short-Term Liabilities 2,210.2 2,005.4 Total 4,666.70 4,494.50 Solvency Ratio 0.27 0.19 Solvency is used to measure the company’s ability to meet its long-term obligations. In other words, it measure’s the ability of the company to go on with meeting its debt requirements. The solvency ratio of 2011 was financially healthy, but that of 2013 was not healthy because as a general rule of thumb a ratio that is greater than 20% is considered financially healthy. It is discouraging to note that the company’s solvency ratio is dropping because this could expose the company to a situation of defaulting on its debt obligations (Gates, 2002). Debt to equity ratio Debt to equity ratio = Total debt/ [Owner’s Equity] 2012 2011 Industry Total debt 2,778.8 2,677.4 Owner’s equity 4,494.5 4,666.7 Debt to equity ratio 61.8 57.3 42.35 The debt-to-equity ratio indicates the degree of financial leverage that the company is using to improve its profitability. This ratio has increased to 61.8 from 57.3 in 2011, which may imply that the management should restrain use of additional increases in debt caused by purchases of fixed assets or inventory. The management can improve this ratio by either increasing the amounts of earnings retained in the firm pending the balance sheet date or by paying off a substantial portion of the debt. An example of doing this includes repaying of the planned bonus or by repaying the revolving debt before the balance sheet date, and if necessary borrowing it after the balance sheet date. In comparison with the industry average, it seems M&S is using too much debt in its capital structure, which is financially unhealthy as it can expose the company into risk of bankruptcy (M&S, 2012). Total debt to total assets 2012 2011 Total debt 2,778.8 2,677.4 Total Assets 7,273.3 7,344.1 Debt to equity ratio 0.38 0.36 Total debt to assets measures the proportion of an entity’s assets that are financed with borrowed cash. As a rule of thumb, a total debt to assets ratio of 0.5 is considered financially favourable, therefore, the company’s ratio for the two years are too low. The ratios of 0.36 and 0.38 for years 2011 and 2012 respectively indicates that the company is under using leverage, which is not recommendable since the company is not optimizing its investment opportunities. This ratio can be improved by borrowing more debts and invest it in viable business opportunities. Solvency against KPI In 2010, the company set out a target to increase its revenue by ?1.5bn to ?2.5bn over the subsequent three years. If this improvement is realized, the company can be able to finance its projects from the internal sources, hence stop over relying on debt because it is already overused (M&S, 2012). Working capital management Working capital turnover Working capital turnover = sales/ working capital 2012 2011 sales 9,934.3 9,740.3 Working capital -545.3 -568.5 -18.21 -17.13 This ratio measures the effectiveness in which the working capital is invested to generate sales. The working capital for this company is negative, yet the sales figure is very huge, it means that the management has invested it well to generate revenue. Networking capital ratio Networking capital ratio= current assets/ current liabilities 2012 2011 Current assets 1,460.1 1,641.7 Current liabilities 2,005.4 2,210.2 0.73 0.72 Mark & Spencer have reported a working capital ratio of 0.72 in 2011, which increased to 0.73 in 2012. This liquidity position is not healthy because it means that it might be difficult to meet its short-term obligations. Therefore, the management should make efforts to correct this negative working capital with different working capital management strategies. Working capital management against KPI The company’s projection of an increase in revenue as a result of international market expansion, if realised, will open opportunities for the company to rely less of short-term liabilities, which will go a long way in balancing the deficit in working capital. Profitability ratios Gross profit ratio Gross profit ratio = Gross profit/ Net Sales 2012 2011 Industry Gross profit 746.5 836.9 Net sales 9,934.3 9,740.3 7.5 8.6 43.12 Gross profit ratio shows the extent of the company’s profit margin after deducting operating and administrative expenses from sales. This ratio has declined from 8.6 in 2011 to 7.5 in 2012, which is an unfavourable trend since it indicates that the company is becoming more unprofitable. The matter seems to be even worse comparing the company’s gross profit ratio because stands at 43.12. Return on capital employed (ROCE) ROCE = EBIT/ [Total Assets – Current Liabilities] 2012 2011 EBIT 658.0 780.6 Total assets 7,273.3 7,344.1 Current liabilities 2,005.4 2,210.2 5267.9 5133.9 ROCE 0.125 0.152 Return on capital employed is used to measures how well the company is using capital employed to generate income. This ratio has declined from 0.152 in 2011 to 0.125 in 2012, which is alarming since it means that the company is losing its profitability potential. This also means that the management has not properly utilized the investments provided by the owners and the creditors. The management should ensure that ROCE is always higher than the rate at which it is borrowing, in order to ensure that the shareholder’s earnings are maximised. Profitability against KPI Although the unfavourable economic conditions have driven the company’s profitability downwards, the expected increase in sales can set off this effect because, after all, high sales will promise more profits. Returns of Shareholders Funds (ROSF) Return on Shareholders’ Funds = [(Net profit after taxation & preference dividend) / (Ordinary share capital + Reserves)]* 100% 2012 2011 Industry Net profit after taxation & preference dividend 371.4 782.7 Ordinary share capital + Reserves 2,790.2 2,673.5 13.31 29.3 17.9 The Return on Shareholders’ Funds (ROSF) is a measure of the profit that is attributable to the shareholders. This ratio has dropped from 29.3 in 2011 to 13.31 in 2012. This is worrisome to the shareholders because this means this will mean less return for them. Asset efficiency ratios Fixed assets Turnover Ratio = Net Sales/Average Fixed Sales 2012 2011 Net Sales 9,934.3 9,740.3 Average Fixed assets 5,813.2 5,702.4 1.71 1.71 Fixed assets Turnover Ratio tells how the management has effectively used the company’s fixed assets to generate income for the shareholders. The ratio of 1.71 is quite high, which means that the fixed assets are efficiently used to generate revenue. Total assets turnover = Net sales revenue / Average total assets 2012 2011 Industry Net Sales 9,934.3 9,740.3 Average Total Sales 7,273.3 7,344.1 1.37 1.33 1.6 This ratio measures the effectiveness of all the assets in generating revenue for the company. It is positive to note that this ratio has increased slightly in 2012, but this is still not the best because it is below the industry average. Therefore, the management would want to find ways of investing the assets even more effectively to reach or surpass the industry average. The high industry ratio is possibly as a result of cat- throat and competitive pricing that is common in the retail industry (Williams et al., 2008). Asset efficiency against KPI There is much expectation that the sales will continue to increase in the future. If this increase will be achieved without substantial addition of assets, then the asset efficiency ratios will keep improving (Groppelli and Ehsan, 2000). Uses of KPIs in assessing organization performance Uses of KPIs in assessing organization performance, means selecting factors that are critical to the organization achieving its goals. For example, M&S has increase in sales as one of its most important KPI, which helps it achieve its goal. As such, different departments have different KPIs, depending on their goals. For example, the marketing department may have “Increased customer Satisfaction” as their KPI while the manufacturing department may have “Reduced Number of Defects” as their KPI, all aligned to their specific goals. The most important M&S’s KPI, which has been discussed in this paper, is “Increase in Sales”, which is motivated by the company’s goals of achieving its financial stability (M&S, 2012; Fitzpatrick, 2000; Denton, 2006). Advantages and limitations of the analysis techniques Financial ratio analysis makes it very easy to understand financial statements, because it concentrates a lot of data into a simple figure. In addition, by use of the industry average or ratios from other companies, it becomes easy to make comparison with companies of different size. Also, by comparing a single company’s rations from one year to another, this method helps in trend analysis, hence knowing whether the company is improving or worsening financially. On the other hand, one disadvantage of this method is that it cannot make comparisons between different companies that operate in different industries might not be compared. Furthermore, financial information is affected by assumptions and estimates, since accounting standards permit different accounting policies – this leads to misleading comparisons. Finally, although users are more interested about current and future information, ratio analysis is concerned with the past information. References Bodie, Z., Alex, K. and Alan J. M., 2004. Essentials of Investments, 5th ed. McGraw-Hill Irwin. Damodaran, A., 2002. Investment Valuation, second ed. New York, NY: John Wiley & Sons. Denton, D. K., 2006. Measuring relevant things. Performance Improvement, 45 (3), pp. 33- 38. Fitzpatrick, P., 2000. A Comparison of the Ratios of Successful Industrial Enterprises with Those of Failed Companies. New York: The Accounting Publishing Company. Gates, S., 2002. Value at work: The risks and opportunities of human capital measurement and reporting. New York: The Conference Board. Groppelli, A. and Ehsan N. (2000). Finance, 4th ed. Barron's Educational Series, Inc. p. 433. HayGroup. , 2006. Leading the global organization: Structure, process, and people as the keys to success. Hay Group Insight Selections, 11, pp. 1-4. Houston, J.F. and Brigham, E.F., 2009. Fundamentals of Financial Management. Cincinnati: Ohio. M&S, 2012. Annual Reports. (Online) Available from: http://corporate.marksandspencer.com/documents/publications/2012/annual_report_2 012 [13 August 2012] Weston, J., 1990. Essentials of Managerial Finance. Hinsdale: Dryden Press. Weygandt, J. J., Kieso, D. E., & Kell, W. G., 1996. Accounting Principles (4th ed.). New York: Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons Weygandt, J. J., Kieso, D. E., & Kell, W. G., 1996. Accounting Principles (4th ed.). New York, Chichester, Brisbane, Toronto, Singapore: John Wiley & Sons, Inc. Williams, K. et al., 2008. Financial & Managerial Accounting. McGraw-Hill Irwin. p. 266 Read More