Compass Group Financial Analysis - Essay Example

? Compass Financial Analysis and Sources of Finance Used by the Company By + State Date Introduction The financial performance of the Compass Group Plc (UK) can be analysed by using financial/accounting ratios, as explored under the following paragraphs. Accounting/financial ratios Calculating/interpreting financial accounting ratios can be done using relevant calculations to facilitate the understanding and interpretation of financial data. In this regard, Compass Group Plc Company’s 2010 and 2011 financial reports have been used. Gross Profit Ratio It is calculated by the following formula. Gross profit ratio = [(Gross profit / Net sales) ? 100] The results are presented in Table 1. Table 1: Gross profit ratio of the Compass Group Plc Company ? million 2011 2010 Gross Profit 1,010 983 Net Sales 15,833 14,468 Gross profit ratio 6.38% 6.79% There is a decrease in the gross profit ratio that has been realized amounting from 6.79% in 2010 to 6.38% in 2011. This can be attributed to poor sales strategies and an increase in the cost of goods sold (Compass Group Plc 2011, p.63). Mark Up It is calculated as shown below. Mark up = (Sale price / Cost) – 1 The results are shown in Table 2. Table 2: Mark up of Compass Group Plc ? million 2011 2010 Sales price 15,833 14,468 Cost 14,823 13,485 Mark up 6.81% 7.29% The mark-up decreased slightly from 7.29% in 2010 to 6.81% in 2011 (Compass Group Plc 2011, p.63). This can be contributed to low sales turnover, coupled with an increase in the costs of sales. Net Profit Ratio It is calculated by means of the following formula: Net Profit Ratio = (Net profit / Net sales) ? 100. The results are shown in Table 3. Table 3: Net profit ratio of the company ? million 2011 2010 Net profit 734 680 Net sales 15,833 14,468 Net profit ratio 4.63% 4.70% The overall profitability of the firm decreased, because the net profit ratio reduced from 4.70% in 2010 to 4.63% in 2011. Return on Capital It is calculated in the following way: ROCE = EBIT/ (total assets – current liabilities), Where: ROCE = return on capital, EBIT = earnings before interest and taxes. It is represented in Table 4. Table 4: Return on capital of Compass Group Plc ? million 2011 2010 EBIT 958 913 Total Assets Current liabilities 9,410 (3,990) 8,254 (3,239) Net profit ratio 17.68% 18.21% A significant decrease in ROCE was realised, when it reduced from 18.21% in 2010 to 17.68% in 2011 (Compass Group Plc 2011, p.67). However, it is necessary to note that the rate of capital employed should always be higher than the company’s rate of borrowing, otherwise proportionate increase in borrowings would result into proportionate reductions in earnings of company’s shareholders. Current Ratio This is a ratio between current assets and current liabilities, where “current” means the assets and liabilities that need to be paid within one year. This ratio shows how well the assets can repay the amount of liabilities of the company, and it also assesses the liquidity of the company’s assets (see Table 5). In the Compass Group Plc’s case, the current ratio appears lower than it should be. Even though there are not even enough assets to pay the liabilities, the company is doing pretty well (Dobbs, Huyett & Koller 2009, p.54). Table 5: Calculations of the current ratio ? million 2011 2010 Current Assets 3,475 2,752 Current Liabilities 3,990 3,239 Current Ratio 0.87 : 1 0.85: 1 Acid Test (Quick) Ratio There is the following formula used for the calculation of this ratio: acid test (quick) ratio = (current assets – inventories)/current liabilities (see Table 6). Table 6: Acid test ratio of the company ? million 2011 2010 Current Assets Inventories 3,475 270 2,752 238 Current Liabilities 3,990 3,239 Quick Ratio 0.803 : 1 0.776 : 1 Compass Group Plc’ quick ratio was 0.803:1 and 0.776:1 in 2011 and 2010 respectively. Given that the quick ratio of 1:1 is considered as a satisfactory financial condition, Compass Group Plc is sufficiently liquid (Compass Group Plc 2011, p.67). The ratio of 0.803:1 shows that even if the company’s inventories are sold, Compass Group Plc will still be able to meet its current liabilities, if they need to be paid immediately (Libby & Short 2005, p.56). Furthermore, the ratio indicates a significant improvement from the results of the previous year, and this indicates operational excellence within the company in the current year (Glautier, Underdown & Morris 2010, p.94). Sources and Application of finances Compass Group Plc uses both traditional and contemporary methods to source for its financing. The traditional method includes shares (equity) and retained earnings. On the other hand, the contemporary method of financing includes bank borrowings, franchising, venture capital, and government assistance (Dobbs, Huyett & Koller 2009, p.102). The company has used bank loans and overdraft (debt financing) as its source of contemporary financing. It is necessary to note that Compass Group Plc should forgo debt financing and choose equity financing. Equity financing is advantageous, because the funds are committed to the business and its projects (Marshall 2010, p.47). Investors can only realize returns when the company is performing well. The realization is often achieved when new stock is floated in the market or when the business is sold to new investors. Moreover, there are no costs involved for debt finance services and bank loans. This implies that the capital raised can be used for company’s operations at no cost (Bennett 2010, p. 57). Investors, who have contributed capital to the company, always expect the corporation to perform well, and this makes the management team to come up with strategic growth plans. In certain situations, the investors are capitalists who have wide knowledge and experience in business, thus they can bring invaluable expertise, skills and experience to the company. Such important skills are necessary for strategic decision-making processes. Besides, the investors will be ready to monitor and provide more funding to the company (Bebbington, Gray & Laughlin 2001, p.124). Even though, equity financing has many advantages, it suffers certain limitations. The process of equity financing is tedious and procedural, because legal and regulatory procedures must be complied with, before the process of raising capital begins (Weygandt 2008, p.127). This type of financing consumes a lot of time and valuable resources of the company. Moreover, it implies that the company’s attention on its daily business operations can be easily diverted to other activities (Brealey & Myers 2008, p.97). At the initial stages of financing, only limited amounts of funds can be realized. In addition, outside investors may take control of the company, especially when they have more shares allocated to them. In sum, following the argument above, it is an appropriate decision for the Compass Group Plc to opt for the equity financing, instead of the debt financing. Debt financing suffers the limitation of higher interest charges/costs of borrowing. In this regard, the company can choose to issue stocks instead of bonds since the latter are loans paid back with interests. In addition, the bonds are repaid in full amount with interest. Reference List Bebbington, J, Gray, R & Laughlin, R 2001, Financial accounting: Practice and principles, Thomson Learning, New York. Bennett, G 2010, Accounting principles and practice, BiblioBazaar, Charleston. Brealey, A & Myers, C 2008, Corporate finance: capital investment and valuation, McGraw-Hill Publishers, Washington DC. Compass Group 2011, Annual Report 2011, viewed 27 March 2013, Dobbs, R, Huyett, B & Koller, T 2009, The CEO’s guide to corporate finance, Havard University Press, NewYork. Glautier, M, Underdown, B, & Morris, D 2010, Accounting: Theory and practice, Prentice Hall, New York. Libby, R & Short, D 2005, Financial accounting, McGraw Hill, Sydney. Marshall, P 2010, A complete guide to the principles and practice of business accounting, How to Books Publishers, London. Weygandt, J 2008, Accounting principles, John Wiley & Sons, New York. Read More