Essay: Financial performances

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Q1) financial performances: (profitability)

a) Sales turnover index:

It is the total amount sold within a specific time period, usually a year. Sales turnover can be expressed in terms of the total amount of stock or products sold. ( paul W. Farris, Neil T. Bendle, Phillip E.Pfeifer, David J. Reibstein, pg no 243)

Formula:

(current year sales/base year sales)*100

	2004	2005	2006	2007
Cyrrent Year Sales	8000	8400	12600	13860
Base Year Sales	8000	8000	8000	8000
Sales Turnover Index	100%	105%	157.5%	173.25%

Interpretation: This index tells about the turnover in that specific period. From the above numerical values, it is very clear that sales turnover has increased from year to year. This is a very good sign for a company.

b) Gross profit margin:

It captures the relationship between sales and merchandising costs. It provides information about a firms profitability from the operations of its core business.

(Gerald I.White, Ashinpaul C.Sondhi, Dov Fried, Pg no 133)

Formula: (gross profit / total sales)*100

	2004	2005	2006	2007
Gross profit(EBIT)	2000	2100	2520	2495
Total sales	8000	8400	12600	13860
Gross profit margin	25%	25%	20%	18%

Interpretation:

An increase in this ratio is viewed as a positive trend. In this case, even though total sales are increasing, there is a decrease in gross profit margin. So from this we can infer that cost of sales is increasing rapidly and thus leading to decrease in gross profit margin.

c) Net profit margin:

It shows how much net profit is derived from total sales. It indicates how well the business has managed its operating expenses and whether the business is generating enough sales volume to cover minimum fixed costs and still generate an acceptable profit. (Gerald I.White, Ashinpaul C.Sondhi, Dov Fried,Pg no 133)

Formula:

(net profit / total sales)*100

	2004	2005	2006	2007
Net profit(EAT)	480	525	525	375
Total sales	8000	8400	12600	13860
Net profit margin	6%	6.25%	4.1%	2.7%

Interpretation: From the above figures, it is very clear that there is a decrease in net profit margin. This decrease is due to increase in operating expenses, interest expenses and tax expenses. This indicates that Tobermoray Ltd is not able to manage its operating expenses properly.

d) ROCE: It is the measure of efficiency and profitability a business is making on the total capital employed. ( Return on capital employed).(Gerald I.White, Ashinpaul C.Sondhi, Dov Fried, Pg no 135)

Formula: (EBIT/ capital employed)*100

Capital employed= Total assets- current liabilities

	2004	2005	2006	2007
EBIT	800	840	1000	800
Capital employed	4330	4335	5505	5630
ROCE	18.475%	19.3%	18.16%	14.2%

Interpretation: The resulting ratiorepresents theefficiencywith which capital is being utilized to generaterevenue. This ratio is been decreased from 2004 to 2007. This is not a good sign.

Solvency ratios:

a) Current ratio: current ratio is computed by dividing current assets with current liabilities. It shows the ability of a firm to pay its debts. It is the most commonly used measure of liquidity.

(Stice Stice ,pg no 78 )

Formula: current assets/ current liabilities

	2004	2005	2006	2007
Current assets	1570	1905	2080	2400
Current liabilities	880	940	1975	1770
Current ratio	1.7:1	2.02:1	1.05:1	1.35:1

Interpretation: The higher the current ratio, the more capable the company is of paying its obligations. A ratio under1 suggests that the companywouldbeunable to pay offits obligations. As the current ratio is greater than “ 1 “ ,it is a good sign. For most industrial companies, 1.5 is an acceptable current ratio.

b) Acid test ratio: It is a measure of the ability of the company to pay its debts as they fall due from net liquid assets such as cash and other current assets. It as an acid test of solvency and a measure on how quickly current assets can be converted into cash. (Financial Statement Analysis, John J.Wild, K.R.Subramanyam, Robert F. Halsey,pg no 32 )

Formula: quick assets/ current liabilities

	2004	2005	2006	2007
Quick assets	1020	1305	1380	1500
Current liabilities	880	940	1975	1770
Quick ratio	1.15:1	1.3:1	0.69:1	0.84:1

Interpretation: There is some difference between current ratio and quick ratio; from this we can say that Tobermoray Ltd stocks are large. Additionally, the acid test ratio has decreased over the four year period, meaning that Tobermoray Ltd has a weaker liquidity position than it had before.

c) Interest cover: It measures the protection available to creditors as the extent to which earnings available for interest cover interest expense. (The Analysis And Use Of Financial Statements, Gerald I.White, Ashinpaul C.Sondhi, Dov Fried, pg no 132)

Formula: EBIT/interest

	2004	2005	2006	2007
EBIT	800	840	1000	800
Interest	160	140	300	300
Interest cover	5 Times	6 Times	3.33 Times	2.66 Times

Interpretation: A high coverage ratio may suggest a company is "too safe" and is neglecting opportunities to magnify earnings throughleverage.

Capital (financial gearing)

a) Debt/total capital employed: it represents the proportion of borrowed funds used to acquire the company’s assets. It a measure of leverage. ( Stice Stice pg no 78)

Formula: (debt/ total capital employed)*100

	2004	2005	2006	2007
debt	2880	2690	4475	4270
Capital employed	4330	4355	5505	5630
Debt/capital employed	66.5%	61.7%	81.2%	75.8%

b) Debt/equity: Thedebt to equityratio indicates the extent to which the business relies on debt financing. (Financial Accounting Reporting And Analysis, Stice Stice pg no 78)

Formula: (debt/ equity)100

	2004	2005	2006	2007
Debt	2880	2690	4475	4270
equity	2330	2605	3005	3130
Debt/equity	123.6%	103.2%	148.9%	136.4%

Interpretation: The lower the number implies that a company is using less leverage. A high debt to equity ratio means that company is being aggressive in financing its growth with its debt.

Asset utilization:

a) Stock turnover: it measures the efficiency of the firm’s inventory management. A higher ratio indicates that inventory does not remain on shelves but rather turns over’s rapidly from the time of acquisition to sale. (Gerald I.White, Ashinpaul C.Sondhi, Dov Fried,pg no 120)

Formula: cost of goods sold/ average inventory

Average inventory= closing stock+ opening stock/2

Stock turnover (in days)= 365/STR

	2004	2005	2006	2007
COGS	6000	6300	10080	11365
Avg stock	525	575	650	800
Stock turnover	11.42	10.95	15.50	14.2
Stock turnover in days	31.96 days	33.3 days	23.5 days	25.70 days

b) Debtor’s turnover ratio: it measures the effectiveness of the firm’s credit policies. It indicates the level of investment in receivable needed to maintain the firm’s sales level. (Gerald I.White, Ashinpaul C.Sondhi, Dov Fried,pg no 120)

Formula: net credit sales/ average debtors

Debtors turnover ratio in days= 365/DTR

Average debtors= opening + closing/2

	2004	2005	2006	2007
Credit sales	8000	8400	12600	13860
Avg debtors	880	902.5	1152.5	1440
DTR	9.09	9.30	10.9	9.625
DTR( in days)	40 days	39.2 days	33.4 days	37.9 days

c) Creditor’s repayment period: It defines the time spread between when suppliers must be paid and when payment is received from customers. It is critical for retail firms. Formula:365/ (Net credit purchases/Trade Creditors)

	2004	2005	2006	2007
Net credit purchases	6050	6350	10180	11565
Trade Creditors	600	600	970	950
	10.08	10.58	10.49	12.17

	2004	2005	2006	2007
No.of days in year	365	365	365	365
Net credit purchase / Trade creditors	10.08	10.58	10.49	12.17
Creditors Repayment Period	36.1983 days	34.4881 days	34.7789 days	29.9827 days

Interpretation: creditors repayment period has decreased, this is very good sign. From this above ratio , its is clear that firm is taking only 30 days to repay its debits in year 2007.

d) Working capital cycle: A metric that expresses the length of time, in days, a company takes in order to convert resource inputs into actual cash flows.(Pauline Weetman,2003,Pgno:368)

Formula: Working Capital cycle = Stock Holding period + Debtors collection Period – Creditors Payment period

Stock Holding period = (Average stock held / cost of sale) *365

Stock holding Period

Stock Holding Period	2004	2005	2006	2007
Average stock	525	575	650	800
Cost of sales	6000	6300	10080	11365
Stock Holding Period	31.9 days	33.42 days	23.5 days	25.6 days

Working capital Cycle

Stock Holding period + Debtors collection Period – Creditors Payment period

	2004	2005	2006	2007
Stock Holding Period	31.9 days	33.42 days	23.5 days	25.7 days
Debtors collection Period	40.15	40.1934	39.9761	39.5021
Creditors Payment period	36.1983	34.4881	34.7789	29.9827
Working Capital Cycle	35.8892 days	39.0187 days	28.7339 days	35.2123 days

e) Fixed asset turnover: this is the ratio of net sales to non-current assets. It measures the degree of non asset utilization by management to generate revenue and new resources. (The Analysis And Use Of Financial Statements, Gerald I.White, Ashinpaul C.Sondhi, Dov Fried,pg no 121)

Formula: sales/ fixed assets

	2004	2005	2006	2007
sales	8000	8400	12600	13860
Fixed assets	3640	3390	5400	5000
Fixed assets ratio	2.19:1	2.47:1	2.33:1	2.772:1

Interpretation: It measuresa firm’s efficiency at using its assets in generating sales or revenue. The higher the number the better is the asset utilization.

f) Total asset turnover: It analyses the extent to which management of a business enterprise utilizes all available financial resources to generate sales. (Financial Accounting Reporting And Analysis , Stice Stice pg no 79)

Formula: sales/ total assets

	2004	2005	2006	2007
sales	8000	8400	12600	13860
Total assets	5210	5295	7480	7400
Total assets ratio	1.53:1	1.586:1	1.684:1	1.872:1

g) Working capital turnover: This ratio measures the efficiency of utilization of working capital. (The Analysis And Use Of Financial Statements, Gerald I.White, Ashinpaul C.Sondhi, Dov Fried,pg no 121)

Formula: cost of sales/ working capital

Working capital = current assets- current liabilities

	2004	2005	2006	2007
sales	6000	6300	10080	11365
Working capital	690	965	105	630
Turnover ratio	8.695	6.528	96	18

Interpretation: The higher is the ratio: the lower is the investment in the working capital and the greater are the profits.

Investor’s ratio:

a) Return on share holders equity: Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. (Financial Accounting,2003, Pauline Weetman,Pgno:365)

Formula: (Profit after Tax/ (share capital+reserves))*100

	2004	2005	2006	2007
Profit after tax	480	525	525	375
Share capital/reserves	2330	2605	3005	3130
ROE	20.6008	20.1535	16.8053	11.9808

b) EPS: This is the income that the stockholders are entitled to receive (per share of stock owned). This income may be paid out in different forms such as dividends, retained and reinvested by the company, or a combination of both. (Financial accounting, Daniel M.Kimuda, pg no 336)

Formula: Net income/ outstanding shares

	2004	2005	2006	2007
Net income	480	525	525	375
shares	2000	2250	2500	2500
EPS	0.24	0.233	0.21	0.15

c) P/E Ratio: A valuation ratio of a company’s current share price compared to its per-share earnings. (Financial accounting, Daniel M.Kimuda, pg no 336)

Formula: Market value per share/ EPS

	2004	2005	2006	2007
Market value	1.50	1.50	1.50	1.50
EPS	0.24	0.23	0.21	0.15
P/E	6.25	6.52	7.142	10

d) Dividend per share: Theamountofdividendthat a stockholder will receivefor eachshareofstockheld. (The Handbook Of International Financial Terms, Peter Moles, Nicholas Terry, pg no 167)

Formula: dividend paid / no of outstanding shares

	2004	2005	2006	2007
dividend	400	500	375	250
shares	2000	2250	2500	2500
Dividend paid	0.2	0.22	0.15	0.1

e) Earnings yield: The earnings yield shows the percentage of each dollar invested in the stock that was earned by the company. (Analysis For Financial Management, Robert C.Higgins, pg no 203)

Formula: EPS/ Share price

	2004	2005	2006	2007
EPS	0.24	0.233	0.21	0.15
Share price	1.5	1.5	1.5	1.5
Earning yield	0.16	0.155	0.14	0.1

f) Dividend yield: A financial ratio that shows how much a company pays out in dividends each year relative to its share price. (Financial accounting, Daniel M.Kimuda, pg no 337)

Formula: dividend paid per share/ market price per share

	2004	2005	2006	2007
dividend	0.2	0.22	0.15	0.1
share price	1.5	1.5	1.5	1.5
Dividend yield	0.133	0.146	0.1	0.06

g) Dividend cover: Dividend cover shows a company’s ability to pay ordinary dividends to shareholders out of total profits earned. (The Handbook Of International Financial Terms, Peter Moles, Nicholas Terry, pg no 167)

Formula: EPS/ annual dividend per share

	2004	2005	2006	2007
EPS	0.24	0.233	0.21	0.15
Dividend per share	0.2	0.22	0.15	0.1
Dividend cover	1.2	1.05	1.4	1.5

b) Organic growth rate means, the growth rate that a company can achieve by increasing output and enhancing sales. This firm wants to go for organic growth in order to increase its market share. From the above ratio analysis, it is clear that there is a decrease in gross profit margin and net profit margin. This decrease is due to increase in operating expenses. ROCE has also declined. One important observation which can be made from ratio analysis is that there has been increase in asset utilization ratios. Asset turn over ratio and fixed asset turn over ratios have increased from past four years. Stock turnover period has decreased, which is a good sign because number of days required to convert raw material into stock has decreased. This ratio is very important for this firm because it is a retail store. For any retail store number of days taken to convert stock into sales is very important. As this ratio has decreased, there is a rapid improvement in sales. Debtors’ turnover period has decreased which says that company is able to collect its debts efficiently. ROE has decreased from 25% to 15% which means that share holder wealth maximization is not been properly done. EPS, dividend yield and earnings yield has also decreased. Firm has seen major decline in investor ratios, but investors will be mainly interested only in these ratios. If these ratios are improved, then firm can expect a good amount of capital in the form of share holder’s funds. With this capital, firm can go for expansion. This analysis clearly shows that firm has to work on its profitability. If DuPont analysis is done to break ROE into three parts namely profitability, efficiency and leverage. There is an incline in efficiency but, there is a decline in profitability and leverage which is leading to decrease in ROE. Current ratio and acid ratios has been decreased which implies that liquidity position of this firm has decrease. So, from the over all analysis, company strengths are its asset utilization and stock turnover ratios. While it lags in profitability and leverage.

Now, in this present situation firm want to go for organic growth by opening new retail stores. Company has to analyze the product life cycle first whether their products are in growth stage or maturity stage. If their product is in growth stage, then they can go for organic growth. This firm also has to consider external factors like competition, economic uncertainty, political environment and legal environment. If the company believes that there will be share holder wealth maximization by organic growth, then they can go for organic growth. Cost benefit analysis should be done before taking a decision on that. If benefit is more than the cost, then company can go for organic growth. ROI( Return on investment) analysis also has to be done, this ratio speaks about the amount of return a firm gains upon the amount of pounds invested. If return is greater than investment, then a firm can go for organic growth. If cost is more that benefit, it’s better to postpone the expansion program.

c) Impact of expansion program on the company can be analyzed by using cost benefit analysis. Cost benefit analysis can be done if the estimated cost and benefit are given. So this analysis would have been more meaningful if those values were given. From the balance sheet given, it’s clear that there is increase in operating expenses, but enough information regarding overhead costs is not given. If overhead costs were given, then some interpretation of that can be done, and some suggestions regarding how to decrease over head costs can be made. This interpretation will be useful for the firm in cutting down their expenses. Firm may have developed innovative strategies that have lead to high growth, but as the products mature or approaches market saturation, growth will be low. So, some information regarding the product life cycle was required to do accurate analysis. This firm being a retail store, it has to spend good amount on marketing. So information regarding marketing expenditure will be useful to do analysis. To do accurate analysis in this case, return on marketing investing can be done (ROMI). To do this calculation, investment on marketing and impact of marketing on sales is required. From the above ratio analysis, firm is able to collect its debts in 37 days while it has to pay back for its creditors in 30 days. So company is paying their creditors from other sources like using cash in bank. If company is repaying this amount by taking some amount on loan. It has to spent some amount on interest expenditure. So some information regarding this would be useful for analysis. Information regarding salaries and bad debts is also not given; if this information was given some analysis of expenditure can be done. If ratios of other firms who are in the same business were given, then comparative analysis can be done. This firm being a retail store, it may be operating in different geographical areas. If that data was given, then intra comparison can be done using ratio analysis. If industry averages were given they would be useful in making inter firm comparison. Current ratio and acid test ratios cannot be compared with usual average because it differs from one industry to another industry. This firm being a retail store, it will have a large amount of stock as its current asset, but this stock cannot be converted into cash. So usually acid test ratio of retail stores will be less. This analysis would have been better if industry averages were given. If the growth rate of overall industry was given, then scope for growth can be estimated. If growth is very high that is if industry is growing at double digit rate. Then firm can go for expansion because highest growth rate says that there is lot of opportunity. Some information about competitors, political environment and legal environment is required to comment about strengths and weakness of a particular firm. If the economic situation of customers is bad and if there is a decrease in their consumption level. Then it’s better to postpone the expansion. If all the required information was available, then correct analysis of whether this firm has to go for organic growth would be done. This analysis would be more useful and meaningful.

d) Ratio analysis will provide useful information about company’s operations and financial conditions, but it does have some limitations. Ratio analysis does not tell the entire story. Large firms operate in different divisions, setting an industrial average for these firms are a bit tough task. Using this ratio analysis for a large firms will not a meaningful task. This ratio analyses is best suited for small and narrow focused firms. Usually ratios are used for comparing with past trends and with competitors, but this may not give correct picture due to differences in accounting policies and accounting periods. Inflation may have badly affected firm’s balance sheet, but impact of inflation will not be properly reflected in ratio analysis due to historic cost convention. Inflation will also have an affect on depreciation charges and inventory cost. This in return will affect profit. So in this case interpretation should be done with a judgement. Ratio analysis will not take seasonal factors into picture. With out considering seasonal factors, meaningful interpretation cannot be done. In some situations firms may also go for a technique called “window dressing” in order to showcase their financials as stronger. So usefulness depends upon the accuracy of the data. Having a single ratio out of line with an industry average does not necessarily mean there is a problem, because there may be good business reasons to support management’s decision to reduce or increase liquidity or fixed assets in a different manner than the rest of the industry. Ratio analysis gives clear picture about past and present trends, but not about the future trends. There are different accounting policies and procedures for depreciation and inventory valuation. These may indirectly affect the profitability. This difference is not clearly depicted in ratio analysis. It is difficult to generalize about whether a particular ratio is good or bad. For example, high current ratio implies that liquidity position of the firm is good, but excess cash in ban is a non earning asset. So high current ratio in all situations cannot be a good sign. For a particular company some ratios may be good and some may be bad. In this case it will be difficult to comment on company’s overall financial situation. Ratios are interrelated and therefore single ratio cannot be used for interpretation. Ratio analyses ignore the qualitative aspect because it is a quantitative measurement.