1143001600200Financial Analysis and Management’s assignment
00Financial Analysis and Management’s assignment
HYPERLINK “http://upload.wikimedia.org/wikipedia/en/a/ab/Gloucestershire_University_arms.png”
2171700118745Student’s name: Izmagambetova Zhanylsyn
Student ID: B0431RTRT0812
MBA Stage 2_Group_B_MSE
16 October 2012
00Student’s name: Izmagambetova Zhanylsyn
Student ID: B0431RTRT0812
MBA Stage 2_Group_B_MSE
16 October 2012
Question 1
Pyramid of Ratios
Return on Capital Employed Revisited
The Pyramid of Ratios or the du Pont Technique
160020050165ROCE
Profit for the year
Equity shareholders’ funds
00ROCE
Profit for the year
Equity shareholders’ funds
057150Profit margin
Profit for the year
Turnover
00Profit margin
Profit for the year
Turnover
354330057150Asset Turnover
Turnover
Equity shareholders’funds
00Asset Turnover
Turnover
Equity shareholders’funds
Secondary Ratios
Figure 1: Top two levels of the pyramid
ROCE (Return on Capital employed) is referred to as the Primary Ratio since it appears at the top of the pyramid. ROCE shows the capability of the company to get profit of the capital it invests. Based on Parrino and Kidwell (2009) explanations, ROCE is calculated by determining the fraction of the company’s capital utilized that the company made in pre-tax profits before the costs of borrowing. This is how the ratio looks:.
-10160451485ROCE = Profit for the year margin (Profit before interest and tax) x Capital Employed Turnover
00ROCE = Profit for the year margin (Profit before interest and tax) x Capital Employed Turnover
This is how the ratio looks:
These relations are essential and this is seen better when the formula is written out in full:
ROCE= Annual profit/Turnover=Turnover/ Equity Shareholders’ Funds
01143000ROCE=Profit for the year/Turnover=Turnover/ Equity Shareholders’ Funds
00ROCE=Profit for the year/Turnover=Turnover/ Equity Shareholders’ Funds
011430Return on Capital Employed (ROCE) = Annual profit * 100
Equity Shareholders’ Funds 00Return on Capital Employed (ROCE) = Annual profit * 100
Equity Shareholders’ Funds and ROCE=Profit for the year/Turnover=Turnover/ Equity Shareholders’ Funds
When the profit margin and invested capital turnover ratios are put together and cancelled, the ROCE is got:
092075Profit for the Year = Profit for the Year * Turnover
Equity Shareholders’ Funds Turnover Equity Shareholders’ Fund
00Profit for the Year = Profit for the Year * Turnover
Equity Shareholders’ Funds Turnover Equity Shareholders’ Fund
When the ordinary elements cancel out from the profit margin and invested capital turnover ratios, Return on Capital employed is obtained;
053975Profit for the Year = Profit for the Year * Turnover
Equity Shareholders’ Funds Turnover Equity Shareholders’ Fund
00Profit for the Year = Profit for the Year * Turnover
Equity Shareholders’ Funds Turnover Equity Shareholders’ Fund
Giving
061595ROCE = Profit for the Year = Profit for the Year
Equity Shareholders’ Funds Equity Shareholders’ Funds
00ROCE = Profit for the Year = Profit for the Year
Equity Shareholders’ Funds Equity Shareholders’ Funds
Usefulness of pyramid of ratios in interpreting financial statements
For the beginners, ROCE is essential in balancing the relative profitability of a company. According to Barnes (2006) it is also an effective measurement of the sort since ROCE determines a firm profitability refereeing to the amount of capital used. When the capital involved is slotted in, one can easily determine whether the firm is using the profit appropriately or not (Barnes, 2006). When ROCE is high, it is an indication that bigger earnings can be reinvested into business for the shareholder’s benefits. The amount reinvested in the firm further produces higher earnings-per-share. The companies with higher ROCE are always considered successful.
b) Discuss the usefulness key investor ratios in comprehending the performance of a business:
dividend rate
dividend yield
earnings per share
P/E ratio
1) Earnings per share (EPS) is the sum of money earned for a give period of time per share of common stock.
0148590Earnings per share (EPS) =Net income available to common shareholders/Number of common shares oustanding
00Earnings per share (EPS) =Net income available to common shareholders/Number of common shares oustanding
According to Clayman & Fridson, George (2012), companies ought to provide information on their earnings per share in their financial statements. The two earnings per share ought to be disclosed in the financial reports are basic and diluted earnings per share.
Basic earnings per share are obtained by getting the difference between net earnings and dividends, then dividing difference by the mean number of outstanding shares. The diluted earnings per share are obtained by getting the difference between income and preferred dividends then dividing the difference by number of outstanding shares taking into account all dilutive securities for example, options and convertible debt. The diluted earnings per share are indications of the possible dilution of earnings (Clayman & Fridson, George 2012). A significant difference is seen between the basic and diluted earnings per share for large companies with various dilutive securities for instance stock opinions and or convertible preferred stock.
Book value equity per share is the quantity of the book commonly referred to as the carrying value, of equity per share of stock. This is obtained by dividing the value of shareholders equity by the amount of shares of regular outstanding stocks. As earlier mentioned, the value of book equity and market value may differ. The market value per share, suppose available, is a better measure of the shareholder’s investment in a firm (Bayldon & Woods & Zafiris 1984).
2) The price-to-earnings ratios (P/E or PE ratio) is the ratio of the price per share of common stock to the earnings per share:
0205740Price-to-earnings ratio=Market price per share/Earnings per share
0Price-to-earnings ratio=Market price per share/Earnings per share
Parrino, R., Kidwell, D. (2009) argue that the earnings per share typically used in the denominator is the sum of earnings per share for the last four quarters. In this case, the P/E is often referred to as the trailing P/E.
On the contrary, the leading P/E is determined using approximate earnings per share for a period of four quarters. At times, P/E is using a proxy for assessing the firm’s capability of making cash flows in the coming days. The evaluations are generally carried out by investors. Suppose the company has less than one earnings, P/E is considered to have no meaning.
3) The dividend yield ratio connects the cash return from a share to its current market value. This can help investors to assess the cash return on their investment in the business.
The ratio is expressed as a percentage: where t is the dividend tax credit rate of income tax.
-571580645Dividend yield = (Dividend per share/(1-t)*100))/Market value per share
0Dividend yield = (Dividend per share/(1-t)*100))/Market value per share
In the world, investors who get a dividend from a business get a tax credit as well. As this tax credit can be offset against any of income tax, at the dividend tax credit rate.
According to Rouse (2007), majority of the investors prefer comparing returns from shares with the ones from other investments. Since the other investments forms are quoted on a gross basis, it is essential to accumulate the dividend to make easier comparisons. This can be attained by dividing the dividend per share by (1-t), where t is the dividend tax credit rate of income tax.
Use of dividend yield formula:
As mentioned by Brooks (2012), the dividend ratio formula can be used by investors looking to increasing or reducing trends of the dividend yield. A firm which is paying less dividends compared to its price may be having difficulties or could be retaining some of percentage of its net income. When approximating a stock, there is the necessity of considering the company as a whole and the worth of net income the company is retaining as reinvestment of the company’s income can lead to better further growth and profitability.
The other importance of the formula is that it is essential for investors who depend on dividends from their investments. However, reduced dividend is not an indication of lower dividends since the hare prices could have increased. As earlier mentioned, a decreasing trend in dividends should only necessitate examination and not doing away with the investment (Brooks 2012).
4) The dividend cover ratio is an estimate of various commonly employed when determining the financial strength of a firm (Jonathan & Peter & Jarrad 2012). The ratio is concerned with the connection between dividends paid by the firm and the earnings that it makes. Presented is a fundamental of dividend cover ratio. To determine the dividend cover ratio, the earnings per share of a firm are divided by the yearly dividend per share.
The investors using dividend cover ratio can get various information. By considering the ratio, one will be able to determine if the firm is struggling to pay its dividends or if the company meets its obligations. Investors only like to be associated with companies that are bale to pay their dividends. Even though, the dividend ratio has a lot of information about a company’s liquidity, there are other various factors to be considered by investors before making an investment.
Various things could determine the numbers, and investor has to consider the entire situation when determining the company’s liquidity. Though the ratio and other things, one can easily determine which company is able to invest in.
Question 2
1) The significance of Profits and Liquidity
Importance of liquidity
As mentioned by Ekanem (1994), suppose a manager says the company has liquidity or problems in getting working capital, this is an indication that the company will run into problems meeting its obligations. This is an indication that the firm do not have cash at hand and might not be expecting enough finance to run the business.
Liquidity is required for the running of the business, pay dividends and wages, suppliers and others. For a short period, liquidity is essential than gains, but over a long time, it does not make sense having cash if it has not come form the profit made by a company. Positive cash flow is essential to a company’s success and among the main areas for financial ratio analysis is the company’s level of cash. The liquidity gives the extent to which a firm is able to meet its obligations both over the short and long term basis.
Liquidity ratio is over a short period, so companies that use current assets and liabilities accounts. The accounts trace the assets that are to be converted to money in the short term and liabilities to be overcome in the short term. Suppose a company is not capable of meeting its short-term obligations, it might find itself being bankrupt (Benjamin & Spencer 2008).
To gauge the liquidity of the firm, a few key ratios are given to help understand the potential near-term cash flow:
0-42545Cash ratio=Cash/Current liabilities
00Cash ratio=Cash/Current liabilities
Importance of Profitability
Gains are the reason for a business existence, and it is the ability to make profits that encourage business owners to take risks in investment. The most significant role of profit is rewarding the entrepreneurs. The other importance of profits are
• Profits give money for investments. Gains kept in a company and reinvested assists the company grows. •It is through a company’s profits that new investors are attracted. This leads to increased capital. •It is through profits that business value is increased, and this gives the business owners capital gain. •Through the profit, a company is able to repay its loans, and hence reducing company’s reliance on other firms or individuals (Saleem 2011).
Importance of profitability is explained by profitability ratios. Profitability ratios measure how competently the firm is turning sales or assets into income. Ultimately, what financial manager want to know is how well company has performed overall, that is, how the company has generated profits. The following ratios help to analyse that overall performance:.
Connection between liquidity and profitability
According to Saleem (2011), liquidity and profitability are correlated. They two are inversely related since an increase in one leads to decrease in the other. Evidently, there are various conflict between decisions made by managers concerning profitability and liquidity. For instance, suppose higher investors are kept in expectation of an increment in prices of goods, profitability goal is approached but this endangers the firm’s liquidity.
There is a direct connection between higher return and higher risk which endangers liquidity. A company may increase its profitability through an enhanced debt equity ratio. However, when a firm increases money from other sources, it commits itself to making the payment of interest.
In all areas of financial management, he management select between risks and profits. The management ought to forecast cashflow and analyse different sources of money. It is mainly the forecasting of cash flow and managing it that results to liquidity, control of prices and forecasting coming benefits are among the roles of management and these leads to business profitability.
2) Liquidity risk
Short-term investments represent a temporary store of funds that are not necessarily needed in company’s daily transactions. If a substantial portion of a company’s working capital portfolio is not needed for short-term transactions, it should be separated from a working capital portfolio and placed in a longer-term portfolio. The long-term portfolios are normally dealt with by a given area or a manager under strict company’s supervisions. In this way, the risks, maturities, and portfolio management of longer-term portfolios can be managed independently of the working capital portfolio (Pastor and Stambaugh 2003).
One of these risks is liquidity risk. Risk liquidity is the risk which is difficult to deal with as a company might not realize its assets or the company might increase funds to fulfill commitments regarding financial instruments. In this Figure 2, liquidity risk and attributes and safety measures are associated. The attributes describe the conditions that contribute to the type of risk, and the safety measures describe the steps that investors usually take to prevent losses from the risk (Pastor and Stambaugh 2003).
Figure 2. Liquidity risk, safety measures.
Type of Risk Key attributes Safety Measures
Liquidity Security is difficult or impossible to sell
Security must be held to maturity and cannot be liquidated until then
Stick with government securities
Look for good secondary market
Keep maturities short
Working capital
The cash conversion cycle
Brooks (2012) states that working capital (WC) consists of a company’s current assets and liabilities. Managing these assets and liabilities in a way to improve the company’s flow is what working capital management is all about. This strategy focuses on retaining effective levels of both present assets and present liabilities so that a company has greater cash inflow than cash outflow.
Managing WC is the operational side of budgeting. When we put a budget together, we anticipate future cash flow and the cash flow timing. When we manage WC, we are trying to ensure that we produce the required level of cash inflow at the appropriate time to handle the cash outflow. To achieve this, a company decide when and what to order, when to extend credit, when to write off debts, and when to make informed short-term financial decisions.
In general, we know that a company must build the product before it can sell the product, so we need to understand how long a company must finance its operation before a customer pays. The cash conversion cycle helps determine that length of time by measuring the amount of time money is tied up in the production and collection processes before the company can convert it into cash. Three different cycles constitute the company’s overall cash conversion cycle:.
1.The production cycle: the period it takes to build and sell the product
2.The collection cycle: this is the period of collecting from customers (receiving accounts receivable).
3.The payment cycle: the taken to pay suppliers and labour (paying accounts payable)
This is the time cover in order to finance its operations. In other words, the CCC begins when a company first pays out cash to its suppliers and ends when it receives cash in from its customers. Essentially, it measures how quickly a company can convert its products or services into cash. We can show the relationship as:
047625Cash conversion cycle=Production cycle+Collection cycle-Payment cycle
00Cash conversion cycle=Production cycle+Collection cycle-Payment cycle
We should make one further distinction within the CCC: the business operating cycle. This cycle starts at the time production begins and finishes with the cash collection from the sale of the product. It is the core of the business: making and selling the product and collecting the revenue from the customers. In other words, the business operating cycle has two components: the production cycle and the collection cycle. If one recalls the «march to cash» in the opening of this assignment, the operating cycle describes this movement up the balance sheet from inventory to accounts receivable to cash. We «pull out» the CCC’s operating cycle to focus only on what it takes to move from cash outlay (the payment cycle) to cash inventory. Figure 3 shows various graphical relationships of the CCC (Brooks 2012).
Figure 3. The cash conversion cycle.
0101600Start of production to receipt of cash from sale of product
00Start of production to receipt of cash from sale of product
2400300119380Production cycle:
0Production cycle:
114300119380Collection cycle:
0Collection cycle:
The time to product a product The time from the sale to the
and then sell it to a customer. receipt of cash for the sale.
240030099060Cash conversion cycle:
0Cash conversion cycle:
-11366599060Payment cycle:
0Payment cycle:
The time between when a raw The time between when a company
material is ordered and received pays for raw materials and when it
and when it is paid for. Receives payment for its product sale.
Let’s look at the different cycles in Figure 3. The overall CCC through the experiences of a small company, Corporate Seasonings, a catering company. Corporate Seasonings caters mainly to the business community by providing box lunches and breakfast food trays. The company typically receives food orders three days to a week in advance of an event. Customers pay after delivery, but the company receives some payments immediately and some over the next few months. Because Corporate Seasonings receives payment after production, it must figure out how to finance its daily operations. Let’s have the owner explain her business in her own words.
Minimise the risk of liquidity (Working capital)
A firm ought to have a sufficient level of working capital to achieve the present obligations and continue with business operations. The firm has to sure that it does not run out of operations due to liquidity. The failure of a company to meet its obligation as a result of insufficient liquidity is risky since it will lead to poor credit imagine, lose of investors confidence, or at times the company might close down.
The liquidity is affected in cases where the level of capital is holding more of the present assets of the company. In other words, the working capital should not be either too high or too low. A well supervised least working capital level at a calculated risk is normally advantageous for increased profitability.
Question 3
According to Chandra (2007), the policy of dividend is concerned with making a decision concerning cash dividend in the current or paying increased dividend later. The company can decide to pay also through stock dividends, which is not the case with cash dividends as they do not offer liquidity to the institutional investors. Cash flow dividends however ensure the shareholders gain capital. The expectations of the dividends by the shareholders assists them estimate the value of a share and it is significant in decision making by financial managers of a firm. Importance of this dividend policy is described by Christie’ company dividend policy. Christie settles dividends to its shareholders annually in cash. From the chart above, it can be seen that dividends per share and EPS were increased. (Figure 4,5). Such a situation means that dividend policy is likely to be acceptable to its institutional investors.
38100231140
Figure 4. Dividend per share (pence)
Because of increase of EPS there is a rise in the payout ratio figure, graphically:
788035109220
Figure 5 Earning per share (pence).
EMBED Excel.Chart.8 s
Figure 6. Payout ratio.
Regular Dividend Policy
Dividend policy of Christie’s firm can be commented also by regular dividend policy. The normal dividend policy is founded on the payment of a non changing dollar dividend in every period. The policy allows the owners to have positive general information, and hence reducing their risks. Mostly, firms using the policy increase the normal dividend if there is an increase in earnings. Under this policy, dividends are almost never decreased (Lambert & Lanen, Larcker 1989).
The dividend policy of Christie is to pay about £9 per share until per share earnings have exceeded £29 for three consecutive years (Figure 5). Form that point, the yearly dividend is increased to £11.4 per share, and new earnings plateau is made. The firm does not expect to reduce its dividends till its liquidity is reducing. Data for Christie’s earnings, dividends share price for the past 6 years follow.
No matter the earnings level, Christies paid dividends of nearly £9 for every share in 2004. In the proceeding year, the price of dividends rose to £11.1 for every share since earnings exceeding £29 had been attained for the three years as illustrated in Figure 5. In the same year, 2005, the firm established a new earnings plateau for the increased dividends. The mean price per share for Christie became stable, increasing behaviour despite the earning patterns (Brennan & Thakor 1990).
Figure 7. Payout ratio of Christie’s company.
Year 2006 2005 2004 2003 2002 2001
Payout ratio 0.333 0.336 0.339 0.336 0.33 0.335
Mostly a normal policy is built referring to target dividend-payout ratio. Under the policy, the firm tries to pay a given fraction of earnings, but not to let the dividends fluctuate, the firm pays stated dollar dividend and increases the dividend to achieve the targeted payout as earnings rise (Brennan & Thakor 1990). For example, Christie seems to have a target payout ration of about 33.5% or £8.5/£25.4 when the policy was set in 2001, and at the time dividend was increased to £11.1 in 2005, the payout was approximately 33.6% or £11.1/£33 as illustrated in figure 6.7.Bibliography
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