Profitability of the Company International Commitments Ltd - Assignment Example

? Corporate Finance Assignment Corporate Finance Assignment Board of DirectorsSubject: Financial Analysis Date: 21-07-2012 a) The company’s profitability in the year to 31/12/2011 Income Statement Analysis: I am required to present a report on the profitability of the company International Commitments Ltd. The company in the year 2011 had net sales of € 13,193,000, which seems to show that the company is a large scale company. The cost of goods sold represents 30.7% of the net sales and other expenses comprise around the same of 30.6% of the net sales. The company is incurring large amount of other expenses, the expenses other than the ones directly attributable to the production of good and services which almost equals the cost of goods sold which show the company has some room for cost cutting as the other expenses in the companies can be cut down and most of the times are less than the cost of sales. The non-cash expense depreciation amounts to € 2,518,000 which is 19% of the revenue incurred by the company and decrease the EBIT by 19%. The company has invested heavily in the non-current assets which is € 19,973,000 which is the reason of high depreciation charge every year. On the other hand the company is bearing high interest expense of € 685,000 which is because of the high amounts of long term liabilities obtained. The income before tax of the company for the year is € 1,881,000 which makes a gross profit of 14.25%. The GP ratio shows the company is profitable and is successful in meeting its expenses seeing its revenue. The income after tax amounts to € 1,223,000 which makes a net profit of 9.27% which is a good NP ratio for any company as it is meeting its expenses and earning a profit. By the profit and loss statement analysis the company seems to do well in all the areas is a profitable entity which is able to earn profit after meeting its expenses. Balance Sheet Analysis: The profitability of the company by seeing its balance sheet can be analyzed by determining the fact how profitable the business had been considering the amount of the resources invested in the business. The balance sheet can even help in determining the changes that incurred in business’s assets or liabilities from previous years and can be a good determinant of company’s performance considering its position from last year. That is, the earnings obtained from the assets employed in the execution of the business shows its profitability. International Commitments Ltd. The return on capital employed of the company can be calculated as 5%, considering the net income and the long term assets invested in the company to generate the earnings. ROCE of the company seems to be stable and the company is profitable in this aspect which means it is earning well according to the amount invested in its assets. Another profitability ratio that could be used to determine the balance sheet standing is Return on Equity (ROE) which analyzes the net income earned and the shareholders equity to generate that income. This shows the level of earnings made in comparison with the amount of equity introduced by the shareholders. International Commitments Ltd. The return on equity of the company can be calculated as 12.5% considering the net income and the equity invested in the company by the shareholders to generate the earnings. The company also seems to be profitable in this aspect. The company’s Earning Price Ratio (EPS) is a good measure for company’s performance reflected by the number of shares issued by the company, that is the amount of ordinary shares issued and the capital obtained from the shareholders initially. The company’s EPS can be calculated as € 0.59, which means the company earns € 0.59 per share issued by the company. (b) The company’s financial performance in the same year in terms of liquidity, financial leverage, and value added during the year. Liquidity: Liquidity ratios are important to analyze company’s liquidity position. The company cannot execute its operations successfully until it isn’t self sufficient in its cash resources. It is important for any company to finance its operations on mostly cash basis to avoid additional costs associated with borrowing cash. Liquidity ratios analyze the level of readily available cash in the company to finance its expenses. Firstly the borrowing ratio of the company can be calculated as 185% which shows the level of borrowings made by the company including the short term and the long term borrowings as compared to the shareholder’s equity in the company, this signifies the level of borrowings made in terms of equity invested in the company. The company seems to have a very high borrowing ratio and the shareholder’s equity isn’t sufficient to payoff all the liabilities of the company. Another ratio to determine the liquidity is the net working capital ratio which takes into account the current assets, current liabilities and total assets of the company. This can be calculated as -0.04, which shows that the company has liabilities more than the assets it has to pay off its debts. On the other hand the company’s quick ratio that is without considering the inventories as they are less liquid assets, the acid test ratio can be calculated as 0.69:1, which means the company has 0.69 assets to payoff its liability of 1. This shows the company has fewer assets and more liabilities. If today the business has to be closed down, despite of being profitable, it will not be able to pay off its liabilities. Financial leverage: The financial leverage or gearing ratios are a measure to analyze company’s debts against its total assets or equity. This measure whether a company is financed mainly by equity or its debts. High gearing ratios shows that the company is heavily in debts and its assets or equity are not enough to pay them off. The company’s debt to asset ratio can be calculated as 65%, which means the company’s total liabilities against its assets are 65% which is a reasonably acceptable ratio. On the other hand the company’s debt to equity ratio is 185% which means the company has mainly used debts as the source of finance and the equity is way lower than the debts taken. Other Ratios: The company pays out dividends of € 856,000, which makes the dividend as € 4.17/ share, which is a good paying out dividend. Accordingly, the dividend yield of the company is 4%. The company pays a good return to its shareholders in terms of dividend. The PE ratio of the company compares its market price of stock and its earning; PE ratio is a very important measure of the company’s analysis. The PE ratio of the company is 142.3, which is a really high P/E ratio which means that the investors are paying more on the company’s shares. The asset turnover ratio of the company represents the company’s sales as compared to the assets employed in the company. The company’s asset turnover ratio is 50%, which means the company generates 50% of the revenue compared to the assets employed in it. The account receivable seems to decrease from € 2,490,000 to €2,382,000, decreasing by 4%, on the other hand the accounts payable have also decreased by 15% which shows the company has relied on less credit from suppliers this time. Inventories have also decreased at the end of the year as compared to last year by 25% which means the company is trying to lower its investment in inventories for better working capital management. The cash and marketable securities of the company have decreased by 43%, which could be reasoned by the heavy dividends paid during the year and the interest expense borne by the company. The company’s reliance on long term liabilities have also increased this year which could be seen by an increase in long term debt and leases and other long term liabilities which have increased relatively from last year. 2. The Board of Directors is anxious to develop a policy of sustainable growth in the company’s operations over the next number of years. Describe the main financial issues to be taken into account in formulating such a policy. A specific policy is not required, just the main issues to be considered. The International Commitments Ltd. is a profitable company with the GP ratio of 14.25% and NP ratio of 9.27% and is doing well currently. However, the company seems to have a few issues which if not attended can be a problem in the future. For smooth running of the business along with maintaining its profitability the company needs, in order to grow sustainably without the shot term approaches the company needs to consider a few issues which are: Cashflow: The International Commitments Ltd is a profitable company but with the financial analysis undertaken it seems to be not so self sufficient. The company has current ratio of 0.74:1 which means it has poor liquidity position and will not be able to pay off its liabilities in the short term. The cash and other marketable securities have also decreased as compared from last year which is an indicator of cash being less in hand. However, the company has improved it working capital management this year and there seems to be less money invested in receivable, payables and inventories which makes it obvious that the company is not relying on short term cash sources anymore. The major reason for cash flow issues to arise despite of better working capital management is the increased expenses. One of the expenses that can be directly associated with the cash flow position is the interest expense which results due to company’s heavy reliability on debt as a source of finance. On the other hand, the company has a heavy dividend payout ratio and has paid € 4.17/ share of dividend which is a high cash expense for the company. Even if the company is profitable it isn’t necessary it pays out dividend. International Commitments Ltd has caused itself cash flow issues by increased cash expenses and now seems to rely heavily as debt as a source of finance. Sources of finance: International Commitments Ltd, as mentioned above is not relying on short term cash sources anymore and has invested heavily in long term debts. The company has a debt to equity ratio of 185%, which show that the company has used debt as a source of finance. Debt as a source of finance can be a good option is rare circumstances. The company has a lot of room to issue shares and use equity as a source of finance which is preferred and recommended source of finance. In debt as a source of finance, a lot of issues arise such as high interest payments on the debts taken and its repayment along with interest amount, which can cause great affect on the cash flow position of the company which can further enhance the problems in the long run. High debt also causes increased financial risks for the company. On the other hand, at times the company chooses debt as a source of finance for other benefits such as for saving tax for the company. As the interest expense goes to the income statements it automatically lowers down the company’s profit and less tax is to be paid. Therefore from the profitability point of view it is widely accepted that debt is a cheaper source of finance. However, with equity as a source of finance, the only cost to be incurred by the company is the dividends that are to be paid out, which can be deferred, unlike the debt option where the interest and repayment of loan cannot be deferred and has to be paid on time. The option of choosing the source of finance should be carefully analyzed for the long run, the company should trade off its risks and returns and should invest carefully that would benefit the company in the long run. (CRUNDWELL. 2008). 3. Include on your report your understanding of some of the main pitfalls in financial statement analysis. Financial statement analysis is important for any company for a lot of reasons mainly for the assessment of its own performance and the assessment made by the investors. The ratios analysis is a widely used method of analyzing financial statements. It does guide and provide with results that could be relied on. However like every other method it has pitfalls. Firstly, the financial statements are prepared on the historical cost basis and the whole analysis is done on the same basis. This could be a problem as it doesn’t represent a true picture of the current standing of the business which could have been better assessed by the current market value approach, for e.g. the property and equipment stated at cost in financial statements will have much higher or lower realized market value. (PETERSON DRAKE & FABOZZI. 2006) Secondly, when the companies’ financial results are used for comparison there could be high differences in accounting policies adopted for e.g. depreciation rates and policies, inventory valuation etc. which causes a lack of like to like comparison between the results of analysis. Even if a change in accounting policy is made by the company, its affects the financial results and makes the trend analysis difficult. Thirdly, the selection and interpretation of ratios could also differ when comparison is being undertaken of financial statements, which could also cause a problem. (PETERSON DRAKE & FABOZZI. 2006) Thirdly companies often restate its financial data due to adjustments in errors and mistakes, problem arises when analysis is to be made and question arises to use the reported or restated data. On the other hand classification of few items, which are very technical to classify, can change the whole financial analysis if not classified properly. (PETERSON DRAKE & FABOZZI. 2006) Bibliography CRUNDWELL, F. K. (2008). Finance for Engineers Evaluation and Funding of Capital Projects. London, Springer-Verlag. http://proxy.uqtr.ca/login.cgi?action=login&u=uqtr&db=springer-eb&url=http%3A%2F%2Fdx.doi.org%2F10.1007%2F978-1-84800-033-9. PETERSON DRAKE, P., & FABOZZI, F. J. (2006). Analysis of financial statements. Hoboken, N.J., Wiley. Read More