Net Assets Gearing Ratio Increase in EPS - Assignment Example

How Ratio Analyses Can Assist Value Private and Public Company Student’s Name Course Instructor Date Introduction Ratios are a very essential tool of analysing the performance of companies. They can be used to compare performance across different companies in the same industry. At the same time, financial ratios can be used to compare performance of a company with respect to different fiscal years (Shall & Haley 1998, p.212). In this scenario, the ratios have been used to compare the performance of the company for two years. It is true that these ratios reveal a lot of information regarding the performance of the company. For instance, current ratio provides details about the ability of the company to meet its maturing short-term obligations. The ability of ratios to provide crucial information is not just limited to current ratio, instead it applies to all other ratios. In analysing financial ratios of the two companies, one initial focus will be on the results of the financial year 2011. The other years will be dealt with when analysing trends. Return on Capital Employed Return on Capital Employed = Operating Profit (i.e. before Interest and Tax) x 100% (Net Assets) Share Capital and Reserves plus Non-Current Liabilities Sainsbury Company: 2011 ROCE =  ROCE = 7.91% Williams Co.: 9.65 The figures above show that ROCE of the private company is higher than ROCE for the public company. This ratio measures the company’s gains on the capital that is invested in the company. The ratio provides information relating to the profitability of the company in connection with long term investment (Fridson & Alvarez 2002, p.50). The long term investments are also referred to as capital. In this case, it is implied that the private company receives better returns on every dollar invested in the company. Therefore, investors will be interested in acquiring ownership in the company that has better returns record. Nevertheless, the information provided cannot be enough for an investor to make sound judgement over the company that he can invest in. In other words, this ratio alone is not adequate in analysing the overall performance of the company. Gross Profit Margin Gross Profit Margin = Gross Profit x 100% Sales Revenue Sainsbury Co: 5.5% Williams Co: 24.36% The gross profit ratio is concerned more with the cost of goods sold over the period in question. The ratio brings into limelight the issue of mark-up. It is therefore aimed at providing information on the proportion of profits a firm is making on every single commodity sold. In relation to the two companies, it shows that the private company is making huge profit on every single product sold. The gross profit margin for Williams Company is 24.36% while Sainsbury is making 5.5%. This ratio means that for every item sold, the company is making that proportion of profit. On the issue of valuation of a company, the gross profit margin does not provide enough information for that kind of conclusion. This is because the gross profits can be deceptive in conveying information about the value of the company. For instance, a company may have a big gross margin yet the overheads and other expenses are also very many. At the end of it, the company may register a lower net profit margin compared to the company which had a low gross profit. Net Asset Turnover Net Asset Turnover = Sales Revenue______________ Total Assets less Current Liabilities Sainsbury Co: 2.5 Williams Co: 2.1 The net asset turnover is a ratio that evaluates the relationship between the assets employed and the sales revenue. When the turnover ratio is high, it means that the company is using well its assets to generate revenue (Fridson & Alvarez 2002, p.56). At the same time, the large ratio shows that the company is in a position to translate the assets available into revenue as fast as it can. This ratio has nothing to do with the profitability of the company. Instead, the ratio is only centred on assessing the cash flow ability of the company. Therefore, the higher the ratio the more liquid the organization is expected to be. The net asset turnover ratios of the two companies seem to be close, but Sainsbury is higher than that of Williams. This means that in terms of utilizing the assets, the private company in this case has excelled. This ratio is very crucial when it comes to assessment of the management’s ability to engage the assets of the company in generating sales revenue. Return on Net Assets Return on Net Assets = Net Profit Margin (%) x Net Asset Turnover Sainsbury Co: 3.03% Williams Co: 7.6% This ratio measures profitability of the firm in connection to utilization of resources of the company. The aim of this particular ratio is quite specific. The company uses this ratio to assess the long term ability to maintain profitability and enhance value for itself (Bandler 1994, p.178). The ratio helps the company put into perspective the factors that might affect the performance of the company in the long run. In comparing the two companies, the returns on net assets of Williams Company is more than two times the ratio for Sainsbury. This in real sense means that Williams Company has a better prospect of its future productivity. This is in relation to utilization of both fixed and current assets in generation of revenue. This definitely places Williams Company on a better scale as compared to Sainsbury. Nevertheless, evaluation of the worth of the company may not be easy with the information provided by this ratio. It is true that the company is making quite good profits, but that does not automatically place it above the public company when one is assessing investment information. Current Ratio Current ratio = Current Assets Current Liabilities Sainsbury Co: 0.58 Williams Co: 1.5 The current ratio evaluates the company’s ability to fulfil all its maturing current financial obligations. Current financial obligations may include paying creditors, settling accrued expenses, paying bank overdraft, etc. The ratio evaluates if the company has the required resources to manage fulfilling these obligations whenever the time is due during the year (Bandler 1994, p.181). In other words, the ratio is used to assess the liquidity of the company. The higher the ratio, the more the chances than the company is liquid. In relation to the ratios above, the two companies exhibit different abilities in relation to meeting their short term obligations. The two companies have not met the required ratio for most industries, which is 2.0. Nevertheless, Williams is doing better than the public company. The ratio for Williams Company is more than twice that of Sainsbury. That means that Williams is better placed to be able to settle its current liabilities. On the side of Sainsbury, the company may be required to advance a loan to be able to settle its short-term liabilities. As if that is not enough, it may be discovered that Sainsbury is in much trouble if acid test ratio is calculated. The acid test ratio is the modern current ratio and is more reliable than the traditional current ratio. This is because the acid test ratio eliminates the element of stock from the value of current assets. The rationale behind this is that stock is the current asset that is not easily convertible into liquid. Gearing Ratio Capital Gearing ratio = Borrowings (long term) Total equity (shares plus reserves) plus Borrowings (long term) Sainsbury Co: 29% Williams Co: 1% This is used to measure the level of financial leverage of the company. The ratio is an illustration of the portion of the company’s capital that is financed by debts (external sources) or equity (internal mechanisms). In relation to the two companies, Sainsbury finances 29% of its capital through debts and other forms of borrowing. On the other hand, Sainsbury uses only 1% of its capital from external sources. In financial terms, the gearing level of Sainsbury is quite high compared to Williams Company. Similarly, this may not be sufficient for an analyst to conclude that Williams is worth investing in. EPS Earnings per Share = Profit after Interest and Tax Number of Ordinary Shares Earnings per Share are the ratio that shows the percentage of profits of the company that is given to owners of the company. Since it is a publicly traded company, the owners are the shareholders. The allocation of earning in this regard is based on the number of shares an investor has in the company. The ratio is one of the most significant ratios used to evaluate the worth of the business. Investors are probably more interested in EPS than any other ratio of company for decision making. This is because there is a very close relationship between the EPS and the intrinsic benefits that an investor draws from the company (Bull 2007, p.98). The Sainsbury Company’s EPS has been growing over the last three years. In 2009 the company’s EPS was 21.2, 2010 was 23.9 and in 2011 recorded 26.5. The trend is quite impressive. This shows that the overall performance of the company has been growing all through the years. The company’s current market share is $336 per share. The company’s shares have been on a rising trend for the last three years. A part from a few occasions where the share price dropped so much, the average price of shares has been rising. The lowest price the share attained is $281 per share and it was over a year ago. At the same time, the market capitalization grew with the increase in share price. This lays a platform where it is easy to draw conclusions between the increase in share price and the EPS ratio. Dividend Yield Dividend Yield = Dividend per Share x 100% Current Market Price per Share The dividend yield measures almost the same aspects as those measured by the EPS. The dividend yield graph has been positive all through from 2008. The increase in dividends yield over such period indicates that the company is performing financially well. Analysis and Recommendation This report was directed at analysing so many ratios and how these ratios impact on the process of valuing the company. For both private and public company, most of the ratios relayed the information that was not sufficient to provide the basis for valuing the company. The various categories of ratios like profitability, liquidity, turnover, etc. provided partial information about the performance of the company. For instance, profitability ratios provide details about the profitability of the company, but cannot express the level of efficiency in terms of utilization of resources. The same story is true with other ratios. They provide information only suitable for assessing a specific aspect of the company. When it comes to investor ratios, they provide information that is mostly used by investors for investment decisions. For instance, the EPS is the ratio that is used in business valuation models. This ratio therefore does not just focus on a single aspect of the company. It encompasses all other aspects that determine the overall performance and worth of the business (Shall & Haley 1998, p.203). The EPS and the dividends yield communicate information that is crucial to the determination of the real value of the company. There is a reason why the trends in these ratios flows the same direction as the trends in market price of shares and market capitalization. Market capitalization is determined by the share price and the volume of shares traded. Therefore, as the share price is increasing, the market capitalization is also on the move. This is the reason the three components are moving the same period throughout the period under survey. Conclusion We have come to find out that each financial ratio has particular information that it communicates to the users of financial statements. Not every ratio can be of help when assessing the value of the company. From the analysis above, it is clear that valuation of a private company by use of ratio is almost impossible. This is because we found out that investor ratios are the oneswhich provide the required information in relation to valuing firms. Since private firms do not have shares and consequently market price, it is difficult to calculate the investor ratios to be used for valuation of the business. Therefore, ratios are of great use in the valuation of public companies. On the side of private companies, the information provided by the ratios is not adequate to draw such conclusion. References Bandler, J 1994, How to Use Financial Statements: A Guide to Understanding the Numbers, McGraw-Hill, New York, p178-188. Bull, R 2007, Financial Ratios: How to Use Financial Ratios to Maximize Value and Success for Your Business, CIMA Publishing, Oxford, p98 Fridson, M & Alvarez, F 2002, Financial Statement Analysis: A Practitioner’s Guide, 3rd Ed, Wiley, New York, p.46-93. Shall, L & Haley, C 1998, Introduction to Financial Management, McGraw-Hill, New York, p212-206. Read More