Profitability analysis of GSK Plc and Pfizer for year 2016 and 2017

GSK plc refers to GlaxoSmithKline and it ranks amongst the top companies in FT Global 500 companies. GSK is top pharmaceutical company in the world and it operates in two major sectors: Consumer Healthcare and Pharmaceuticals. The purpose of this section of assignment is to evaluate the financial performance of GSK Plc through use of ratio analysis. The motive is to evaluate the profitability performance of the company through calculating some of important profitability ratios such as return on capital employed, operating profit margin and earnings per share.

In addition to ratio analysis, various competitive and macro-economic influences on each of profitability ratios has also been discussed in this section of the assignment. Profitability performance of GSK plc has been compared with one of its top most competitors, Pfizer Inc. Pfizer also rank amongst the top pharmaceutical company of the world and this company was founded in New York, USA (GSK Plc, 2017).

Profitability analysis of GSK Plc and Pfizer for year 2016 and 2017

Profitability analysis through ratios aims to measure the management ability to earn the profits in relation to sales revenue, equity and assets. Profitability analysis also embarks its importance on return earned by the company on the total capital invested during the period. It is expected from the management to make sure that there is optimum utilization of resources to earn maximum sales revenue. Management must also make sure cost of goods sold and operating expenses should be kept at lowest level so that company can earn maximum profits.

Profitability ratios aim to assess the ability of the company to generate profits, cash flows and earnings in relation to some base often referred to as total capital invested, or any similar basis. It can be said that profitability ratios is very useful to evaluate how effectively the profitability of the company is managed. Each profitability ratio provides different category of information about the financial health and performance of the entity. For example, operating profit margin and net profit margin provides information on how effectively company manages its expenses whereas return on capital employed information on how effectively company uses its capital to generate the returns. Earnings per share tell how much profit earned by the company on each share of issued in the market (Higgins, 2012).

Return on Capital Employed

It is the most important profitability ratio that measures the profits earned by company on percentage of capital employed. Here capital employed means total of shareholder’s fund and non-current liabilities that is used by the company to financed the assets of the company.

Formula: EBIT/ (shareholder’s Funds + Non-Current Liabilities)

Return on capital employed for GSK

• For year 2016: £ 2598 /(£ 35117+ £ 1124) = 7.17%
• For year 2017: £4087 + ( £ 26323 + (-68)) = 15.57%

Return on capital employed for Pfizer

• For year 2016: £ 8351 / (£ 80661 + £ 59840) = 5.94%
• For year 2017: £ 12306 /( £ 69714 + £ 71656) = 8.70% (Horngren, 2009)

Return on Capital Employed
Particulars	GSK Plc	Pfizer
	2016	2017	2016	2017
Ratio	7.17%	15.57%	5.94%	8.70%

(GSK Plc, 2017)

Return on capital of employed of GSK Plc was better than the Pfizer in both the years. In year 2016, the return on capital employed was 7.17% and it was increased to 15.57% in year 2017. On the other hand, return on capital employed of Pfizer was 5.94% in year 2016 and it got increased to 8.70%. So, it can be said that GSK plc has provided better returns on the total capital employed by the company.

Return on Capital Employed

Operating Profit Margin

This ratio is used to evaluate the operating performance of the entity and it indicates the percentage of sales earned by the company after paying cost of goods sold charges and operating expenses. It is generally expressed as the percentage of sales. This ratio is the best tool to evaluate the performance of one company with the performance of other company (Kaplan and Atkinson, 2015).

Formula: Operating profit margin / Sales Revenue * 100

Operating profit margin for GSK

• For year 2016: £ 2598/£27889 = 9.32%
• For year 2017: £4087/£ 30186 = 13.54%

Operating profit margin for Pfizer

• For year 2016: £ 8351 / £ 52824 = 15.81%
• For year 2017: £ 12306 / 52546 = 23.42%

Operating Profit Margin
Particulars	GSK Plc	Pfizer
	2016	2017	2016	2017
Ratio	9.32%	13.54%	15.81%	23.42%

(GSK Plc, 2017)

On the basis of above graph it can be said that operating profit margin of GSK Plc was lower than the Pfizer. It can be said that Pfizer has lower rate of operating expenses as compared to GSK plc that helps them to maintain higher rate of operating profit margin. So it can be said that GSK plc has poor profitability due to lower operating profit margin.

Earnings per share: Earnings per share refer to that part of profits that is meant for distribution to the shareholders on each outstanding share. Earnings per share is very important form the investors point of view as it is very good indicator of profitability. It is the reason why this ratio is widely used to assess the profitability of companies (Firer, 2012).

Formula: (Net Profit after Taxes) / Number of Equity Shares

Earnings per share
Particulars	GSK Plc	Pfizer
	2016	2017	2016	2017
Ratio	£               0.19	£              0.31	£            1.19	£               3.58

(GSK Plc, 2017)

 Pfizer has higher EPS as compared to GSK plc and it is because Pfizer has successful in keeping its expenses low as compared to GSK plc. EPS of GSK plc was £ 0.19 in year 2016 whereas it was £1.119 in the same year. However, EPS of GSK plc has increased in year 2017 as compared EPS in year 2016. Pfizer has much better EPS as compared to GSK plc.

Overall it can be said that GSK plc has poor profitability performance as compared to Pfizer in both the year. However, return on capital employed of GSK Plc was more than Pfizer.  

There are many macro-economic factors that influence all the above ratios. Some of these macro economic factors are market size, rate of inflation, discount rate, gross domestic product, and change in customer preferences, government restrictions and many other factors that controls the profitability of the company. Profitability ratios are largely impacted by the competitive factors such as technology innovation, demand of the product and services, bargaining power of buyers etc (Horngren, 2009).

Zero Based Budgeting

Zero based budgeting is type budgeting method used under the budgeting process of the entities. Under this process budgeting is performed from the zero base ie all the data and information are gathered first time. In zero based budgeting process either past information is not available or management wants from cost manager to formulate complete budgets without using the past information. Zero based budgeting process is time consuming as it requires evaluating every line item of the cash flow and other budgets. It requires all the cash inflows and outflows to be justified in detail so that there will be very less variance in the budgets and actual outputs (Wetherbe and Montanari, 1986).

Operating Profit Margin

Zero based budgeting is most important budgeting system that is based on current estimates of all the activities whether old or new. It does not take into account the budget developed for the past activities. The application of zero based budgeting takes organization very far away from the incremental based budgeting or traditional budgeting. In incremental budget previous year budget is taken as the starting point and any addition or modifications are carried on previous budgets to formulate the current year budgets. Whereas in zero based budgeting cost manager starts from zero point and takes an assumptions that previous spending patterns are no longer used (Varlotta and Jones, 2010).

Under zero based budgeting organization are divided into lowest level possible and these units are called as decision units. Budgeting decisions are now taken for these decisions units and after than all the data is combined to prepare the current year budget. The procedure adopted in zero based budgeting is complicated as compared to incremental based budgeting and it requires more time to prepare the budgets as each cost in an activity is cross examined before preparing the new budgets.

Managers in each decision unit are required to provide detailed information about all the activities including the spending plan required to achieve the goals of those decision units. This end ups with minimum three decision packages of each decision units and to the maximum it can be 10 or more. The three important decision packages that are prepared are base package, current service package, and enhanced package. There are some difference in these decision packages that describes difference of marginal spending and other variances (Varlotta and Jones, 2010).

Benefits of the zero based budgeting

• Zero based budgeting is quite useful to increase the accuracy within the departments as it ensures through examination of each of the functions performed within the department. Under this budgeting technique managers need to examine needs of resources by each activity and also the level of efforts and different ways to complete the activities are identified.
• Zero based budgeting takes into account the opinion and concerns of mid level as well as line managers as this budgeting technique requires detailed information for lowest level of decision making units.
• Zero based budgeting is regarded as the most important basis for cutting the cost of budgets. Zero based budgeting offers rational and comprehensive ways to reduce the budget expenses.  Various decision packages are developed for each of decision unit which act as the base to make use of best decision package that is suitable for the particular activity and also provides maximum benefits as per the expenditure incurred for that particular activity. It is possible because spending of each activity has been put under scrutiny before any decision has been taken (Kavanagh, 2012).
• Another major advantage that zero based budgeting provides is that it helps the top level management to gain the greater insights of the workings of the lower level departments. All the details such as activities, spending and estimates of cost and profits of each department are documents by each line manager are forwarded to the top level manager to include into the budgets after performing the complete evaluation.
• Resources are allocated in systematic way as operations and programmes of each activity are evaluated in detail that provides deep insight view of resources required by each activity. So resources are allocated systematically and in required manner to fulfill the objectives defined under each activity.
• It allows cost benefit comparison of each department budgets on the basis of decision packages developed for each activity. Unlikely in other budgeting system there is no arbitrary allocation of resources in case of zero based budgeting (Lalli, 2011).
• Activities that are redundant or unproductive can be easily identified and removed after verification. So it can be said that zero based budgeting is very cost effective and it allows including all those activities that are valuable and provides some productive results.
• Zero based budgeting helps to improve the coordination and communication between the departments. In turn it helps in increasing the efficiency of the employees as they are involved in decision making.

Drawbacks of the zero base budgeting

• Zero based budgeting is not the one day process as it involves huge time period as well as requires investment of huge amount of money. So, zero based budgeting is very hard to implement and requires a decision of top management before making it implement.
• It is highly important to make successful implementation of ZBB but it requires full support from the top management and it has been seen many times support from the top management is not readily available due to many issues and communication problems.
• At the time of preparing the zero based budget there is requirement of experts at every department that can formulate the decision packages in proper manner (Ackah and Agboyi, 2014).

Situations when zero based budgeting is most appropriate to use

There are many situations where zero based budgeting is very useful for the companies but it is necessary to make cost benefit analysis before taking the decision to implement the activity based budgets. When there is situation where it is not possible to implement the incremental budgeting technique due to major modifications in the existing process and company is ongoing with the major expansion. Although zero based is cost expensive but its advantages proves to be beneficial in near future as it leads to major reduction in cost that is proportion to activities that are redundant in nature (Ackah and Agboyi, 2014). 

Critical Evaluation of Strengths and Weaknesses of the Balance Score Card (BSC) form of Performance Measurement

The business executives are increasingly viewing the traditional systems used for performance measurement are largely proving to be ineffective in managing the complexity of their business operations. This is because the traditional form of performance measurement only assesses the business performance on the basis of financial parameters and does not take into consideration the operational measures. As such, the need for business executives to track the financial and operational metrics has lead to the development of balance scorecard that assesses the performances of businesses on the basis of four set of parameters. These are financial measures, customer satisfaction, internal processes, innovation and improvement.

Earnings per share

The financial perspective includes the financial metrics that need to be adopted for examining the financial performance such as return on capital and cash flow. Customer satisfaction includes measures such as time, quality, performance, service and cost for measuring the satisfaction level of the customers. The internal processes include measures such as cycle time, quality, employee skills and productivity for assessing the internal performance of the businesses. The innovation and learning perspective of the balance scorecard measures the performance of the company on the basis of the parameters such as its ability to innovate, improve and learn in relation to the value created for the customers. The strengths and weakness of the balance scorecard form of performance measurement can be described as follows:

Strengths

BSC acts as a strategic management tool for businesses as it enables the managers in developing an insight into the internal as well as external performance system. It facilitates the business managers in transforming the strategy into tangible measures by aligning the strategy with the overall mission and vision. The business executives with the use of BSC system can effective coordinate a wide range of management processes such as performance appraisal, setting of goals, allocating of resources and fostering the employee growth and development.

The project managers can integrate the use of BSC system for transforming the tasks into tangible performance measures for successful completion of the project. It can prove to be extremely beneficial for the project managers to continuously monitor the success of a project and identify the gaps in the performance in advance so that they can be effectively overcome. This will help in maximizing the chances of project success by identifying the tasks that are behind the schedule and taking effective measures for overcoming the performance in gaps.

Thus, it will help in enhancing the survival chances of an organization by developing a strategy map that helps in development of a set of interrelated strategic objectives. The development of various key performance indicators helps the businesses in gaining an overview of their overall performance level. The balance scorecard enables the companies to report higher quality management information and facilitates the decision-making process. The development of a well implemented balance scorecard helps in aligning the organizational processes as per the strategic priorities and goals.

Weaknesses

The weaknesses of the BSC can be regarded on the basis of high cost and time required on the part of the companies to implement this management tool. The usefulness of the balance scorecard depends on outweighing the cost and benefits that are associated with the implementation of this scorecard. In addition to this, the employee resistance to change can also negatively impact the successful implementation of the BSC and thus can undermine the benefits that an organization could achieved by its adoption (Awadallah, 2015).

Extent of Adoption of BSC in global Context

Balance scorecard can be regarded as an integrated performance measurement system that is being largely accepted by several countries. The large and complex firms are adopting the use of balance scorecard as the increasing number of stakeholders within these firms requires the use of comprehensive measurement systems that enables them to adopt the use of such systems that helps in assessing both financial as well as non-financial performance. For example, Philips Electronics has adopted the use of BSC for aligning its vision and mission with its overall strategy. The use of BSC has proved to be largely beneficial for the company for assessing both its qualitative and quantitative performance. It has been prove to be largely helpful for the management of the company to measure its qualitative as well as quantitative performance and thus facilitating the quick decision-making process (Neely, 2005).

Another example that can be cited in the context of a global corporation implemented a BSC is Toyota Motor Corporation, recognized as most successful and renowned global automaker. The company has developed its corporate scorecard in the year 2003 for assessing the performance of its operational, internal business processes, financial and stakeholders. It has established its key performance indicators in all the above mentioned business areas for continual review of performance of overall business.

The adoption of BSC concept has proved to be largely helpful for the company to record sales and profits, improving customer loyalty and increasing employee commitment and morale (Kaplan and Norton, 2005). Therefore, it can be stated from the above examples that global corporations are adopting the use of BSC concept for attaining competitive advantage by measuring of its financial and non-financial performance. The operational and financial measures assessed by the development of BSC are aligned with the company’s strategies for promoting its overall growth and development. It is regarded as critical for promoting the success of companies in a highly competitive global environment (The Balanced Scorecard, 2014).

The drawbacks that have been faced by the global corporations by the adoption of a balance scorecard approach are its increasing complexity and consumption of large amount of resources on the part of the company for its successful implementation. The implementation of BSC has resulted in creating workload for some department of companies implementing it as it requires gathering of complex data. It has also resulted in causing employee resistance and thus it has been stated in this regard that these potential issues faced by the companies for adoption of BSC have resulted in incurring them more costs rather than achieving benefits (Mahmoud , 2014). 

Evaluation of key financial issues that must be considered before making a decision about a significant financial commitment to a new investment project in your business

Some of key financial issues that must be considered before making the decision of projects are as follows:

Cash flows 

Cash flow is most significant financial issue that needs to be considered for a business entity while making the decision regarding the future growth and development. Cash flows are important when making the capital purchases and also while making working capital investment. So it is important all such cash expenditure must be noted properly and it is essential to consider the time of expenditure. Another significant portion of cash flows is the cash inflows and cash outflows during the project period.

It is important to check whether depreciation has been subtracted for tax calculation and added back to the project cash inflows as depreciation is the non cash expenses that do not require cash flow of funds. Expenditures that are relevant to the project only must be considered and all other cash flows must be ignored. For example, cash flows expenditures that were already paid than such expenditure must be ignored as such cash expenses have already been occurred and does not required any cash flow of funds after taking up the project.

Tax Rate

 Tax rate is dependent upon the country tax system and it is essential to consider the tax impact on the profits gain under the project. It is important to consider the tax savings on depreciation or other tax saving expenditures but it is vital to add back such expenses as they are non cash expenses only considers for the tax purposes. The tax system of a country need to be considered by a business entity while making the significant investment decisions as it have  a direct impact on the amount of revenue generated by a company. The lower the tax burden enables the company to significant decrease the price and thereby creating higher revenue that can be used for promoting the future growth of the company.

Discount Rate

 Discount rate is very important factor that can impact the project decisions as higher discount rate is significantly reduces the present value of the future cash flows. Discount rate can be cost of capital or interest rate of the company. The discount rate is the interest rate charged by the commercial banks on the amount of loan and thus need to be taken into account by businesses while making the investment decisions.

The feasibility of the project can be analyzed effectively with the use of following capital budgeting techniques that can be described as follows:

Accounting Rate of Return (ARR)

It measures the amount of profit or return that is expected to be realized on an investment. It is a capital budgeting metric that is used for assessing the viability of a project but does not take into account the concept of time value of money. It is calculated as percentage return and the project is accepted if ARR is greater than required rate of return. The annual percentage is calculated by dividing average net profit by average investment. The major benefit of using ARR is that it is easy to apply and also can be understood easily. However, the major drawback of the method is that it does not consider the time of money and risks for long-term investments. In addition to this, the results can easily be manipulated as per the changes in the depreciation methods and therefore can provide mislead information.

Payback period

It can be defined as the time-period required for recovering the cost incurred in carrying out a project. The payback period determines the feasibility of a project as shorter the period there is more probability for availability of a project. It is calculated by dividing the cost of an investment by the annual cash flow. 

Net Present value

Net present value is the most important capital budgeting method used to evaluate the projects through using the cost of capital as the discounting rate and discounting all the cash flows to arrive at the present value of the project. Thos method considered time value money that makes it better than other methods of project evaluation and also provide how much return the project will provide to the company if is implemented on the particular date.

So the main advantage that must be NPV takes into account is that it considers that future value of dollar is worth less than a dollar today. As NPV consider the cost of capital that is determined by the company, it can be said that NPV will change according to cost of capital of each company. In other words, NPV deviates when the cost of capital changes.  NPV also considers the risks that are important for making the projections about the future. The major disadvantage about the NPV is that it is totally dependent upon the cost of capital. If cost of capital is not calculated properly than it will lead to wrong NPV or even affects the decision of accepting or rejecting the project.

Internal Rate of Return

Internal rate of return is also one most important method that is used in capital budgeting for estimating the profitability provided by the potential investments. Practically internal rate of return refers to discount where net present value becomes zero. IRR is similar to net present value as it considers time value of money which is not used in accounting rate of return and payback method. In normal circumstances when IRR is greater than the cost of capital the project can be accepted as IRR considers cost of capital as the hurdle rate for making the decision. In some cases, company has its own internal rate of return to be taken as the hurdle rate. Overall it can be said that internal rate of return provides exact profit percentage that is earned today if project is undertaken. The major disadvantage of IRR is that it ignores economies of scale as project with higher IRR will be accepted whether it provides lower value of return as compared to other. 

References

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