Profitability Position Analysis

This report analyses the financial performance of Zurich Plc., which is public limited company and is engaged in the business of manufacturing and distributing the various kinds of office equipment. The financial statements of the company have raised the concerns in the eyes of the board of directors of the company as they are not depicting the satisfactory results. To understand the reasons of such concerns, financial analysis of the company using the most effective tool of financial management i.e. ratio analysis is carried. Ratio analysis not only provides the results about the various financial components of the company but also facilitates the typical interpretation of such results. Using ratio analysis, several aspects of financial performance of the company are evaluated such as its profitability and liquidity position, its efficiency of utilisation of different assets possessed by it, adequacy of its capital structure and the potential of company to attract towards its business, the potential investors of the market.

Profitability position of the company is said to be sound when it has the capability to earn enough of profits that all its cost incurred during the course of business is recovered by the revenues generated by it from its normal operations. Profits of the company have the significant impact on the financial health of the company. To evaluate the profitability position of the company, the analysis of three main ratios has been undertaken. Following are the ratios and their final results.

Formula	2015	Results Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	2016	Results
Gross Profit/ Net Sales	7,382/18,920	39.02%	5,825/16,243	35.86%
· Net profit Ratio
Formula	2015	Results	2016	Results
Net Profit/ Net Sales	972.84/18,920	5.14%	570.17/16,243	1.56%
· Return on Equity
Formula	2015	Results	2016	Results
Net Income After Preference Dividends/ Average Common Stock Holder’s Equity	972.84/20,108	4.84%	570.17/19,635.16	2.90%

Formula	2015	Results	2016	Results
EBIT/ Capital Employed	2,582/27,528	9.38%	1,783/24,927.60	7.15%

Analysis of results:

Gross profit ratio measures the quantum of profit earned by company after recovering its cost of goods sold. In the present case of Zurich Plc. The percentage of gross profit ratio has declined from the year 2015 to 2016 as there is reduction in sales in year 2016 as compared to 2015 but the direct expenses of the company have not reduced with the same proportion of sales. The company must try to control its manufacturing cost in order to achieve higher profitability. Further, the decline in percentage of net profits in 2016 from that of 2015, shows that the company’s operating expenses have increased and the revenues from sales have also decreased. The declining percentage of profits shows that the demand of the product is not enough in the market. The company must try to improve the quality of its products so as to attract more customers towards it. Return on equity ratio measures the quantum of profit earned by the company by utilising the funds of its shareholders. ROE of Zurich Plc. is declining in 2016 as compared to that of 2015, which indicates that the company is becoming inefficient to generate sufficient returns by investing the monies of its shareholders in its business. The return on capital employed is declined in 2016 as compared to 2015 and it indicates that the firm is not managing its total assets to earn return for the shareholders.

Liquidity Position Analysis

Liquidity position of a company is achieved when it is able to pay off its short liabilities by using its short terms assets without having the need to dispose its fixed assets. Liquidity position of Zurich Plc. is analysed using its current and quick ratios. Ideally, the current ratio of any firm must be at least 2:1 (Gibson, 2011).

Formula	2015	Results	2016	Results
Current Assets/ Current Liabilities	6,503/4,701	1.38	7,006/2,410	2.91
· Quick Ratio
Formula	2015	Results	2016	Results
Quick Assets/ Current Liabilities	4,960/4,701	1.06	5,686/2,410	2.36

Analysis of results:

The current and quick ratio of Zurich Plc. in 2016 is higher than that of 2015 which indicates that the firm is efficient enough to meet its current obligations by utilising the current assets (Saleem and Rehman, 2011). Also, the current ratio and quick ratio of the company are higher than the ideal standard which proves that the company has sound liquidity position. It will not have to dispose its fixed assets whenever its current liabilities will become due as it has sufficient current assets to deal with them (Vogel, 2014). It must try to maintain and increase its liquidity ratios in the forthcoming years.

Formula	2015	Results	2016	Results
Cost Of Goods Sold/ Average Inventory	11,538/ 1543	7.48	10,418/1,320	7.89
		Times		Times
· Receivables Turnover Ratio
Formula	2015	Results	2016	Results
Net Sales/ Average Total Receivables	18,920/4,960	3.81	16,243/ 4,230	3.84
· Fixed Asset Turnover Ratio
Formula	2015	Results	2016	Results
Net Sales/ Average Fixed Assets	18,920/25,726	0.74	16,243/20,331.60	0.80

Analysis of ratios:

Asset utilisation ratios show that how efficiently the firm is using its overall assets to operate its business. In the current case of Zurich Plc., it can be observed that the company has improved its efficiency to manage its key current asset i.e. inventory. The ITR of both the years are somewhat similar but it is moving on the upward side which shows that the company has converted more inventories into sales in 2016 as compared to 2015. Same goes with the receivables turnover ratio and fixed asset turnover as the company has been successful in managing its important current as well as total fixed assets (Zainudin, Zainudin, Hashim and Hashim, 2016). The slight increase in the ratios in 2016 proves that the company is striving to maintain its assets effectively.

Formula	2015	Results	2016	Results
Total Debt/ Total Assets	11,821/32,229	37%	7,702/27,337.60	28%
· Debt to equity ratio
Formula	2015	Results	2016	Results
Total Debt/ Total Equity	11,821/20,108	59%	7,702/19,635.16	39%
· Equity ratio
Formula	2015	Results	2016	Results
Total Equity/ Total Assets	20,108/32,229	62%	19,635.16/27,337.60	72%

Analysis of ratios:

The ratios calculated above helps in determining the appropriateness of capital structure of the company. Capital structure comprises of debt and equity component of the company. In the present case the debt ratio is declining and equity ratio is increasing in 2016 as compared to 2015. This shows that the company’s has financed its assets more from the equity financing and less from the external debt financing (Bragg, 2012). This proves that the company is not facing financial risk due to its lower leverage in the market. The solvency position of the company can be said to be sound as it is using internal financing to fund its total assets. Moreover, the declining debt to equity ratio in 2016 proves that the capital structure of the company is being managed appropriately(Higgins, 2012).

Formula	2015	Results	2016	Results
Net Income After Preference Dividends/ Total Common Stock	972.84/12,410	7.84%	570.17/12,410	4.59%
· Book value per share
Formula	2015	Results	2016	Results
Average Common Stock Holder’s Equity/ Total Common Stock	20,108/12,410	162.03%	19,635.16/12410	158.22%

Efficiency of Asset Utilization Analysis

Analysis of ratios:

The book value per share and earning per share of the company has reduced in 2016 as compared to 2015, which shows that company is not earning sufficient profits for its shareholders.

Ratio analysis is the key analytical tool of financial management as it provides necessary information about the financial performance of the company. Financial reports serves as the base to evaluate the true picture of company’s financial performance. The ratio analysis of a firm is undertaken by taking into account various elements of financial reports prepared by the reporting entity. Using ratio analysis, the company’s performance in terms of profitability, liquidity, solvency, efficiency and effectiveness can be determined.  The results of ratio analysis are required to be appropriately interpreted so as to gain a proper understanding of the financial results achieved by the company in any financial year (Kimmel, Weygandtand Kieso, 2010). Though this tool is used by various professionals such as credit analyst, financial analyst, stock analyst to determine the worth and financial standing of the company, it does not always offer realistic results because it suffers from certain limitations which are discussed as below:

• Emphasis on historical data:

The data set that is used in ratio analysis is based on the historic events and transactions that took place in the course of the business. However, it is not always possible that business will continue to follow its previous trends in the future periods. There are various factors that influence the overall performance of the business such as environmental, political, economic, legal factors. Ratio analysis does not take into account the impact of changes in such factors on the business.

• Historical cost v/s Current cost:

It is generally observed that income statement of any firm is prepared on the basis of the current year transactions or events that took place in the recent most years however as a matter of general practice many of the components of balance sheet of the firm are recorded on the historical cost basis in the records. This causes variations in the treatment of different elements of the firm’s books of accounts leading to disparity which causes unrealistic financial results of the concerned firm.

• Inflation:

If in any period which is under review, there is a high impact of inflation on various items of financial statement, then the financial information will not be comparable to the other periods and in such cases ratio analysis fails to achieve its basic purpose.

Capital Structure Adequacy Analysis

For instance, if the inflation rate in any particular year under consideration is 100%, then the revenue figures of that specific year will be reported in the financial statements at the double amount, however, in reality the actual sales did not change significantly in that year.

• Point in time:

Usually, for the purpose of ratio analysis, figures as on the last date of reporting period are used. However, sometimes the sudden spike or decline in the figures of last day of the financial year affects the financial statements drastically and offers unrealistic results on the reporting date (Lee, Lee and Lee, 2009).

• Company strategy:

Ratio analysis is undertaken to compare the results of two or more years of a single firm (intra firm ratio analysis) or the results of two or more firms operating in the same industry (inter firm comparisons). When inter-firm comparisons are made the ratios using the financial results of both the firms, it is necessary that the data of those companies must be comparable. If both or all the companies are following different accounting treatments, policies, assumptions and strategies, then their financial data cannot be compared.

• Interpretations:

It is not always possible to identify and understand the reasons of various ratios and in such cases interpretation of such ratios gets difficult.

• Quantitative analysis not qualitative:

The ratio analysis that is performed as a function of financial management emphasises only on the financial results of the company and the non-financial information such as sustainability, corporate social responsibility initiatives etc., are ignored under such analysis.

• Window dressing:

The analysts blindly rely on the financial reports of the company to apply ratio analysis to assess its financial standing. However, ratios cannot always scan the true financial position of the business of the firm which manipulates its financial statements for the sake of depicting soundness of its financial health to the outsiders (interested parties). The creative accounting done merely for the purpose of falsifying the financial results of the company to deceive its stakeholders is commonly known as window dressing (Warrenand Jones, 2018).

From the above report, it can be summarised that the application of ratio analysis technique to the financial information has become more of an art than the science. It requires requisite knowledge, skills, perception to apply this technique to the company’s financial information because of complexity of the financial information.

Years	£                          –	£                   1.00	£                   2.00	£                   3.00	£                   4.00	£                   5.00	£                          6.00
Initial Investment	-£    2,000,000.00
Cash Inflows		£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£         1,220,000.00
Cash Outflows		-£     350,000.00	-£     350,000.00	-£     350,000.00	-£     350,000.00	-£     350,000.00	-£            350,000.00
Net Cash Flows	-£    2,000,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£             870,000.00
Terminal Cash Flows							£             500,000.00

Years	0	1	2	3	4	5	6
Payback Period	£                          –	£                   1.00	£                   2.00	£                   3.00	£                   4.00	£                   5.00	£                          6.00
Cash Flows	-£    2,000,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£         1,370,000.00
Cumulative Cash Flows	-£    2,000,000.00	-£ 1,130,000.00	-£     260,000.00	£      610,000.00	£  1,480,000.00	£  2,350,000.00	£         3,720,000.00
Payback period (years)	2.30

Note: The payback period of the new machinery is 2.30 years which considerably lesser than its useful life. Hence, it seems to be acceptable.

Discounted Payback Period	0	1	2	3	4	5	6
Discounted Cash Flows	-£    2,000,000.00	£      790,909.09	£      719,008.26	£      653,643.88	£      594,221.71	£      540,201.55	£             773,329.28
Cumulative Discounted Cash Flows	-£    2,000,000.00	-£ 1,209,090.91	-£     490,082.64	£      163,561.23	£      757,782.94	£  1,297,984.49	£         2,071,313.77
Discounted payback period	2.75 years

Market Attractiveness Analysis

Note: The discounted payback period of the new machinery is 2.75 years which considerably lesser than its useful life. Hence, it seems to be acceptable.

Accounting Rate of Return	Average Income	£  6,20,000.00	50%
	Average Investment	£  1,250,000.00

	0	1	2	3	4	5	6
Initial Investment	-£    2,000,000.00
Cash Inflows		£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£  1,220,000.00	£         1,220,000.00
Cash Outflows		-£     350,000.00	-£     350,000.00	-£     350,000.00	-£     350,000.00	-£     350,000.00	-£            350,000.00
Depreciation		-£     250,000.00	-£     250,000.00	-£     250,000.00	-£     250,000.00	-£     250,000.00	-£            250,000.00
Net Income		£  6,20,000.00	£  6,20,000.00	£  6,20,000.00	£  6,20,000.00	£  6,20,000.00	£  6,20,000.00

Average Income	Total Income
	Total No. of Years
	£ 1,820,000.00
Average Investment	Salvage Value+0.5(Initial Investment- Salvage Value)
	£  1,250,000.00

Note: Annual rate of return of the company is significantly higher than the minimum required rate of return of 10%. Hence the investment seems to be favourable.

Year	0	1	2	3	4	5	6
Net Cash Flows	-£    2,000,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£             870,000.00
Terminal Cash Flows							£             500,000.00
	£                     1.00	£                   0.91	£                   0.83	£                   0.75	£                   0.68	£                   0.62	£                          0.56
Present Value of Cash Flows	-£    2,000,000.00	£      790,909.09	£      719,008.26	£      653,643.88	£      594,221.71	£      540,201.55	£             773,329.28
NPV	£    2,071,313.77

Note: The NPV of the cash flows from new machinery is positive and hence the company must accept the proposal of acquiring it.

Net Cash Flows	-£    2,000,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£      870,000.00	£         1,370,000.00
At  38%	1.000	0.725	0.525	0.381	0.276	0.200	0.145
	-£    2,000,000.00	£      630,434.78	£      456,836.80	£      331,041.16	£      239,884.90	£      173,829.64	£             198,356.32
	£          30,383.60
At 40%	1.000	0.714	0.510	0.364	0.260	0.186	0.133
	-£    2,000,000.00	£      621,428.57	£      443,877.55	£      317,055.39	£      226,468.14	£      161,762.96	£             181,950.12
	-£          47,457.27
At 39%	1.000	0.719	0.518	0.372	0.268	0.193	0.139
	-£    2,000,000.00	£      625,899.28	£      450,287.25	£      323,947.66	£      233,055.87	£      167,666.10	£             189,946.71
	-£            9,197.13

Lower Rate    +	PV at lower rate * (Higher Rate – Lower Rate)
	PV at lower rate- PV at upper rate

IRR = 38.77%

Note: The IRR of the new machinery is higher than the required rate of return of 10%. Hence it is acceptable.

A project involves huge amounts of funds to be invested as the capital expenditure for a long period of time as no project generates returns immediately at the time of investment. These capital expenditure decisions are usually irreversible in nature and hence are very crucial in nature. Therefore, it is of utmost importance to appraise the economic worth of any project which is proposed to be taken up with the systematic investment criteria must be selected. In capital budgeting decisions, the capital costs and resources once utilised are almost sunk. Financial management studies suggest a broad variety of such techniques that helps the analystto assess the overall worth of the project. These techniques are discussed in details below:

1. Payback period:

This is the key capital investment appraisal technique which determines the maximum time a project will require to its initial investment through the inflows of the project. The project with the least payback period is always selected to be taken up as a capital investment decision because it has the capability to recover the initial cost involved in the project in the minimum possible time and after that particular time-frame it will start generating inflows. In case of evaluation of single project, the decision is taken on the expected period as decided by the project management team. If the resulted payback period is less than the expected period then it must be accepted otherwise it must be rejected. There are various strengths and limitations of this method:

Strengths:

• It is easy to be calculated and implemented in the project investment appraisal function.
• It is more advantageous for the firms with shortage of funds availability as it will enable them to select the project on the basis of its ability to recoup its initial outlays.
• It helps the firm to identify the risk involved in the project by determining the time length required to start generating the required return from the investment.
• It is more appropriately applicable to the industries where technical obsolescence of the product comes in short spans of time.

Limitations:

• Ignorance of time value of money is the major disadvantage of payback period tool. The treatment of all the cash flows of project in different years, at par does not offer realistic results to the investors.
• It does not take into account the net income of the project to determine the risk involved in the investment. Rather, the decisions are based on the cash flows associated with the project which often ignores the non-cash expenses such as depreciation, amortisation costs etc., related to the proposed investment.
• The salvage value of the project is also ignored in this technique.
• It also ignores the cash flows of the project after the payback period which can be significant enough for the decision making about the efficiency of the proposed investment.

1. Discounted payback period:

It is the advanced version of payback technique as it takes into account the discounted capital flows to calculate the period in which the project will recoup its initial investment. Discounted cash flows are those cash flows from the project that are calculated considering the time value of money at the particular cost of capital. Following are the benefits and limitations of using this method to determine the project feasibility.

Conclusion

Benefits

• This method helps in identification of actual risk associated with the capital investment plan.
• It respects the time value of money involved in the proposed capital investment.

Limitations

• Implementation of this technique to identify the project’s worthiness is quite complex and time taking process as it involves determination of present values of all the cash flows related to the project.
• It does not offer the results to identify whether the project will enhance the value of the firm or not.

1. Net present value:

It is the common most capital budgeting technique which is being widely used in the practical world. Net present value of any project is the aggregate of difference between the present values of all the cash inflows and cash flows that are associated with the project. The project which has positive NPV is capable of being accepted by the investors. In case of two or more projects, the project with highest NPV is acceptable (Daunfeldt and Hartwig, 2014). Even NPV method has certain limitations that will be discussed further.

Benefits:

• The cash flows over the full life of the project are considered under this method.
• Also, it takes into account the time value of the money associated with the project.
• It provides clear results and the interpretation of the results is quite easy.

Limitations:

• As compared to other techniques, application of NPV is difficult as it involves determination of company’s cost of capital (discounting rate) to be used to determine the present value of the cash flows related to the project.
• Those projects which have different life scales are difficult to be evaluated and compared using NPV method (Penman, Reggiani, Richardson and Tuna, 2017).

1. Accounting rate of return:

This method is often known as financial statements method as it takes into consideration two important elements of financial statements of the firm. Those elements are net income and capital investment. The average of both the elements is used under this method. Each firm has to set a cut off rate which is the minimum rate of return required from the investment project (Venkatesh and Gugloth, 2017). If ARR is lower than the cut off rate it must not be accepted and if it is beyond the cut off rate the project can be accepted. Following are the advantages and disadvantages of ARR method:

Benefits:

• It takes into account the income from the investment instead of cash flows. Net income of the project is the true component that determines the investment’s profitability in terms of returns.
• This method has an easy approach and it is also simple to understand (Warren, Reeve, and Duchac, 2011). 

Limitations:

• Though, ARR uses net income concept to determine project’s return potential but it does not take into account the concept of money’s time value and hence it does not provide accuracy in results.
• It also neglects the shrinkage of the original investment by charging depreciation against the reported earnings of the firm. The concept of capital’s regular recovery over a period of time does not set well under this approach.
• ARR cannot be used in instance where capital investment is not made at the initial stage of project.

1. Internal rate of return:

It the rate used to determine the discounting factors of every year to calculate the present value of the cash flows related to the project. At this rate, the present value of both cash inflows and cash outflows equalises and hence the NPV of the project is zero at this point (Borgonovo, 2017). The following are the advantages and disadvantages of IRR method:

Advantages:

• IRR methods gives due consideration to the concept of time value of money.
• The cash flows related to the project across its total life are considered under this method.
• This method meets the objective of maximising the owner’s welfare.
• It is more reliable and sophisticated technique than other techniques of capital budgeting (Bierman and Smidt, 2014).

Limitations:

• It follows the most difficult approach of project evaluation as it involves application of number of hit and trial runs to reach at the accurate rate.
• The results of this technique are difficult to interpret.

In the practical world only few of the capital budgeting techniques are employed by the managers or investors to determine the worthiness of the investment. Firstly, the net present cash method is generally found to be applied in most of real life examples as it is an easy method and its results are easily interpretable by the potential investors. Further, in certain real life instances, the application of payback period method is also observed as it determines the period within which the project will recover its initial cost and thereby helps the project managers to determine the amount of funds that will be required till that stage. Rest other techniques such as ARR, IRR etc. are generally not commonly found in the real life instances of capital budgeting decision making as they involve requisite time and skills to apply and understand their results.

As in the present case it can be observed that Johnson’s Ltd. is considering the proposal of acquisition of new machinery that will cost it 2,000,000 pounds. The amount required for the capital investment seems to be quite large and hence it will require raising funds from different possible and suitable sources. Also, the life of the project is 6 years which is considerably longer period therefore it can be said that the investment in new machinery would not bring immediate returns to the project rather it will take few years to achieve the acceptable profitability of investment. Since, the company is already having its existing business in the market; it would not find difficulty in raising funds from external sources of funds. The purpose of purchase of new machinery is to expand the business rather than starting up a new business. Following could be the possible sources of funding the new machinery:

• Loans from banks and financial institutions:

If the business of the Johnson’s Ltd has satisfactory track record of its sound financial position, the company would it easy to raise funds from the banks or other financial institutions at a particular rate of interest and for the defined period. Before granting the loan to the present company, these providers of finance will assess the credit worthiness of the company in the market through its previous year’s financial reports. Such loans and borrowings are the external sources of finance (Krantz and Johnson, 2014).

• Internally generated funds:

This is one of the best sources of finance in case of expansion of business. It is commonly known as retained earnings. Johnson’s Ltd can finance its requirements of investment in new asset by utilising the funds which are generated as a result of normal operations of business. Such earnings are ploughed back in the business for the purpose of further expansion of business, rather than depositing them in some income generating areas such as banks or other places (Godwin and Alderman, 2012).

• Trade credit:

Trade credit can also be chosen as the suitable option if the company finds the machinery vendor who is willing to sell the machinery on credit term basis. In such cases, the purchase value of machinery might increase, as it will involve the finance cost charged by the vendor to supply the machinery on the credit basis. But it will be a convenient source of funding for the company (Jenter and Lewellen, 2015).

• Angel investors:

These are parties who invest their own funds in the business of the existing entrepreneurial company. They are different from the institutional providers of finance as the latter parties use the funds of other people to lend money to the firms in requirement of funds (Baker, Jabbouri& Dyaz, 2017).

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