As a matter of fact business cannot grow and expand unless they generate enough profits that cover up their expenses and reward the investors off for taking the risk of opening up such investment. These investors should also measure the efficiency and return of their invested capital and resources which all cannot be done without the usage of some mandatory profitability, liquidity and gearing ratios (each will be fully explained later) which are calculated through the usage of the two most important financial statements for any business and these are their balance sheets and income statements.
The importance of such statements lies in the fact that they are beneficial for both the investor as well as the management. From the investor point of view, it's useful because they can evaluate how successful their decision to invest in the business is, as mentioned previously. For the management, it's also useful as they use it to predict future conditions and circumstances and more importantly making decisions and plans for corrections and better performance.
Thus the main aim of this assignment will be to analyze the financial standpoint of the famous Arab contractors company (one of the leading construction companies in the Middle East and Africa) and then interpret the results through putting them in context of comparison with the industry benchmark "Orascom" S.A.E. Orascom is another leading construction contractor active in emerging markets and it also undertakes projects for both public and private customers.
Note:
Since there were no recent financial statements published on the internet for the two companies. For "Arab contractors" I have uploaded the annual report for 2008-2007 fiscal years and for Orascom I have used the financial results for the year 2008 which was found in their annual report for the year 2009-2008.
There is no industrial average followed in Egypt, Therefore, this paper is based on comparing the concerned company with the main competitor as a bench marking.
Please consider the limitation of ratio analysis regarding the relative performance of the "Arab Contractors" with its benchmark "Orascom"
2. Profitability:
Basically, any business exists to achieve the primary goal of creating, increasing and growing the owners' wealth. In sake of that target, profitability ratio is one tool to measure that profit/loss figures for owners that will affect further on taking a strategic/tactical decision.
(Atrill& McLaney 2008)
2.1. Return on Ordinary shareholder's Funds (ROSF)
Definition:
This ratio compares the amount of profit for the period available to the owners with the owners' average stake in the business during that same period.
(Atrill& McLaney 2008, p.188)
Formula of ROSF:
ROSF= Net profit/ordinary share capital + reserves.
Calculation of ROSF
ROSF ("Arab Contractors "Construction Company) 2007 =27%
ROSF ("Arab Contractors "Construction Company) 2008=40%
ROSF "Orascom"2008= 31%
Analysis
The ratio indicates that the net profit has been increased in the year 2008 from 27% to 40%.
The higher ROSF of "The Arab Contractors" (40%) than the ROSF" Orascom"
[Benchmark] (31%) for the fiscal year 2008 will encourage the shareholders to continue their investments in the company.
2.2. Return on capital employed (ROCE)
Definition:
The main objective of making investments in any business is to obtain satisfactory return on capital invested. Hence, the return on capital employed is used as a measure of success of a business in realizing this objective. Return on capital employed establishes the relationship between the profit and the capital employed. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business.
(Atrill& McLaney 2008)
Formula of ROCE:
[Return on Capital Employed= (Operating profit/share capital +reserves+non-current liabilities) Ã-100]
Calculation of ROCE:
ROCE ("Arab Contractors "Construction Company) 2007 =28%
ROCE ("Arab Contractors "Construction Company) 2008=32%
ROCE "Orascom "2008= 19 %
Analysis
The increase in the ROCE from 2007-2008 indicates that the company is more efficient in using its available funds in 2008.
Regarding the comparison with the benchmark company, the ROCE ratio shows a satisfactory return on capital invested.
2.3. Operating profit margin
Definition:
It is the ratio of cost of goods sold plus operating expenses to net sales. It is generally expressed in percentage. Operating ratio measures the cost of operations per dollar of sales. This is often regarded as the most appropriate measure of the operation performance.
(Atrill& McLaney 2008)
Formula of operating profit margin:
Operating Ratio = [Operating profit / Sales Revenue] Ã- 100
Calculation of operating profit margin:
Operating ratio ("Arab Contractors "Construction Company) 2007=7%
Operating ratio ("Arab Contractors "Construction Company) 2008=8.5%
Operating ratio"Orascom"2008= 20 %
Analysis:
The operating ratio shows the operational efficiency of the business. Higher operating ratio shows higher operating profit and vice versa. Hence, "Arab Contractors" is achieving higher operating profit in the year 2008.
Although the difference between the benchmark's ratio and the "Arab contractors" ratio for the year 2008 is high, this has no implication on our analysis.
2.4. Gross profit margin
Definition:
Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed as a percentage. It expresses the relationship between gross profit and sales.
(Atrill& McLaney 2008)
Formula of Gross Profit margin:
[Gross Profit Ratio = (Gross profit / Sales Revenue) Ã- 100]
Calculation of gross profit margin:
GP margin ("Arab Contractors "Construction Company) 2007=9 %
GP margin ("Arab Contractors "Construction Company) 2008=10%
GP margin "Orascom"2008= 26 %
Analysis:
Gross profit ratio may be indicated to what extent the selling prices of goods per unit may be reduced without incurring losses on operations. It reflects efficiency with which a firm produces its products. As the gross profit is found by deducting cost of goods sold from net sales, the higher the gross profit, the better it is. There is no standard GP ratio for evaluation. It may vary from business to business. However, the gross profit earned should be sufficient to recover all operating expenses and to build up reserves after paying all fixed interest charges and dividends. Although, there is no significant difference between GP margins of "Arab Contractors" fiscal year 2008 compared to 2007, the 1% increase is a reflection of better operation performance. The difference between the benchmark's ratio and the "Arab contractors" ratio for the year 2008 is high but this percentage rate can vary greatly from business to business, even those within the same industry. Sales, location, size of operations, and intensity of competition are all factors that can affect the gross profit rate.
"Arab Contractors" 2007
"Arab Contractors" 2008
"Orascom "
2008
ROSF
27%
40%
31%
ROCE
28%
32%
19%
Operating profit margin
7%
8.5%
20%
Gross profit margin
9%
10%
26%
3. Gearing:
3.1. Gearing ratio:
Definition:
The gearing ratio is a measure of the contribution of long term lenders to the long term capital structure of the business.
(Atrill& McLaney 2008)
Formula of gearing ratio:
Gearing ratio= Long-term liabilities/ [share capital+ Reserves+ Long-term liabilities]*100
Calculation of gearing ratio:
Gearing ratio for "Arab Contractors" 2007= 49%
Gearing ratio for "Arab Contractors" 2008= 53%
Gearing ratio for "Orascom" 2008= 38%
Analysis:
Arab Contractors gearing ratio in 2008 has increased by 4% than 2007 to become 53%, which means that its creditors have supplied more than half the total financing. The Management would probably be subjecting the firm to the risk of bankruptcy if it sought to increase the debt ratio any further by borrowing additional funds. When compared to the benchmark the ratios indicate an increase of the "Arab Contractors" business becoming insolvent.
3.2. Interest Cover Ratio:
Definition:
The interest cover ratio measures the amount of operating profit available to cover interest payable.
(Atrill& McLaney 2008)
Formula of gearing ratio:
Interest Cover Ratio = Operating Profit/ Interest Payable
Calculation of gearing ratio:
Interest Cover Ratio for "Arab Contractors" 2007= 1.6
Interest Cover Ratio for "Arab Contractors" 2008= 2.9
Interest Cover Ratio ratio for "Orascom" 2008= 6
Analysis:
The ratio indicates the ability of the "Arab Contractors" to cover its interest payable has increased in the year 2008.
4. Liquidity:
4.1. Current ratio
Definition:
Current ratio may be defined as the relationship between current assets and current liabilities. This ratio is also known as "working capital ratio". It is a measure of general liquidity and is widely used to make the analysis for short term financial position or liquidity of a firm. It is calculated by dividing the total of the current assets by total of the current liabilities.
Formula of Current ratio
[Current Ratio = Current Assets / Current Liabilities]
Or
[Current Assets: Current Liabilities]
Calculation of Current ratio
Current ratio for "Arab Contractors" 2007= 1:1
Current ratio for "Arab Contractors" 2008= 1:1
Current ratio for "Orascom"2008= 1.4: 1
Analysis
The ratio of 2008 and 2007 indicates that Arab Contractors liquidity did not change over the two years.
The current ratio for "Arab Contractors "is comparable to its benchmark "Orascom".
Generally the minimum level for this ratio is often stated as 1.0 times or 1:1. In addition, it represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. (Atrill& McLaney 2008)
5. Conclusion:
The results of "Arab contractors" company for the fiscal year 2008 in comparison with the results of year 2007 have showed better performance in all ratios except for the gearing ratios which indicates that Arab contractors is highly dependent on external financing. This is on the normal scale but in comparison with Orascom, they both show high and close levels to this type of financing.
6. Recommendations:
Since the gearing ratio for the "Arab Contractors" is high (53%), and this high ratio will contribute to the company stock volatility, thus management should revaluate the financing source and choose alternative techniques than long term external loans. For example they should consider increasing the equity shares.
