The company selected for the purpose of this study is Royal Dutch Shell Group. The company is a multinational operating across all three sectors of the economy i.e. primary, secondary and tertiary industry. The Shell Group is involved in oil exploration, extraction, refining and but also retailing oil and oil related products. The Shell Group is also listed on the London Stock Exchange.
Collection of relevant financial data, raw or processed is an important part of managing and tracking business's financial activities.
Businesses can obtain data from two sources, either through business's own internal records or through third party sources.
Internal financial data is usually obtained from reports prepared by the control functions, such as reports prepared by the production department. These reports also include the financial aspect of the departments operations and hence provide the accounting and finance division with essential expenditure and revenue details incurred and generated over a time period. Since these reports are usually detailed, the finance division of the business can easily observe and classify expenditure into revenue and capital expenditure as well as facilitates classification of income.
The other means by which business obtains its financial data is through external actors such as banks and suppliers. These third parties are usually stakeholders either as business suppliers or as its customers. Data provided by these third parties is an important countercheck on the accuracy of business's internal records.
The data from the two sources internal and external is often complimentary to each other. One source facilitates accuracy of the other. In some cases one source is and maybe the only source of data and hence it is essential for business to obtain and consider information from both sources in order to maintain complete as well as accurate financial statements.
Business cannot depend on financial information being just quantitatively sufficient. Information collected and used should also be of appropriate quality that is it is accurate, timely and usable. A business hence has to validate its information for quality on a five point criteria.
The financial information business obtains should be accurate. Inaccurate data is of little or no use and must be ignored when processing financial records so that financial statements are true and fair.
Information collected and selected for processing should be complete if it has to have any usefulness. Incomplete data is meaningless and misleading.
Relevant information is another characteristic of utile data. A business can obtain loads of data but as long as they are irrelevant it is useless.
Business also need to be able to have access data when they need it, data hence need to be collected on a timely basis. Delays and time lapses between occurrence of transactions and recording them leave data less useful.
Organizations need to ensure economy of collection of data. Data collection must not cost more than the benefit the organization can derive from it.
Business also needs to assess, appraise and monitor the data they collect on a regular sampling basis for its validity. This could be done by internal auditors or external auditors. Internal auditors are assessors of business accounting, control systems and operations. Internal auditors work directly for the organization and are usually permanent employees that provide services all round the year. External auditors on the other hand concentrate of financial statements and are independent of the organization. They are usually used towards the end of accounting year to assess validity of financial statements and data relevant to it only.
Financial data in isolation is often less useful, unrepresentative and sometimes even meaningless. For instance if a company is able to make a profit of $10000 less can be concluded about its performance unless we are told for instance it was just a percent of the capital employed or on the other hand it was ten percent of its capital. Now conclusions can be made about its performance, in the first case it is poor and the second one is a far better figure despite the profit literally being the same.
Ratio analysis is a detailed assessment of business's financial statements. It covers various aspects of performance such as profitability, liquidity, efficiency and investment assessment etc.
As the name suggests, profitability ratios analyze business figures corresponding to its profits. It is a measure of business competency on the profit side. These are commonly used and are easy to compute.
Return on Capital Employed (ROCE) is a measure of how much profit a business is able to generate in its current level of resources. It is important indicator for whether capital in business is put to good use or whether better returns could be achieved elsewhere. It is calculated as
(Profit before interest and tax/capital employed) *100
A higher ROCE ratio signifies business ability to generate higher profits out of same or lower capital levels.
Net Profit margin is another profitability ratio. It is indicative of the part of sales revenue that is business's profit. In other words net profit margin shows what part of every $100 sales of business is profit. Business with high net profit margins reflect competency over low margin rivals. But charging premiums and cutting down on essential expenditures may increase the NP margin and but put down potential sales and profits in absolute terms and affect business performance adversely. NP margin is calculated as
(Net Profit/ Sales Revenue) *100
Gross Profit margin is the part of revenue that is businesses mark up. It is an indicator of premium that a business is able to charge on its actual cost of sales. Higher GP ratio reflects better prospects of earning profit. However like NP margin if GP margin is kept on the higher sie by inflating prices will affect sales volume and hurt profit levels. GP margin is calculated as
(Gross Profit/Sales Revenue)*100
Liquidity is another important prospect of business that is of interest to various stakeholders. Liquidity refers to business ability to pay off its short term debts without becoming insolvent. Two important liquidity ratios discussed below are good assessors of business's liquidity position.
Current ratio is a comparison of business current assets to its current liabilities. Literally, it shows how much current are available to pay each $ of business's current debt. It is calculated as
Current Assets/ Current Liabilities
Current ratios equal to 1 reflect that a business just has enough current assets t meet its current obligations, it is however a dangerous position to be in given that some of its current assets such as stock and debtors may be overvalued. Ratios less than 1, points towards potential inability of business of meet its short term debts with its current resources. The business is likely to have working capital issues and liquidity problems. Ratios in excess of 1.25 show good liquidity position. However very high current ratios are also not preferred since it means excess working capital is tied up in current assets.
Liquid/Acid Test Ratio is similar to the current ratio apart from the fact that when current assets are accounted stocks and inventory is ignored because of its relatively illiquid nature. Stocks cannot be converted into cash immediately and hence the current ratio gives an unfair depiction of business liquidity. It is calculated as
(Current Assets -Inventory)/Current Liabilities
Asset test ratio, less than 0.8 in most industries, signals liquidity problems. Ratios on excess of one point to higher opportunity cost of excess working capital tied in these less yielding assets. Liquidity results around one are desirable in most circumstances and reflect business ability to fulfill its short term obligations with relative ease.
Efficiency ratios measure the effectiveness aspect of business performance. They assess the efficiency with which business resources are used to generate income and revenue.
Utilization of Capital Employed is assessment of business effectiveness to generate revenue out of its current level of capital. In other word it shows how much of sales are generated for every $100 of capital employed. It is calculated as
(Sales/Capital Employed) *100
Higher capital employed utilization adduces better and efficient use of capital. However there is no strict line of measurement of this results and performance varies from industry to industry.
Utilization of Fixed Assets is an analysis of business efficiency of generating sales for every $100 of fixed assets. It is computed as
(Sales/ Fixed Assets) *100
Higher utilization ratio shows business competency to generate more sales in its given fixed assets.
Investment Ratios are of particular interest to business shareholders and equity owners. But their intrest is however third to debenture holders and preference shareholders.
Gearing ratio is a reflection of business's capital constituents. It shows the percentage of capital that is borrowed out of the total business capital employed. Higher gearing ratio indicates more borrowed and risky capital. Any increase in cost of borrowing hurts businesses with high gearing ratios and can add to financial inefficiencies. It is calculated as
(Borrowed Capital /Total Capital) *100
There is no widely accepted range of this ratio. Some venture firms find it difficult to raise equity capital and hence might have high gearing ratio but this does not necessarily mean it is ineffective.
Dividend Cover Ratio is of particular interest to shareholders. It shows the number of times a business is able to pay its current dividends out of its existing distributable profit levels.
(Profit available to pay ordinary dividends/ Ordinary dividends paid)
It is difficult to say that whether it should be higher or lower because of different stakeholder interest. Investors would like to have a low dividend cover ratio but high actual dividend, that is want most of profits to be paid out. The management on the other hand would prefer to pay limited dividends and plough back excess profits for the future.
Dividend yield is a measure of share profitably at current market prices. It is the dividend declared as a percentage of market prices of the share. It is calculated as
(Dividend per share/ Market Price per share) *100
Strictly speaking investors would like to have higher returns on investment and hence higher dividend yields.
A combination of all ratios and their analysis provides a deep insight into the health of the company that otherwise would have been difficult to assess.
Results of the Royal Dutch Shell Group used are for year end 31st December 2009. Latest results, that of 2010 is not available as to this moment. (Figures in millions of $)
Return on Capital Employed= Profit before interest and tax/capital employed *100
21562/292,181 *100 = 7.38 %
Return on Equity= Profit before tax but after preference dividend/ Ordinary share capital and reserves *100
21362/138,135 *100 = 15.46%
Net profit Margin= Net profit/Sales *100
12718/278,188 *100 = 4.57%
Operating Profit margin= Profit before interest and tax/ Sales *100
21562/278,188 *100= 7.75%
Current Ratio= Current Assets/Current Liabilities
96,457/69,257 = 1.39:1
Liquid Ratio= Current Assets -Inventory/ Current liabilities
69,047/69,257 = 0.996:1
Utilization of Capital Employed= Sales/Capital Employed *100
278,188/292,181 = 95.2%
Utilization of Fixed Assets= Sales/ Fixed Assets *100
278,188/195,724 = 142.1%
Gearing Ratio= Borrowed Capital/Total Capital *100
154,046/292,181 *100 =52.7%
Earnings per Share= Total Distributable profits/ Total number of ordinary shares
The Royal Dutch Shell Group seems to be financially sound business but nothing can be said with complete guarantee since company standards nor are industry standards available. The following analysis is hence on individual basis.
Liquidity aspect of the business looks ideal. With a strong current ratio of 1.39:1 the business has fair ability to fulfill its short term commitments. The liquidity ratio shows that the business has around 99 cents of liquid assets for every 100 cents of current obligations. This is fairly reasonable ratio and Shell has taken advantage of lower opportunity cost by not tying up its resources. Stock price volatility in the oil industry is high and Shell seems to have found a solution to eliminate maximum possible risk by limiting stock holding to just 28.4% of current assets.
The profitability aspect is difficult to analyze given that no comparisons are available with past or industry's performance. The Shell group is earning a 7.4% return on capital and a 15.46% return on equity. This reflects high debt servicing cost of borrowed capital. Shell has a 7.75% Operating profit margin but a 4.57% Net Profit margin. This 41% difference in operating profit margin and net profit margin is on account of interest and tax payments which together account for a 3.18% of sales revenue and 80.7% of net profit.
The resource utilization ratio of Shell is on the higher side. Its sales revenue is 95.2% of its total capital employed. Comparison will be required however to enable any further analysis of the ratio. Likewise Shell's sale is a 142% of its fixed assets which accounts for 67% of the business's capital employed.
Gearing ratio of Shell is fairly high with 52.7% of capital being borrowed. This is one reason for high debt servicing costs which account for 2.5% of operating income. Shell operates in a capitally intensive industry and since these require huge sums of finance such high gearing may be industry standard. Shell has also on Earnings per Share of $2.04 but inconclusive information does not allow us to rate the performance in this aspect.
Shell's performance from 2008 to 2009 has been generally poor. Its profitability, efficiency and investment aspect have performed poorly. Only the liquidity side of the business has fared well showing slight improvements only.
The ROCE has fallen by almost 60% year on year falling from 18.4% to 7.38%. This huge fall on returns on capital is an alarming situation for the Shell management. Shell had already experienced almost a 4% fall year on year in returns from 2007 to 2008 (19.2% to 18.4%).
The operating profit margin of the business has also nosedived from 11.34% to 7.75%, a 31.6% fall in operating profit margins year on year. As a result Shell has also experienced a fall in net profit margin from 6.96% in 2008 to 4.57% in 2009. This is on account of falling sales and rising cost of sales despite the fact that debt furnishing costs have reduced by 54.1% year on year.
The liquidity aspect of the business is the only one where slight improvements are noticeable. The current asset ratio has increased from just $1.1 of current asset for every $1 of current liability in 2008 to $1.39 of current asset for every $1 of current liability in 2009. The acid test ratio also improved from 0.92:1 to 0.99:1. The liquidity aspect of the business has improved year on year showing improvement from 0.88:1 in 2007 to 0.99:1 in 2009.
On the efficiency side business performance has declined. Despite just a marginal increase of 3.34% in capital employed and in fixed assets of 18%, Shell's capital utilization has fallen drastically from 162% in 2008 to just 95.2% in 2009. Fixed asset utilization also showed a similar decline from 276.4% in 2008 to 142% in 2009. The major chunk of declining asset and capital utilization can be accounted for by around 39% fall in revenue generation from 2008 to 2009.
On the investor's outlook business performance has been disappointing. Gearing ratio has almost remained stagnant though the business still managed to reduce interest payment expense. Earnings per share however fell from $4.27 in 2008 to $2.04 in 2009, a 51.5% fall year on year. Earnings per share had also shown a similar decline between 2007 and 2008, falling from $5 in 2007 to $4.27 in 2008 and now to $2.04.
All in all Shell's performance over the years has worsened for most aspects. The management needs to be aware of this but also should be able to identify causes for poor performance and if within their scope should root them out.
Businesses financial records need to be accurate and fair. To ensure this they are subject to various assessment and examination to ensure accuracy and verity. Companies especially those that are listed are obliged by law to maintain independent checks on business accounts to protect shareholder interests. Auditors are responsible for assuring accuracy of books as well as detecting window dressing and cooked books.
Internal auditors are auditor employed directly by the business for keeping an all year round check on business operations. They are responsible for overseeing almost all aspects of company operations. Internal auditors scrutinize organizational procedures, management and governance to look for ways to improve organizational efficiency.
External auditors on the other hand examine on a one off basis transactions and record relevant to the financial stamen and required disclosures. They are responsible for reviewing accounting standards and principles applied by the management. Since eternal auditors are acting on behalf of the shareholder, they have to ensure that financial records are fair and true and hence they should not only be competent in their profession but should also be independent of the firm they are auditing to ensure impartiality.
Internal auditors are responsible for counterchecking on all ledger a business maintains with relevant control accounts. Any discrepancies should be matched and accounted for immediately. Internal auditors usually conduct auditing on a sampling basis. The may query or question any particular department or employee to assist management in controlling the business. Impartiality is essential in this case too.
The external auditors on the other hand examine data to the extent that it is related to the financial statements. External auditors only verify mistakes in financial statements. Their assessment of data is hence limited to deter inconsistencies in the financial statements and documents that pertain to it. They are however responsible for assuring accounting policies and procedures used comply with Financial Reporting Standards, FRS, as well as comply with local and international legal procedures. They need to assure that sufficient disclosures are made and that financial statements are fair le presented.
A budget is a future plan of the organization based on monetary basis. It also is a plan of their business position at the end of the time span. Budgets are an important part of management process since it gives a sense of direction and a goal to work towards. Preparation of budgets however is not an easy task and requires delicate precision.
Budgets prepared should be SMART that is Specific, Measurable, Achievable, Realistic and Time bound. Budgets lacking these qualities are likely to be ineffective and lack the realistic factor that pushes people to work harder toward the goals.
Preparation of budgets involves various analysis and steps;
Corporate Strategies is the first factor that needs to be considered when setting budgets. Business need to consider their long term business objectives and than prepare budgets that work towards these objectives. Setting budgets that are unaware of long term organizational goals are likely to lead organization into disarray.
The second step of preparing budgets is by identifying the principal budgets or the limiting factor that the organization is faced with. Business are not free to set up budgets, they are faced with constraints. The constraints could be in the form of a limit on the number of goods a business could sell (demand is limiting factor) or constraint could be the number of hours a particular type of skilled workforce could work. Once the limiting factor has been identified, principal budget is prepared. Principal budget is the budget of the limiting factor. Mostly the limiting factor facing firms is demand for goods and hence sale budget, the principal budget is often the first budget prepared.
The next step preparing an effective budget is assessment and coordination of internal factors. People preparing budget need to be fully aware of capabilities of employees, size of workforce that would be available and finance available. This step is aimed at ensuring budgets set are achievable and are not unrealistically demanding.
After preparing draft departmental budgets important assessment of external factors needs to be carried out. External economic, political and international circumstances must be taken into account while preparing budgets. Budgets must be suited to forecasted business environment. This can help reduce risk of budgets failing but cannot eliminate risk of failure.
Last but not the least businesses need to coordinate departmental budgets such as production budgets, sales budgets, purchase budgets, labor budgets etc. This is important since it allows master budgets to be drawn as well as allow for internal efficiencies. Each department in such situation knows its expected role in the success of the business and is likely to perform according to it.
Budgets are financial plans of the management and it is highly unlikely that actual performance is same as budgeted performance. Comparison has to be made to enable assessment of performance. The budget than is just a yardstick of performance, allowing comparison between expected and actual performance to be made. Variances are used to measure difference between actual performance and budget performance. Adverse variances reflect below par performance and favorable variances reflect performances par expectancy. Specialized variances are used to identify business performance in each individual aspect.
Material price and volume variances, labor rate and efficiency variances are measures of economy and efficiency. Sales price and volume variances reflect impact on performance as a result of changes in demand levels and prices.
Because variances allow particular aspects of poor business performance to be identified it is an important correction task once adverse variances have been identified. Management needs to identify reasons for poor performance. For instance if material variances turn out to be adverse management needs to identify the reason for this poor performance, for instance it could just be because of raw material price rises or could be result of damaged poor quality raw material leading to high wastage levels. It is easier to take corrective action that is effective once the root of problem has been identified. Hence budgeting allows for performance standards to be set and variance analysis allows for reasons of performance to be identified but will facilitate further future performance.
When managers assess proposals their aim is to decide upon the most effective proposal, one that yields efficiency and is beneficial in the long run. The Tucker model assists managers in choosing the most effective proposal and allows manager insight into the decision making process.
Tucker's five question model sets a simple but effective criterion for assessing project feasibility. It is in order as follows
-Is the proposal/decision profitable?
-Does the proposal satisfy legal requirements?
-Is the proposal fair to all stakeholders? What is the likely impact of implementing the proposal on stakeholders?
-Is the proposal ethical?
-Is the proposal sustainable?
Using this criterion for judging proposals is an effective way of limiting risk and increasing chances of implementing effective proposals.
When implementing changes in work patterns and equipment and when replacing old machines and technology business are faced by a variety of options. Selecting the best method out of all options is not an easy task. Capital expenditure appraisal hence becomes very important, particularly because capital expenditure involves huge amount of money and also because it has the power to affect long run business prospects. In such cases poor decisions are not easily reversible. Since it is too important to take the right decision, managers need to take utmost care and take into account both financial and also non financial prospects of proposals. Some tools have been developed and designed to assist managers in taking effective decisions.
Breakeven analysis is a process designed to assess business costs (both variable and fixed) relating to a proposals and than using it to ascertain the level of sales or production that will allow business to cover all costs. This method while appraising two or more projects calculates the lowest value or volume of output from each proposal that would be breakeven level (sales revenue=total costs). Managers are likely to choose proposals with lower breakeven output since it will accommodate without impacting business of demand fluctuations. Breakeven output is calculated as
Fixed Costs/ Contribution per unit
Where contribution per unit is calculated by
Contribution per unit= Selling Price per unit -Variable cost per unit
Payback period method calculates the time a project takes before it is able to recover it initial outlay cost. Risk is an important factor for consideration when choosing between alternatives. Projects with longer payback periods are riskier since they keep capital tied up for longer. Capital itself has an opportunity cost. Projects with shorter paybacks hence are given preference over longer payback projects.
Project A payback period= 3 yrs + 1000/6000*12 = 3 Years and 2 Months
Project B Payback period= 2 Years + 9000/10000*12 = 2 Years and 11 Months
Using payback project B seems feasible because of its short payback period.
Net Present Value is very similar in approach to payback period except that it calculates the value of project rather than recovery of capital. These values however are discounted that is time value of money is taken into account. Money looses value over time and $1 spent today is more valuable than $1 recovered after 2 years. In the NPV approach the project with the highest positive Net Present Value is selected over the others since it reflects positive value of project after x years in today's terms.
Discounting factors used are usually the prevailing level of interest or inflation rates. The discount rates are used to discount net flows in terms of today's values and a cumulative discounted flow is kept. Proposals with negative NPV reflect loss of capital expenditure value in future at current money value.
Capital investment appraisal methods have certain drawbacks but also advantages over rival methods. To limit wrong and poor decision making managers must take into account results of more than one assessment method.
The Payback method is relatively simple to calculate. Payback method is also more objective approach since cash flow amount and timings are taken into consideration than profitability. Payback method indicates projects that are least risky as one who have relatively shorter initial outlay recouping period. Payback is an essential measure of assessment for firms focusing on liquidity. Projects judged and selected using paybacks are usually quick growth generators because of quick liquidity and investment recovery.
Payback assessment method however ignores the life expectancy of projects. Proposals with quicker payback may also have shorter operation life and hence may be less useful and effective later. It may also happen that two projects may have similar payback period though their pattern of inflows may be different, one, for instance, being more liquid initially than the other.
Net Present Value method of capital expenditure appraisal is realistic in the sense that it takes into account time value of money. It hence produces more meaningful results than simple payback method. However NPV requires large volumes of complicated calculations.
Breakeven analysis has a more targeted approach when appraising projects. Its realism is in the sense that it sets out clear prerequisites for selected proposal to be successful. Managers for instance know that one project is preferable over the other only as long as they are able to sell as per expected forecasts.
Breakeven analysis has however technical weaknesses in the aspect that it ignores chances of occurrence of semi variable cost as well as small changes in selling price. Breakeven analysis has less focus on business liquidity. Other unrealistic expectations include the assumption that all production will be sold and that customers will not ask for discounts on volume purchases. It is hence a weak appraiser if used alone.
Since weaknesses of one method are somewhat eliminated by the strengths of the other methods it is essential that managers use more than one method of appraisal. These combined will reduce risk of poor decisions.
Strategic objectives are the plans set in motion by those charged with governance, to set a target for the organization followed by a strategy which indicates how the organization will go about in achieving those targets. The management should consider the purpose or mission and then develop goals for the business to pursue so as to ensure that it succeeds in achieving its purpose.
In order to design and develop strategies for implementation each goal or target is split into detached commercial or financial objectives, each of which must be realistic, achievable, identifiable and measurable.
Once corporate objectives have been set business functioning should be aligned in a manner that allows for these objectives to be accomplished.
For instance if the objective is to increase manufacturing capacity as well as upgrade production equipment the business will have to find finance for the objective as well as set a standard for performance that should be achieved by the objective, for instance a 15% return on investment.
Business competency will only increase if each business department is playing a role towards the achievement of corporate objectives at all levels.