The Gross Profit Ratio tells us the profit of a business makes on its cost of sales or cost of good sold. The performance was better in 2006, as it was 28.05%. The percentage decreased 5.37% in 2007 which is not good as they have less profit for their activities that take place in the service. But 2008 performance was again better, as it was 24.32%.
Reason
The Gross Profit Margin shows how well the business is managing its purchase of stock. If it is high figure it shows that the business is doing well as it is controlling the cost of its purchases. The negative aspect about this ratio is that it provides figures that may mislead Spectrum e.g. if Spectrum do not know the difference between net and gross profit margin as many people get mixed with these two figures. I have used this ratio for Spectrum and I found out that their Gross Profit Margin for 2006 was 28.05%, in 2007 it was 22.68% and in 2008 it was 24.32%. By looking at their Gross Profit Margin, I found out their Gross Profit Margin decreased bye 5.37%, which means that the performance of Spectrum has gone down. In 2006 Spectrum's sales figure was £21,015 and in 2007 their sales figure was £27,450. This means that the sales are not the reason of why their Gross Profit Ratio has decreased, as you can see that their sales have increased from £6,435. The reason why their Gross Profit ratio figure has decreased in 2007 is because in 2006 their cost of sales was £15,120 and in 2007 it was £21,225 which means that the cost of sales has increased bye £6,105.
This ratio can improve Spectrum Gross Profit margin by increasing the sales revenue and Spectrum can do this by selling as much as possible. Spectrum could advertise more in order to make more sales. By looking at their Gross Profit Margin, I found out their Gross Profit Margin has increased by 1.64%, which means that the performance of Spectrum has gone up. The reason why their Gross Profit ratio figure has increased in 2008 is because in 2007 their cost of sales was £21,225 and in 2008 it was £16,575 which means that the cost of sales has decreased by £4,650, and the main reason why cost of sale of Spectrum was less as compare with 2007 just because in 2008 they had cheap material. Material cost was decreased by 19.77% in 2008. Appendix 1
Net Profit Margin
2006: 8.72%
2007: 8.09%
2008: 10.85%
Explanation
In 2007, the business was profitable but the profit fell compared to the previous year it was 8.09%. Their expenses have increased due to the difference. The directors have taken a larger salary, but 2008 performance was again better, the profit up as compared to previous year it was 10.85%.
Reason
Net Profit Margin provides information on the relationship between the net profits, which is the profit when all the expenses have been subtracted (gross profit - expenses) and the sales revenue has been made by Spectrum. I have used this ratio for Spectrum and I have found out that in 2006 their Net Profit Margin was 8.72% and in 2007 it was 8.09%. This tells me that the performance of Spectrum has gone down as compared to 2006. Spectrum's Net Profit has fallen down by 0.63% from 2006 to 2007. Again Spectrum's sales figure is not the reason of why their Net Profit Margin ratio figure has decreased. The reason why their Net Profit Margin ratio has decreased in 2007 is because their Net Profit has decreased as in 2006 their new Profit was £552 and whereas in 2007 it was £836. This tells me that Spectrum's expenses have increased. This is the reason why their Profit Margin ratio has decreased in 2007.
By decreasing some of the expenses Spectrum can increase their Profit back up and this can make their cash flow healthier. This ratio can improve Spectrum Net Profit Margin by raising the sales revenue and by selling more. Spectrum will also need to ensure that they are keeping their sundries expenses, utility bills and drawings are kept minimum. So that they can save money and can spend on important things such as stock. They can also improve their gross and net profit by advertising more but they need to make sure that they are not spending to much money on advertising. Spectrum can do this by advertising where their market audience is.
Net profit Margin ratio has increased in 2008 is because their net profit has increased as in 2008 their new profit was £994 and whereas in 2007 it was £836, this tells me that Spectrum's expenses have decreased. This is the reason why their profit margin ratio has increased in 2008. Appendix 1
ROCE (Return On Capital Employed)
2006: 21.24%
2007: 28.45%
2008: 40.44%
Explanation
ROCE is a ratio that indicates the efficiency and profitability of a company's capital investments. This is good as the return on capital employed has increased in 2007 and 2008, which is good for business as it is better. ROCE is refers to payments back to capital owners of a business. So if the number increases it means that the business is getting their payments on time which is good for the business. Appendix 1
Leverage Ratio
Explanation
A Leverage Ratio measure's a company's ability to meet its financial commitments and its financing methods (debt or equity). It is an important measure to consider because an investor can figure out where their invested money is going and how much of it will be reinvested to create a return.
Reason
The debt to assets ratio measures the percentage of assets that are financed by debt. It also measures the amount of risk a company is taking in case of a debt-load. In this case, about 47.14% of assets are being finance by debt, which is good when compared to previous years 2006 was 63.12% and 2007 was 62.80%. The company is relying less on debt and therefore paying less interest out to third parties. The debt to equity ratio measures the proportion of assets that are being financed by debt and equity. Once again the percentages have been decreasing from 171.17% in 2006 to 90.14% in 2008. This confirms the debt to asset ratio, the company is using less debt to finance its assets and therefore spending less on paying interests on loans to third parties. The money is staying in the company by shareholder's money is being invested and the return going back to shareholders. Long term debt to equity same as debt equity, the interest coverage ratio measures the ease with which a company can pay interest payments on its outstanding debt. Its 28.76% in 2008 which means company's interest coverage ratio increased significantly which means it can pay off all its interest payments with ease when required, it was 74.62% in 2006 and 73.25% in 2007 so in 2008 its better then previous years. Additionally, this ties into our previous ratios where the company's debts had decreased and they would therefore have to pay less interest. The company is therefore generating a sufficient amount of revenues to cover its interest payments. Appendix 1
Current Ratio
2006: 1.84
2007: 2.12
2008: 2.88
Explanation
The current ratio in 2006 was £1.84 to every £1, in 2007 it was £2.12 to every £1 and in 2008 it was 2.88. The current ratio shows us the current idea of the money that the business needs to pay back. This is progress for Spectrum as in 2006 they had to pay less back but now in 2007 and 2008 they are paying more.
Reason
This ratio shows how many assets a Spectrum has compared to liabilities, in other words how easily it would be able to pay its creditors. If the figure is just over 1 then the business may be in a difficult position for payment as it current assets would be virtually to its liabilities. It is considered good to have a figure of between 1.5 and 2, so that the business can be sure it can pay its liabilities easily. A figure higher than 2 would not be good as the money should be placed elsewhere to improve the business. The figures for Spectrum show me that the business is doing well in 2008 and 2007 compared to 2006. The amount of assets in 2008 and 2007 has increased. In 2006 the current ratio shows that for every £1 Spectrum owes they owned £1.84 but in 2007 the figure was £2.12 and in 2008 the figure was £2.88. Another reason why their business is not performing well is because of their current liabilities. In 2006 the current liabilities figure was £4,770 and in 2007 it was £4,307 and in 2008 it was £1,916. This shows me that the business is in dept as Spectrum owes more money in 2006. The figures had dropped and their business was not as healthy.
Therefore this could be harder for Spectrum to pay their bills and other expenses, which are necessary for their business. In 2007 and 2008 the performance of their business was good as they could pay all their expenses. Spectrum improved the performance of their business by improving the ratio. Appendix 1
Advantages of Ratios
Ratio is an important and old technique of financial analysis. These are the following advantages of Ratio.
1. Accounting ratio help to major profitability of the business, it tells the company about changes in the earning capacity of the business. Profitability shows the actual performance of the company.
2. Ratios give all factors with successful and unsuccessful company.
3. It helps planning and forecasting, ratios can assist management, Ratio analysis helps all outsiders about profitability to pay them interest and dividend etc.
4. Ratio analysis also makes big different in performance of the company. Accounting ratios are helpful in giving difference in past and compare it to future.
5. Ratio analysis helps outsiders who are interested in investments in our company or banks giving loan etc.
6. Ratio analysis helps to workout in efficiency of the company with the help of various ratios. Ratios are use to check the performance of the companies in the utilising resources.
Shortcoming or Limitations
To calculate Ratios are easy and simple to understand, there are certain limitations or shortcoming of the Ratios analysis and they should keep in mind while using interpreting financial statements.
1. Different companies use different polices, one company can not always compare with other companies. Different companies use LIFO basis and some other companies will use FIFO basis.
2. If the Ratios answer is correct the only ratio will be use, for example if the valuation of stock is based on higher price, the price will be inflated and it will give the wrong answer.
3. Companies never take ratios as a final answer regarding good or bad financial position of the business.
4. The price changes often and it make difficulties in comparison, companies should make comparison before price-level changes.
5. Ratio analysis are expensive, big companies can easily afford it but small companies are not able to afford it.
6. Companies are not differing in their nature, companies of similar companies are differ in their size. There are no more standard ratios, which can be accepted universally for comparison as the ratio analysis technique is reduced.
Financial and Non-financial Techniques
In this part we will discuss about financial and non-financial techniques, which are as follows.
1. Profitability (Financial)
2. Activity Ratio (Financial)
3. Benchmarking (Non Financial)
4. Customer Service (Non Financial)
1. Profitability Ratio (Financial)
We used profitability ratio for Spectrum Company, profitability ratio is a class of financial metric that are use to access business's to make profit compared to their expenses. We had checked that how Spectrum Company managers are good in generating profit. We use Profitability ratio to check how company is doing. Higher value of competitor's ratio, will check previous year result that company is doing well.
2. Activity Ratio (Financial)
Activity ratios show how efficiently a company has managed liabilities and short-term assets. Spectrum Company would change their production in to cash or sales because it will lead to higher revenues, but it is common for the year end value to be used in order to obtain figures for comparative purposes.
3. Benchmarking (Non Financial)
Spectrum Company will check its cost, cycle time, productivity, or quality to another that is widely considered to be an industry. Benchmarking provides a snapshot of the performance, Spectrum Company would use benchmarking for better performance of business and will help to understand in relation to a standard. Spectrum Company would try to make good quality to make a best performance using a specific indicator in resulting in a metric performance that is then compared to others.
4. Customer Service (Non Financial)
Many business organisations use monitoring and evaluating to improve customer service. Spectrum monitors and evaluate their customer service, Spectrum Company monitor their services by doing surveys, asking customers feedback, asking them to fill the questionnaire and comment cards. They also give can make improvements for the customers by training their staffs (customer service training) do that they know where the products are and they can help the customers to find the product. They can improve their sales by installing new software's in their website for those customer's who are unable to go to factories they can do shopping online.
Q1. (b): Agency Theory
Agency theory is the financial economics that looks at conflicts between people with different interests in the same assets. The conflicts between,
Shareholders and managers of companies
Agency Theory is the theory that covers the conflicts between agent of the firm and the principal of the firm, the agents are the managers and the principal are the stockholders, there will be a conflict if the goal of the agents managers are not consists with the goal of the stockholders and that goal is basically maximization of the stockholders wealth, And if there is conflict between this goals you will see will be agency cost and those cost could involved millions of dollar in under performance of the firm.
Spectrum Company is very diverse group of companies and Spectrum company's shares are owned by institutional investors, they are in board and they can speak up in front of directors. There may be a conflict of interest between the board and the institutional investors management as they Spectrum companies management don't take that much risk while diversifying their business in India and other country. Institutional investors take the higher risk rather than normal companies.
Q1. (c): Dividend Policy
Dividend policy is company use to decide how much they have to pay dividend from the net profit. Now the company has to decide what they have to pay in terms of dividend there are three methods of paying dividends.
Residual
Stability
Hybrid
Residual:
Residual dividend policy use to generate equity to finance on new projects. Dividends can be pay out after deducting all the new projects equity.
Stability:
Stability policy use by companies to set a fixed fraction of quarterly earnings, or some companies use table policy where they will set fraction quarterly dividends of yearly earnings . Stability policy reduces uncertainty of the investors and provides them income.
Hybrid:
Hybrid policy is the combination of stability and residual, in this case companies must view the debt/equity ratio and it will be for long-term rather than short-term.
There are three main positions, which are as follows.
1. No Dividend Policy (Zero Dividends)
2. Constant Dividend Policy (real/money terms)
3. Fixed percentage Payout Ratio policy
1. No Dividend Policy (Zero Dividends)
Spectrum Company is investing in other countries for more business, they would use this policy because they will invest their profit for investment. They are acquiring three textile companies and four commercial companies in Russia, Singapore, Japan and Germany. In Annual General meeting they will discuss about this projects and will ask from there shareholders.
2. Constant Dividend Policy
This policy concern with real or money terms, Spectrum Company would use this policy in case they are not investing in other projects, so they can easily pay Constant Dividend to there shareholders.
3. Fixed Percentage Payout Ratio Policy
If Spectrum Company decides they are paying dividend but should keep some of it for investment in their new projects, then they can use Fixed Percentage Payout Ratio policy which means they would use ratio of organisation or 10% of the profit as dividend and remaining will be use in projects or investments.
Does Dividend Policy Matter?
Its depend upon the Company management, what type of policy they chose if they will go with stability then they have to pay dividends and if they will go with the Residual then they will invest money first and from the remaining amount they will pay the dividend and its also depend upon the inventor, what they are expecting at the end u have to give a conclusion to them does dividend policy matter or not.
Q2. (a):
Debt financing encouraged due to the fact that interest expensed are deductible for taxation purposes, dividends paid to shareholders is not considered as an expense for taxation purposes.
Q2. (b):
There are following three main sources to finance Public Limited Companies.
The capital market: (1) New Shares (2) Right Issues
Bank borrowings
Retained earnings
1. The capital markets
Ordinary Shares is the company main source for financing, they issue ordinary shares in market. The ordinary shares have nominal or face value like £1 or 50 pence. The company always issue ordinary shares for cash, the issue price of ordinary shares must be greater than or equal to nominal value.
New shares issue by companies to rise up their finance, those which are already listed on Stock exchange don't need to apply for new registration, they can issue new shares in market.
A Right issue rising up new shares capital in market, they can offer it to new customer as well as old customer.
2. Bank Borrowings
Taking borrowings from banks are also source of financing a Public Limited Company, Companies invest this money in new projects or in another branches where they need finance.
Short-term is an overdraft, which company keeps in limit set by bank with variable rate, short-term is amount which borrowed by company from bank, it can be borrowed for up to three years.
Medium-term is a loan, which borrowed by company three to ten years. The medium-term loan margin is set by banks, its interest rate is variable or fixed which is set by banks.
3. Retained Earnings
Retained Earnings is a profit, which we pay part on dividends and the remaining we use for Investments in new projects or sometime we keep as a profit. We use retained earnings to invest in new projects rather then pay higher dividends.
