The following analysis of performance will consider the position as shown in the reported financial statements
Return on Capital Employed
ROCE is used in finance as a measure of the returns that a company is realising from its capital employed. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital.( by Deryl Northcott 1992)
The ROCE is often considered to be the primary measure of operating performance, because it relates the profit made by an entity (return) to the capital (or net assets) invested in generating those profits. The return on capital employed of Reactive is impressive being more than 14.28% higher than to 2005. The reason for the improved profitability is due to increase efficiency in use of the company's assets.
The income from fixed asset is also including in profit. If we just take PBIT exclude income from fixed asset, it will show ROCE 24%, below than last year. It will also affect t the net profit margin as well.
Asset turnover
The asset turnover ratio simply compares the turnover with the assets that the business has used to generate that turnover. In its simplest terms, we are just saying that for every £1 of assets, the turnover is £x.( by Charles K. Vandyck 2006)
There is increase efficiency in use of the company's assets, increasing from 4 to 5.9 times. Net assets show how efficiently company is able to generate income from its assets.
Gross profit margin
Gross profit margin indicates the relationship between net sales revenue and the cost of goods sold. A high gross profit margin indicates that a business can make a reasonable profit on sales, as long as it keeps overhead costs in control.( by Charles K. Vandyck 2006)
Gross profit margin has decreased by 14%. The performance is appeared to be due both to company strategy of offering rebates to wholesales customers if they achieve as level of orders, and it's also beneficial for a company increase sales revenue from advertising campaign.
Net profit margin
T he net profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure, so that comparison of one with another can have little meaning. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss.( by Charles K. Vandyck 2006)
The net profit margin further decrease to 5%, and the reason behind decrease in company's net profit margin could be linked to beneficial impact on the sales revenue of advertising campaign.
The net profit margin will go down if we take profit without the income from disposable of asset. The net profit margin will go down and show 4% in 2006. On the basis of current year performance is worse than that of the previous year.
Liquidity
Current ratio
The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities.( by Wilbert 1973)
The company's liquidity position as measured by the current ratio has deteriorated dramatically during the period. A relatively healthy 1.6:1 is now only 1.27:1. It means the company is will be hardly to pay their current liabilities.
Stock days
The stock days ratio shows how many times over the business has sold the value of its stocks during the year. The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive. However, it will vary between industries and so it is important to compare within an industry.( by Wilbert 1973)
The closing stock period has decreased from 46 days to 26 days indicating more efficient stock holding. This is due to short lead times when ordering bought in products.
Debtors days
A ratio used to work out how many days on average it takes a company to get paid for what it sells.( by Wilbert 1973)
The debtors collection period is looks constant as compare to last year. The credit department should chase customers to pay their dues within 30 days.
Creditors days
The debtors collection period is looks constant as compare to last year.( by Wilbert 1973)
The creditors days has decrease from 55 days to 45 days which has increased the current ratio.
Dividend yield
The annual dividend income per share received from a company, divided by its current share price. Put simply - how much income is a shareholder getting out of the company for the capital locked up in it?( Stephen A. Ross, Randolph W Westerfield, and Jeffrey Jaffe (2007)
The current year dividend yield of 6%looks impressive when compared with that of the previous year of 3.75%,
Section 2
Budget
An estimate of the income and expenses needed to carry out programs for a fiscal year.( and Michael C. Ehrhardt (2004)
A detailed plan of income and expenses expected over a certain period of time. A budget can provide guidelines for managing future investments and expenses.( Eugene F. Brigham 2004)
"A budget is a statement of what it reasonable to believe can be made to happen". ( Jae K. Shim and Joel G. Siegel 2005)
Budgeting has the following elements :( CMI financial management notes)
Co-ordination:
It co-ordinates activities of the various parts of the organization and to ensure that the parts are working together.
Planning:
It encourages planning.
Motivation:
To motivates managers to work towards the organizational objectives. Once the budget is approved, the various responsibility managers know what is expected of them.
Control:
It provides control benchmarks against which to measure actual performance. Through the comparison of actual and versus budget, variances can be identified and corrective actions taken where necessary.
Communication:
To communicate plan to various responsibility managers. The budget setting process is an important avenue of communication between the different levels of management in the organization.
Types of budgeting
There are following different types of budgets.
Incremental budgeting
Incremental budgeting involves taking last year's figure and adding a bit on for inflation or whatever, or even taking a bit off, due to perhaps, downsizing.
Advantages:
quickest and easiest method
assuming that the historic figures are acceptable, only the increment needs to be justified
Avoids 'reinventing the wheel'.
Disadvantages:
builds in previous problems and inefficiencies, e.g. an overspend may result in a larger budget allowance next year.
uneconomic activities may be continued, e.g. the firm may continue to make a component in house when it might be cheaper to outsource.
managers may spend unnecessarily to use up their budgeted expenditure allowance this year, thus ensuring they get the same (or a larger) budget next year.
Activity Based Budgeting
Traditionally, there has been a tendency to take an incremental approach to budgeting for overhead costs, and prepare next year's budget by simply adding a percentage to the current year's budget, to allow for inflation. ABB is an alternative method which may produce more accurate budgets and enable greater control of overhead expenditure.
ABB is defined as: 'a method of budgeting based on an activity framework and utilizing cost driver data in the budget setting and variance feedback processes'.( Geoffrey Woodhall, Alan Stuttard, and Matthew Cripps Nov 2004)
Advantages of ABB
The advantages of ABB are similar to those provided by activity based costing (ABC).
It draws attention to the costs of 'overhead activities'. This can be important where overhead costs are a large proportion of total operating costs.
It provides information for the control of activity costs, by assuming that they are variable, at least in the longer term.
It provides a useful basis for monitoring and controlling overhead costs, by drawing management attention to the actual costs of activities and comparing actual costs with what the activities were expected to cost.
It also provides useful control information by emphasizing that activity costs might be controllable if the activity volume can be controlled.
ABB can provide useful information for a total quality management (TQM) programmed, by relating the cost of an activity to the level of service provided (for example, stores' requisitions processed) - do the user departments feel they are getting a cost-effective service?
Disadvantages of ABB
A considerable amount of time and effort might be needed to establish an ABB system, for example to identify the key activities and their cost drivers.
ABB might not be appropriate for the organization and its activities and cost structures.
A budget should be prepared on the basis of responsibility centers, with identifiable budget holders made responsible for the performance of their budget centre. A problem with ABB could be to identify clear individual responsibilities for activities.
Flexible budget
A budget prepared with the cost behavior of all cost elements known and classified as either fixed or variable. The budget may be prepared at a number of activity levels and can be 'flexed' or changed the actual level of activity for budgetary control purposes. (ACCA Financial Management 2007)
Flexed budget
Once the actual level of activity is known, the appropriate part of the flexible budget can then be used as a basis for the preparation of a flexed budget for purposes of comparison and variance analysis.
Zero based budgeting
Zero based budgeting is method of budgeting whereby all activities are revaluated each time a budget is prepared. Discrete levels of each activity are valued and a combination chosen to match funds available. (Murray Dropkin, Jim Halpin, 1981)
Zero based budgeting makes no initial assumption; each year's budgets are compiled by assessing each potential activity from scratch
Advantages
It helps to create an organisational environment where change is accepted
It helps to management to focus on company objectives and goals.
It can assist motivation of management at all levels
It provides a plan to follow when more financial resources become available
It establish minimum requirements from departments
Disadvantages
It takes more management time when conventional system, in part because manager need to learn what is required of them
There is temptation to concentrate on short term cost savings at the expense of longer term benefits
It takes time to show the real benefits of implementing such a system
Rolling budgeting
A budget kept continuously up to date by adding another accounting period (e.g. month or quarter) when the earliest accounting period has expired. (ACCA Financial management)
Aim: To keep tight control and always have an accurate budget for the next 12 months.
Suitable if accurate forecasts cannot be made, or for any area of business that needs tight control.
Advantages
the budgeting process should be more accurate
there should be much better information upon which to appraise the performance of management
the budget will be much more 'relevant' by the end of the traditional budgeting period
It forces management to take the budgeting process more seriously.
Variance feedback is more meaningful
It might help to increase management commitment to the budget
Disadvantages
they are more costly and time consuming
an increase in budgeting work may lead to less control of the actual results
There is a danger that the budget may become the last budget 'plus or minus a bit'.
The organisation might be required to operate annual budget
Manager will be faced with a greater work load and additional staff may be required
Cash Budgets:
Cash budget shows the expected receipts and payments during a budget period and are a vital management control tool, especially during the times of recession.
The preparation of cash budgets or budgeted cash flow statements has two main objectives:
To provide periodic budgeted cash balances for the budgeted balance sheet.
To anticipate cash shortages/surpluses and thus provide information to assist management in short and medium term planning and longer term financing for the organisation.
Sales variance:
Sales variance is the difference between the actual sales and the budgeted sales. It is used to analyse the business results and measure the performance of sales function.
As the budgeted and the actual units sold are the same in quantity so the adverse variance is due to the sale of products at a price lower than budgeted. This means that rock field ltd was unable to sell its products at the estimated price. The reason for adverse selling price could be linked with the achievement of the budgeted sales volume at a lower price or there could be an unexpected downturn of the market in which the company is operating.
Ingredients:
Ingredients price variance is the difference between what the ingredients did cost and what it should have cost. In Rock field ltd the actual cost of the ingredients is 40,000 more than budgeted cost. The reason for this difference could be the unexpected rise in the prices of the material or the company is unable to obtain the bulk discount that was expected.
Labour:
The total labour variance depends on the labour rate variance and the labour efficiency variance. In Rock field Ltd the variance for labour and energy is favourable, which means that been achieved due to the less labour cost than it should have cost or due to more hours worked than should have worked or it could be possible that the net effect of both the estimates is favourable giving a favourable variance.
Fixed overhead:
The fixed production overhead expenditure variance measures the under or over absorption caused by the actual production overhead expenditure being different from budget. In Rock field Ltd there is an adverse variance for fixed production overhead. There could be two reasons for this.
The work forces have been working at a less efficient rate than standard to produce a given output. Or
Regardless of the level of efficiency, the total numbers of hours worked could have been more than was originally budgeted
Section 3
Return on Capital Employed:
The return on capital Employed or Accounting Rate of Return (ARR) expresses the profit from a project as a percentage of capital cost. There are different approaches to find the ROCE but the most common approach produces the definition given.( by Stephen Lumby 1991)
ROCE=average annual(post depreciation)profits before interest and tax x 100
Initial capital cost
Advantages:
It is easily understood and easily calculated as being based on widely reported measures of return profit and balance sheet values.
In assessing the business or sector of a business it is a widely used measure. It is expressed in percentage terms which the managers and accountants are familiar.
Disadvantages:
It fails to take account of either the project life or the timing of the cash flows.
It might ignore working capital requirements.
ROCE figure for identical projects would vary from business to business due to the different accounting policies used by the businesses.
Payback Period
Description Payback allows us to see how rapidly a project returns the initial investment back to the company. In practice, companies establish "rules" around payback when evaluating a project. For example, a company might decide that all projects need to have a payback of less than five years. This is also referred to as the cut off period.(Deryl Northcott 1992)
Pros - Allows for an easy understanding by management and stakeholders of when the initial investment will be recouped. This allows go, no-go, decisions to be made based on simple cut off date rules.
Cons - Does not take into account the time value of money. Discounted cash flow should be the preferred way to evaluate payback since it does recognize the time value of money. That is cash in the future is not worth as much as much as cash today. Payback period also ignores all cash flows that occur after the payback period is reached.
Internal Rate of Return (IRR)
The internal rate of return, or discounted cash flow rate of return, offers analysts a way to quantify the rate of return provided by the investment. The internal rate of return is defined as the discount rate where the NPV of cash flows are equal to zero. The IRR can be calculated using trial and error (changing the discount rate until the NPV = 0). Generally speaking, the higher a project's internal rate of return (assuming the NPV is greater than zero), the more desirable it is to undertake the project. The rule with respect to capital budgeting or when evaluating a project is to accept all investments where the IRR is greater than the opportunity cost of capital. Under most conditions, the opportunity cost of capital is equal to the company's weighed average cost of capital (WACC).( Deryl Northcott 1992)
Strengths
It is widely accepted in the financial community as a quantified measure of return and it's also based on discounted cash flows - so accounts for the time value of money. And when used properly, the measure provides excellent guidance on a project's value and associated risk,
Weaknesses
There are three well known pitfalls of using IRR that are worth discussing:
Multiple or no Rates of Return - if you're evaluating a project that has more than one change in sign for the cash flow stream, then the project may have multiple IRRs or no IRR at all.
Changes in Discount Rates - the IRR rule tells us to accept projects where the IRR is greater than the opportunity cost of capital or WACC. But if this discount rate changes each year then it's impossible to make this comparison.
IRRs Do Not Add Up - one of the strengths of the NPV approach is that if you need to add one project to an existing project you can simply add the NPVs together to evaluate the entire project. IRRs on the other hand cannot be added together so projects must be combined or evaluated on an incremental basis.
It is worthwhile on financial ground to invest on this project because the project is expected to earn better rate of return from target rate 17% (calculation shown in appendixes)
Conclusion
The above analysis of performance seems to give mixed message. The company has invested in new projects. This appears to have affected the share price. The expansion will take a little time to bear fruit. Cash generation remains sound and if this continues, the poor current liquidity position will soon be reversed
The company profitability seems to have improved as a result of directors actions at the start of the current year. The apparent improvement is due to change in supply policy and the huge benefit from disposal of plant.
In conclusion, the financial results do not show the full picture. The firm has fundamental weaknesses that need to be addressed if it is to grow into the future. At present it is being left behind by a changing industry and changing competition.
The company is liquidity is now below acceptable levels and would have been even worse than the disposal not occurred. It appears that investors have understood the underlying deterioration in performance as there has been a marked fall in the company's share price
Variance of any type should be signal for some sort of investigation action by management. This can involve either looking to see how the variances have been arisen or re-assessing the suitability of the standards that have been set. It might have to accept that the standard by which material and labour performance is being measured might not be accurate one.
The company should invest on those projects those give positive NPV .
Reactive plc is invested in new project is giving more rate of return than target rate of return .this means the project is worthwhile.
Calculations
Section 1
Ratios
Profitability 2006 2005
Return on capital employed
PBIT/capital employed 220/1160-480*100 32% 28%
Net asset turnover
Turnover/capital employed 4000/680 5.88 times 4 times
Gross profit margin
Gross profit/sales 550/4000x100 13.75% 17%
Net profit margin
Net profit/ sales 200/4000x100 5% 6.30%
Liquidity ratios
Current ratio
Current assets/current liabilities
610/480 1.3:1 1.6:1
Stock days
Stock/cost of sales 250/3450x365 26days 46days
Debtors days
Debtors/salesx365 36o/3000x365 44days 45days
Creditors days
Creditors days/cost of sales
430/3450 45days 55days
Dividend yield
Dividend per share/share price 23/375x100 6% 3.75%
Section2
Budgeted Actual variances
Units 240000 240000
£000 £000
Sales 1200 1080 120 A
Materials (40%) 480 520 40 A
Labour and energy (10%) 120 110 10 A
Gross profit 600 630
Contribution 600 450
Fixed overheads 300 340 40 A
Profit 300 110 190 A
SECTION 3
Internal rate of return (IRR)
Year
cash flow
discount factor
present value
discount factor
present value
@ 10%
@ 10%
@ 20%
@ 20%
$
$
$
$
$
0
(50000)
1.00
(50000)
1.00
(50000(
1
18000
0.909
16362
0.833
14994
2
25000
0.826
20650
0.694
17350
3
20000
0.751
15020
0.579
11580
4
10000
0.683
6830
0.482
4820
NPV
8862
(1256)
IRR= L + NL x (H-L)
NL-NH
IRR= 10% + 8862 X (20% - 10%)
8862-(-1256)
IRR = 18.75%
