INTRODUCTION
Spectrum Manufacturing Company is a public limited company. The Company was incorporated on 15th June 2000 in the United Kingdom. The Company has subsidiaries in the United States of America, France, Germany, Japan and China.
The strategic plan of the Company is to acquire three textile companies and four commercial companies in Russia, Singapore, Japan and Germany. The Company also plans to establish six branches in India, Spain, Singapore and South Africa.
We have been given the task to analyse the performance of Spectrum Manufacturing Company (PLC) using the profitability ratios, leverage and current assets ratios. We have explain the reasons why we have used these ratio, what are the advantages and shortcoming of these ratios and also discussed four additional financial and non financial techniques that Spectrum Manufacturing Company could use.
We have been asked to explain the term Agency Theory and also discuss the implications of agency theory with regard to the Board of Directors of Spectrum Manufacturing Company with the shareholders.
At the end of the project we have explained in detail the dividend policy and the three main positions on question, "Does dividend policy matter? And the last question was to comment on why it is generally held by several analysts that debt financing is often encouraged relative to equity financing and three main sources of financing a public company.
1. Profitability Ratios:
"Profitability ratios are used to assess the business ability to generate earning of business as compare to expenses over a specific period of time. The tutorials define the ratios and walk you through the calculations including where on the financial statement the numbers can be found."1
The analysts can assess a company's business i.e. its sales, assets or equity using the profitability ratio. While using the profitability ratios analysts not only can check the current status of a company's business but also can foresee signs for its future problems.
There are many ways to calculate the profitability of an organisation through profitability ratios, some of these which I have used are as under:
2. Leverage Ratio:
"Financial leverage ratios provide an indication to the long-term solvency of the firm and are concerned with short-term assets and liabilities. These ratios measure the extent to which the firm is using long term debt." [2]
We use leverage ratio to evaluate the borrowing of an organisation compared to the total capital employed. A higher degree of this ratio mean the company is considered more risky and is more vulnerable to downturns in the business because the company must continue to service its debts regardless of how bad sales are.
3. Current Assets Ratio:
"This ratio provides the acid test of whether the company has sufficient liquid reserves (debtors and cash) to settle its facilities. The norms for the quick ratio range from 1 to 0.7. Similar to the current ratio it is important to consider the nature of the business when using the current assets ratio. It also takes into account those assets which are bank, cash, and short-term investments. The ratio also includes trade debtors. The ratio excludes prepayments and stock. Quick liabilities include bank overdraft which is usually repayable on demand. Trade creditors, tax and social security and proposed dividends. Corporation tax is usually excluded." [3]
This important ratio measures any business ability to pay its debts that are due soon with those available assets that should raise cash quickly.
WHY WE USED THE RATIOS TO ANALYSE COMPANY'S PERFORMANCE
As shown above I have used profitability ratios, leverage ratio and current assets ratio to measure the performance of Spectrum Manufacturing Company PLC. There are many reasons why I have used these ratios and I have explained each of the ratios as under:
1. PROFITABILITY RATIOS:
I have used six different ratios under profitability section and each one of them is described as under:
1.1 Gross Profit Margin
Gross profit margin is used to assess the profitability of Spectrums core activities, excluding fixed costs. Gross profit margin shows how well each pound of business revenue is available to meet its expenses and profit earned after paying for the goods or services that were sold. A high gross profit margin during the year 2008 Spectrum earned indicates that it can make a reasonable profit on sales, as long as it keep overhead costs in control.
"The gross profit margin ratio provides clues to the company's pricing, cost structure and production efficiency. The gross profit margin ratio is a good ratio to benchmark against competitors." [4]
1.2 Operating Profit Ratio
To measure that how much proportion of an organisation's revenue before taxes and other indirect costs such as rent, bonus, interest etc is left over we use operating profit ratio and this all is after deducting the costs of production i.e. wages, raw materials etc. A high price and high margin will result in lower sales as we have seen for the year 2006, while year 2007 was a good year for operating profit for Spectrum. A good operating profit margin shows the ability of a company that it can pay for its fixed costs such as interest on debt. So if we look into year 2006 where the operating profit ratio indicates 10.85%, this means that Spectrum made £0.10 before interest and taxes for every pound of sales.
1.3 Return on sales (ROS)
We use return on sales (ROS) to measure an organisation's operational efficiency. ROS is also known as a firm's "operating profit margin" because it shows the management how much profit is produced per pound of sales.
An increasing return on sales ratio means that Spectrum was sufficiently growing in year 2006 and we see it was making profit for that year of £6.21 of each £1 of sales and when we look at the very recent years this figure was decreased especially in 2008 where it was dropped to £2.63 of each £1 sale, which is an alarming signal of the financial troubles for Spectrum Manufacturing.
1.4 Operating Ratio:
The profit before interest and tax (PBIT) is also known as operating profit. Operating ratio is a very important ratio for analysts because it calculates the profitability of a business before incurring other financing costs. It shows the profit a business earns by each £1 of turnover, so as we seen that Spectrum's operating profit the year 2007 was 91.91 which is higher than the other two financial years.
1.5 Return on Capital Employed (ROCE):
Return on Capital Employed (ROCE also known as Return on Investment (ROI) is very important and key ratio in profitability. It shows the total capital employed in any business and measures the efficiency of the business to the total capital employed. Thus this ratio is very important assessing the financial achievement of an organisation because it shows the earning strength of the operations of a business.
The objective of an investor when invests in any business is to get reasonable and satisfactory return on its investment, so Return on Capital Employed (ROCE) is used to evaluate the success of a business to realise the objectives and it creates a relationship between the profit and capital employed and it not only shows the total profitability of the business but also reflects its efficiency over the specific time. So after calculating Return on Capital Employed for Spectrum Manufacturing we have noticed that the company was performing well during the year 2006 where ROCE was 40.44% but it dropped down in 2008 to 21.24% and in 2007 it was standing on 28.45%.
2. LEVERAGE RATIO:
Leverage ratio is also known as gearing ratio and we use this ratio to measure how much financial leverage a firm has taken on. When an organisation borrows money from any financial institution or from any other available sources, it is committed to make series of interest payments on that borrowed money and then to repay the amount that it has borrowed at an agreed time. The debtors regularly receive the fixed interest payment during the time when organisation is generating profit and during the bad time where organisation is struggling and not making any profit at all and debtors do not receive the interest payment, this is the time when shareholders have to bear all the pain. For example if the company is going through hard time and not been able to pay its debts, the company is then bankrupt and shareholder lose their entire investment, because debt increases returns to the shareholders when a company is generating good profit and reduces them in bad times, so it is said to create financial leverage. This ratio measure how much financial leverage an organisation has taken on for its operations. As we have used two further ratios under leverage ratio so please read the following:
a. Debt ratio
Debt ratio shows us that how much company relies on debts to finance its assets. If the debt ratio is higher than 1 this alarms that the company has more liabilities than its assets and on the other side if its less than 1 that mean the company has more assets than its debts. So in Spectrum's case we have noticed that in year 2006 the company's debt ratio was really low to 0.47 which went up in 2008 but as its still under 1 so there are no threats for the company.
b. Debt-to-equity
Same in all other leverage ratios if the debt to equity ratio is higher that is alarming signals for a company that company is using debts to finance its assets. So lower this ratio is better for the organisation and we seen in our result for debt to equity ratio that in 2006 it was only 0.90 but higher in 2008 where it went upto 1.71.
3. CURRENT ASSETS RATIO:
We use current assets ratio to analyse the overall liquidity of an organisation. This ratio shows the cash position of an organisation and reflects the ability to meet the organisation's short term obligations. This ratio basically assesses and indicates of an organisation's market liquidity and its ability to meet the demands of its creditors. It is strongly considered that if an organisation's current liabilities are higher than its current assets the organisation can have some problems to meet the short-term obligations of the organisation. So if the current asset ratio is too high that means that the organisation is not using its current assets properly. As we notice that current assets ratio is showing that for every £1 Spectrum owes it had £2.88 available in current assets during the year 2006 and during the year 2008 it has been dropped down to £1.84.
Advantages and shortcomes of using these ratios
1. Profitability Ratio
Advantages
Profitability ratios help the management to know about the earning capacity of the business concern and these ratios reflects the actual performance of the business and quickly tell how much profit is being made for every £1 invested. So when profitability ratios are high that means that an organisation can grow itself by reinvesting its earnings and on the other hand when these ratios are low the organisation have to borrow money or issue more shares to get finance growth.
Shortcomes
Profitability ratios are limited to assess the profit of a business only whereas it doesn't shows the losses as it is only dependent on the balance sheet which is produced once a year by a business. Profit and capital employed are arbitrary figures and they depend on the accounting policies adopted by an entity. Further shortcomings and limitations of profitability ratios are as follows:
2. Leverage Ratio
Advantages:
Leverage/Gearing has important implications for the long term stability of a company because of its impact on financial risk. Companies closely monitor their leverage/gearing ratios to ensure that their capital structure aligns with their financial strategy.
Disadvantage
The calculation used in these ratios is based on past performance so these may not reflect the current position of an organisation. Performance ratio analyses can also sometimes be misleading if their interpretation does not also consider other factors that may not always be easily quantifiable and may include non financial information, for example customer satisfaction and delivery performance.[5]
There may be inconsistencies in some of the measures used in ratio analysis. Calculation of the ratios for one company for one year is also very limited. It is more relevant to compare companies operating in the same market and to analyse how a company has changed over the years. However difficulties inevitably arise because it is sometimes impossible to find another company that is strictly comparable with the company being analysed.
3. CURRENT ASSETS RATIO
ADVANTAGES:
Current assets ratio is to assess a company's liquidity status instead of the static. It is often calculated alongside the quick ratio and the cash ratio, to provide analysts with a more complete picture of the short-term liquidity of the company being analyzed. Although these ratios have their flaws, the dynamic current ratio has several advantages compared to the quick and cash ratios.
SHORTCOMES:
The drawback of the current ratio is that we do not know how liquid inventory and accounts receivable really are. This means that a company with a very large part of its current assets tied up as inventory could show a relatively high current ratio but still exhibit a rather low level of liquidity
FOUR FINANCIAL TECHNIQUES TO MEASURE
A COMPANY'S PERFORMANCE
There are many other ways to analyse a company's performance as in financial techniques we can use:
We define each of the above financial techniques are under:
1. BUDGET & BUDGETARY CONTROL
Budget is usually prepared once a year to carry out organisational activities within an organisation and an estimated allocation of fund is provided for and the exercise of control in any organisation with the help of these budgets is called budgetary control. Budget & budgetary control are helpful to measure a company's performance because:
2. BALANCED SCORECARD
The balanced scorecard is the most and widely applied performance technique these days. This system was originally introduced and developed as financial technique to measure the performance of a company in 1992 by Dr.Robert Kaplan and Dr.David Norton at the Harvard Business School. The balance scorecard measures a company's performance from different perspectives i.e. financial, customer, internal business process, and innovation perspective and provides more "balanced" view of an organisation's performance.
3. QUALITY MANAGEMENT
These days many organisations are adopting various quality programmes, such as Total Quality Management (TQM), Six Sigma, European Foundation Quality Management (EFQM), and The Bald Ridge National Quality Program. Such programmes aim to assist organizations to improve their quality of the manufacturing and service offerings. The programmes measures businesses and focus on their continuous improvement.
4. CASH FLOW STATEMENT
"A financial statement that reflects the inflow of revenue vs. the outflow of expenses resulting from operating, investing and financing activities during a specific time period" [6]
Cash flow statements show us an organisation's results in terms of cash in and out of their respective business, without any adjustment for accrued revenues and expenditure. The cash flow statement doesn't predict the profitability but it shows the cash position of the business at any given point in time by measuring revenue against outlays. This statement tracks the cash position of an organisation on monthly basis so a good positive cash flow shows the good performance of a company.
FOUR NON FINANCIAL TECHNIQUES TO MEASURE
A COMPANY'S PERFORMANCE
There are many non financial techniques to measure a company's performance and few of them are as under:
We define each of the above non financial techniques are under:
1. MARKETING EFFECTIVENESS
2. SERVICE QUALITY
AGENCY THEORY
The relationship between the shareholder and company's manager is called agency theory. The Forbes Digital Company INVESTOPEDIA explains the term agency theory as under:
"Agency theory is a very academic term. Essentially it involves the costs of resolving conflicts between the principals and agents and aligning interests of the two groups." [7]
It is always considered that manager's main objective in any organisation is to maximise the shareholders wealth and whether this happens in practice it is another matter. The problem occurs when manager make decisions which are not in consistent with the objective of shareholder wealth maximisation. There are three main important features that contribute when agency problem exists within public limited companies as follows;
Ä Divergence of ownership and control where by those who own the company (shareholders) do not manage it, but appoint agents (managers) to run the company on their behalf.
Ä The goals of the managers differ from those of the shareholders and as human nature being what it is managers are more likely to look to maximise their own wealth rather than the wealth of shareholders of the company.
Ä Manager who run the company's business on a day to day basis have more access to management accounting data and financial reports rather than the shareholders who only receive annual reports which may be subjects to manipulation by the management.
Whereas these three conflicts are occurred together it should be clear that managers are in a position to maximise their own wealth and without necessarily being detected by the owners of the company. Jensen and Meckling (1976) argued that the company can be viewed as a whole series of agency relationships between the different interest groups involved. These agency relationships are shown in exhibit in Fig 2:
IMPLICATIONS OF AGENCY THEORY
According to the strategic plan of Spectrum Manufacturing Company is to acquire three textile companies and four commercial companies in Russia, Singapore, Japan and Germany, the company would need huge investments and one of the main source of the financing will be shareholders money. So according to the agency theory the management of the company have a fiduciary duty to act in the best interest of the shareholders and only then shareholders will be happy and confident to reinvest in new projects and the management will receive bonuses for their hard work.
So the strategic plan of Spectrum indicates that the shareholders have a good relationship with the company's management and the management is running companies operation upto their requirement i.e. maximising shareholders wealth. We have noticed this from the financial data of the company that the dividend was paid every year to the shareholder as under:
So we have come to this conclusion after studying Spectrum's strategy that the company is in a position to expand their business as the relationship between the shareholders and the management of the company are sound and they are working hard to achieve their objectives.
DIVIDEND POLICY
When deciding within an organisation that how big a dividend payment should be made is called dividend policy.
"Dividend policy may be explicitly stated, or investors may infer it from the dividend payments a company has made in the past. If a company states a dividend policy it usually takes the form of a target pay-out ratio." [8]
The investor can infer in if a company has not stated a dividend policy and investors are likely to make the assumptions that dividend per share will be maintained at least previous year's level unless dividend cover is very low or company has already given the warning that dividend cut is possible. It is seen that companies do not increase dividends unless they are confident that the increase is sustainable and this means that when dividend is increased this is a sign that management of a company can signal the investors that they are confident. Conversely, some permanent deterioration in a company's business is often an acknowledgement for dividend cuts. it only reflects a need sometimes to keep cash for capital expenditure.
THREE MAIN POSITIONS ON DIVIDEND POLICY
DOES DIVIDEND POLICY MATTERS?
It is stated in Companies Act 1985 that "A company may only pay dividends out of profits available for dividends."
There are three main opposing views on dividend policy which effect on firm value. There are three types are as under:
Dividend irrelevance proposition means that in a perfect capital market the policy is irrelevant be there will be no market imperfections as no taxes and no transaction costs. The argument is that investors do not need dividends to convert their shares into cash. Thus as the effect of the dividend payment can be repeated by selling the shares, investors will not pay higher prices for firms with higher divided payouts.
This is another important position of dividend policy and it reflects that high dividends will increase firm value. The main explanation is that there exists natural clienteles for dividend paying stocks, to maintain a steady source of cash many investors invest in stocks. If paying out dividend is cheaper than letting investors realise the cash by selling stocks, then the natural clientele would be willing to pay a premium for the stock. One reason to this is the transaction costs that why it is comparatively cheaper to payout dividends. Anyhow this does not follow that any particular firm can benefit by increasing its dividends.
As we have already discussed that high dividend increase firm value so here we discuss how low dividend increase firm value too. The main reason is that dividend income is often taxed, so organisations can convert the dividends into capital gains by shifting their dividend policies and if dividends are taxed heavily than capital gain then taxpaying investors should welcome such a move. As a result firm value will increase since total cash flow retained by the firm and held by shareholders will be higher than if dividends are paid. Thus if capital gain are taxed at a lower rate than dividend income, companies should pay the lowest dividend possible.
DEBT FINANCING VS EQUITY FINANCING
WHAT IS DEBT FINANCING?
Debt financing is the money which a company borrow in the shape of secured or unsecured loan to run its businesses. Based on the type of loan you are seeking, the debt financing is divided into two categories:
A. LONG TERM DEBT FINANCING
Long term debt financing is used to finance the assets of the company i.e. equipment, machinery, building and land and its term is usually more than one year.
B. SHORT TERM DEBT FINANCING
Short term debt financing is used to generate the finance to meet the day to day operation of the business such as stock, supplies, or pay the wages of workers. Short term debt financing repayment takes place in less than on year.
WHAT IS EQUITY FINANCING?
When a company issue more shares of common or preferred stock to generate money is know as equity financing and this is normally used when company's per share prices are high so the most money is raised by selling a small number of shares.
ADVANTAGE OF DEBT FINANCING OVER EQUITY FINANCING
It is implied truth that companies need finance (money) to run their business. As there are two main categories of generating the finance i.e. debt finance and equity finance, so now a days several analysts says that debt financing is better than equity financing, the question arises why, so we explain it as under:
THE ADVANTAGES
There are three main advantage of debt financing over equity financing as source of finance for a business:
THE DISADVANTAGES
The disadvantages of debt financing over equity financing are as under:
MAIN SOURCES OF FINANCING A PUBLIC COMPANY
There is a vast range of funding alternative available to the company and many new developments occurs everyday. The few mostly used sources of financing a public company are as under:
As per the question, we discuss here the three main sources of financing as under:
1. RETAINED EARNINGS
When a company generate profit, it always reserve some part of this profit for future use and its known as retained earnings and also called as internal generated because it is generated within the company. This is the cheapest way to finance a company.
2. THE CAPITAL MARKET
As all the public limited companies have to be listed on the stock exchange so when in need the public companies can acquire help from stock exchange and can raise the finance these companies can issue the ordinary shares. The cost of issuing more shares is very low and attractive to many companies.
3. BORROWINGS FROM BANK (OVERDRAFTS)
Overdraft is a credit facility, provided to a set limit, to provide working capital. The level of the facility is usually limited to the security offered.[9]
Overdraft is the great way to finance a public company as compared to the loans, as in overdrafts the interest rate is very low and a company gets a limit through this facility and as longer that agreed limit is not exceeded the company can use this money as desires.
REFERENCES
