Spectrum Manufacturing Company is a multinational company. The income and expense statement of the company shows an increase in income year by year. The company has also cleared out its bank loan and there has also been a decrease in the long term debt over the years. The financial statements show that the company is going very well. However, we will critically analyse the performance of the company in order to gain an in-depth knowledge. This analysis will take the form of using financial and non-financial techniques.
Profitability ratios
These ratios are used to examine the profits of a firm and comparing them with the sales or assets of the firm. This helps in knowing the percentage of profit made by firm on sales/assets. It also helps in examining the performance of the firm compared with its previous years or with competitors.
Gross Profit Margin
Gross profit is the income from sales retained after deducting the direct costs associated with its production or manufacturing. Gross profit margin expresses gross profit as a percentage of sales. This helps in realising the percentage of direct costs. The higher the percentage, the better is it showing that sales price is kept very high that the cost of manufacturing the product. However, high ratio means that sales price is too high and can result in losing customers and thus reducing sales. We can see that the ratio for company is good in all three years. A reduction in 2007 and then again a bit increase in 2008 can be associated with either an increase in cost of materials or a decrease in sales price. This is because material's cost amounted to 50% of sales rising to 60% in further years.
Net Profit Margin
Net profit is the income left over with the company after all expenses and taxes have been paid. Net profit margin expresses net income as a percentage of sales and it's obvious that the higher the percentage the better it is. The advantage of this ratio is that it clearly outlines the percentage of the income earned on sales by the company and can be compared with other companies. The net profit margin is very less for the three years but showing an increase year by year. The decrease in gross profit margin does not result in a decrease of net profit margin due to reduction in depreciation expense and the amount paid as dividends in 2008. The advantage of these ratios is that they can be easily manipulated by providing for provisions in years of high profits and reducing provisions in year of low profits. This can also be done through other expenses and dividends. This helps in presenting the ratios in a smooth manner and not showing much fluctuation year by year.
ROCE
Return on capital employed (ROCE) is the rate of return a business is making on the total capital employed in the business. Capital will include all sources of funding (shareholders funds + debt). To be consistent with this the return should be taken prior to interest (the return to lenders) and tax.
The return on capital employed is increasing over the period and a return of 40.44% in 2008 is very good. This shows that the performance of the company is increasing; however, we should also investigate the reasoning behind this. The rise is due to an increase in net operating income and a decrease in shareholder's equity and long-term debt. The only factor affecting most is the long term debt. The company has repaid a huge part of its debt especially in 2008. This has caused the debt to decrease and also affected the interest payments leading to an increase in ROCE. This ratio shows that the company is working very well and using its equity efficiently to generate profits rather than relying on long term debts.
Leverage
Leverage is the amount of debt used to finance a firm's assets. Low debt to equity firms are considered as low leverage firms and those with high debt to equity ratio are considered as highly leveraged. This ratio is calculated by dividing total debt of a firm that is short-term debt and long-term debt by the shareholder's equity. It appears as a percentage of debt used for financing as compared to total equity. From the table, we can see that the company was highly leveraged in 2006. This was a point of concern for the company as there are more chances of going bankrupt and any additional loan is granted on many stringent terms. But we can see that the company repaid its loan and brought the ratio down to 43% in 2008. The company has improved its position in the market and can get further loan on better terms.
Current Assets Ratio
Current assets ratio is also known as current ratio. This ratio measures a company's ability to pay its liabilities or short term obligations from the assets which can create cash quickly. This ratio is a measure of current assets by current liabilities. The current asset ratio of the company is very favourable for every year. The company had almost double current assets to pay its short term obligations going to thrice in 2008. The position is favourable and the company will not be having any trouble to pay off its current liabilities. The increase in current ratio represents improvement in liquidity. The limitation of this ratio is that even the ratio is favourable, the firm may be in financial difficulties due to the stock value included in ratio. Stock is not that easily convertible into cash. Another problem is that the ratio can be easily manipulated by overvaluing current assets such as stocks.
The additional techniques that Spectrum Manufacturing Company could use involve the labour power of the company. The directors of the company are from various countries and highly skilled. This will help them to formulate any strategy relating to entering a specific country where the director can share his knowledge. The directors are highly skilled and have diversified experience, so any new project will involve heavy consideration before a decision is made. Even now the directors are using their experience to post good results and that the company can perform better. Company should seek whether the labour power is being fully utilised.
Another technique would be the use of balance scorecard. Balance scorecard is a performance management tool that focuses on four factors: Customer satisfaction, creating value for shareholders, learning and growth and internal business processes. A focus and success in these four factors will contribute a lot towards performance and so the balance scorecard is useful for performance measurement.
Another performance measure will be analysing actual performance against targets. The company may be showing very good performance and its financial statements may also look very favourable but they should also be compared with targets to see whether the targets have been achieved. Achievement of set targets is an important part of performance measurement.
Boston matrix is also a useful measure of performance. Boston matrix helps in analysing the positioning of the product with regards to market share and market growth (the investment needed in the product). There are four quadrants in the matrix: cash cow, stars, dog and problem child. The product of a firm is placed in a quadrant according to its market share and market growth. The quadrant of cash cow is the best as it consists of high market share and requires less re-investment. The placing of product in any quadrant will help the company to measure its existing performance and formulate future strategy and plans accordingly.
Agency theory is the theory that explains the relationship between the principal and the agent hired to perform the work. This can be seen in any part of business where an agent is hired to perform a duty and is paid a commission or a fixed salary. A very simple example of this can be hiring an agent to sell a car or a house. The agency theory also outlines that the goals of an agent should not conflict with the goals of the principal and he should not perform work in order to benefit him rather than the principal. However, it is very difficult to identify that the agent is working for his own interest.
Agency theory is concerned with resolving the issues of conflict of interests between the agent and the principal and also helps in verifying the acts of agents (Eisenhardt 1989).
Agency theory in the context of a company and over here with regard to the board of directors of Spectrum Manufacturing Company means that directors are agents of shareholders. They are appointed by shareholders to act in the best interest of the company and shareholders. The directors of the company should seek to make decisions that maximise profits and shareholder's equity rather than going for options that are in their best interests. The interests of the directors of Spectrum Company should not conflict with the interests of the shareholders of the company. The directors are merely employees appointed by shareholders and so are paid a salary for the work they do. But one important point is that the directors and shareholders will be having different attitudes towards risk and this will affect the decisions they make. The directors may be willing to take more risky decisions whereas the shareholders might not, and so in this situation it is difficult to say that directors are not acting appropriately as agents.
The term dividend policy relates to the policy adopted by a company with regards to paying its dividends to the shareholders. A company can adopt any type of policy but it is better to be consistent with the policy adopted rather than changing in subsequent years. Some companies may pay a fix percentage on net profit after tax as dividends and some may have a constant dividend policy, which is not concerned with whether the profits are higher or lower. Some companies do not pay any dividend at all and so it is re-invested. Shareholders are more attracted to those companies that are consistent with their dividend policy.
The main propositions on dividend policy are that dividend policy is irrelevant and the other is that dividend policy is relevant. The dividend irrelevancy theory says that dividend policy does not matter. The shareholders can make homemade dividends, no matter what the dividend policy is. If the shareholder want to receive more dividends, he can sell some shares or if want to receive less dividends, he can buy shares from the extra dividend received. This theory also believes that the dividend policy does not affect a firm's value or its cost of capital. This shows that dividend policy does no matter. However, the theory relating to relevancy of dividend policy is more realistic. Taxes are to be paid by shareholders on their income and selling or buying of shares also incurs brokerage fees. So the earnings will be less if dividends are home-made. The dividend policy also affects the firm value. So it's better for shareholders to invest in a company that adopts dividend policy which they require. An optimal dividend policy is one that strikes a balance between current dividends and future growth and this leads to the maximization of firm's stock price.
The dividend policy gives a signal about the future of a firm. Any increase or decrease in dividends will notify the shareholders about the future and this will lead to an increase or decrease in stock price.
Debt financing is when a firm raise money by issuing bonds and debentures. This is a type of loan for a fixed period and at fixed rate of interest. Equity financing is done by issuing shares for cash. Equity financing is done at the incorporation of a firm or later to raise more cash for investment purposes.
It is generally held that debt financing is much cheaper than equity financing. This is because the interest paid on debt financing is tax deductible. So less tax will be paid in the case of debt financing as compared with equity financing. For example, if £100 is tax before interest and debt financing is used, than a company can use interest paid on debt to lower taxable profits. Tax savings will occur and this will go in shareholder's equity. The interest paid will obviously lower the net profit than it would have been in equity financing but the cash flows will be greater due to tax savings.
Other factors that encourage debt financing are that it takes less time to raise cash. Cash is raised easily rather than inequity financing where it takes a long time to search for investors who are willing to invest in the company. Debt can be acquired from anywhere easily depending on the financial performance of the company. The ownership of the company is also retained in this type of financing. One another factor is that there are more costs involved in equity financing which includes printing and issuance costs.
The first source of financing a public company is by issuing shares to the public in general. This is the most common source of finance. This can be done through initial public offering or by issuing more shares. There are no restrictions on the number of shares to be bought. The issue price must be equal to or more than the nominal price of shares. However, this type of funding involves printing, advertising and issuance costs.
Another source of finance is debentures. Debentures are long-term loans and usually carry a fixed rate of interest and floating rate in some cases. Interest has to be paid on debentures and the principal to be repaid at the end of the contract term. If the interest rate is agreed upon as being floating, it could be attractive to both lender and borrower. The interest has to be paid even if a company makes a loss. This makes debentures a secured form of finance.
Retained earnings are another important source of finance. This is an internal source of finance. The main advantage of this is that there are no constraints attached with this as in the case of debentures or other type of long-term loans. There are also no issuance costs and it is easy to obtain rather than searching for investors willing to invest their money in the company. Retained earnings are those profits that would have been paid as dividends. New projects can be financed with earnings retained without the involvement of outsiders or shareholders. It also avoids a change in control resulting from issuing new shares.
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