New Sources of Development Finance Jackson Plc

Question: Describe and analyse the performance of the company Jackson Plc based on the financial statements for the year FY2014 and FY2015 using ratio analysis as a key enabling tool. The analysis of the various ratios is being carried out to comment on the performance of the company during the given period. Answer: Profitability Ratios The relevant profitability ratios for the company are shown in the tabular format below. Ratio Formula FY2014 FY2015 Gross profit margin Gross Profit/ Revenue 45.25% 41.71% Net profit margin Net Profit/ Revenue 12.85% 5.09% Return on Assets Net Profit/ Total Assets 17.56% 6.56% Return on Equity Net Profit/ Total Equity 24.27% 10.79% It is apparent from the ratios above that the profitability of the company has severely declined in the year FY2015 as compared to the previous year i.e. FY2014. The drop in profits is more dramatic at the net level than at the gross level. At the gross profit level, the sharp rise in manufacturing costs is responsible for the margin decline. The administrative expenses have almost become twice in FY2015 even though the increase in revenue is only around 15%. Further, the selling expenses have also increased by a much greater proportion as a result of which the net profit margins have plummeted. Another contributory factor in this regard is the increase in interest expense in FY2015 which has surged by more than 50% due to the increase in the debt on the books. The decline in ROA and ROE are mainly attributed to the fall in the net profits which has decreased by more than 50% in FY2015 (Damodaran, 2015). Liquidity Ratios The relevant liquidity ratios for the company are shown in the tabular format below. Ratio Formula FY2014 FY2015 Current Ratio Current Assets/ Current Liabilities 2.63 1.62 Quick Ratio (Current Asset - Inventories)/ Current Liabilities 1.56 0.85 On the liquidity front, there has been a marked decline in FY2015 as compared to FY2014. The decline in the current ratio at the end of FY2015 can be explained on the basis of the bank overdraft facility which was availed in FY2015 to the tune of 1.13 million which led to a surge in the current liabilities. The decline in the quick ratio at the end of FY2015 can also be explained on the back of rise in current liabilities owing to bank overdraft. However, the liquidity position of the company in the short term still remains robust (Brealey, Myers Allen, 2008). Gearing Ratios The relevant gearing ratios for the company are shown in the tabular format below. Ratio Formula FY2014 FY2015 Debt to equity ratio (Short term + long term debt)/ Total equity 0.22 0.53 Interest Coverage Ratio Operating Profit/ Interest Expense 3.79 1.94 Long term debt to equity ratio Long term debt/Total equity 0.22 0.39 The gearing ratios for the company have progressively worsened in FY2015 which may be explained on the basis of the account of increase in both short term and long term debt while the equity component has only marginally increased on account of retained earnings. On account of the debt, the interest expense has surged by over 50% in FY2015 which is responsible for the decline in the interest coverage ratio. Despite the increase in the debt component, the gearing ratios continue to remain healthy and if these debts levels could be sustained, the company should be able to avoid any liquidity issues going forward (Johnson, 2009). Asset Utilisation Ratios The relevant asset utilisation ratios for the company are shown in the tabular format below. Ratio Formula FY2014 FY2015 Asset Turnover Sales/Total Assets 1.37 1.29 Inventory Turnover Cost of goods sold/Inventory 5.90 6.23 Receivables Turnover Sales/Accounts Receivables 11.42 9.60 Payables Turnover Cost of goods sold/Accounts Payable 8.78 15.15 The asset turnover ratio has declined in FY2015 which indicate towards lesser efficiency of usage of assets to generate sales. This is primarily due to lower proportionate increase in the sales as compared to the total assets. The inventory turnover has improved which is positive for the company as it indicates improvement in demand for the companys products. The receivables turnover has declined in FY2015 which indicates that higher time is taken to convert the sales into cash which may cause liquidity issues going forward. The payables turnover has increased in FY2015 which indicates a lower credit period to the company from suppliers (Parrino Kidwell, 2011). Investor Potential Ratios The relevant investor potential ratios for the company are shown in the tabular format below. Ratio Formula FY2014 FY2015 Earnings per share Net profit/Number of shares outstanding 0.38 0.18 Dividends per share (Pence) Total dividends/Number of shares outstanding 18.71 9.36 From the above calculation, it is apparent that there is a decline in the EPS and the per share dividend which is attributed to the decline in the net profits. Conclusion On the basis of the above calculations, it may be inferred that the companys performance in FY2015 is significantly inferior as compared to the corresponding performance in FY2014. This is apparent from the decline in profitability and increase in the debt levels which in general has resulted in liquidity crisis. Inventory days (2014) = 365/5.90 = 61.88 days Inventory days (2015) = 365/6.23 = 58.58 days Receivable days (2014) = 365/11.42 = 31.96 days Receivable days (2015) = 365/9.60 = 38.03 days Payable days (2014) = 365/8.78 = 41.57 days Payable days (2015) = 365/15.15 = 24.09 days Working capital cycle (2014) = 61.88 + 31.96 41.57 = 52 days Working capital cycle (2015) = 58.58 + 38.03 24.09 = 73 days From the above calculation, it may be inferred that the liquidity position of the company has worsened in FY2015 since the working capital cycle has increased to 73 days from 52 days in FY2014. There are certain limitations with regards to usage of ratio analysis. The ratio analysis is based on historical financial performance which may be indicative of the future performance of the company. Hence, making decisions with regards to firms based on the time series historical performance may not be appropriate. Additionally, the firms may enter into new customer segments which may fundamentally alter the key ratios that may not be highlighted by the ratio analysis (Palmer, 2006). In cross sectional comparison, the firms ratios are compared with that of the industry which may not be accurate since the various individual firms that constitute the industry may be operating in different markets and hence the comparison of ratio is not advisable since conclusions drawn would not be reliable (Damodaran, 2008). Part B In order to ascertain the economic feasibility of the given project using various appraisal techniques, it is critical to ascertain the incremental cash flows associated with the project on a yearly basis which is summarised in the table shown below. YEAR Particulars 0 1 2 3 4 5 6 Cash inflow from sale of products 1120000 1120000 1120000 1120000 1120000 1120000 (-) cash outflow due to expenses 275000 275000 275000 275000 275000 275000 (-) Depreciation expense 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 (-) Cash outflow initial outlay 3350000 Pre-tax cash inflow/(outflow) -3350000 370416.7 370416.7 370416.7 370416.7 370416.7 370416.7 Tax (@ 30%) 0 111125 111125 111125 111125 111125 111125 Post tax cash inflow/(Outflow) -3350000 259291.7 259291.7 259291.7 259291.7 259291.7 259291.7 (+) Salvage value cash inflow 502500 (+) Depreciation Expense 0 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 Net post tax cash inflow/(outflow) -3,350,000 733,875 733,875 733,875 733,875 733,875 1,236,375 It is imperative to note that since the tax rate information has not been provided for the given question, it has been assumed at 30%. On the basis of the above shown incremental cash flows, the various investment appraisal techniques would be applied in the manner shown below. Payback Period Initial investment = 3,350,000 Cash inflows during the first four years = 733875*4 = 2,935,500 Remaining investment to be still recovered = 3350000 2935500 = 414,500 Time required from the 5th year to recover the above = 414500/733875 = 0.56 Hence, payback period = 4.56 years Accounting rate of return It is evident from the table shown above that the average accounting profit for the company post tax is 259,291.7. Average investment = 0.5*(Investment Salvage value) = 0.5*(3350000 502500) = 1,423,750 Hence, the ARR = (259,291.7/1423750)*100 = 18.21% The NPV for the project has been estimated in the tabular format below taking the cost of capital as 7% pa. YEAR Particulars 0 1 2 3 4 5 6 Cash inflow from sale of products 1120000 1120000 1120000 1120000 1120000 1120000 (-) cash outflow due to expenses 275000 275000 275000 275000 275000 275000 (-) Depreciation expense 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 (-) Cash outflow initial outlay 3350000 Pre-tax cash inflow/(outflow) -3350000 370416.7 370416.7 370416.7 370416.7 370416.7 370416.7 Tax (@ 30%) 0 111125 111125 111125 111125 111125 111125 Post tax cash inflow/(Outflow) -3350000 259291.7 259291.7 259291.7 259291.7 259291.7 259291.7 (+) Salvage value cash inflow 502500 (+) Depreciation Expense 0 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 Net post tax cash inflow/(outflow) -3350000 733875 733875 733875 733875 733875 1236375 PV of cash inflow/(outflow) @(7%) -3350000 685864.5 640994.8 599060.6 559869.7 523242.7 823848.9 NPV () 482,881.26 Hence, the NPV of the project is 482,881.26. IRR or Internal Rate of Return The IRR for the project is estimated for the project as shown in the table below. YEAR Particulars 0 1 2 3 4 5 6 Cash inflow from sale of products 1120000 1120000 1120000 1120000 1120000 1120000 (-) cash outflow due to expenses 275000 275000 275000 275000 275000 275000 (-) Depreciation expense 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 (-) Cash outflow initial outlay 3350000 Pre-tax cash inflow/(outflow) -3350000 370416.7 370416.7 370416.7 370416.7 370416.7 370416.7 Tax (@ 30%) 0 111125 111125 111125 111125 111125 111125 Post tax cash inflow/(Outflow) -3350000 259291.7 259291.7 259291.7 259291.7 259291.7 259291.7 (+) Salvage value cash inflow 502500 (+) Depreciation Expense 0 474583.3 474583.3 474583.3 474583.3 474583.3 474583.3 Net post tax cash inflow/(outflow) -3350000 733875 733875 733875 733875 733875 1236375 PV of cash inflow/(outflow) -3350000 659806.7 593213.9 533342.2 479513.2 431117 653007.1 NPV 0.00 The discount rate used for the above computation is 11.22% which is the IRR. Discounted payback It is computed by taking into consideration the discounted incremental post tax cash flows assuming the cost of capital for the company to be 7%. Initial investment = 3,350,000 Discounted Cash inflows during the first four years = 685864.5 + 640994.8 + 599060.6 + 559869.7 + 523242.7 = 3,009,032.4 Remaining investment to be still recovered = 3,350,000 3,009,032.4 = 340,967.6 Time required from the 6th year to recover the above = 340967.6/823848.9 = 0.41 Hence, discounted payback period = 5.41 years Recommendation On the basis of the above investment appraisal techniques, it may be concluded that the machine should be bought and project should be pursued because of the following reasons (Petty et. al., 2015). The NPV of the project is greater than zero and hence the project is value accretive for the companys shareholders. The IRR of the project is greater than the cost of capital which stands at 7% for the given project. The payback period along with the discounted version both stand at values which are lesser than the project life. The critical appraisal of the various investment evaluation techniques presented above is carried out below. Payback Period Benefits It is easy and convenient to use since the calculations are minimised. It is not sensitive to any changes in the discount factor. Limitations The time of money is not considered in this metric. All cash flows occurring beyond the payback period are not reflected in the calculations. Due to the above limitations, the usage of payback period as a primary evaluation metric is rare. However, it is often deployed along with other superior metrics for determining the commercial viability of the projects (Bodie Merton, 2011). Accounting Rate of Return (ARR) Benefits It is easy and convenient to use since the complexity and underlying calculations are less It takes into consideration the underlying profitability of the project. Limitations The time of money is not considered in this metric. Consistency is an issue since its calculation varies widely due to which comparison becomes unreliable. The method is not based on cash flow information but is rather based on accounting income which limits its usage. Owing to the various limitations, ARR is almost never used as a standalone metric to analyse project feasibility. Its usage as a complementary metric of evaluation is rather limited due to the above issues that have been identified (Fridson Alvarez, 2007). NPV (Net Present Value) Benefits It is a reliable evaluation technique and can be deployed even when there are multiple outflows. It takes into consideration the cash flow over the whole life of the project and also considers the time value of money. Limitations It is comparatively complicated as compared to the other techniques with regards to calculation and overall complexity. It is particularly sensitive to the cost of capital or discount factor. NPV is without doubt the most widely used evaluation technique in capital budgeting due to its benefits. Further, with the advent of computers, calculations over long horizon are also simple to achieve. Also, with the aid of technology the prediction with regards to discount factor is becoming more accurate and dynamic to adjust with the changing times (Groppelli Nikbakht, 2011). IRR or Internal Rate of Return Benefits It takes into consideration incremental cash flows over the entire project life along with underlying time value. It is independent of the discount factor deployed though final decision is derived from the same. Limitations It is not reliable in cases when there are net cash outflows during the project. It is comparatively complex as compared to the other simpler techniques. Despite its limitations, IRR has wide acceptability in the industry and is used along with the NPV. In projects, where there is no net cash outflow during subsequent years besides at the beginning, IRR is a reliable metric (Jarrow, Maksimovic Ziemba, 2011). Discounted Payback Period Benefits It takes into consideration time value of money. It is a simple metric to compute compared to NPV and IRR. Limitations It does not consider the cash flows beyond the discounted payback period. Discounted payback period is a comparatively superior method compared to payback period since it considers the time value of money and hence is used as a complementary metric to NPV and IRR (Damodaran, 2008). Part C Internal Financing Means One source of internal finance that can be used for raising finance is in the form of equity from the promoters. This means of financing has certain benefits but also has some limitations. One potential benefit of promoter financing is that there is no equity dilution or loss of control which is pivotal for making crucial strategic decisions. Besides, this is a quick means of financing since it does not involve the usual legal and operational hassles which are involved in raising equity finance from capital markets. Additionally, from a company perspective there are no interest or repayment obligations which also eliminate bankruptcy risk and associated costs (Atrill McLaney, 2014). Despite the benefits, there are certain limitations of using promoter equity as a financing means. This is primarily because promoter may have only limited resources and hence the scope of this financing would be limited only. Further, considering the high risk involved in equity investing, the promoter may not be interested in putting high amount of equity as this may yield to huge losses. Besides, relying too much on promoter equity would cause concentration of ownership which may not be in the best interest of the company as diversity in ownership groups is preferable (Brigham Ehrhardt, 2013). External Financing Means One potent means of external financing is the issue of bank loan. It is a common means of external financing which is readily deployed. One of the benefits associated with availing a bank loan is non-dilution of equity and hence being able to retain control over the organisation along with key decision making. Besides, the bank loan is associated with interest payments which lower the tax liability of the company (Atrill McLaney, 2014). However there are certain limitations with regards to raising finance through bank loan. Since the loan needs to be repaid through monthly instalments along with the interest payment, there are significant liquidity risks and associated bankruptcy costs. Additionally, the banks typically impose various debt covenants that tend to limit the flexibility available to business. Besides, the interest payments owing to debt would tend to erode the business profitability and hence debt could be raised in moderation only (Brealey, Myers Allen, 2008). Break even analysis is an evaluation tool which is often applied in the organisation so as to aid decision making particularly with regards to price. However, the usage of break-even analysis is essentially based on a plethora of assumptions which are critically analysed below. The break even analysis is based on the core assumption that the various costs and expenses can be divided into two segregated compartments i.e. fixed costs and variable costs. However, this is not true for all costs since some of them may be mixed costs which have both fixed component and variable costs. Such sticky costs may put into question the decision reached by break even analysis model. An example of such costs could be electricity costs which to some extent would be fixed but also has a variable component and hence suitable changes need to be made (Parrino Kidwell, 2011). Further, the fixed costs are assumed to be constant irrespective of the activity level which may not be true especially beyond a certain specified activity level when even fixed costs would escalate. Usually this is not taken into consideration which adversely impacts the applicability of this technique. However, considerations may be made for this based on input from management (Damodaran, 2008). Also, it is assumed that variable cost varies in direct proportion with the activity level. However, this may not be true as due to economies of scale or diseconomies of scale, the per unit variable cost may decrease or increase respectively. This has assumed particular significance in the globalised world where production levels have become increasingly higher and hence the variable costs do not remain constant (Groppelli Nikbakht, 2011). The product and sales mix is assumed to be constant for break-even analysis which is not true especially in a globalised world which is hyper competitive. As a result, the sales mix is highly dynamic based upon the underlying market dynamics and thus rendering break even model with limited utility (Fridson Alvarez, 2007). An additional assumption is that the market conditions would remain constant which is not obeyed especially in the global markets where any happening in one part of the globe tends to have global impact of varying degree. Also, the consumer base of the multinational companies is increasingly becoming global due to which there are frequent variation in prices and cost (Petty et. al., 2015). From the above, it may be inferred that in the globalised world, the utility of the break even model has been put to question, however some of the above limitations can be dealt with by making the model more dynamic while maintaining the core model intact. Hence, the users of the model should made necessary changes to account for the various dynamic changes so that its utility remains intact going ahead. References Atkinson, A 2005, New sources of development finance, 3rd ed., Oxford University Press, Oxford Atrill, P McLaney, E 2014, Accounting and Finance for Non-Specialists, 9th ed., Trans-Atlantic Publications, Philadelphia, USA Bodie, Z Merton, R 2011, Finance. 3rd ed., Prentice Hall, Upper Saddle River, NJ Brealey, R, Myers, S Allen, F 2008, Principles of Corporate Finance, 9th ed., McGraw Hill Publications, New YorkBrigham, E F Ehrhardt, MC 2013. 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