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You have been working as a finance manager in a company. The chief financial officer of the company has decided to invest in shares in either of these two companies  and  he  has  asked  for  your  help  in making a decision.

M&S is one of the UK’s leading retailers. The company management is committed to making every moment special for customers, through their high quality, own brand Food, Clothing & Home products in 1,433 stores worldwide and online. M&S sells beautifully designed, high quality, own brand clothing and homeware through 343 full line stores, Outlets and  the  M&S.com  website.  The Womenswear, Menswear, Kids wear, Lingerie, Beauty  and  Home  products  account  for  40%  of  UK  turnover.  The company sells food through 1,025 UK stores, including 253 owned and 383 franchises of Simply Food stores.Further information can be found through the Marks and Spenser website and a recent annual report 

The NEXT retail chain  was launched  in February 1982, and the first store opened  with an exclusive coordinated  collection  of  stylish  clothes,  shoes  and  accessories  for  women.  Online  shopping  was introduced  in  1999.  Today,  NEXT  trades  from  more  than  500  stores  in  the  UK  and  the  Republic  of

Ireland and around 200 stores in 40 countries overseas. Over the last few years, several larger format fashion and home stores have opened across the UK. Further information can be found through the Next Plc website and a recent annual report from the link below

Required

Prepare a report for potential investors which analyses the financial information for both companies and recommends which company would be a more viable option to invest in. The report must include analyse the performance, financial position and investment potential of both  companies.  You should use charts to compare  performance  of  two  companies.    You  will  need  to  look  at  the audited financial statements and carry out further research to explain the performance of each company for two years.                                                                                                       

Provide recommendations of how the financial performance of the poorly performing business can be improved.

Discuss the limitations of relying on financial ratios to interpret companies performance.

Computation of Key Financial Ratios of the Companies

The assessment is subdivided into two parts which is task 1 and task 2 and both the parts are covered in the discussion section. The first part analyzes the business of two companies which are Marks and Spencer and Next Plc which is operating in the same industry. The purpose of the analysis is to understand which business is performing better in financial terms.

The first part shows application of ratio analysis for interpretation of financial performance of the business. The first part also shows limitation of ratio analysis and how the same can affect the decision-making process. The second part of the assessment is regarding investment appraisal techniques which is applied for estimating the better project which is Project Alpha and Project Beta. This part also considers the limitations which are associated with investment appraisal techniques.

Computation of Key Financial Ratios of the Companies

Mark & Spencer

Next Plc.

Particulars

 

2018

2017

2018

2017

Current Assets

A

1317.9

1723.3

1797.5

1660.6

Current Liabilities

B

1826

2368

914.8

725

Current Ratio

C=A/B

0.722

0.728

1.965

2.290

Inventory

D

781

758.5

490.1

451.1

Prepayments

E

Quick Ratio

F=(A-D-E)/B

0.294

0.407

1.429

1.668

Total Revenue

G

10698.2

10622

4055.5

4097.3

Net Profit

H

29.1

115.7

591.8

635.3

Net Profit Margin

I=H/G

0.27%

1.09%

14.59%

15.51%

Gross Profit

J

4047.3

4087.8

1356.2

1386.6

Gross Profit Margin

K=J/G

37.83%

38.48%

33.44%

33.84%

Total Assets

L

7550.2

8292.5

2561.5

2404.8

Total Liabilities

M

4596

5142.1

2078.9

1894.3

Gearing Ratios

N

1.643

1.613

1.232

1.269

Market Price per share

O

270.2

337

5218.00

3850

Earning Per Share

P

0.278

0.304

4.167

4.413

P/E Ratio

Q=O/P

971.94

1108.55

1252.22

872.42

Operating Profit

R

156.5

253.2

759.9

827.7

Capital Employed

S=(G-B)

8872.2

8254

3140.7

3372.3

Return on Capital Employed

T=R/S

1.76%

3.07%

24.20%

24.54%

Cost of Sales

U

6650.9

6534.2

2699.3

2710.7

Average Inventories Turnover per Period

V=U/D

8.52

8.61

5.51

6.01

Dividend Paid per share

W

0.187

0.233

2.93

2.03

Dividend Pay-Out Ratio

X=W/P

67.27%

76.64%

70.31%

46.00%

Analysis of Financial Performance of Both Companies

The above table shows analysis of key financial ratios for two companies which are engaged in the retail business and provides various clothing options for the customers of the business. The analysis is shown for the two years period which is shown in the above table which is 2017 and 2018. The ratios which are shown in the above table covers important aspects of the business such as liquidity, solvency, efficiency and capital structure of both the companies (Carraher and Van Auken 2013). Both the companies which are considered are close competitors of each other and operates in UK mostly.

The above table shows the current ratio and quick ratio of both the company which are important estimate which measures the liquidity position of both the companies and are also considered to be important financial indicators for the overall success of the business. The liquidity ratios helps to determine whether the business has the capability to meet the current obligation of the business effectively or not (Ongore and Kusa 2013).

As per the table above, the current ratio of both the companies shows that there is a significant fall in current ratio for both the companies in comparison to previous years analysis (Delen, Kuzey and Uyar 2013). The quick ratio of the business also shows decline in the estimates which further suggest that the ability of the both the companies to meet the current obligations of the business has fallen slightly as shown in the table which is shown above. In case of both the companies, the expenses of the business has increased and a part of the loans has been repaid which has led to decrease in liquidity of the business which is reflected by current and quick ratio.

The chart which is shown above demonstrates the liquidity ratios of the business of both Marks and Spencer and also Next Plc. The chart shows that the liquidity ratios of Next Plc is more appropriate in comparison to the liquidity ratios which are shown for Marks and Spencer.

The profitability ratios of the business which mainly comprises of Net profit margin and gross profit margin are shown in the table which is demonstrated above. The gross profit margin of Marks and Spencer is shown to have slightly fallen which can be due to the rise in the operating costs of the business and thereby would result in the fall in profitability of the business (Weygandt, Kimmel and Kieso 2015). The gross profit margin for Next Plc is also shown to have fallen and the estimate which is shown for 2018 is shown to be 33.44% and the fall in the profitability shows that the business of Next Plc is also facing the same problem of high operating costs of the business (Lartey, Antwi and Boadi 2013).

The net profit margin for both the companies also shows a fall in the net profits of the business for the year 2018. The net profit margin for both the companies also show fall in the estimates which suggest that the overall profitability of both the business has significantly fallen during the year in comparison to previous year analysis. The fall in the profitability of the business also suggest that the business is unable to effectively control the costs of the business. The annual report of the business shows increase in the operating cost of the business for both Marks and Spencer and Next Plc. The management needs to monitor such expenses in an efficient manner in order to further enhance the profitability of the business.

The above chart shows the profitability ratios of the business for the year 2018. The analysis shows that even though the gross profit margin of Marks and Spencer is higher than the Gross Profit Margin of Next Plc but the accurate result is demonstrated by net profit margin of the business which is shown to be higher for Next Plc in comparison to Marks and Spencer.

The gearing ratio, Price earnings ratio and Return on Capital Employed are part of the capital structure ratios of the business. The gearing ratio of both the companies shows the Marks and Spencer is more equipped with debt capital and therefore the level of risk in Marks and Spencer is more than the level of risks which is present in Next Plc as shown in the table above. The price earning ratio is shown to be higher for Next plc for the year 2018 in comparison to Marks and Spencer.

Next Plc.

The return on capital employed is an important financial indicator for the overall success of a business and the same shows that the return on capital employed for Next Plc is more than the Marks and Spencer which suggest that the profitability and financial performance of Next Plc is much better than Marks and Spencer. The average inventory turnover ratio shows the efficiency level of the business which reflect how well the operations of the business is being conducted by the business (Gitman, Juchau and Flanagan 2015). The dividend payout ratio shows the maximum dividend which is paid by the business and the estimates which is computed for the year 2018 shows that the dividend payout ratio for the business is better for Next Plc. This shows that the business of Next Plc is better the business of Marks and Spencer ltd.

Thus, on the results of the ratios which are computed in the above table the ratio, the potential investors should invest in the shares of the business of Next plc as the all the significant ratio of the business is shown to be appropriate for the company. The potential investors of the business should concentrate on the aspects of liquidity ands profitability of the business in order to make appropriate decisions regarding investments in a business.

Recommendation to Improve the Performance

The above ratio analysis which is conducted in the above paragraph clearly reveals that the management of the Marks and Spencer needs to concentrate on the sales and profitability of the business. The profitability ratios of the business reveal that there has been a significant fall in the profit5ability of the business for which the management needs to make plans in order to improve the profit generating capacity of the business (Lawrence 2013). The management of Marks and Spencer needs to follow an aggressive sales strategy in order to increase the sales of the business and thereby also the profit generating ability of the business.

The same can be said for Next Plc which also has low profitability and the same can be improved with higher sales or low costs of operations of the business. Another alternative approach which is available to the management of the company is to maintain the costs of the business and control the costs of the business. The costs of the business can be maintained effectively by effectively incorporating strategies which can help in reducing the overall costs of the business. The liquidity ratios of the business show various aspects which allows the management to effectively check on the financial resources of the business.

Analysis of Financial Performance of Both Companies

The liquidity ratio of the business is shown to be low for the business of Marks and Spencer which the management needs to improve in order to improve overall business structure of the company (Tinoco and Wilson 2013). The liquidity of Next Plc is also affected by high operating costs and thereby the management needs to effectively monitor the costs of the business for maintaining the cash balances of the business which is linked with liquidity of a business. The management also needs improve the capital structure which is used by the business during the period. The management of Marks and Spencer needs to reduce the use of debt capital in the business and attain an appropriate capital structure balance in order take more advantage of the capital structure of the business.

The management of Marks and Spencer needs to set up appropriate control in the business in order to monitor the expenses and revenue of the business (Posner and Weyl 2013). The control would also help the management to improve the profitability of the business by cutting out the expenses of the business. The efficiency ratio of the business is shown to be effective however, there is further scope of improvements for both Marks and Spencer and Next Plc which can be done by improving the average inventory turnover ratio further which would help the business to improve the profitability of the business,

The dividend payout ratio of the business is also shown to have slightly decreased which can be attributed to the fall of profitability of the business. The management of the company needs to formulate appropriate strategies in order to ensure that the profitability of the business is improved. The dividend payout ratio of the business would improve significantly when the overall profitability of the business is improved for the business.

Limitation of Ratio Analysis

One of the key methods of analyzing the financial performance of a business is with the help of ratio analysis in which significant ratios are computed which shows different area of performance for the business. Ratio analysis can be used by business for the purpose of establishing the profitability, liquidity and solvency of a business and interpreting the results of the performance of the business. There are certain limitations which needs to be considered before applying ratio analysis techniques in order to ensure that the interpretation process of the results of the business are effectively done. Some of the limitations which can be identified for Ratio analysis is shown below in details:

  • The ratio analysis considers actual historical data for the purpose of computing the results of different ratios which may not be the same in the near future (Masini and Menichetti 2013). The management needs to consider this aspect before relying on the information which is considered in the process of computing key financial ratios of the business.
  • The ratio analysis process does not consider the inflationary effect which can affect the items which are shown in the financial statement and the same would affect the different ratios which are computed under the process of ratio analysis.
  • The interpretation of key financial ratios of the business can be a very difficult process as the estimate of current ratio for a company may be showing impressive but the same might not be case as there are various consideration which needs to be considered while conducting ratio analysis (Ehrhardt and Brigham 2016).
  • The ratios which are computed for the purpose of comparative analysis between business may not actually establish comparison due to different nature of business or difference in size of the businesses. Therefore, the applications of ratio analysis cannot be universally applied to all businesses.
  • The application of ratio analysis in forecasting and decision may not be accurate at all times. Suppose in case a business has low liquidity, it does not mean the business is in crisis, the actual result may be quite different.

Alpha Project:

2018

2019

2020

2021

2022

2023

Particulars

0

1

2

3

4

5

6

Cost of Capital

20%

 

 

 

 

 

 

Initial Investment

-£125,000

 

 

 

 

 

 

Net Profit

£60,000

£60,000

£60,000

£50,000

£50,000

£40,000

Add: Depreciation

£20,833

£20,833

£20,833

£20,833

£20,833

£20,833

Net Operating Cash Flow

 

£80,833

£80,833

£80,833

£70,833

£70,833

£60,833

Residual Value

 

 

 

 

 

 

£0

Net Cash Flow

-£125,000

£80,833

£80,833

£80,833

£70,833

£70,833

£60,833

Cumulative Cash Flow

-£125,000

-£44,167

£36,667

£117,500

£188,333

£259,167

£320,000

Discounted Cash Flow

-£125,000

£67,361

£56,134

£46,779

£34,160

£28,466

£20,373

Net Present Value

£128,273

 

IRR

58.85%

 

Payback Period

1.55

 

Beta Project:

2018

2019

2020

2021

2022

2023

Particulars

0

1

2

3

4

5

6

Cost of Capital

20%

 

 

 

 

 

 

Initial Investment

-£125,000

 

 

 

 

 

 

Net Profit

£20,000

£30,000

£40,000

£70,000

£80,000

£65,000

Add: Depreciation

£22,500

£22,500

£22,500

£22,500

£22,500

£22,500

Net Operating Cash Flow

 

£42,500

£52,500

£62,500

£92,500

£102,500

£87,500

Residual Value

 

 

 

 

 

 

£10,000

Net Cash Flow

-£125,000

£42,500

£52,500

£62,500

£92,500

£102,500

£97,500

Cumulative Cash Flow

-£125,000

-£82,500

-£30,000

£32,500

£125,000

£227,500

£325,000

Discounted Cash Flow

-£125,000

£35,417

£36,458

£36,169

£44,608

£41,192

£32,653

Net Present Value

£101,497

 

IRR

43.91%

 

Payback Period

2.57

 

(Table Showing computations of Investment Appraisal tools for Beta Project)

Source: (Created by the Author)

As per the tables which is provided above, the business of Brooks private ltd has the option in front of them of either choosing Project A or Project B which are both mutually exclusive and the requirement of both the project is a machinery which needs to be incorporated by the management of the business (Baum and Crosby 2014). The project which are to be considered by the business are similar in nature and the same can help the business in increasing the revenue generation and profitability of the business.

The projects which are considered are Alpha Project and Beta Project as shown the tables which is provided above. In order to effectively ascertain the profitability of the project, the management has decided to apply investment appraisal techniques in order to know the worth of the two projects and also arrive at a decision as to which project would be more profitable for the business (Harris 2017).

In order to arrive at appropriate decisions, the techniques of NPV, IRR and payback period is considered as shown in the tables which is provided above. In addition to this, the computation process also considers certain assumption on the basis of which the entire computation process is shown in the table above. The cost of capital for both the project is shown to be 20% and the initial investment in both the project is shown to be £125000 which is recognized as the initial cost of the machinery which is required in order to undertake the project (Aggarwal and Thakur 2013). The analysis is conducted for a period of 6 years as shown in the tables above. The period of analysis is taken as 6 years as the useful life of the machinery used in case of both the project is shown to be 6 years.

In the case of Alpha Project, the net cash flow which is computed shows that the cash inflows are positive, however the same falls from the fourth year which is shown in the table above. The residual value of the machinery in this project is shown to be nil. On the basis of the cash flows which is computed from the project, the NPV of the business is computed which is shown to be £128,273 and the same is shown to be positive which is a good sign for the business (Zhou et al. 2015). The IRR and Payback period is also shown to be positive and favorable for the business.

In the case of Beta Project, the net cash flows are shown to be lower than the cash flows which is generated by Alpha Project and thus the net cash flows from operations is also shown to be lower. The machinery in this case does have a residual value which is shown to be £ 10,000. The NPV of the project is shown to be £ 101,497 which is positive and shows that the project is capable of generating profits for the business. The IRR and payback period of the business is also shown to be positive as shown in the table above.

In comparative analysis with the results of investment appraisal techniques for both the projects are considered for the purpose of taking appropriate decisions relating to selection of the project. The NPV of the Project Alpha is shown to be more than the NPV of Project Beta which shows that Project Alpha will be able to generate more profits for the business in comparison to Project Beta. On the other hand, the payback period of Project Alpha is shown to be more favorable in comparison to Project Beta. This shows that the management of the company is able to earn quick revenue and recover the outflows of the business quicker in case of Project Alpha. Thus, from the above discussion, it is clear that the management of the business must select Project Alpha as the same is shown to be more profitable from the analysis process which is conducted above.

Limitation of Investment Appraisal Techniques in Long term Decision Making  

The decision-making process which is conducted with the help of investment appraisal technique in most cases are able to generate accurate results (Bianchini et al. 2016). However, in certain cases such investment appraisal techniques cannot be relied upon as there are certain limitations which are associated with the use of such investment appraisal techniques. The limitations of using investment appraisal techniques are listed below in details:

  • The tools which are used in investment appraisal such as NPV analysis, IRR approach and other tools as well are a bit complex in computing and therefore the same are also difficult to understand and interpret.
  • In some tools which are used in the investment appraisal, the concept of time value of money is abandoned which makes the results which are computed as unrealistic. In other words, whenever a tool of investment appraisal does not apply the concept of time value of money, it is likely that the results are not appropriate for the purpose of decision making process of the business.
  • Some of the effective investment appraisal techniques such as IRR is a very time-consuming process and is also very complex in nature. The method of IRR requires trial and error approach which makes the process very much time consuming.
  • In some cases, the investment appraisal techniques which are utilized by businesses are not appropriate for mutually exclusive projects.

Conclusion

The discussion in the first part shows that the business of Marks and Spencer and also Next Plc needs to make tremendous improvement in liquidity and profitability aspects. The ratio analysis shows that the other areas of business is appropriate. The above discussions the limitations which is associated with the technique and how the same can have an impact on decision making process of the business. The second part shows application of NPV, IRR and Payback period for identifying the more profitable project from the perspective of the business. The second part also states the limitation of investment appraisal techniques in a business.

Reference

Aggarwal, A. and Thakur, G.S.M., 2013. Techniques of performance appraisal-a review. International Journal of Engineering and Advanced Technology (IJEAT), 2(3), pp.617-621.

Baum, A.E. and Crosby, N., 2014. Property investment appraisal. John Wiley & Sons.

Bianchini, A., Gambuti, M., Pellegrini, M. and Saccani, C., 2016. Performance analysis and economic assessment of different photovoltaic technologies based on experimental measurements. Renewable Energy, 85, pp.1-11.

Carraher, S. and Van Auken, H., 2013. The use of financial statements for decision making by small firms. Journal of Small Business & Entrepreneurship, 26(3), pp.323-336.

Delen, D., Kuzey, C. and Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications, 40(10), pp.3970-3983.

Ehrhardt, M.C. and Brigham, E.F., 2016. Corporate finance: A focused approach. Cengage learning.

Gitman, L.J., Juchau, R. and Flanagan, J., 2015. Principles of managerial finance. Pearson Higher Education AU.

Harris, E., 2017. Strategic project risk appraisal and management. Routledge.

Lartey, V.C., Antwi, S. and Boadi, E.K., 2013. The relationship between liquidity and profitability of listed banks in Ghana. International Journal of Business and Social Science, 4(3).

Lawrence, A., 2013. Individual investors and financial disclosure. Journal of Accounting and Economics, 56(1), pp.130-147.

Masini, A. and Menichetti, E., 2013. Investment decisions in the renewable energy sector: An analysis of non-financial drivers. Technological Forecasting and Social Change, 80(3), pp.510-524.

Ongore, V.O. and Kusa, G.B., 2013. Determinants of financial performance of commercial banks in Kenya. International Journal of Economics and Financial Issues, 3(1), pp.237-252.

Posner, E. and Weyl, E.G., 2013. Benefit-cost analysis for financial regulation. American Economic Review, 103(3), pp.393-97.

Tinoco, M.H. and Wilson, N., 2013. Financial distress and bankruptcy prediction among listed companies using accounting, market and macroeconomic variables. International Review of Financial Analysis, 30, pp.394-419.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.

Zhou, C., Gong, Z., Hu, J., Cao, A. and Liang, H., 2015. A cost-benefit analysis of landfill mining and material recycling in China. Waste management, 35, pp.191-198.

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