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You are a financial analyst at Zurich Plc; a public limited company specialising in Manufacturing and distributing office equipment. The Board of Directors have looked into the financial statements of the company for the last two years and have raised concerns regarding both the company’s profitability and liquidity. The financial statements of Zurich Plc for the last two years are given below.

Johnson Ltd. a manufacturer of office equipment is considering purchasing a new machine for £2,000,000. The company is expecting an annual cash inflow of £1,220,000 from the sale of products and an annual cash outflow of £350,000 for each of the six years of the machine’s useful life. The annual cash outflows do not include annual depreciation charges for the machine. The machine is depreciated using the straight-line method. The machine is expected to last for six years, with a residual value estimated to be £500,000 at the end of the sixth year. The cost of capital for Johnsons Ltd. is 10%.

Liquidity ratios

Zurich Plc. is a publicly listed company specialising in manufacturing and distributing office equipment. In this report, company’s profitability and liquidity position are gauged for 2015 and 2016 financial years through the computation of five categories of ratios. These are liquidity ratios, profitability ratios, asset utilisation ratios, gearing ratios and market value ratios. The financial records are given. Also this report critically assesses the limitations of ratio analysis for the decision making purposes.

Ratio analysis means assessment of the company’s financial and operating health by using the information contained in financial records. The assessment is done in the form of five kinds of financial ratios such as liquidity ratios, profitability ratios, asset utilisation ratios, gearing ratios and market value ratios.

Liquidity ratios are those ratios which helps in evaluating the company’s short term solvency performance. The performance is analysed that whether total current assets are sufficient to recompense its total current obligations when they come to be payable. Two common liquidity ratios mostly computed by companies are: current ratio and quick ratio (Morning Star, 2018).

  1. Current Ratio: This ratio evaluates the short term solvency position by taking total current asset and total current liabilities. Ratio more than one is always depicts the favourable position of the company. Mathematical formula is Total current assets/Total current liabilities.
  2. Quick Ratio: This also evaluates the short term solvency performance. However, the only difference is that quick ratio only considers liquid assets which can be easily converted into cash and cash equivalents in very short span of time. In addition to this only liquid assets are used in paying off its current liabilities. Ratio more than one is always depicts the sound position of the company. Mathematical formula is Total current assets less inventories/Total current liabilities.

Computation

Liquidity ratios

Current ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

Total Current Assets

 £       6,503.00

 £       7,006.00

Total Current Liabilities

 £       4,701.00

 £       2,410.00

Current ratio [CA/CL]

1.38

2.91

Quick ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

Total Current Assets

 £       6,503.00

 £       7,006.00

Inventories

 £       1,543.00

 £       1,320.00

Total Current Liabilities

 £       4,701.00

 £       2,410.00

Quick ratio [(CA-inventories)/CL]

1.06

2.36

Comment

According to the above current ratio and quick ratio, it is analysed that total current assets of the company is increased by £ 503000 whereas total current liabilities of the company is decreased by £ 2291000 which indicates that short term solvency performance of Zurich Plc. is sound in 2016 financial year in comparison to 2015 financial year.

Gearing ratios are also termed as long term solvency ratios and financial leverage ratios. In gearing ratios, long term solvency position is gauged. The company has better financial position if long term financial commitments are paid off (Morning Star, 2018). Further if the debts are more than the shareholder’s equity then it depicts unsafe position. Debt ratio and interest coverage ratios are most common gearing ratios.

  1. Debt Ratio: This ratio computes the capacity in paying off its debt obligations from the utilisation of assets. It can be said that low debt ratio is more favourable because it infers that the company has low debts than the assets. Mathematical formula is Total liabilities/Total assets.
  2. Interest coverage Ratio: This ratio computes capacity of the company to pay interest expenses in timely manner. The interest coverage ratio is used by the shareholders for the purpose of identifying profits in a company. In this case, ratio greater than one is always favourable. Mathematical formula is Operating profit or EBIT/Interest Expenses

Computation

Gearing ratios

Debt Ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

Total Liabilities

 £    11,821.00

 £       7,702.00

Total Assets

 £    32,229.00

 £     27,337.60

Debt ratio [Total Liabilities/Total assets]

36.68%

28.17%

Interest Coverage ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

EBIT or operating profit

 £       2,582.00

 £       1,783.00

Interest Expenses

 £       1,130.00

 £           932.00

Interest Coverage ratio [EBIT or Operating Expenses/Interest Expenses]

2.28

1.91

Comment

According to the above debt ratio and interest coverage ratio, it is analysed that total assets of the company is decreased by approximately 15% whereas total liabilities of the company is also decreased by approximately 35% which means that ratio of decrement of liabilities is more than the ratio of decrement of assets which implies that 2016 has better debt ratio than 2015. Further addition to this, Zurich Plc has low interest expenses in 2016 as compare to 2015 which also shows a sound position. Hence, as a whole long term solvency position of Zurich Plc. is sound in 2016 financial year in comparison to 2015 financial year.

Computation

Asset utilisation ratios are also termed as efficiency ratios and turnover ratios. This ratio evaluates the profits earned by the company from the asset utilisation (Morning Star, 2018). Productivity of the company is assessed through computation of asset utilisation ratios. Asset turnover ratio and inventory turnover ratio are computed.

  1. Asset Turnover Ratio: The company’s efficiency is evaluated by utilising the assets in producing returns. Higher ratio is always favourable because it denotes that the company has effectively utilised its assets. Mathematical formula is Revenue/Total assets.
  2. Inventory Turnover Ratio: The company’s effectiveness is identified through the computation of this ratio by analysing the utilisation of inventories in an accounting period. Mathematical formula is Cost of sales/Total inventories.

Computation

Asset utilisation ratios

 

Asset turnover ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

Revenue

 £    18,920.00

 £     16,243.00

Total Assets

 £    32,229.00

 £     27,337.60

Asset turnover ratio [Revenue/Total assets]

0.59

0.59

 

Inventory turnover ratio

Particulars

 2015 (£ 000)

 2016 (£ 000)

Cost of sales

 £    11,538.00

 £     10,418.00

Total inventories

 £       1,543.00

 £       1,320.00

Inventory turnover ratio [Cost of sales/Total inventories]

7.48

7.89

Comment

According to the above computation of ratios it has been analysed that in case of asset turnover both 2015 and 2016 financial years’ company has commendably generating income from the asset utilisation. Also in case of inventory turnover, ratio is higher in 2016 than 2015 financial year which denotes that inventories are appropriately measured in 2016 which is a positive sign. Hence, efficiency and the productivity of Zurich Plc. is sound.

PROFITABILITY RATIOS

Profitability ratios are computed for the purpose of analysing profitability position of the company. These ratios are very important for the shareholders because it helps them to assess the earnings engendered from the business tasks (Morning Star, 2018). In this case, net profit ratio, return on assets and return on equity are calculated.

  1. Net Profit Ratio: This ratio gauges how proficiently company earned returns from per value of sales. Net profit ratio considered as most important ratio to the stakeholders of the company because this will evaluate the company’s profitability position. Higher ratio is always favourable because it depicts the company has convert more revenue into earnings. Mathematical formula for computing net profit ratio is Net profit/Revenue. It is expressed in percentage form.
  2. Return on Assets: It is a profitability ratio where company determine returns earned on assets of the company. It can be inferred that greater amount of returns from the assets means effectively managing of assets. Mathematical formula for computing return on asset is Net profit/Total assets. It is also expressed in percentage form.
  3. Return on Equity:This ratio defines that the ability of the company to earn income from the shareholder’s investments. More income earned from the investors funds depicts better stability and better financial health of the company. High ratio is always preferable. Mathematical formula for computing return on equity is Net profit/Shareholder’s equity. It is also expressed in percentage form.

Computation

Profitability ratios

 

Net profit margin

Particulars

 2015 (£ 000)

 2016 (£ 000)

Net Profit

 £          972.84

 £           570.17

Revenue

 £    18,920.00

 £     16,243.00

Net Profit margin [Net Profit/Revenue]

5.14%

3.51%

Return on Assets

Particulars

 2015 (£ 000)

 2016 (£ 000)

Net Profit

 £          972.84

 £           570.17

Total assets

 £    32,229.00

 £     27,337.60

Return on Assets [Net profit/Total Assets]

3.02%

2.09%

 

Return on Equity

Particulars

 2015 (£ 000)

 2016 (£ 000)

Net Profit

 £          972.84

 £           570.17

Shareholder's Equity

 £    12,410.00

 £     12,410.00

Return on Equity [Net profit/Shareholder's equity]

7.84%

4.59%

Comment

From the computation of all the above three categories of profitability ratios, it is gauged that all the ratios earned low returns in 2016 as compare to 2015 which is not a good sign for the company.

MARKET VALUE RATIOS

For the purpose of determining stock value of the company in terms of overvalued, undervalued or fairly valued, this ratio is computed (Morning Star, 2018). Company’s stock value is very crucial for the stock holders of the company. It is also termed as market prospect ratio. For this purpose, earnings per share is calculated.

  1. Earnings Per share: This ratio means amount of income earned from per value of stock. Higher EPS depicts more income will be dispersed to the shareholders which is a positive indication towards the company. Generally, EPS ratio is always shown in Profit and loss statement of the company. The formula for the computation of EPS is: Net Profit/Number of shares.

Computation

Market value ratio

 

Earnings per share

Particulars

 2015 (£ 000)

 2016 (£ 000)

Net Profit

 £          972.84

 £           570.17

Number of shares

12410.00

12410.00

Earnings per share [Net profit/Number of shares]

 £               0.08

 £               0.05

Comment

From the above EPS it is seen that Net profit is decreased in 2016 by £ 402670 from 2015 financial year which means EPS in 2016 is comparatively low from 2015. This signifies that market value position of Zurich Plc. is not good.

From the above computation of all the five kinds of financial ratios, it is summarised that the liquidity as well as gearing ratios portrays that both the short-term and long-term solvency position of Zurich Plc. is stable. In terms of asset utilisation ratios, efficiency and the productivity of Zurich Plc. is sound. In addition to this, profitability performance of the company in 2016 is not sound due to decrement in net profit, revenue and the total assets in comparison to financial year 2015. Further market value ratios also depict that due to decrement in net profit in year 2016 from the year 2015 market value position of Zurich Plc. is not sound.

Gearing ratios

Following are the limitations of ratio analysis:

  1. At times from the ratio analysis, correct financial position of the company remains undisclosed.
  2. Industry outcomes only depicts approximations and not the actual results.
  • There are various accounting standards adopted for the particular type of calculation for example for computation of depreciation figure the company can adopt straight line method or written down value method. Hence, due to difference in adoption of different accounting standards ratio analysis sometimes not suitable.
  1. Ratio analysis only takes into account monetary items and ignores non-monetary items.

Due to some limitations of the ratio analysis, directors of Zurich Plc. should not only depend on financial records but should also considers other factors such as employment welfare policies, customer satisfaction ratings, market value etc. for the purpose of decision making about the company’s performance.  

Given Information:

Particulars

Cost of machine

 £ 20,00,000.00

Annual cash inflow

 £ 12,20,000.00

Annual cash outflow

 £    3,50,000.00

useful life (years)

6

Depreciation method

SLM

residual value

 £    5,00,000.00

Cost of capital

10%

  1. The Payback Period

Payback period = Total initial capital investment/Annual expected after tax net cash flow

Particulars

 

Cost of machine

 £ 20,00,000.00

Annual net cash flow

 £    8,70,000.00

Payback period (years)

2.30

 

Recommendation:

From the above calculation of payback period, it has been seen that cost of the machine will be recovered in 2.30 years from the cash inflows which is more than the given period of time (6 years). Thus, it is feasible to Johnson Ltd to acquire the machine.

  1. The Discounted Payback Period

 

Discounted Payback period = Total initial capital investment/Annual expected after tax net cash flow

Years

0

1

2

3

4

5

6

Annual net cash flow

-£20,00,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

Cumulative cash flows

-£20,00,000.00

-£11,30,000.00

-£      2,60,000.00

 £      6,10,000.00

 £    14,80,000.00

 £    23,50,000.00

 £    32,20,000.00

Discounted cash flow (PV)

-£20,00,000.00

£7,90,909.09

£7,19,008.26

£6,53,643.88

£5,94,221.71

£5,40,201.55

£4,91,092.32

Cumulative discounted cash flow

-£20,00,000.00

-£12,09,090.91

-£4,90,082.64

£1,63,561.23

£7,57,782.94

£12,97,984.49

£17,89,076.81

Discounted payback period (years)

2.75

 

 

 

 

 

 

 

Notes:

Cumulative discounted cash flows become positive sometime after 2 full years, with approximately $ 490082.64 still to be recovered in next year.

Discounted cash flow in year 3 is $ 653643.88. Assuming cash flows in at a constant rate during year 3, discounted payback period = 1 + 490082.64/653643.88 = 2.75 years.

Recommendation:

From the above calculation of Discounted payback period, it has been seen that cost of the machine will be recovered in 2.75 years from the discounted cash inflows which is more than the given period of time (6 years). This method is considered to be the grander because it takes into account time value of money. Thus, it is feasible to Johnson Ltd to acquire the machine.

  1. The Accounting rate of return (ARR)

Accounting Rate of return = Average annual net income*100/Average investment

Particulars

Average annual net income

 £    6,20,000.00

Average investment

 £ 12,50,000.00

ARR

49.60%

Recommendation:

From the above calculation of Accounting rate of return (ARR), it has been seen that net income from the entire life of the project is considered and determines the investment’s profitability position. Thus, in this case, Johnson Ltd earns 49.60% which is more than the required rate of return (10%). Thus, it is feasible to Johnson Ltd to acquire the machine.

  1. The Net Present Value (NPV)

Net Present value = PV of Cash inflows - PV of cash outflows

 

Calculation of Present value of cash outflows:

Years

0

Annual cash outflow

£20,00,000.00

Present value

? -20,00,000.00

Total PV of cash outflows

? -20,00,000.00

Calculation of Present value of cash inflows:

Years

1

2

3

4

5

6

6

Annual net cash flow

 £    8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

Residual Value

 £      5,00,000.00

Present value

? 7,90,909.09

? 7,19,008.26

? 6,53,643.88

? 5,94,221.71

? 5,40,201.55

? 4,91,092.32

? 2,82,236.97

Total PV of cash inflows

? 40,71,313.77

NPV

? 20,71,313.77

Recommendation:

From the above calculation of Net Present Value (NPV), it has been seen that net present value of cash inflows is higher than net present value of cash outflows. Thus, NPV is $ 2071313.77 which is beneficial for Johnson Ltd to acquire the machine.

 

  1. The Internal Rate of return (IRR)

Years

0

1

2

3

4

5

6

Annual net cash flow

-£20,00,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

IRR

36.89%

Recommendation:

From the above calculation of Internal rate of return (IRR), it has been seen that IRR of the project is 36.89% which is more than hurdle rate (10%). Thus, it is beneficial for Johnson Ltd to acquire the machine.

Working Notes:

1. Calculation of depreciation

Depreciation = (Cost of machine - Residual Value)/number of useful lives

 

Cost of machine

 £ 20,00,000.00

Residual value

 £    5,00,000.00

useful life (years)

6

Depreciation

 £    2,50,000.00

 

 

2. Calculation of Net Income

Net income

1

2

3

4

5

6

Sale from products

 £ 12,20,000.00

 £    12,20,000.00

 £    12,20,000.00

 £    12,20,000.00

 £    12,20,000.00

 £    12,20,000.00

Less: expenses

 £    3,50,000.00

 £      3,50,000.00

 £      3,50,000.00

 £      3,50,000.00

 £      3,50,000.00

 £      3,50,000.00

Net income

 £    8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

 £      8,70,000.00

Less: Depreciation (w.no.1)

 £    2,50,000.00

 £      2,50,000.00

 £      2,50,000.00

 £      2,50,000.00

 £      2,50,000.00

 £      2,50,000.00

Income after depreciation

 £    6,20,000.00

 £      6,20,000.00

 £      6,20,000.00

 £      6,20,000.00

 £      6,20,000.00

 £      6,20,000.00

(Refer Excel sheet)

  1. BENEFITS AND LIMITATIONS OF DIFFERENT APPRAISAL TECHNIQUES
  2. The Payback Period

Benefits

  1. This capital budgeting technique does not consider discounted cash flows.
  2. The time required to recoup the investment value can also serve as an estimation of the risk involved because longer payback period is less trustworthy.
  • It is very easy in respect to calculations.
  1. This method determines the estimation of time required to cover the investment costs.

Limitations

  1. Ignorance of longer payback period will lead to non-enhancement of its competitive position.
  2. This method failed to consider the total profits from the project because it only reflects cash flows till the payback period is reached and disregards cash flows after the payback period.
  • The payback period technique ignores time value of money.

According to the real life business taking an example of computer business, where technology is changing rapidly then in that scenario quick payback period is more appreciated (Drake, 2018).

  1. The Discounted Payback Period

Benefits

  1. This capital budgeting technique considers time value of money considers to be the more appropriate way of calculating payback period.
  2. This method is considered to be more appropriate in gauging non-recoverability of investments.
  • This method determines the estimation of time required to cover the investment costs by taking into consideration of discounted cash flows.
  1. This method also provides a sign of risk and liquidity.

Limitations

  1. It does not present an absolute decision rule rather it involves a judgement in its elucidation.
  2. Does not considers the post payback period cash flows.
  • Due to multiple negative cash flows, its calculations can be difficult.

According to the real life business taking an example of computer business, where technology is changing rapidly then in that scenario quick payback period is more appreciated. But as a whole, both methods that is payback period and discounted payback period are unacceptable because both of these does not considers all the cash flows of the project (Drake, 2018).

  1. The Accounting rate of return

Benefits

  1. This capital budgeting technique uses data which is readily available from the financial books.
  2. According to the results of this capital budgeting technique, performance based on the operating results and management performance is assessed.
  • ARR method also ensures consistency in decision making process.
  1. The profitability position of an investment is evaluated because ARR method considers net incomes of the total life of the project..

Limitations

  1. It does not consider net cash flows instead it considers only net income.
  2. The accounting rate of return technique ignores time value of money.
  • It only considers the initial investment cost and ignores working capital and other disbursements.

According to the real life business, this method will be used where the management decides to accept the proposed project only when average annual return must be greater than minimum required rate of return (Drake, 2018).

  1. The Net present value method

Benefits

  1. This capital budgeting technique is most commonly used for the decision making process for the purpose of investment performance.
  2. It also taken into account time value of money.
  • The cash flows from the entire life of the project are considered.
  1. The positive Net present value method adds the value to the firm and vice versa.
  2. The NPV method also increases the wealth of the shareholders.
  3. In case of mutually exclusive projects, project with higher NPV is selected..

Limitations

  1. Computation are difficult.
  2. This method is difficult to apply in case of different lives of mutually exclusive projects.
  • This method is also difficult to apply in case of different initial costs of mutually exclusive projects.
  1. The decision under NPV method is based on absolute measure.

According to the real life business, this method will be mostly used by the companies which maximises the value of the shareholders (Sangster, 1993).

  1. The Internal rate of return method

Benefits

  1. It also taken into account time value of money.
  2. This capital budgeting technique is used mostly for the purpose of making decisions.
  • IRR method assessed the return on the initial investment.
  1. This method is very easy for the understanding purpose.
  2. Dealing with the IRR method is more appreciated than NPV method.  
  3. In case of mutually exclusive projects, project with higher IRR is selected.

Limitations

  1. IRR method sometimes lead to bothersome about some projects that are not in the finest interest of the shareholders.
  2. This method is difficult to apply in case of mutually exclusive projects.
  • This method is also difficult to apply in case of capital rationing.

According to the real life business, this method will be mostly used by the companies because it is a measure of yield (Sangster, 1993).

The following possible sources of finance are:

  1. Johnson Ltd can use Hire purchase as a source of finance.
  2. Assistance from government in form cash grants or from direct sources.
  • Lease either operating or finance can also be a source of finance.
  1. Bank borrowings are also an important source of finance.
  2. Issuing of ordinary shares are also a source of finance to the company.
  3. Raising of long term debt.

References

Morning Star, 2018, Efficiency ratios, viewed on 16th May 2018 from https://news.morningstar.com/classroom2/course.asp?docId=145093&page=3&CN=sample.

Morning Star, 2018, Liquidity ratios, viewed on 16th May 2018 from https://news.morningstar.com/classroom2/course.asp?docId=145093&page=4.

Morning Star, 2018, Leverage ratios, viewed on 16th May 2018 from https://news.morningstar.com/classroom2/course.asp?docId=145093&page=5&CN=sample.

Morning Star, 2018, Profitability ratios, viewed on 16th May 2018 from https://news.morningstar.com/classroom2/course.asp?docId=145093&page=6&CN=sample.

Sangster. A., 1993, “Capital Investment appraisal techniques: A survey of current usage”, Journal of Business Finance & Accounting.

Drake. P.A., 2018, Capital Budgeting techniques, viewed on 9 June 2018 from https://educ.jmu.edu/~drakepp/principles/module6/capbudtech.pdf.

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