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Question:
Finding financial information.

You are required to find the appropriate financial information in Telefonica’s financial statements (see guidelines below) and calculate the following ratios for each of the financial years 2012 to 2014:

1. return on capital employed (ROCE)
2. return on sales (ROS)
3. asset utilisation ratio (AUR)
4. gross profit margin
5. current ratio and quick ratio
6. gearing
7. interest cover
8. inventory days
9. trade and other receivables days
10. trade and other payables days
11. return on equity (ROE).

Return on Capital Employed (ROCE)

If the amount invested in business was invested elsewhere, would it have earned more interest than the income earned by the business? This is the question that ROCE answers. It measures the efficiency with which the funds of Shareholders, Debenture holders, and long term loans have been utilized. It is computed as below

Profit before Interest and Tax (PBIT) / Capital Employed

Where PBIT is directly available from the Income statement, Capital Employed can be computed as Total Assets – Current Liabilities.

 Formula 2012 2013 2014 PBIT / Capital Employed 10798/(129773 – 31511) x 100 9450/(118862-29144) x 100 6967/(122299-29699) x 100 10.99% 10.53% 7.52%

Return on Sales (ROS)

This is also known as Net Profit ratio. It reflects the overall efficiency of the business. It measures the net profit in relation to revenue from operation. It is measured as

Profit After Tax (PAT) / Revenue from Operation x 100

Both above numbers are directly available from the Income statement

 Formula 2012 2013 2014 PAT / Revenue * 100 4403/62356 *100 4969/57061*100 3252/50377 *100 7.06% 8.71% 6.46%

Asset Utilisation Ratio (AUR)

This ratio measure the efficiency with every asset has been used in the business to generate revenue. This is calculated as below

Net Sales / Total Assets

 Formula 2012 2013 2014 Net Sales / Total Assets 62356/129773 57061/118862 50377/122299 0.48 0.48 0.41

Gross Profit margin

This ratio measures the gross margin on the products manufactured. It indicates the margin available to cover the operating and non-operating expenses. A higher Gross profit is favorable. It is computed as below

(Revenue from operation – Cost of revenue from operation) / Revenue from operation x 100

Revenue from operation is directly available in the income statement. Cost of revenue has been computed as Supplies + Personal Expenses + Other operating expenses where

• Supplies is assumed to be direct material
• Personal Expenses is assumed to be direct labour
• Other operating expenses have been taken from Note 18

 Formula 2012 2013 2014 (Revenue from operation – Cost of revenue from operation) / Revenue from operation* 100 (62356 – 18074 -8569 - 399) / 62356 * 100 (57061 – 17041 – 7208 - 288) / 57061 * 100 (50377 – 15182 – 7098 - 368) / 50377 * 100 56.63% 57.00% 55.04%

Current Ratio and Quick ratio

Current ratio measures the ability of the company to pay off its current liabilities. A very high current ratio though is not healthy as it shows improper utilization of funds. It is calculated using the following formula

Current Assets / Current Liabilities

 Formula 2012 2013 2014 Current Assets / Current Liabilities 25596 / 31511 29265 / 29144 22864 / 29699 0.81 1.00 0.77

Quick ratio is calculated to assess the liquidity of the company. It is also called Acid test ratio. It is calculated as

(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

 Formula 2012 2013 2014 (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities (10711+1872+9847) / 31511 (9640+2117+9977) / 29144 (10606+2932+6529) / 29699 0.71 0.75 0.68

Gearing Ratio (Leverage ratio)

This ratio measures the proportion of the debts to the equity of a company. It shows whether the company is more dependent on debt fund or shareholders equity. Too much reliance on debt is highly risky for the business during downturns. It is computed as under

(Long term debt + Short term debt + Bank Overdraft) / Shareholders’ Equity

 Formula 2012 2013 2014 (Long term debt + Short term debt + Bank Overdraft) / Shareholders’ Equity (56608 + 10245) / 27661 (51172 + 9527) / 27482 (50688 + 9094) / 30289 241.69% 220.87% 197.40%

Interest Cover

This ratio measures the ability to pay interest on its debts. It measures how many times the Earnings are covering the interest expenses. It is calculated as below:

Earnings before Interest & Tax (EBIT) / Interest Expenses

EBIT and Interest Expenses are directly available from the income statement as Operating Income & Finance costs respectively

 Formula 2012 2013 2014 Earnings before Interest & Tax (EBIT) / Interest Expenses 10798/4025 9450/3629 6967/3511 2.68 2.60 1.98

Inventory days

This measures the value of average inventory held by the company with respect to the cost of goods sold. This gives the measure of in how many days the inventory can be converted into sales. A higher inventory turn days indicates higher inventory storage and handling cost. It is computed as below

(Average Inventory x 365) / Cost of goods sold

Average inventory is arrived at by adding opening & closing inventory and dividing by 2. Cost of goods sold is directly available from the Income statement as Supplies.

 Formula 2012 2013 2014 (Average Inventory x 365) / Cost of goods sold [(1188+1164)/2]  X 365 / 18074 [(985+1188)/2] X 365 / 17041 [(934+985)/2] X 365 /  15182 23.75 23.27 23.07

This measures the value of average receivables held by the company with respect to the revenues. This gives the measure of in how many days the receivables can be converted into cash. A higher receivable turn days indicates higher interest incurred on working capital invested in business. It is computed as below

(Average Receivables x 365) / Revenue

Average receivables is arrived at by adding opening & closing receivables and dividing by 2. Revenue is directly available from the Income statement.

 Formula 2012 2013 2014 (Average Receivables  x 365) / Revenue [(10711+ 11331)/2]  X 365 / 62356 [(9640 + 10711)/2] X 365 / 57061 [(10606 + 9640)/2] X 365 /  50377 64.51 65.09 73.34

This measures the number of days the company takes to pay its creditors. A higher payable turn days the company is paying to its Suppliers slowly which may be an indication of worsening financial situation. It may also mean that credit terms have been revised with the supplier through better negotiation. It is computed as below

Total supplier purchase / Trade & Other payables

Total Trade and other payable numbers are directly available from the financial statements. Average of trade and other payables have not been taken as previous year figures of 2011 have been regrouped and the correct opening balance is not available from the Annual Report. Total Supplier purchases is directly available from the Income statement as Supplies.

 Formula 2012 2013 2014 Total supplier purchase / Trade & Other payables 365 / (18074 / 17089) 365 / (17041 / 15221) 365 / (15182 / 16943) 345.11 408.64 327.06

Return on Equity (ROE) consolidated

This measures the ability of the company to generate income from its shareholders investments. It measures how much net income is generated from every dollar invested by shareholders in the company. It is computed as below

Net Income / Average Shareholders’s equity

 Formula 2012 2013 2014 Net Income / Average Shareholders’s equity 4403/ [(27661 + 27383)/2] 4969/[(27482+ 27661)/2] 3252/ [(30289+27482)/2] 16.00% 18.02% 11.26%

Return on Equity (ROE) Attributable to owners

Net Income attributable to owners / Average Shareholder’s equity attributable to owners

 Formula 2012 2013 2014 Net Income / Average Shareholders’s equity 3928/ [(20461 + 21636)/2] 4593/[(21185+ 20461)/2] 3001/ [(21115+21185)/2] 18.66% 22.06% 14.19%
Introduction

Telefonica, one of a major player in the telecom industry has published its Annual report. This detailed report attempts to interpret the reported numbers of the past 3 years and tries to benchmark the same with the major competitor Deutsche Telekom and the Industry as a whole. The entire report is based on detailed ratio analysis which is based on 5 success factors viz. Profitability, Liquidity, Solvency, Efficiency and Investor perspective.

Profitability

On a review of the Profitability of Telefonica with respect to Deutsche and the Industry as a whole the following observation can be made.

Observation - It is observed that the Return on capital employed of Telefonica has been on the downtrend over the years. What used to be as high as 10.99% in 2012 has now reduced to 10.53% in 2013 and as low as 7.52% in 2014. This is a major set-back to Telefonica as it can be observed that the same numbers for Deutsche as well as the industry is on the uptrend. The return on sales have also dropped from 7.06 % in 2012 to 6.46% in 2014. Same is the case with Asset utilization Ratio and Gross Profit ratio.

Causes – The major cause for this can be attributed to reducing EBIT. The EBIT for 2014 has gone down by 35 % when compared to 2012. This is partially due to a reduction in topline by 20% and increase in the other expenses. The capital employed is more or less at same levels and has not contributed much to the ROCE fall. A drop of 1.6 % in the gross margins can be seen as the next major cause of the falling numbers after the fall in sales which is directly due to a rise in Raw material costs vis a vis the revenue.

Implication on Telefonica – As a direct result of increasing raw material cost and the consequent fall in gross margins, the ROCE is adversely affected. On the other hand Deutsche and Industry outlook is looking vibrant. As a result, the Shareholders are likely to switch to Deutsche or other companies in the industry. Consequently, Telefonica may have to borrow more to ensure more funds to be used in the business which however will increase the interest costs and affect the gearing. This will put more pressure on Telefonica to further improve its position.

Concerns – On the other hand Deutsche has shown remarkable progress from its past. ROCE and ROS which were negative in 2012 have turned around. Even-though the pressure on gross margins is also evident from Deutsche numbers, there is a dramatic turnaround in ROCE & ROS. It can be thus derived that Deutsche has consciously reduced their capital employed over the years. This they may have achieved by reducing the non-current assets and marginally increasing the payable number of days.

Liquidity

Observation – Current ratio is the ability of a company to pay off its current liabilities. A current ratio of 1 is generally considered a healthy number for any company. In the case of Telefonica, it was a good position in the year 2013. However, in 2014 it has worsened to 0.77. Even quick ratio has gone down and overall working capital is in the negative. The same numbers for the Deutsche and the industry as a whole is looking vibrant again!!

Causes – The first and foremost cause for this is a very high trade payable position. On a quick look at the payable number of days, it can be seen that trade payables are as high as 365 days. This gives clear indications that there is severe strain on the net cash position. Telefonica is not in a position to regularly pay off its dues to its suppliers and is unable to generate regular cash from the business. Moreover, receivable number of days have also been rising over the years putting heavy strain on short term borrowing which will in turn increase the interest costs and adversely affect gearing again.

Implication on Telefonica – When the competitor and the industry position is looking good in this area, there is a high chance that the suppliers would gradually like to withdraw doing business with Telefonica. They may also demand a higher price in the endeavor to reduce business with Telefonica.

Concerns – With a healthy working capital position, Deutsche is in a commanding position to attract all the suppliers. They may as well negotiate a better price for the Raw material thereby saving further on Direct material and in turn improve gross margins. With better gross margins, Deutsche can improve on the ROCE further and create more problems for Telefonica in future.

Solvency

Observation – Telefonica has been operating at a very high gearing. The ratio has been 200% or more. This is as such not a very healthy sign for any company to have. Too much dependency on borrowing will have a very high interest cost and repayment can be a major concern in times of downturn. Even as per industry standards, Telefonica is at a disadvantage. However, the borrowings have reduced from 241.69% in 2012 to 197.4% in 2014. Interest cover is also reducing recently mainly because of a lesser profitability.

Causes – the above cannot be seen as a healthy sign. It may also be an indication that with the deteriorating performance, the lenders are shy to lend and hence the borrowings are coming down. With a reducing amount of borrowing, there can be high pressure of working capital management and will call for further funds from Shareholders. A reducing interest cover on the other hand is an indication of fall in profitability for the reasons discussed above.

Implication on Telefonica – A higher pressure on shareholders will put more pressure on the business to show better results. This will put severe constraints on working capital management and this vicious cycle will continue until the performance improves. The burden of interest payment on the profits is also increasing whereas the interest cover ratio for Deutsche is showing a healthy sign. So is the industry as a whole.

Concerns – The industry as a whole is very well placed in terms of gearing, leverage and interest cover. This will put a lot of pressure of Telefonica to perform and show good results. Telefonica should take aggressive short term steps to improve revenues and generate cash fast. It can even have a quick liquidation plan in place to improve the solvency position.

Efficiency

Observation – Even with a deteriorating revenue and profitability situation, the inventory number of days has been maintained. However, the receivables number of days are increasing. For Telefonica, which is under a downturn in terms of profitability, leverage and solvency, having an increasing receivable days is not desirable. Telefonica has managed to bring down the payable number of days from 408 in 2013 to 327 days in 2014. However, the reduced number of days itself is a very high number and is not desirable.

Causes – Increase in receivable days seems to be an issue for the competitor as well as the industry as a whole. Telefonica as well seems to have been bitten by this. As far as inventory number of days is concerned, Telefonica has only managed to retain the same levels whereas Deutsche and industry as a whole has maintained excellent standards of inventory holding. This may be due to improper planning within Telefonica. In case of payables, the above two factors have created severe working capital crunch and has adversely affected the payment to suppliers.

Implication on Telefonica – Poor working capital will affect payments to suppliers which will in turn delay and increase the cost of purchase of raw material. This will in turn affect the product cycle time and throughput which will ultimately affect the selling price and timely collection of payments from customers. This vicious circle will continue and expand the working capital cycle thereby directly affecting the profitability of the company

Concerns – in this area as well, the Deutsche and industry are very well placed when compared to Telefonica. The company will gradually lose its upper hand in negotiation with the suppliers as well as with the vendors. The inventory holding and handling cost will also increase again causing a dent on the profitability.

Investor interest

Observation – The return on equity position is one of the best for Telefonica. This is the strength area so far for this company in front of the competitors as well as the industry as a whole. However, in the year 2014, there is a heavy drop in the ROE to 11.26% and Deutsche is fast approaching that mark!!

Causes – The obvious reason for this is that the capital is heavily geared in debt funds. Under such a situation, when the company was able to generate, good returns, it reflected a healthy ROE. However, a gradual reversal of the gearing situation coupled with a lower profitability due to lower margins, the ROE position is going down which is also a concern.

Implication on Telefonica – Deutsche, with a slightly higher capital gearing than the industry is able to offer 9.52% ROE. This is a major setback for Telefonica and hence needs to watch out for the competitor who may easily topple this number as well in the coming years.

Concerns – Telefonica is already going through heavy pressure on margins, profitability, working capital management as well as capital gearing. As a result of all these factors, the strength area which was ROE is also gradually on a reversing trend and may severely affect the future of the company. Investors with high risk appetite (bulls) may still continue to invest in the company. But the bears may shy away and look out of other options within the industry including Deutsche.

Conclusion & Recommendation

On a comprehensive analysis of the reported numbers of Telefonica with respect to the main competitor Deutsche and the telecom industry as a whole, the competitor Deutsche and the industry is well position on the following grounds

Deutsche is managing a good ROCE in spite of a fall in gross margin

Deutsche has done a dramatic turnaround in the past 3 years and is able to match the industry averages in profitability parameters

Deutsche has managed to stabilize its liquidity position which is now perfectly balanced and matched with the industry average

Even-though the capital is slightly more geared than the industry average, it has managed to give a decent return on equity. This is a strong point from the investor point of view

Efficiency parameters are also superiorly placed though not matched with Industry average.

Given the above circumstances, Telefonica has to go a long way to reverse the setbacks and really come back and command a good market share. The following are the recommendations to Telefonica which will help in its comeback and establish its place in the industry

Gross margins are going down for Telefonica, so is for the competitor. This is market driven and there is not much that can be done except internal operational efficiencies and cost reductions

Telefonica can try to cut down on its total assets in order to improve its ROCE number

The top most priority for Telefonica should be to improve its working capital position. Aggressing measures should be taken to liquidate inventories and collect receivables through rigorous follow up. It should also pay off the supplier dues which have been long pending thereby improving their confidence and support in future supplies. A well lubricated working capital cycle can ensure better performance.

Capital gearing is a concern area. However, this should not be targeted in the short term as there are other issues at hand which need immediate attention and improvement. In the long run, Telefonica should work towards a better capital gearing. The interest costs will continue until sufficient stability is achieved in capital gearing.

References

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financeformulas.net, n.d. Days in Inventory, [Online], Available at:  https://www.financeformulas.net/Days-in-Inventory.html, [Accessed date: March 28, 2016]

wallstreetoasis.com, n.d. Accounts Receivable Days Definision, [Online], Available at:  https://www.wallstreetoasis.com/finance-dictionary/what-is-accounts-receivable-days, [Accessed date: March 28, 2016]

wallstreetoasis.com, n.d. What is Accounts Payable days?, [Online], Available at:  https://www.wallstreetoasis.com/finance-dictionary/what-is-accounts-payable-days, [Accessed date: March 28, 2016]

investinganswers.com, n.d. Return on Equity (ROE), [Online], Available at:  https://www.investinganswers.com/financial-dictionary/financial-statement-analysis/return-equity-roe-916, [Accessed date: March 28, 2016]

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