By considering the extracts of the annual report of ABC consulting, it is observed that the net revenue of the company has increased from £3,005 to £3,145 in 2018 as compared to the previous year. This has shown an increase of 4.66% in the net sales of the company. This upsurge is because of the expansion plan of ABC which stimulates the flow of the new range of products at the starting of the year. Being the consultant company, the staff costs are considered as a proxy for the cost of sales. Looking at them, the costs have shown a significant increase in 2018 from £ 1,537 to £ 1,620 million. Following this, the amount of depreciation has also raise from £55 million to £68 million along with the upsurge in marketing cost worth £210 million to £322 million and conveyance fees amounted to £112 million.
The reason for the rise in the staff cost is the expenses incurred on the training and development of company’s employees. As ABC is looking for its expansion in European market plus the promotion of consultancy services contributed to the increased marketing costs. However, the cost of technology support reduces from £253 million to £154 million during the year. Due to this the overall operating cost increases by 6.70% which reduces the net operating profit by 7.55%. However, the overall increased sales reflected that despite facing a downturn in US expansion, ABC is performing better and is focused on making profits from its expansion strategy.
Profitability ratios
|
2018 |
2017 |
%change |
|
|
Profitability Ratios: |
|||
|
Net profit ratio |
26% |
30% |
-3% |
|
Gross Margin |
48% |
49% |
0% |
|
Return on Equity (ROE) |
87% |
132% |
-45% |
Gross profit ratio
It measures the financial health of a company. GPR is derived by dividing the amount of gross profit with total sales. The value is been represented as the percentage of total revenue (Bragg, 2012).
In 2017, the ratio was 49% that reduces to 48% in 2018, as reported in the annual report. However the decrease is not very much significant but it does reflect an increase in the company’s cost. Moreover, the change in sales is more than the change in gross profit. Revenue increased by 4.66% whereas the gross profit of ABC rises by 3.88%. In addition, increase in company’s cost of goods sold also reduces the ratio to some extent. The COGS of ABC shows an increase of 5.40% which eventually affected its profit. As a result of which, 1% decline is been there in the ratio.
Net profit ratio
Another profitability ratio which determines the overall situation of the company’s profits.It is also expressed in terms of percentage of sales and indicates the financial performance of the company as a whole (Bragg, 2012).
Just like the GPR, ABC’s net profit margin has also reduced by 3% in 2018. This is due to the reduction in the net profits of the company, showing a decline of 7.55%. This is due to increase in prices of the services offered by ABC in Australia. However, the prices remain constant in the United Kingdom, yet the profits of the company reduce. Another reason for such decline may be the setback experienced in US expansion.
Return on equity
It indicates the company’s ability to make profits from the money invested by the shareholders. The ratio shows the amount of net profit in proportion to the total equity of the firm, reflecting the return offered to the stakeholders (Gibson, 2011).
ABC’s ROE shows a huge decline of 45% in 2018. In 2016, the ratio was 132% which reduces significantly to 87% in 2018. This is due to the reduction in the net profits of the company with 7.55%. Moreover, the change in shareholder’s equity is way more than the decrease in net profits of ABC. Overall, it can be said that the company does not have a strong profitability position.
Statement of financial position analysis
Efficiency ratios
|
2018 |
2017 |
%change |
|
|
Efficiency Ratios: |
|||
|
Receivable days |
139 |
143 |
-3% |
|
Debtor turnover ratio |
2.63 |
2.55 |
3% |
|
Days Payables Outstanding (DPO) |
171 |
184 |
-8% |
|
creditor turnover ratio |
2.13 |
1.98 |
7% |
|
Total Asset Turnover (TAT) |
1.45 |
1.63 |
-13% |
Receivable turnover ratio
It is an efficiency ratio which measures the capability of the firm to collect its debtors quickly, during a specific period of time. It shows the amount of turnover made by the company from its debtors (Godwin and Alderman, 2012).
As it is already perceived that the revenue of ABC Consulting has improved in 2018, its debtor turnover ratio also increases from 2.55 times to 2.63 times, reflecting an increase of 3%. This is because the increase in debtors is only 1% where has the revenue reflected an increase of 4.66%. It causes an upsurge in the ratio, thus enhancing the capacity of ABC to collect its debtors (Vogel, 2014).
Receivable days
With the increase in DTR, the receivable days of the firm have also reduced from 143 days to 139 days in 2018. As ABC provides management consultancy services and others to the customers, so it may be possible that many of them prefer to pay cash in return of such services which eventually reduces the debtors of the company (Higgins, 2012).
Creditor turnover ratio
It is another activity ratio which measures the credit value of the entity. In other words, it determines how frequently company makes payments to its creditors. The CTR shows the competence of firm in meeting its short-term financial obligations (Jenter and Lewellen, 2015).
Rise in the ratio over the year means that the business is paying its creditors on time. The same is in the case of ABC Consultancy. Its ratio increases from 1.98 times to 2.13 times. Reason is the overall decrease of 2% in the accounts payable of the firm. It reflected that despite an upsurge in COGS and reduction in cash, the company manages to pay off its payables during the year.
Payables days
Just like receivable days, payable days also decreases from 184 to 171 days. It means ABC does not take the longer time to meet its short-term financial commitments that make the company more efficient and worthwhile (Kimmel, Weygandt and Kieso, 2010).
Asset turnover ratio
This ratio evaluates the total assets with the net sales of the company. It determines the efficiency of ABC in managing its assets and generating revenue from them (Krantz and Johnson, 2014).
The ATR of ABC reduces from 1.63 to 1.45 times despite having an increase in the total revenue. Reason being, the total assets of the company increases by 18% whereas the increase in revenue is only 4.66%. This means a company has not properly utilized its total assets to generate revenue.
From the above efficiency ratios, it is identified that though ABC does not have strong profitability position the operations of the company are efficient enough to generate revenue from its assets.
liquidity ratios
|
2018 |
2017 |
%change |
|
|
Liquidity Ratios: |
|||
|
Current Ratio |
1.61 |
1.74 |
-8% |
|
Quick Ratio |
1.61 |
1.74 |
-8% |
|
Cash Conversion Cycle (CCC) |
-33 |
-41 |
-26% |
Current ratio
It is a ratio which measures the capacity of the firm to pay off its current liabilities with the use of its current assets. The ideal ratio is considered to be 2:1 and it is used as a pointer of company’s financial health (Lee, Lee and Lee, 2009). In the fiscal year 2017-18, the CR of ABC shows a reduction of 8% that is from 1.74 to 1.61. In both the years, the ratio was lesser than the benchmark of 2:1. This reduction shows that the company does not have enough CA to meet its CL. This can be seen through the low amount of cash company has at the end of the year.
Quick ratio
It determines the company’s liquidity position by unveiling its competence of paying immediateliabilities with its quick assets. The ideal ratio is 1:1 (Saleem and Rehman, 2011). The quick and current ratio of ABC is the same as the company has no inventory because it operates in the service sector. As per its balance sheet, its CA comprises of only cash and accounts receivables (Tracy, 2012).
Gearing ratios
|
2018 |
2017 |
%change |
|
|
Gearing Ratios: |
|||
|
Debt to Equity |
47% |
55% |
-8% |
|
Interest Coverage (Times Interest Earned) |
108.63 |
218.00 |
-101% |
It is one of the financial gearing ratios which show the degree of financial risk undergone by the firm. It measures the debt portion of the company against the amount of total equity. A high ratio shows high financial risk for the entity and indicates that most of the assets are financed through debt. Therefore, a low D/E is always favourable for the entities (Nikolai, Bazley and Jones, 2009).
The long-term borrowings of ABC show an increase of 21% that is from £369 million to £445 million. In comparison to that ABC’s equity increases by 40% and reaches £940 million in 2018. Such an upsurge reduces the debt-equity ratio of ABC by 8%. In 2017, it was 55% which reduces to 47% in 2018. This shows that the company has a low financial risk as most of its assets are financed through equity.
Interest coverage ratio
It evaluates how many times an entity has paid its interest from its earnings before interest and tax. Generally, it is useful for the creditor as it gives them an indication of the ability of the firm for making repayments. A high ratio is considered to be favourable for the entity (Salunke and Bagad, 2009).
Talking about the ICR of ABC, it has been reduced from 218 times to 108.63 times, showing an overall reduction of 101%. This is due to the slightest decline in the operating profit of ABC from £872 million to £869 million. In addition to that, the finance cost or interest expense of the company got double in the year 2018. Prior to this, it was £4 million which increases to £8 million in 2018. Doubling of the expense brings a significant fall in the ratio making the company less efficient.
Statement of cash flow analysis
Cash flow statement is a document prepared by the companies along with the other financial statements. It shows the inflow and outflow of the cash in the operationsthrough a particulartime period. The statement reflects the movement of cash within three types of activities named as operating, investing and financing. The net amount is the total decrease or increase in the cash and cash equivalents. The data recorded in the cash flow statement is totally based on the cash basis. Analysis of CFS includes looking at the cash flows from all the three activities.
Looking at the operating activities of ABC consulting LLP, it is observed that the net cash flow from them is £861 million. Though the EBIT is reduced, the working capital adjustments has generated a cash amounted to £906 million in a year. The activities have generated enough cash that ABC can easily pay off its expense related to interest and income tax. After paying all the expenses, the net cash generated is £861 million. A positive figure indicates that despite a decrease in the profit, the company has enough amounts to set off all the adjustments and expenditures. Talking about investing activities, the section shows that the entity has invested £525 million in the purchase of property, plant and equipment. Apart from this, it has not made any kind of purchases related to assets. Also, no sales proceeds were there which ultimately shows that overall net cash used in investing activities is £525 million.
As far as financing activities are concerned, they also show the net cash used in them amounting to £475 million. The activities show a payment made to the members worth £551 million during the financial year. Such payment is considered as the dividend payments to the shareholders. Company has low profitability and insufficient cash but still it has made payments to its members. The action was right as it will be beneficial for ABC LLP in future as it can retain its investors and members for longer period by paying them regular dividends. Financing activities also reflected the inflow of cash by showing an increase in the long-term loan worth £76 million. However, such inflow of cash was not enough to set against the cash used in the purchase of PPE.
As a result of which, a net cash outflow is been there from the activities. Considering the net effect of the movements of cash in the business, it is observed that ABC Company has experienced an overall reduction in its cash and cash equivalents. The cash generated from operating activities is not sufficient enough to cover the cash used in financing and investing activities. Due to such reduction, the amount of cash reduces to £75 million at the end of the year. Moreover, despite having a drop of 17.5% in average payments made to the members, ABC LLP most of the cash is utilized in making payments to its members worth £551 million which can’t be covered with the cash generated from operating activities
From the above analysis of CFS, it is concluded that the company is lacking cash in business and might become cashless in near future. Being operating in the service sector, it does not have any inventory which also leaves a significant impact on the cash position of ABC. Talking about the cash conversion cycle of the company, it is negative in both the years due to the absence of inventory days. In 2017, CCC was -41 days which reduces to -33 days in 2018. This negative figure was because of the fact that the receivable days of ABC are very much lower than the payable days. However, the days have reduced but are still in negative. In order to make it positive, ABC needs to pay its creditors earlier than its debtors since it has zero inventories in the business. Usually a positive and shorter CCC is favourable for the companies as it indicates quick acquisition of cash in the business.
While considering the margins for each segment, Australia segment has the highest gross margin of 70.57% in 2016-17 which reduces to 55.13% in 2017-18. On the other hand, the gross profit ratio for UK remains almost same. This is because of the proportionate change in total revenue and profits of the divisions. Considering the above analysis, the board should focus on making strategies related to cutting of staff costs for US and Australia divisions. Strategies focused on enhancing the revenue in same segments should also be formulated by the board.
Part-2 Investment Appraisal
Management forecast
Initially, more cash inflow was expected by the management as per its forecast but the same did not happen because of the high variable costs in initial two years.
Appraisal Techniques
Payback period
It is one of the simplest techniques of appraising an investment proposal. It basically determines the amount of time taken by the company to recover its original investment. Although the managers from non-financial background may not understand the calculation of PBP they will surely get to know about the number of years, the expansion project will be taking to recoup the initial investment (Bierman and Smidt, 2014).
Benefits
Limitations
Considering the case of ABC, the payback period calculated as per the management forecast is 2 years and 7 months. This means the time required will be more than half of the project’s whole life. It will take more than 2.5 years to return back the initial investment of £800 million. However, looking at the cash position of the company, the project will deliver a huge amount of cash in the fourth and fifth year worth £1050 million and £2010 million.
Accounting rate of return
Another capital budgeting technique which calculates the return generated from the investment’s net income. The calculated ARR is then compared with the targeted ARR of the company. If the calculated value is more than the required one then the project will be accepted, otherwise rejected (Gotze, Northcott and Schuster, 2016).
Advantages
Disadvantages
The calculated and targeted ARR of ABC consultancy is the same as 100%. This means neither it is more than the required rate nor less than it. It indicates that the project will earn the profits equal to the required rate of return. Hence, it is favourable and acceptable for the company.
Net Present Value
The cash flows calculated are discounted at the cost of capital of 15% and the value of NPV is positive and more than zero. In addition, the portion of project’s NPV against the initial outflow is 111% which clearly indicates that the investment plan will be profitable in future.
Sources of Finance
The phase two of expansion strategy deals with the extension of the business in the markets of Eastern Europe. ABC is seeking to expand its operations and for that it requires an initial investment of £500 million. However, in order to arrange such amount there are various sources of finance available to the company. The two types of sources are:
These are those, through which a company raises the finance internally. It includes issuing the share capital, the sale of assets, and use of profits, cash balance, retained earnings, reduction in working capital and many more. Since ABC has the low amount of cash which is not enough for raising the required amount. Moreover, the company’s return from its assets is also less in the year. So, it has an option of raising the fund by issuing the share capital. Improvement in the profitability ratio can help ABC to increase its share price and attract potential investors. Furthermore, the company can collect more of its debtors so that more cash can be generated in the business. Since there was no information about the payments of dividend during the year, so the expansion of the project may ask the same from the company in coming years (Barthwal, 2007).
When an entity raises funds externally like taking borrowings from banks, taking an overdraft facility, trade credits, issuing debentures and many more then it means raising funds from external sources. Concerning the external factors, the only way is to increase the long-term borrowings as the company does not have any kind of short-term debt. Moreover, it will not be appropriate for a project having a life of 5 years. In addition to this, ABC has made its interest payments timely plus the company has a low debt to equity ratio. It eventually reflects less financial risk which helps the firm in getting borrowings from the banks and other financial institutions.
Two options available with ABC LLP are issuance of shares and borrowings of long term loans. Both have some benefits and drawbacks. Issue if shares will be suitable for the company as it will increase its equity financing as well as reduces the financial risk of the company. The drawback of this source is that the company will have to distribute more of its profits among its increased investors in the form of dividends. On other hand, taking borrowings from the banks will surely results in tax relaxation as the interest paid is tax deductible expense. However, it also results in increasing the financial risks for the firm and making regular payments which ultimately hampers the cash position. So it can be decided that issuing the equity will be the suitable method for raising funds.
ABC should go ahead with the project as it proves to be beneficial in financial and non-financial terms. It has high NPV and will recover the investment earlier plus expanding in European market will help the firm to increase its revenue and profitability position.
|
Statement of profit and loss |
|||
|
2018 |
2017 |
% |
|
|
£m |
£m |
Change |
|
|
Net Revenues |
3145 |
3005 |
4,66% |
|
Operating Expenses |
2276 |
2133 |
6,70% |
|
Operating Profit |
|||
|
Finance cost |
8 |
4 |
100,00% |
|
Profit before tax |
861 |
923 |
-6% |
|
Income tax expense |
41 |
36 |
13,89% |
|
Net profit |
820 |
887 |
-7.55% |
|
Financial Ratios |
|||
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References
Baker, H. K. and English, P. (2011). Capital budgeting valuation: Financial analysis for today’s investment projects (Vol. 13). New Jersey: John Wiley and Sons.
Barthwal, R.R., (2007). Industrial Economics: an introductory textbook. 2nded, New Delhi: New Age International.
BiermanJr, H. and Smidt, S. (2014). Advanced capital budgeting: Refinements in the economic analysis of investment projects. Oxon: Routledge.
Bragg, S. M. (2012). Business ratios and formulas: a comprehensive guide (Vol. 577). New Jersy: John Wiley and Sons.
Bragg, S. M. (2012). Financial analysis: a controller’s guide. New Jersy: John Wiley and Sons.
Daunfeldt, S.O. and Hartwig, F. (2014). What determines the use of capital budgeting methods? Evidence from Swedish listed companies. Journal of Finance and Economics, 2(4), 101-112.
Gibson, C. H. (2011). Financial reporting and analysis. USA: South-Western Cengage Learning.
Godwin, N., and Alderman, C. (2012). Financial ACCT2. USA: Cengage Learning.
Gotze, U., Northcott, D. and Schuster, P. (2016). INVESTMENT APPRAISAL. (2nded.). New York: Springer.
Higgins, R. C. (2012). Analysis of financial management. New York: McGraw-Hill/Irwin.
Jenter, D. and Lewellen, K. (2015).CEO preferences and acquisitions. The Journal of Finance, 70(6), pp.2813-2852.
Kimmel, P. D., Weygandt, J. J., and Kieso, D. E. (2010). Financial accounting: tools for business decision making. New Jersey: John Wiley and Sons.
Krantz, M., and Johnson, R. R. (2014). Investment Banking for Dummies. New Jersey: John Wiley and Sons.
Lee, A. C., Lee, J. C., and Lee, C. F. (2009). Financial analysis, planning and forecasting: Theory and application. Singapore: World Scientific Publishing Co Inc.
Nikolai, L. A., Bazley, J. D., and Jones, J. P. (2009). Intermediate Accounting. USA: Cengage Learning.
Saleem, Q. and Rehman, R.U. (2011).Impacts of liquidity ratios on profitability. Interdisciplinary Journal of Research in Business, 1(7), pp.95-98.
Salunke, M., and Bagad, A. (2009). Humanities and Social Sciences. India: Technical Publications.
Shapiro, A. C. (2008). Capital budgeting and investment analysis. India: Pearson Education.
Tracy, A. (2012). Ratio analysis fundamentals: how 17 financial ratios can allow you to analyse any business on the planet. Ratio analysis. Net.
Venkatesh, M., and Gugloth, D. (2017).A Review of Capital Budgeting Techniques.International Journal of Economics and Management Studies.
Vogel, H.L. (2014). Entertainment industry economics: A guide for financial analysis. New York: Cambridge University Press.
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