Critical Analysis Of Profitability And Risk Ratios For Investing In MDM PLC

Relevant Profitability Ratios

Write an essay about the  “sustaining organizational performance”.
 

Organizational ability to deliver quality products and/or services to its customers determines its long-term success (Owen et al., 2001). Operational management is a key practice in an organization, which reflects performing and administering business practices to ensure overall efficiency to the maximum possible extent.  It ensures the use of materials and skills of professionals to develop products and/or services and maximize profitability. The organization attempts to ensure balance in terms of managing its cost and incomes to ascertain sustainability in its operations with optimal utilization of resources, workforce, materials and technologies among other organizational attributes (Lewis, 2003). Various functions are involved in the business and each business has its different functional responsibilities, which certainly influences its overall operations. For instance, marketing department of the organization is responsible for determining customers’ demand, promoting sales and designing effective communication. On the other hand, finance department manages the operations related with management of budget, cash flow and investment of funds (Kosan, 2014; Merton and Bodie, 2005). Operational management works as a process to ensure conduct of all the functioning department of the business in a lean and sustainable manner (Al-Ashaab et al., 2016; Saunders et al., 2014).    

Contextually, the paper intends to discuss critically about the relevant profitability and risk ratios that a client needs to consider while investing in MDM PLC and review possible mechanisms for financing a project. 

Analysis of the financial perspectives and performances are integral aspects that investors need to consider while investing their fund in any business. In this context, review of profitability position of the business is one of the key approaches that investors need to consider in their investment decision, as it allows gaining better understanding about the manner in which a business is making money and its financial stability in the industry (Tugas, 2012). The profitability ratios provide overview to the investors regarding the strengths and weaknesses of the company, which also supports to convert its operational effectiveness into profitability (Khan and Dalabeeh, 2013). The investors while investing in MDM PLC can make use of the following ratios to determine profitability of the business: 

The ROA is determined through net income earned by the company divided with the average of total assets in the financial year. The ratio calculation will help the investor to evaluate the manner in which MDM PLC makes utilization of its assets to generate income. Higher the ROA of MDM PLC, more effective will be the performance of assets of the company that represent greater efficiency of the management to replace the non-performing assets.  The net assets position of MDM PLC will includes valuation of liabilities and equities of the investor. Thus, the ratio provides better evaluation of the manner in which the business utilizes investors’ funds to generate income (Kabajeh, et al., 2012).

ROA = Net Income / Average Total Assets

Source: (Kabajeh, et al., 2012)

ROE of MDM PLC is another profitability analysis mechanism, which is calculated from net income evaluation with respect to average of the stakeholders’ equity in the business. The ratio indicates effectiveness of MDM PLC in rewarding its investors by utilizing funds to generate profits. To evaluate the investor’s repertoire valuation, ROE is highly effective. The ratio reflects earning performance of MDM PLC and effectiveness of investors’ funds utilization. ROE is an important indicator that determines whether MDM PLC is performing its operations in a lean manner. Better ROE signifies that MDM PLC can provide substantial amount of returns to investors (Rekhi, 2016).

Inter-linkage between Profitability Ratios

ROE = Net Income / Average of the stakeholders’ equity

Source: (Rekhi, 2016)

In profitability analysis of MDM PLC, profit margin proves as an important aspect, which indicates the amount of profits in the sales of the company within a financial year. The evaluation of this ratio depicts the manner in which MDM PLC is able to utilize its working capital, as share of profit deducts the cost required for generating the sales revenue, all the administration costs and taxable expenses. Profit margin ratio of MDM PLC implies the efficiency to convert its sales revenues into profitability. Superior position of MDM PLC with respect to profit margin ratio reflects effective cost controlling mechanism adopted to generate net income (Gibson, 2012).

Profit Margin = Net Profit / Sales

Source: (Gibson, 2012)

Case	Ratios	Implication
1	ROA increase	Profit Margin increase	Able to improve business performance by generating high revenues
2	Profit Margin decrease	ROE increase	Equity investment of the company decreases
3	ROE increase	ROA decrease	Increase in profitability and additional investment in assets

Investor must analyze the riskiness to evaluate the success of investment, as higher the risk in investment will create loss. To appraise the financial health of MDM PLC, the investors can make use of various risk analysis ratios including Debt-to-Capital, Debt-to-Equity and Interest Coverage. These ratios assist the investor to measure capital structure of MDM PLC and risk level with respect to its debts. To ensure financial soundness as well as ability to maintain operating effectiveness, MDM PLC needs to manage its debt share in an effective manner (Damodaran, 2002). The ratios that investor must consider to determine riskiness in investing at MDM PLC is as follows:   

The D/C ratio is a measure to evaluate the solvency position of MDM PLC by determining the share of interest-bearing debts in the overall capital employed by the company. Higher debts will increase the possibility of solvency due to high obligation of interest payment. Determination of the ratio would be advantageous for the investor, as it allows figuring out the riskiness in investment. If based on the analysis, investor founds high D/C, it indicates that majority of MDM PLC finance is generated from debts. High D/C reflects investors have low trust on the operations of the business and to meet its financial obligations, major portion of capital is from borrowing, which includes repayment obligations (Damodaran, 2002).   

Debt-to-Capital = Total Debts / Shareholder’s Equity + Total Debts

Source: (Damodaran, 2002)

D/E is another mechanism for evaluation of riskiness by comparing debt and equity position. The ratio works as a tool to reflecting the ability to meet the debt obligations. If MDM PLC identified to have low D/E it will indicates superior equity position and facilitates the business to deal with revenue downturns and meet the need to additional capitals. On the other hand, high D/E creates difficulty to MDM PLC in gathering additional capital from the market. MDM PLC with high D/E suggests aggressive financing approach of the business by increasing debts. This perspective is likely to unstable the earnings of investors, as the company needs to bear high interest expenses (Trahair, 2012).        

Debt-to-Equity = Total Debts / Equity

Source: (Trahair, 2012)

The interest coverage ratio reflects the abilities of MDM PLC to manage its financing expenses, which are short-term. The ratio indicates that whether the company can easily payoff the interest expenses, which are outstanding on debts. It can be determined from Earnings before Interest and Taxes (EBIT) divided by interest bearing expenses. The measure is integral aspect in evaluation of riskiness, as if MDM PLC does not able to meet its obligations, than there is high possibility of solvency. Low ratio represents the adverse scenario of financial hardship for MDM PLC in future (Weil, et al, 2013).

Relevant Risk Ratios

Interest Coverage = EBIT / Interest Expenses

Source: (Weil, et al, 2013)

Case	Ratios	Implication
1	D/C decrease	D/E decrease	Increase in equity investment
2	D/C decrease	High interest coverage	Profitability of the company improve due to lowering of debts
3	High interest coverage	D/E increase	The company able to increase its earning with increase in debts

Finance is integral in conduct any capital concentrated projects. Proper financing enable smooth functioning of activities and completes the project within its stipulated timeframe. Lack of funding remains one of the major responsible factors in creating lag in the project and adversely impact on its sustainability (Yescombe, 2002). In similar note, MDM PLC consideration over undertaking a project, which is expected to cost around €200 million, must ensure free flow of capitals to meet its current obligations. To carry out the project, huge working capital will be required that can only be met with the availability of required funds. The source through which the company would be able to finance this project can be internal or external. Internal source of funding include availability of cash with the company in form of reserves (Yescombe, 2002). MDM PLC can possibly utilize different mechanisms or methods to finance this project, which is categorized into two different methods, i.e. equity and/or debts. Each of the method involves different approaches that has its own advantages and risk involvement.

Issuing of common stocks can be one of the integral forms of raising finance from the market for the project. It is advantageous, as it does not involve any legal obligations. The mechanism will improvise and enrich credit worthiness, which will allow the business to conduct the operations smoothly and generate high revenues. Considering investors perspective, the approach facilitates them with the opportunity to earn high returns. Investors are also able to participate in management and controlling the operations of the business with having voting rights. Moreover, MDM PLC can gain the opportunity related to ease of marketability by raising fund through common stocks in comparison to other financing mechanisms. Another form of equity financing for the company can be the preference share issue (Welfens and Ryan, 2011). This mechanism protects the company to control power dilution by limited rights to investors. Such financing involve call provision, which significantly develop flexibility in the company’s capital structure. For the company, utilization of this mode of financing will be comparatively less risky over debt financing. The investors who fund the company can secure fixed revenue generation in the form of dividends (Welfens and Ryan, 2011).   

Bond financing will act as a flexible mechanism for MDM PLC to raise finance for the project. The investors of the funds are entitled to earn interest income against their investment. The fixed income for the investors will provide security against the fluctuating interest rates and economic alterations. The company can be benefited with the utilization of this mode of financing, as it allows them to retain high cash into business and operate the activities of the project in an effective manner. Besides, this approach of financing facilitates the company to lower tax obligations, as expenses are deductable. The company will be able to operate based on its planning, as investors will not have any decision-making role (Welfens and Ryan, 2011).  The bonds can have different attributes, as it may have the obligation of fixed interest, zero coupon, convertible bonds and floating rates. Each type of bonds investment will provide significant advantages to both the investors and the company. For instance, Zero Coupon Bond does not allow the investors with regular fixed rate of income in the form of interest, but entitled to earn high capital gains. Such bonds are issued at lower prices and redeemed at its par value. In addition, convertible bonds provide investors to enjoy the privilege of both equity and debt investment (Welfens and Ryan, 2011).  

Borrowing finance in the form of loan can also be another alternative to avail funds for the project. The borrowed loan by the company from investors or financial institution will be subjected to secure with mortgage property. The loan amount that the company will borrow will involve cost, which holds obligations of interest payment in the predetermined or floating rate. The approach of raising the requirement of finance for the project will be advantageous for the company to lower taxable expenses. As the interest that will be paid by the company for the loan is likely to be deductable from the company’s profit margin, which would lower the taxable liabilities (Welfens and Ryan, 2011). There are different forms of loans that the company can use including term loan and bank overdraft. The term loan mode of financing will provide privilege to the company to lower the cost involvement in raising the finance, as cost involves is comparably lower to equity financing. The approach also provides flexibility of operations to the company, as it will not dilute company’s control over the business process. Besides, the investor will have low risk, as finance will be backed by security(s) of the company. The company has the advantage of determining the maturity period of the loan based on requirement of the fund, as it will have flexibility of negotiation loan terms (Welfens and Ryan, 2011).

Conclusion    

It can be concluded based on the above discussion that for investors it is integral to analyze the profitability position of the business before their investment. Profitability analysis can be done through utilization of various ratios including ROA, ROE and profit margin. These ratios will reflect the financial strength of the company and manner in which it can utilize funds to generate profits. The ratio analyses the effectiveness of the company and future prospects for rewarding investors with generation of high profitability. Along with the evaluation of profitability, determination of riskiness is also important factor for the investor, which will provide outlook of the uncertainty attached with fund allocation. The ratio that investor can consider include D/C, D/E and Interest Coverage ratios. Additionally, to meet the requirements of funds for the project, the company can make use different sources, which include Equity, Debt and Loan financing.

References

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