Financial Ratio Analysis, Interest And Dividend Coverage, Debt To Equity Ratio

Profitability Ratios

In accordance with Bratton and Gold (2017), profitability ratios refer to a class of financial metrics which are utilised to evaluate the capability of the organisation of producing income comparative to its related expenditure. Profitability ratios include mainly profit margins and return on assets.

Table 1: Table of Profitability Ratios

Profitability			2016	2015 Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	2014	2013	2012
Margin	Trading Profit	%	7.8	7.5	7	7.2	7.3
Sales
Return on assets	Trading Profit	%	16.3	17.6	16.2	18.2	18.3
Net operating assets

In order to evaluate the productivity of the firm at different cost levels, profit margins are utilised comprising gross margin, operating margin, pre-tax margin as well as net profit margin. Further, as per study of Clegg, Kornberger and Pitsis (2015), the margin shrinks as layers of additional costs are considered for example cost of goods sold, operating and non-operating expenditures along with taxes paid. Thus, in the present case, as the margin percentage is increasing on a continuous basis, it can be assessed that the appropriate level of additional cost exists in the company.  The profit margin of Outdoor Plc. is boosting which implies that the company is operating in an efficient manner due to which level of the profit is increasing.

Profitability is evaluated in relation to costs and expenditures, and it is assessed in comparison to assets in order to measure the effectiveness of an organisation under deploying assets to produce sales and ultimately incomes. Further, Brigham and Ehrhardt, (2013), specifies that the word return under ROA implies net profit that is the amount of income earned from sales after including all costs, interest as well as expenditures. It is considered that the increase in assets will lead to an increase in sales which in turn results in enhanced profits. In the present case also the there is an increase in assets which leads to enhanced sales and amplified profits. Moreover, ROA of Outdoor Plc of every year is positive which implies upward profit trend that is the profit of the company keeps on increasing. The fact cannot be denied that the company is having a positive return on assets, though it is fluctuated and not sustainable. Thus, the company requires investigating this area in detail in order to apply assets more effectively.

Table 2 Table of Interest and Dividend Coverage Ratios

Interest and Dividend coverage		2016	2015	2014	2013	2012
Interest coverage Ratio	Trading Profit	times	2.9	4.8	5.1	6.5	3.6
Net finance charges
Dividend cover	Earnings per Ordinary share	times	2.7	2.6	2.1	2.5	3.1
Dividend per Ordinary share

According to DeFusco and co-authors (2015), interest coverage ratio (ICR) can be defined as a ratio which measures the capacity of the company for making interest payments on its debt on time. In addition to this, interpreting interest coverage ratio is quite complex since it greatly relies on the extent of risk the creditor or investor is ready to bear (Diamond and Kashyap, 2016). ICR equivalent to 1 indicates that the income earned by the company is only enough to pay its interest. If the company has ICR more than 1, it implies that the firm has earned more than sufficient profit to pay its interest liabilities along with some residual income so that the principal payments can be made. The ICR of Outdoor Plc. is more than 1 signifying that the profit earned by it is more than sufficient to pay its liabilities and there is some residual income also. But the same having decreasing trend which indicates that company requires improving the ratio through enhancing profit for increasing the ratio since the investors’ desires to invest their funds in that organisation only which provides good financial security along with the returns to its investor.

Interest coverage Ratio

Dividend coverage ratio indicates how many times the company is able to give the dividend to its shareholders from revenues generated in the financial year (Grant, 2016). Furthermore, the dividend coverage ratio of less than 1.5 implies that the company is unable to maintain the current level of dividends in case of unpleasant variation in income in future. The dividend coverage ratio of the company in the present case is more than 1.5 in every year, implying that it has the capacity of paying a dividend even at the time when less profit is earned in future.

Table 3 Table of Debt to Equity Ratio

Debt to Equity Ratio			2016	2015	2014	2013	2012
	Net borrowings	%	65.9	61.3	48.3	10.8	36.5
	Shareholders’ funds

It is stated by Lasserre (2017), that, debt to equity ratio refers to the ratio which contrasts total debt to total equity of the firm. This ratio shows the percentage of organisation financing which arrives from creditors and investors. Debt source of finance is more costly in comparison to equity financing. Moreover, lower debt to equity ratio indicates that the firm is financially stable and vice-versa. The percentage of debt to equity ratio in the current case is continuously increasing which implies that the company has financed its operations with more of debt in comparison to equity. Such type of enhancement is considered riskier. It is recommended to consider by Outdoor Plc. that unlike equity financing, debt should be refurbished to the lender. As debt financing also obliges debt servicing or regular payment. Furthermore, the company with excessive debt will not be able of paying its obligations.

Liquidity ratios can be defined as a class of financial metrics which is utilised to assess the capability of the debtor to pay off current debt liabilities, not with increasing external capital.

Table 4 Table of Liquidity Ratios

Liquidity Ratios			2016	2015	2014	2013	2012
Quick ratio	Current assets less stock	%	0.74:1	0.73:1	0.78:1	1.13:1	0.93:
Current liabilities
Current ratio	Current assets	%	1.34:1	1.30:1	1.42:1	1.79:1	1.75:1
Current liabilities

Quick Ratio

According to McLaney and Atrill (2014), the quick ratio indicates the short-term liability position of the company as well as evaluates the capability of the firm to pay off its short-term liabilities with its liquid assets. Along with this, it indicates the amount of cash as well as other assets which are readily translatable into cash in contrast to short-term liabilities of the firm. The ratio with less than 1 implies that the company is unable to its short-term obligations. Further, the same can be observed in the present case that is the quick ratio of the company is higher than 1 in the year 2013 only, indicating that it is not able of paying off its short-term liabilities completely.  

Dividend cover

Current Ratio

The current ratio is utilised to assess short-term liquidity position of the organisation. Moreover, with accordance to Ehiedu (2014), the reason behind naming this ratio as current is, not like other liquidity ratios, it integrates all current assets as well as liabilities. The current ratio is also referred to as a working capital ratio. Along with this, it also gives a quantitative connection between current assets and current liabilities of the firm (Pearson 2016). The current ratio of Outdoor Plc. is more than 1 which indicates that the firm is a desirable situation to pay off its short-term obligations. The same implies that the company has a sufficient amount to pay its short-term liabilities. The company is suggested to improve the efficiency of management so that the income can be increased and liabilities can be decreased.

Asset turnover ratio refers to an efficiency ratio which evaluates the capacity of the firm of producing sales from its assets through contrasting net sales with average total assets.

Table 5 Table of Assets Ratios

Asset ratios			2016	2015	2014	2013	2012
Operating asset turnover	Sales	times	2.1	2.4	2.3	2.5	2.5
Net operating assets
Working capital turnover	Sales	times	8.6	8	7	7.4	6.2
Working capital

Operating Asset Turnover

It is a ratio which shows a number of times operating assess is turnover in the year. Sweeting (2017), asserts that this ratio is also known as operating current assets turnover ratio. The operating turnover ratio of the present company is constantly decreasing which implies inefficient utilisation of funds invested in current assets. Furthermore, retaining an appropriate level of operating assets corresponding to the firm’s turnover is very significant.

Working Capital Turnover

Vernimmen, et al., (2014), asserts that this ratio estimates the efficiency level of the organisation regarding utilisation of working capital to promote a specified level of sales. It is also called as a net sale to working capital; it demonstrates the relationship among funds utilised to finance the functions of firm and as a result the profit generated by it. The working capital turnover ratio in the present case has increased in every year, implying that administration is very effective in utilising firm’s short-term assets and liabilities for promoting sales.

Table 1 calculation of NPV of project A     (Amount in £’000)

Year	Cash Flows	PVF @ 8%	Present value of cash flow
0	-750	1	-750
1	400	0.926	370.4
2	500	0.857	428.5
3	500	0.794	397
4	500	0.735	367.5
		NPV	813.4

Table 2 calculation of NPV of project B            (Amount in £’000)

Year	Cash Flows	PVF @ 8%	Present value of cash flow
0	-1200	1	-1200
1	500	0.926	463
2	600	0.857	514.2
3	800	0.794	635.2
4	1000	0.735	735
		NPV	1147.4

Table 3 calculation of NPV of project C               (Amount in £’000)

Year	Cash Flows	PVF @ 8%	Present value of cash flow
0	-2000	1	-2000
1	500	0.923	463
2	1000	0.857	857
3	1500	0.794	1191
4	1500	0.735	1102.5
		NPV	1613.5

In the given study, Net present value method is used for the purpose of analysing the best investment.  The positive net present value shows that the earnings generated by the investment are more than the expenditure (Almazan, Chen, and Titman, 2017). On the basis of the above analysis, it has been seen that all the projects have positive NPV, but the investor by investing in project C can achieve the maximum return. Therefore it is recommended that an initial investment of £ 2000,000 is beneficial for the investor so that the return can be maximized.

0 = (2000000) + 500/ (1+IRR) + 1000/ (1+IRR) ²+1500/ (1+IRR) ³ +1500/ (1+IRR)

= 34.484%

The process of selection of the investment is not an easy task; it requires too much analysis and method to ascertain whether the investment can generate the required return in the future. There are several techniques available for the selection of the best investment from the various investment projects such as profitability index, internal rate of return, payback period method and so on; however the Net Present Value Method is considered as the best investment appraisal technique for identifying the optimal investment (Chittenden and Derregia, 2015).

Net present value method assist in determining the present value of cash flows on the basis of the rate of return which can be generated from the best alternative investment and along with this, it also helps in finding out the value which will be achieved by the shareholders if the project is selected (Malenko, 2018).

Net present value method is a better method as compared with the internal rate of return method since the internal rate of return ascertains the rate of return which can be generated from the investment. It does not take into account the required and expected rate of return by the investor (Patrick, and French, 2016). The further internal rate of return it is assumed that the discounting of the cash flow and the reinvestment rate is same; however in a practical situation, this presumption is not suitable (Ng, and Beruvides, 2015). On the other hand, Net present value method assumed the market rate as a rate of borrowing as well as the rate of lending, which is practically possible in the market scenario (Johnson, Pfeiffer, and Schneider, 2017).

Further, as compared with the payback period and the net present value method, the net present value method is more preferable because the payback period ignores the time value of money concept, which is very important for analysing the optimal investment by the investor. With this regards, the net present value considers the time value of money concept, and it takes into account all the cash flow from starting when the project is taken to end of the life of the project (Lee, and Lee, 2015).

Moreover, the profitability index calculates the ratio of present value of cash flow with the initial investment. Therefore there are chances that the different project may have the same profitability index, even if the difference in the cash flows and initial investment. This type of situation does not arise into the net present value method (Hopkinson, 2017).

On the basis of the above analysis, it has been seen that different types of problem contain in different methods of capital budgeting. However, the net present value method is very simple for identifying, analysing and evaluating the significant proposals of investment (Benamraoui, & et al. 2017). Along with this, the NPV method also considers the present value and time value of money concept at the time of evaluation of the project. Therefore it can be said that the net present value method is the best investment appraisal technique among the other technique.

In the capital budgeting, there are different methods for evaluation of the optimal investment. In this aspect, a non-discounting method is considered as the traditional methods of investment appraisal. The non–discounting methods differ from the discounting method with respect to the time value of money. In layman language, it can be said the non-discounting method does not consider the impact of the time value of money at the time of evaluating the proposals of investment. Payback period method and the accounting rate of return method are the non-discounting methods of capital budgeting (Harrison and Lock, 2017).

By applying the payback period method, the investor could ascertain about the period in which the initial investment can be recovered. This method is totally based on the inflows from the investment, life of the projects and initial investment. The selection of the offer by the payback period depends on the revenue generation capacity of the project. Moreover, this method gives the main emphasis on the risk factor, as it is concentrated on the recovery of the initial expenditure by the investor (Kashyap, 2017). Therefore for measuring the relative risk from the proposals, this method is the very good technique of investment appraisal. This method is a very simple and effective tool for the selection and rejection of any project; therefore it is still a popular method for analyzing the capital budgeting projects.

The accounting rate of return method determines the rate of return generated from the investment. The manager of the company after setting out the minimum required rate of return from the investment can compare with the accounting rate of return; by this, they can ascertain whether the investment in the particular project will generate the minimum rate of return (Richard, 2014). Along with this, if the criteria for the required rate of return are not fulfilled, then the investor will not go ahead for investing in that project. This method considers the total net earnings over the entire economic life of the project, which shows the perfect portrait of the viability of the project (Li, 2015).

On the basis of the above analysis, it has been constructed that the non-discounted method of capital budgeting is the easy and simple tool for evaluating the proposal of the investment. Therefore it is very popular among the decision making for analyzing the investment appraisal.

There are several factors which lead to influencing the investment decision. It is related with the question whether the expenditure will add value to the wealth of the investor. With this regards, the estimation of the capital expenditure and related future earning by considering the market scenario is a very important factor. Before the investment decision made, the investor should evaluate items of the cost such as the cost of acquiring the plant and machinery, cost of construction, advance expenditure and many another cost. After estimating the cost, the probable inflows generated by the investment should be taken into account. Apart from the cost and inflows, the investor should also consider the tax benefit availed on the investment (Belfield, & et al. 2015). Tax concessions allowed by the government significantly impacts the investment decision. Further, the strategy of the competitors also affects the capital budgeting decision. If the competitor of the company continues by installing the new plant and machinery capturing the market, then it became very risky for the company for not to adopt the new techniques (DeFusco, & et al. 2015).  The technological change in the market also leads to an impact on the investment decision. The manager should analyze the current capital equipment in the company and determines the requirement of installation of the new equipment. Installing the new equipment is a major change in the existing process, therefore before taking any decision the replacement of old machinery, salvage value of old machinery, cost of new machinery and so many other aspects should be evaluated by the management of the company. Moreover, the investment decision also affected by the prediction of the short run as well as the long run market factors (Costanza & et al. 2014).

The availability of the fund is another factor which should be considered before taking any investment decision. By preparing the cash flow, the inflows and outflows can be determined, by which the company can ascertain about the requirement of the fund and availability of the fund. If the investment is financed from the outsiders then the rate of interest on the borrowing also an important factor to be considered (Sari and Kuchta, 2015).  As the higher interest rate leads to more outflow on the investment. The prediction of the demand also helps in the investment decision. If in the future the demand of the product will fall then it is not good to make the capital investment. On the other hand, if it has been predicted that in the future the demand will significantly rise, then the company should enhance its investment.  Further, in the long run, the inflation rate also influences the investment decision, as if the inflation rate is high and not stable then it is very difficult to ascertain the cost of investment. Further high inflation rate also leads to a reduction in economic growth (Maroušek & et.al 2015).

 Above analysis suggests that the investment decision influenced by the various factors, therefore before making the investment decision all the above factors must be considered by the investor.

The given situation is related to the concept of the capital rationing. Capital rationing is a condition, where due to the limitation of the funds, the investor unable to invest in all the projects even if the project has positive Net Present Value (Johnson, and Pfeiffer, 2016). Therefore by implementing the capital rationing methodology, the investor is forced for rejection of a profitable project due to the shortage of funds. In other words, it can be said that capital rationing refers as an evaluation of the profitable projects and selection of the one or more than one projects from the given profitable projects (GU, & et al. 2015). The selection of one or more than one project is based on whether the projects are divisible or indivisible. In the case of the divisible project, the investor can invest in part of the investment, however, the in case of the indivisible project the investor has to either invest fully in the project or reject the project.

The given study is related to the capital rationing because the investor has the limitation of the funds of £ 25, 00,000. It has been stated that the projects are divisible; therefore the investor can invest in the part of the project also, from the given projects.

Table 4 statement showing the ranking of projects as per their profitability index            

(Amount in £’000)

Project	Initial Investment	The present value of annual cash flow	Profitability Index	Rank
A	750	1562.2	2.082	I
B	1200	2345.9	1.955	II
C	2000	3612	1.806	III

*Profitability Index = present value of annual cash flow/ Initial investment

Table 5 determination of the optimal combination of projects  

(Amount in £’000)

Rank	Project	Initial investment	Cumulative investment
I	A	750	750
II	B	1200	1950
III	C	550	2500

On the basis of the above calculation, it has been analyzed that the company cannot invest in all three projects because of the shortage of funds. Since the projects are divisible therefore by applying the capital rationing technique; it has been observed that investor can invest only £550 in project C as the limitation of the funds amounted £ 25, 00,000. Therefore the optimal investment of projects is projected A, B and 27.5% of project C.

Sources of finance refer to the financing capability of the company for its business operation. For the working capital requirement and for capital expenditure business is in continuous need of finance. There are several sources of finance such as debt, equity, government grants, term loans, borrowing, and many others by which the company can avail the funds (Baños-Caballero, García-Teruel, and Martínez-Solano, 2016.).

In the present study, the Board of Outdoor Plc. for the investment program can raise the fund from internally as well from the external source of finance.  

In situation where the company raises funds internally with diluting its ownership, then it is referred to as the internal source of finance. It is also known as equity financing.  The retained earnings, convertible debentures, issue of preference shares, issue of equity shares, private equity, and venture capital are some types of the internal source of finance (Baños-Caballero, García-Teruel, and Martínez-Solano, 2014).

The profits of the company are not sufficient or shortage of funds or the investment, then by issuing the shares to the public the company can get the funds. In the equity source of finance, the ownership of the company gets diluted as the company sells its shares. Further, the angel investors are the main source of financing the internal source of finance. Angel investors are those people who invest in the company with the prediction of achieving the higher rate of return. Along with this, these types of investors also put their knowledge, experience and talent, which is very beneficial for the long run of the company. The company can also by issuing the right shares to the existing shareholders can internally raise the fund (Drover & et al. 2017).

There are many benefits from raising funds through the equity source of finance. In this, there is no requirement of the repayment and the payment of interest. The company can control its financial leverage ratio by equity financing.  It is considered as the long-term capital which stays permanently in the company. The risk of the insolvency also gets reduced through the equity financing. The most attractive part of this type of financing is that the business grows itself as it does not require the borrowing from the outsiders (Ahlers & et al. 2015).

However, availing the funds through the equity financing requires the payment of dividend out of the profit earned. Along with this, the existing shareholder’s control gets diluted because of the new shareholders are introduced. Moreover, it is very costly to raise funds through the owned capital. The dividend is not tax deductible, therefore, the benefit of tax deduction on the payment of dividend is also not availed by the company (Nassr, and Wehinger, 2016).

When the company raises funds through the outsiders for financing its operation, then it is known as the financing through the borrowed capital. Borrowing through the banks, financial institution or by issuing the debenture to the general public are some types of financing through the borrowing capital.  In this, the company borrows funds at the fixed rate or at a floating rate from the outsiders. Borrowings through the bank or financial institution are a popular type of financing. In some cases, the company has to keep its asset as a security to the bank. In the case of liquidation of the company, the lender by selling of the asset can get the payment. The company avail the short term, medium term or the long-term loan as per their requirement (Ozkan, and Trzeciakiewicz, 2015).  The borrower has to pay the interest and the instalment amount regularly to the lender.  For the large size of business, which required the funds for a longer period of time than raising funds through issuing the debenture is also a good financing source.

The main advantage of this type of borrowing is that the ownership remains with the existing shareholders only by the payment of interest and the instalment the company can raise funds. Moreover, the payment of interest is tax deductible; therefore the tax advantage also can avail by the borrower and which leads to a reduction in the net obligation (Scheuering, 2014). The lender does not make any participation in the business decision as they do not have any right of discussion with the management. It also gives the leverage benefit to the company. Along with this, financing through the borrowed fund is less expensive as compared with the owned funds.

Apart from the above advantages, there are some disadvantages also since the borrowing through outsiders requires the timely payment of the interest and the repayment of principal. If any delay in the payment, then this may lead to the significant penalty to the company, therefore before taking the loan from the banks, the owner must certain about the cash generation for the timely repayment. Moreover getting funds through the banks requires the good credit rating and credit worthiness. Therefore, it is not easy to avail the funds from the outsiders.

On the basis of the above analysis, it has been concluded that the company named as Outdoor Plc., can make the investment either by financing through the owned capital or by the borrowed capital. Both sources of finance has its own advantages and disadvantages which already prescribed above.

 The Outdoor Plc., company is large in size and has good earnings. Therefore it is recommended that the company by using the owned funds should invest in the investment program. With the owned capital source of finance, the requirement of the repayment of the funds does not arise, and also the funds can be retained by the company for long-term period.

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