In the highly uncertain and competitive market place, companies directors and managers are require to analyze the financial position and performance of the business so as to make right decisions at right time for deriving success. The present report aims at making profitability and liquidity analysis of GEC (General Electronic Company) through ratio analysis. Moreover, it will also apply modern discounted capital budgeting techniques like NPV and IRR for the project evaluation to assess viability.
1. Profitability and liquidity ratios
Ratio analysis is an strategic financial analysis (SFA) technique that indicates magnitude of relationship between two components of the financial accounts. As per the scenario, GEC Plc is a leading company that is involved in supplying electronics and engineering goods to the consumers. Its manager can examine the financial performance of the firms through interpreting various ratios. Profitability ratios are the measurement of percentage of return on total sales revenues and enable managers to determine that whether business performed well or not (Hwang and Yoon, 2012). In this, gross profit percentage is often used to measure the percentage of GP on total turnover whereas net profit percentage is used to determine the NP % on total sales revenue. On the contrary, liquidity ratios are used to quantify GEC Plc’s capability to pay suppliers and other short-term liabilities on right time. Current ratio measure relationship between current assets and current liabilities whereas quick/acid test ratio measures liquidity performance of the firm ignoring inventory balances.
2. Analysis and interpretation
Gross profit ratio: GEC’s GP ratio shows a continuous decreasing trend from 49.57% to 29.27% in the year 2016. High fluctuations in the turnover over the period due to volatile consumer demand, inflation and competitors offerings is the main reason behind decreasing net profitability. Although, cost of the goods sold shows a declined trend, still, high % fall in turnover decreased the gross profitability of the firm and indicates that GEC gained less gross return on total sales.
Net profit ratio: In2014, firm’s NP ratio got up to 10.25% indicates that company generated better return on sales, however, thereafter it dropped down to -5.23% exhibit loss due to excessive overheads because of poor control (Financial ratio of General Electronic Company, 2013). After this, in 2016, it rose up to 6.61% demonstrates thatfirm gathered high return this year on total sales revenue and indicates good performance.
Current ratio: GEC’s CR got up from 2.34:1 to 2.53:1 in 2014 due to increased inventory, receivables and other current assets, still, as the ratio is greater than the target ratio of 2:1 indicates ineffective use of CA in productive functions. However, in 2016, it came down to1.93:1 near to the standard ratio exhibits that firm strengthen their position to make deferral payments of short-term liabilities on due date.
Quick ratio: In 2016, the ratio dropped down from 2.26:1 to 1.65:1, but still, it is above the target ratio of 1:1 shows that GEC has enough or sufficient resources available to pay creditors timely without having inventory balance in the business (Provost and Fawcett, 2013).
3. Critically evaluate the use and limitations of financial ratios
Financial ratios enable GEC’s managers to determine and examine their profitability performance, as a result, managers can make smarter choices and rational decisions like cost-controlling, pricing & marketing decisions to minimize expenditures and maximize revenue results in high return. However, by evaluating the liquidity performance, directors can determine the availability of current assets in comparison to the short-term obligations and manage resources optimally for making payment to the suppliers and manage liquidity.
Change in the accounting policies, rules & regulations over the year may mislead the results derived through ratio analysis. Moreover, incorrect figures reported in the final accounts also provide misleading interpretation and leads to take inappropriate decisions (Newell, Lagnado and Shanks, 2015). Further, it is based on historical analysis and numerical values, and does not provide any assistance to examine and evaluate the qualitative performance of the business.
To: BOD, SIG Plc
From: Financial controller
Date: 7thMarch 2019
Subject: Investment appraisal and challenges in merger and acquisition
SIG Plc is a leading supplier of special building products in Europe and in the current market, there are two investment opportunities is considering by the firm for the investment in SIG interior and acquisition purpose. The projected life time of the project is expected to 5 year at an initial investment of £7,000,000. Investment appraisal techniques are the best way that suggest investor whether to invest money or not to get an enough or adequate amount of return over the cost of capital.
Discounted cash flow techniques of capital budgeting focuses on discounting the expected cash flows of the project at an appropriate rate and thereafter determine the current value of cash flows. NPV exhibits the excess of present value of cash inflows over beginning outlay, and positive as well as high value of NPV is always considered best for the SIG Plc (Chauhan and Vaish, 2012). However, uncertainty regarding inflation and interest that gives rises to the cost of capital is the main risk associated with NPV. With regards to the stated project, NPV has been computed here at 10% discounting rate in Appendix 2.
NPV @ 10% (000) = £718.28
NPV @20% (000) = -£1029.64
Calculation of IRR
IRR quantify the discounting rate which equates the PV of cash inflow and outflow at zero NPV, computed here as follows:
IRR= Lower discount rate + NPV at lower rate/NPV at lower rate – NPV at discount rate*(High rate-lower rate)
= 10% + (£718.27)/( £718.27 - -£1029.64)*(20%-10%)
= 10% + (£718.27 / £1747.92)*10%
= 10% + 4%
Finding the result of the capital budgeting, it can be suggested to the board members to invest money in the project. It is because, as per the selection criteria of NPV, the project indicates favourable return worth £718.28, thus, it will drive positive return to the company. Moreover, project’s IRR is also greater from cost of capital of 10% to 14%, therefore, it recommend business to put their money in the existing investment opportunity for SIG interior to earn return.
Appraising the financing section
There are various sources through which SIG Plc can gather required amount of capital for the investment purpose such as fixed source of capital and fluctuating source of capital, under the first, SIG’s directors has to bear fixed financial burden whilst under the fluctuating, cost of capital do not remain fixed. For instance, if company take long-term borrowings from the bank, then it will have to pay fixed amount of interest as a financial cost to the lender (Cabral, Grilo and Cruz-Machado, 2012). Moreover, it can also issue preferences shares for the monetary collection and have to pay a fixed rate of dividend to the shareholders. However, if it issue more equity (ordinary) shares then, it will not be necessary for the SIG Plc to pay fixed dividend to the proprietors as it is a kind of fluctuating capital and on this, dividend decisions are taken by the firm considering the business profitability.
Critically analysing the challenges in M&A
SIG’s BOD are considering to acquire Bristol company at a transaction value of£20m, but the directors are concerning about its financing and potential risk & challenges. Acquisition refers to the process of getting ownership rights in another organization. In the given scenario, it is clearly stated that SIG Plc’s managers are looking to acquire Bristol company. Although, M&A corporate strategy helps firm to expand their operations, generate larger revenue and high market share, still, there are number of difficulties faced by entrepreneurs in M&A. For instance, if both the acquiring and acquisition companies are located in two different countries, then it gives rises to the cultural challenges in M&A procedure. Moreover, employee retention is also a challenge exists at the time of M&A. Inherently, at the time of acquisition, companies often face threatening situation to retain their workforce in the organization because Bristol’s employees have negative perception and belief towards organization’s stability and as a result, they can decide to leave the job. It also arise challenges for the SIG. For instance, if Bristol employees require easy access to upper level managers, flexible working practices and others and new management removes it, then workers will be adversely affected results in shrinking productivity to a great extent (Jemison and Sitkin 2013). In merger, company can pay larger focus to the integration and cost-cutting and avoid daily functioning results in loss of revenue. With this, M&A strategy may fail to create significant value for the shareholder.
Further, in the current age of globalization, the introduction of advanced and new technologies leads to increase market uncertainty and create obstacles in M&A procedure. In addition to this, in order to cope up with the M&A, SIG’s directors and managers requires too much time, as a result, there is a risk that they can neglect their core business functioning. Although, there are number of challenges, still, it provides benefits of size and global reach to the SIG through the acquisition of Bristol. It helps to strengthen the competitive position through squeezing greater efficiency; as a result, it can defeat rival firms.
Above project report concluded that GEC’s profitability performance and liquidity position is strong indicates that it is generating good return on their total sales and capable to pay suppliers on right time. Lastly, report founded that at 10% discounting rate, SIG Plc’s proposed project will bring positive return and its IRR is also higher to 14% hence, it is a viable investment opportunity.
Books and Journals
- Cabral, I., Grilo, A. and Cruz-Machado, V., 2012. A decision-making model for lean, agile, resilient and green supply chain management. International Journal of Production Research. 50(17). pp. 4830-4845.
- Chauhan, A. and Vaish, R., 2012. Magnetic material selection using multiple attribute decision making approach. Materials & Design.36. pp. 1-5.
- Hwang, C. L. and Yoon, K., 2012. Multiple attribute decision making: methods and applications a state-of-the-art survey. Springer Science & Business Media.
- Newell, B. R., Lagnado, D. A. and Shanks, D. R., 2015. Straight choices: The psychology of decision making. Psychology Press.
- Provost, F. and Fawcett, T., 2013. Data science and its relationship to big data and data-driven decision making. Big Data. 1(1). pp. 51-59.