The most obvious aspect and the factor that is most effectively recognized in analysis of a company performance analysis is ratio analysis. It is a standard for investors in determining whether to invest in a company or not. This report is prepared for the same and is recommending that Piggle is a good investment or not.
Short Term Liquidity
Short term liquidity position of two companies has been analyzed using current and quick ratios. The current ratios of the two companies are 1.8:1 for Iggle and 2.9:1 for Piggle. This implies that Piggle is more stable than Iggle in meeting short term obligations. This is due to high investment in debt securities and decrease in accrual expenses. The acid test ratio of the two companies also depicts the same picture. Overall short term liquidity as shown by current and acid test ratio is favorable to Piggle as compared to Iggle. The quick ratio measures the immediate ability to pay financial obligations. Inventories are normally the least liquid of a firm’s current assets, which is why they are the current assets on which losses are most likely to occur in a bankruptcy (White, Sondhi and Fried 1997). The current ratio from the perspective of a shareholder is that a high current ratio could mean that the company has a lot of money tied up in nonproductive assets or perhaps it is due to large inventory holdings, which might well become obsolete before they can be sold (Siciliano 2003). This is why shareholders might not want a high current ratio. Thus, in a worst case scenario, a company should have just enough resources that could have been liquidated to cover short-term obligations (Brigham and Daves 2010). Still, before concluding that Piggle and Iggle can meet all its debt obligations based on the current ratio alone, the quick ratio must also be observed. Between the current ratio and the quick ratio, the quick ratio is a better way to assess the company’s ability to meet obligations. Unlike the current ratio, the quick ratio excludes inventory because it is often the least liquid current asset and most likely will be sold under its book value if the company is faced with financial distress
All the profitability ratios show poor results Piggle as compared to Iggle. In fact all of them show Iggle performed well than Piggle. As far as Return on equity is concerned the Iggle had 20% while Piggle 10%. Return on equity measures how stockholders of the company performed during the year. The DuPont analysis breaks down the return on equity into three parts: operating efficiency, asset use efficiency, and financial leverage. The operating efficiency measure net profit margin, the asset use efficiency measures total asset turnover, and the financial leverage measures equity multiplier (Meigs and Meigs 1970).
- ROE = (Net Profit Margin) * (Total Asset Turnover) * (Financial Leverage)
- ROE = (Net Income/Sales) * (Sales/Assets) * (Assets/Equity)
Return on capital employed s shows that Iggle out did Piggle. The company posted very high performance of 35% while Piggle posted 20%. The ROCE is similar to Returns on Assets except that the profits are related to the Total Capital Employed. The term Capital Employed refers to long-term funds supplied by the lenders and owners of the firm and may be computed in two ways. This ratio is the most important measure of the overall efficiency of the management of the business because it relates the result of operations to the total funds used in the business. It sheds more light on the criticality of gearing and, when compared with the acid test, gives an idea as to the company’s vulnerability to take-over and bankruptcy (Brigham and Daves 2010). It is important to highlight that in the following table for calculation of ROCE, the current assets do not include deferred tax and intangibles, the value of these is doubtful in case of trouble. Gross profit ratio is an indicator of the efficiency of the operations of the business as distinct from the selling and general management areas. The calculated percentages show a very high gross profit margin indicating that the other costs are substantial and offer considerable scope for reduction to bring down prices. Iggle is more competitive than Piggle as this ratio indicates. Iggle has a ratio of 44% while Piggle has a ratio of 27%.
Net profit margin shows how operating expenses affect profitability of a company. In this case Iggle appears to manage its expenses’ well. Clearly indicating the need for tighter financial and expense control in Piggle. These ratios are 15% for Iggle and Piggle for 9%.
Price/Earnings Ratio: – This is market share divide by earnings per share. Since the share price changes almost continually, the ratio also keeps changing all the time. The PE ratios for these companies are given as 6 and 10 a share for Iggle and Piggle respectively. This is the most important ratio used by the market generally to assess the relative rating of a share and the candidate’s prospects and, of course, is the easiest to understand (Holmes, Sugden and Gee 2008). It identifies the number of years’ earnings needed to cover the current market price of the share. From this ratio it is clear that Piggle is a better investment as compared to Iggle.
Long-Term Leverage ratio
Capital gearing ratio: This ratio helps us understand the relative importance of long-term debt in the capital structure and can therefore provide useful additional information for assessing the acceptability of the overall leverage position of the business (Delaney, and Epstein 2001). The long-term leverage of Piggle (15%) is good; however, for Iggle (65%) it shows a reliance of debt, indicating that the long-term debt is being used to fund assets and this will impact future interest burden and reduce borrowing capacity in the debt market, should that be required for expansion or takeover of other business.
Asset utilization of the company has been shown Iggle is doing well as compared to Piggle as their ratios are 15 times and 3 times respectively. This is due to sales of the companies during this period. Sales to account receivable shows that Iggle takes longer that is 78 days to convert its receivable into cash while Piggle takes only 25 days. Same is the case with inventory. Iggle is converting its inventory into sales that is 88 days slowly as compared to Piggle that is 21 days. This means Piggle has been quite effective in utilizing its assets quite efficiently as evident from these ratios.
Accounting rate of return
Accounting rate of return is one of the methods which consider average profits and average investment. The figures available in the balance sheet are used in determining the profits to be used. The average accounting profit from the project expressed as a percentage of the average (or initial) investment (Arnold 2007). The denominator needs to be defined and the definition consistently applied.
The formula is calculated as:
- Average of return = average profits after sales
Average annual cash flows
Decision rule is projects with an ARR above a defined minimum are acceptable;
the greater the ARR, the more desirable the project.
In this case project B is desirable as compared to Project B. Since the rate is 20% for project B and Project A is 15%.
This method measures the length of time it will take for a business to recover the investment made. The measure uses the initial cash investment made and the average annual net cash flow (cash inflow – cash outflow). Dividing the former by the latter, the result is a number that represents the cash payback period in number of years (Singh and Gaur 2004). The formula is:
- Cash Payback Period = Capital Investment ÷ Average Annual Net Cash Flow
It is normal to average the annual cash flow since it is usual to see that cash flows are not constant through the period of the active performance of the capital assets obtained through the investment made (Pandey 2009).
The shorter the payback period the sooner the company recovers its cash investment. However, the adequacy of the payback period is dependant on the perceptions of the firm, the type of industry or service, and the macro and micro economic conditions. The payback period is usually considered viable if it is between 2 and 3 years (O’Sullivan, Sheffrin and Perez 2009). In any case, the period has to be considerably less than the useful life of the asset. In some projects, in the initial period the cash flows fluctuate vastly and may even be negative at the start. In such cases, the cumulative net annual cash flow helps determine the time for recovery of the investment (Ayers and Collinge 2005).
This method suffers from the limitation that it does not factor the differences in cash flows due to their timing or the time required for execution of the project. In some cases projects may require the same investment and have the same payback period, but the timing of the cash flows may be quite different. In such a case, the project that yields quicker net cash flows is preferable over the other (Myers 1984).
In consideration of the above project A is more desirable to project B as it has a shorter Payback Period of 4 years as compared to 5 years.
Net Present Value
This method considers time value for money. It is calculated as shown below.
Net present value = present value of cash inflows – net investments. The criteria for accepting rejecting the project are if NPV ≥ 0 accept the project otherwise rejecting the project. The project is accepted when the NPV ≥ 0 because it will increase the shareholders wealth. Incase where the projects are mutually exclusive and have positive NPV then the project with the highest NPV is taken (Tang and Tang 2003).
This case project B is desirable as opposed to project A as it has NPV of £145m as opposed to £120m of project A.
Internal Rate of Return
This method also relies on the concept of calculation of present values. The IRR determines the interest yield of the capital project at which the net present value becomes zero (Ryan and Ryan 2002). Returning to the NPV calculation, we note that a discount rate, based on the needed rate of return of the business, determines the present value of future cash flows. In the case of IRR calculations, the reverse is true, the rate is calculated using the net future cash flows and the IRR is the rate at which the discount will bring the net cash flow to zero, i.e. the present value of the net cash flows and the investment required are the same (Rao 1989). Where the IRR is greater than the expected return or the cost of funds the project is financially viable and projects with higher IRR are more viable (McLaney 2003).
Calculation of the IRR requires two steps. The first step is to calculate the internal rate of return factor using the formula:
- Return Factor = Proposed Capital Investment ÷ Net Annual Cash Flow
The next step consists of locating this factor in the ‘Present Value of an Annuity of 1’ table using the productive life of the capital assets for the number of periods. The discount rate corresponding to these axes is the Internal Rate of Return (Klammer 1983)
In this case project A is acceptable as compared to project B. This because it has 16% as compared to project B with 13% of IRR.
Project B should be acceptable because it gives higher NPV as compared to project A. This is because NPV is superior to all other criteria used in this case. Where there is conflict between NPV and IRR, NPV prevails. In case there is conflict between discounted cash Flow methods and traditional method, discounted cash flow methods prevails (Harvard Business School 2009).
Main sources of capital for Piggle to finance the project
From the capital gearing ratio the company has not exploited long term debt well. Therefore it should exploit it and use a small portion of equity capital but big junk should be from Long term debt. However, they should be careful to make sure profits are available to meet interest (Gitman 2009). The sources that can be exploited include:
Long-term debt: The importance of long term debt to the Piggle capital structure can be seen through there effects on financial leverage, the cost of capital, and capital structure. The presence of long term debt in the Piggle’s capital structure also will lower the firms cost of capital, thereby permitting the firm to invest in the proposed project since it is one of the sources that is not exploited as per the current capital structure
Long term debt financing can be obtained in two ways. One way is to borrow the money directly. These term loans with varying requirements are available from a number of major financial institutions. A second method of raising long term debt can sell small parts of the total debt financing to various purchasers (Brealey, Myres and Marcus 2001).
Preference share: Is a form of financing whereby shareholders are paid a fixed rate of dividend after creditors but before ordinary shareholders. This can be Cumulative preference shares where shareholders are paid a fixed amount of dividends and arrears accumulate. Non-cumulative where they receive a fixed rate of dividend but arrears does not accumulate. Piggle has not exploited this form of capital therefore it should use it as part of the financing.
Common stock: They are number of reasons why they is repurchase of stock by company’s a company may purchase stocks from the stock exchange under a program allowable by security exchange commission. To reduce the excess capital that is circulating in the market. This will stipulate of the company.Secondly it also be done to enable the company collect the undervaluation of the shares of the company. Thirdly it is done in-order to have the correct leverage ratio. Lastly it is done in order to act as incentive to the management.
Companies’ float their share in the stock exchange because of many reasons among the few reasons why companies float their share include:
- To provide a medium for trade for shares of the company thus affecting or improving the share value of the company thus increasing capitalization. This ensures that there is a contuse market for security at a price which is reasonable in the market.
- Issue of shares the market share the company a wide range of sources of the funds. It helps to firm to raise funds of expansion. The security market ensures that the firm has a way of raising a finance thus ensuring thee is liquidity for the firms for investment the long term projects.
- It helps in determining and publishing security prices of the shares of the company.
- Share listed in the stock exchange will always a ready market since they can be taken up by brokers.
- The stock exchange will rationally value the assets of the company with risk returns regardless the management effect.
- Listing in the stock exchange will give many people an opportunity to buy and own the shares of the company.
- It assists in a locating scarce capital, to the best users. For example a person may have money to invest but does not know how to start a business therefore he will be allocated the shares of the company (Gup 1980).
Therefore the company should use a mix of loan capital and common stock in the form of rights issues since it is not a public company.
Capital budgeting techniques used for the project
The Net Present Value (NPV) method should be used to run the project as it is superior. It takes into consideration the time value of money, on the elementary basis that cash flow at present time is worth more to the company compared to cash flow in future periods. In the evaluation of a project, the first step is to estimate the cash outflow and inflow to determine the net cash inflow resulting from its implementation. This net flow is discounted by a rate determined by the businesses’ required rate of return on investment. The estimate of the salvage value of the capital assets at the end of their productive life is made and also discounted by the discount rate to arrive at the present value of all cash flows resulting from the use of the assets and their salvage value. Comparison of the total present value of the discounted cash flow and salvage value with the investment required helps determine the viability of the project. In case of projects with long gestation periods, it is also necessary to discount the investment made in subsequent periods. If the investment required subtracted from the discounted cash flow (NPV) is positive, it indicates that the need of the businesses’ required rate of return has been met (Haka 1987). For most businesses, the required rate of return is the cost of capital, i.e. the rate they have to pay to obtain capital (money) from their creditors and investors. If there is risk involved when cash flows are estimated into the future, some companies add a risk factor to their cost of capital to compensate for uncertainty in the project and, therefore, in the cash flows. Some businesses may also factor in an ‘opportunity cost’ into the required rate of return, which implies that the consideration is for the alternate means of investment available for example in securities and bonds or in the capital markets (Graham and Harvey 2001).
The ratio analysis reveals that Piggle is a good investment and any investor should be ready to put their money in the company as compared in Iggle. This is because growth, profitability ratios and solvency ratios favor it. if the investor intends to take an active role in the management of the company and is willing to sacrifice short term gains for the possibility of long term gains, then an investment in the Iggle can be profitable. For a long term investment, the investor, as the new management, needs to make immediate and drastic reorganization and restructuring of Iggle’s to ensure that assets are use efficiently and effectively.
List of references
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Appendix 1: Accounting Ratios
|Return on Capital Employed||35.00%||20.00%|
|Return on Equity||20.00%||10.00%|
|Average settlement period for debtors||78 days||25 days|
|Average settlement period for creditors||85 days||45 days|
|Gross profit margin||44%||27%|
|Fixed asset turnover||15 times||3 times|
|Capital gearing ratio||65.00%||15.00%|
|Acid test ratio||0.60:1||2.10:1|
|Price earnings (PE) ratio||6.00||10.00|
|Net profit margin (profit after interest but before tax)||15.00%||9.00%|
|Stock holding period||88 days||21 days|
Appendix 2: Capital Budgeting Techniques
CAPITAL BUDGETING TECHNIQUES Project A Project
Payback period (years) 4 5
Accounting Rate of Return (ARR %) 15.00 20.00
Net Present Value (NPV £000) 120,000 145,000
Internal Rate of Return (IRR %) 16.00 13.00