Financial ratios analysis and Profitability Ratios in the Banking Sector
Profitability ratios are the most important ratios to investors in any given industry, because it simply shows how much profit the company has earned over years, does it achieve satisfactory level to investors, banks, and shareholders compared to that of its competitor or the industry. Also by drilling down into figures, profitability ratios can also tell how efficient and effective company conducts its business resources and operation activities such as sales, production or other cost-consumed ones.
This section will examine the reasons why the profitability of GWB is growing upward contrary to that of HB through years, why even generating large sales in 2008 (always twice as much as HB's for 3 years) GWB only achieved very low profit (2,552), nearly one fourth to HB's (9.386) in 2008 and how important cost management can improve the profitability of GWB on one side but reduce HB's on the other side in 2009 and 2010.
Now, this report is to analyze the profitability of the two companies by looking into its ROCE, and its relationship between ROS and AT and Net Profit Margin ratios:
Return on Capital Employed:
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Return on Capital Employed (ROCE) is the key profitability ratio that measures company's profits and business performance. It shows the relationship between the PBIT with the capital employed to make that profit.
Graphs to compare profitability between GWB and HB for 3 years from 2008 to 2010: ROCE, ROS and AT
As seen in the graph:
The ROCE of GWG is upward, and that of HB however is downward for the 3 financial years.
Both AT of GWG and HB are slightly downward, however the ratio of GWG (averagely 2.33) is at higher level than that of HB (averagely 1.56)
While ROS of GWG started at very low rate 2.31% in 2008 compared to the ratio of HB 16.85% but GWG has improved dramatically to 7.11% in 2009 and 12.68% in 2010 since HB dropped considerably to 11.21% in 2009 and 9.27% in 2010.
Since ROCE is equal by AT times ROS, and AT of both companies seems to stay unchanged, the significant changes in ROCE between them largely depends on the fluctuations of their ROS ratios
Actually, a significant increase in ROCE of GWG is as a result of an increase in its ROS and a significant decrease in ROCE of HB is as a result of a decrease in its ROS
Also, the average AT of GWG for 3 years is 1.5 times as much as that of HB means the greater effectiveness of using its assets to generate revenues for GWG over HB.
Once again, because ROS is equal by PBIT/ Sales, and the Sales of both companies slightly increase in approximately same proportion (around 1.15 times by both over 3 years), the significant changes in ROS between them largely depends on the fluctuations of their PBIT.
PBIT of GWG has soared dramatically from very low level 2.552 in 2008 to 8.933 in 2009 and 16.045, while a downward trend has been seen in HB's from 9.386 in 2008 to 6.899 in 2009 and 6.004 in 2010. Here is the key point to analyze why they have achieved different performances.
Even generating large sales in 2008 (always twice as much as HB's for 3 years) GWB only achieved very low profit (2,552) nearly one fourth to HB's in 2008.
Profit is therefore measured as the difference between Sales and Operation Expenses. Operation Expenses and COGS are the key reasons for two companies' performance differences:
There are two reverse pictures of business performance between the two companies: GWB has improved progressively, HB has not.
GWG must do something right in its cost strategies from 2008 to 2009 and 2010 and vice versa for HB.
To simplify, the reasons of positive changes for GWB's profitability and negative changes for HB's are mostly illustrated by the diagram below:
Diagram illustrated the financial ratio factors that make the positive increase in profitability of GWG over 3 years.
- The efficient way of cost management in GWB through 3 years has lead the reduction of its COGs and Operation Expenses, along with the slightly increase in sales which together results in the increase in ROS, ROCE ratios and finally the profitability.
- By the same way, the inefficient way of cost management in HB has made it less profitability performance than it did in previous years.
Net profit Margin (NPM) measures the profit before interest and tax PBIT made out of total sales of the company. It also shows the similar reserve trends between the two companies.
By all the analysis of past performance and comparison, GWB has performed more profitably and efficiently than HB has. GWB has successfully reduced its production cost as well as maintained its high revenues to generate better business performance and profitability over years.
2. Liquidity ratios:
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Liquidity ratios simply measure how companies can meet its current financial obligations in term of cash or how can assets be quickly transferred into cash when needed.
With that view, current ratio indicates the relationship between company's total current assets and its total current liabilities, and how it can pay short term debts (less than 12 months) from the current assets which are mostly able to transform into cash. The higher is the ratio, the better. Below 1:1 is highly not expected and the ideal figure for this ratio is 2:1.
Both of these companies have achieved the ratios above 1:1 however, the trends between them are different.
GWB has consistent uptrend, starting at low level (relative to HB) 1.4 in 2008, but rising moderately to 1.74 in 2009 and 2.04 in 2010.
HB has fluctuated from high level (relative to GWB) 1.87 in 2008, but declining considerably to 1.48 in 2009, and recovering dramatically at 2.11 in 2010.
Liquid ratios have shown the similar trends to the previous ratios between two companies because it is current ratio but deducts inventory asset which is not always easily to turn into cash. As a matter of fact, excluding inventory makes liquid ratios of GWB become relatively higher than those of HB, which means GWB has done better in term of inventory strategies over HB. GWB's inventory has been kept as a consistent level over 3 years around 10.300 accompanied with the increase in total assets which makes the relative proportion between inventory and total asset getting smaller hence higher liquid ratio.
While HB's inventory has been fluctuated (11.890 in 2008, 14.368 in 2009, 12.273 in 2010) and by the same way finally makes that proportion become bigger and hence lower liquid ratio.
Proportion of inventory over total current assets for GWB and HB over 3 years
The different picture has been seen in Cash ratio when GWB has a much higher ability to pay its short term loans in immediate cash than HB. This implies greater risks for HB in the business when it needs cash to cover other operational expenses
3. Efficiency ratios:
Efficiency ratios evaluate the ability of a company to utilize and manage various resources. In the previous section, AT has been assessed to see how GWB use its assets more efficiently to generate revenues than HB.
Specifically, Fixed Assets Turnover measures how efficiently a company uses its fixed assets to generate its sales. The higher is the ratio, the better. The high ratio means the company has less money tied up in fixed assets for each pound generated and the declining ratio indicates that company has over invested in fixed assets such as plant, machinery, ect…
In the chart, the increasing ratios of GWB for 3 years clearly show the efficient utilization of its fixed assets: 2.89 in 2008, 3.23 in 2009 and 3.31 in 2010. On the contrary, HB has the declining and lower ratios over 3 years: 2.68 in 2008, 2.06 in 2009, 2.25 in 2010.
HB has performed less efficiently using fixed assets to generate sales than GWB.
Stock turnover period measures for how long inventories are being hold or how well a company can manage its stock level. The lower period is the ratio, the better; it can help company improve its sales and liquidity. Once again, as analyzed in the profitability ratios, GWB has performed better than HB in term of inventory and COGSs. GWB keeps its consistent lower inventory level while reducing cost of goods sold to maximize its profits.
In the chart, however in 2010, the period of GWB is getting higher to 121 days, compared to the previous years: 109 days in 2009 and 113 days in 2008, while HB has reduced this period over 3 years: from 166 days in 2008, to 164 days in 2009 and 138 days in 2010.
Debtors period and creditors period
Debtors Period is one of most important ratios reflected the ability of a company to collect debts from its credit customers. If the period is high, a company will face difficulty to quickly withdraw its finance to invest in its business operations. It can be seen that GWB's period is much better (2.5 times lower) than HB's, while GWB only needs averagely 30 days to take its debts back and this periods tend to decrease, HB normally needs more than 70 days and this ratios seem not to positively change.
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Creditors period, on the other hand, measures for how long company have to pay for its suppliers. The higher period is the ratio, the better because it can keep cash longer and push the finance risk to its suppliers. GWB's period is still better and 1.6 times longer than HB's for the 3 years, means the pressure of GWB to pay money back to its supplier is smaller than the other.
4. Capital gearing:
Capital gearing ratio determines how well a company can pay for its long term loans. It measures the proportion of long term loans over total capital employed. Two reversed trends have been seen for the two companies. GWB started at very high rate of 32.21% in 2008 but dropped to 22.98% in 2009 and dipped to the lowest 0% in 2010, conversely the other started at very low rate of 0.44% in 2008, but climbed sharply to 18.40% in 2009 and 22.22% in 2010. High ratio also indicates the higher risk of HB to pay high interests to banks and the bigger nervousness of its creditors.
5. Investment ratios:
This is the most important ratio for the investors and it consists of many ratios which are going to see in detail: EPS, DPS, PE
(Data taken from 5 financial year summary of GWB and HB)
EPS represents the earning of the company as a function of the total number of ordinary shares in issue. (O'Regan 2006:295).The shareholders are interested in EPS as it shows the earnings yield percentage and to estimate future growth which will affect the future share price (Elliott, 2008). The two reverse trends in investment picture have been matched with the same previous trends described in profitability ratios. GWB's EPS has been improved substantially as the company generates better profits than it did in previous year. It reaches the highest point 48.4 (p/ share) in 2010, followed by 17.6 in 2009 and -2.4 in 2008, a spectacular trend for investors to look at. Conversely, less profitability, thus less EPS makes HB loose its attractiveness from investors by the downtrend: 9.76 in 2010, 11.17 in 2009 and 16.15 in 2008.
The Price/earnings ratio is one of the most important measures of the company's performance (O'Regan 2006:298). It represents the market's view of growth potential of the company, its dividend policy and the degree of risk involved in investment. This measures the relationship between the earnings of the company and its stock market price. The low P/E means the company is undervalued and vice versa, hence investors might put their money on those stocks rather than those which more than its worth (overvalued). The P/E of GWB and HB are relatively 8.3 and 15.43 means GWB and HB investors will pay relatively 8.3 pounds and 15.43 pounds for every 1 pound of its earnings, which means that HB's stock is less attractive than the other by investors. The upward trend of HB (6.19 in 2008, 13.43 in 2009 and 15.43 in 2010) shows its less attractiveness than GWB (120.58 in 2008, 14.54 in 2009 and 8.83 in 2010). However … HB (high P/E) has more market confidence than GWB (low P/E) ???
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Another key investment ratio is very useful for investors to consider is DPS (Dividend per share). It indicates how much dividend a company pays for its shareholders every year or a quarter of a year. As seen in the graph, there were no dividend paid to GWB's shareholders in 2008 and 2009 but a very large dividend proposed 25 (pence/share) in 2010 while there were lower dividends paid to HB's shareholders for 3 years: 8.52 in 2008, 2.7 in 2009 and 5.04 in 2010.
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