Return On Capital Employed Business Essay

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ROC shows the profitability of the company relative to its total capital invested.This ratio provides an ideaon how wellthe management isutilizing its assets to yield some earnings.Calculated by dividing a company's annual earnings by its capital employed, ROAtells you what earnings were generated from invested capital (assets).

The assets of the company are made up of equity as well as debt. Both of these types of financing are used to fund the operations of the company. The ROA figure of Iggle is 35%. This helps the investors know how efficiently the company has functioned so as to earn a ROA of 35%. The ROA number of Iggle is higher stating that the company is earning more money on less investment. If Piggle has a net income of $1 millionand totalassets of $5 million, its ROA is 20%; however, if Iggle earns the same amount but has total assets of $2.85 million,it hasan ROA of 35%. Based on this Iggle is better at converting its investment into profit. Management's most important job is to make wise choicesin allocatingits resources. Anybody can make a profit by investing a lot of money at a problem, butvery few managers excel at making large profits with little investment.

Return on Common Equity

Ultimately, the most important, or "bottom line," accounting ratio is the ratio of net income to common equity, which measures the return on common equity (ROE): Stockholders invest to get a return on their money, and this ratio tells how well they are doing in an accounting sense. Piggle has 10% when compared to Iggle 20%.

Focusing on the profit margin, Piggle marketing people can study the effects of raising sales prices (or lowering them to increase volume), of moving into new products or markets with higher margins, and so on. Piggle have a strong incentive for improving the company's financial performance, because their compensation is based to a large extent on how well the company does. Piggle should strive to maximize shareholder wealth.

First, ROE does not consider risk. Second, ROE does not consider the amount of invested capital. To illustrate this point, let's have, Iggle has $1 invested in Project A, which has an ROE of 20 percent, and Piggle invested $1 million in Project B, which has a 10 percent ROE. The projects are equally risky, and the two returns are both well above the cost the company had to pay for the capital invested in the projects. In this, Project A has a higher ROE, but since it is so small, it does little to enhance shareholder wealth. Project B, on the other hand, has the lower ROE, but it adds much more to shareholder value. Thus Piggle's PE ratio is higher and has strong confidence among customers'

These discussions suggest that a project's return must be combined with its risk and size to determine its effect on shareholder value. To the extent that ROE focuses only on rate of return, increasing ROE may in some cases be inconsistent with increasing shareholder wealth. With this in mind, academics, practitioners, and consultants have tried to develop alternative measures that overcome ROE's potential problems when it is used as the sole gauge of performance.

Average Settlement Period for Debtors

If the time taken to collect cash from its customers could be reduced by one day, there would be a reduction of assets employed in the business and a corresponding increase in rate of return. Piggle has an idle credit period of 25 days, and due to huge inventory, Iggle has long credit period of 78 days. In effect, the companies are lending customers' money for that period until cash is received, and they must provide the necessary finance to support this.

Cutting inventory or debtor levels reduces the level of assets employed in the Iggle's business and increases profit, thus raising the return on total assets. There is a direct link between the efficient management of cash flows and the overall profitability of a business.

Average Settlement Period for Creditors

Trade creditors represent the amount of money the company owes its suppliers for goods and services consumed during the year. As trade creditors are shown at cost in the balance sheet, they are divided by average daily cost. Iggle has many days (85) to clear all its dues to suppliers, when compared to Piggle which has only 45 days to clear its debts.

The average cash cycle experienced by the Piggle was for cash to be tied up in inventory for 21 days; after goods had been sold to customers it took a further 25 days for the cash to be received. The average company therefore required 46 days' finance to cover inventory holding and credit extended to customers. As an average company took 45 days' credit from its suppliers, it had to finance only a day of the cash cycle itself. Suppliers provided 45 out of the required 46 days' finance for the average company's investment in working capital.

The cash cycle can provide an indication of the short-term financial implications of sales growth. If the average cash cycle of 1 day is used this suggests that for every $100 of sales $0.28 working capital is required, which is negligible.

The average cash cycle experienced by the Iggle was for cash to be tied up in inventory for 88 days; after goods had been sold to customers it took a further 78 days for the cash to be received. The average company therefore required 166 days' finance to cover inventory holding and credit extended to customers. As an average company took 85 days' credit from its suppliers, then it had to finance 81 days of the cash cycle itself. Suppliers provided 85 days out of the required 166 days' to finance for the average company's investment in working capital.

The cash cycle can provide an indication of the short-term financial implications on sales growth. If the average cash cycle of 81 days is used this suggests that for every $100 of sales $22.2 working capital is required, which is high when compared to Piggle. If it was planned to increase sales by $1m, some $220,000 additional working capital must be found to support the growth. It will be huge money.

Profitability Ratio

The profitability ratios show the combined effects of liquidity, asset management, and debt on operating results.

Gross Profit Margin Ratio

The gross profit margin, often known as the gross margin, indicates the basic profitability of a business and is useful when comparing the performance of companies operating within the same sector. The gross margin is the result of the sales less the operating expenses to the sales. This purely gives how the company is performing at operation level. Here Iggle has 44% of gross profit margin and Piggle has 27% of gross profit margin. This shows that the operation team at Iggle is performing the best, and various cost reduction standards like GMP and so on are in place, when compared to Piggle.

Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures how effectively the firm uses its plant and equipment. It is the ratio of sales to net fixed assets.

Piggle's ratio of 3.0 times and Iggle's ratio of 15 times indicates both the firms are utilizing their fixed assets extensively. But Iggle's ratio is very much high means there can be few possibilities that the firm's assets might be older when compared to Piggle fixed asset. The Iggle can be very old company and the assets were bought very long ago, and thus the assets are not correctly valuated for calculating the fixed assets turnover ratio. The other possibilities are the Iggle may perform extremely well when compared to Piggle. Therefore, Piggle seems to have huge amount of fixed assets in relation to Iggle.

Capital Gearing Ratio

Capital Gearing Ratio is a fundamental analysisratio of a company's level of long-term debtcompared toits equity capital. Gearing is expressed in percentage form. This ratio is also known as "financial leverage".

In simpler terms, gearing explains how a company finances its operations -either through outside lenders or through shareholders. Piggle has only 15% of Gearing ratio, meaning it does not have any long term liabilities exceeding shareholder equity and hence in good health. On the other hand, Iggle has 65% of gearing ratio, which may be considered speculative and may lose its business in long run.

Current Ratio

The current ratio is calculated by dividing current assets by current liabilities:

Current assets normally include cash, marketable securities, accounts receivable, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses (principally wages).

For every $1 of current liabilities, Iggle is maintaining at the yearend $1.8 of current assets. If the company paid all its short-term creditors, it would have $0.80 left for every $1 of current asset used as against Piggle is maintaining at the yearend $2.9 of current assets. Generally, for most companies, to exhibit at least a 1.5:1 relationship between current assets and liabilities can be taken as an indication of the ability to meet short-term creditors without recourse to special borrowing or the sale of any assets, except those appearing as current in the balance sheet. Both the company has a commendable position as far as current asset is concerned. On the other side a very high current assets also indicate that the company is not efficiently utilizing the available cash and there may be some problem in the cash cycle. Hence as far as current ratio is concerned, Iggle's financial situation is better that of Piggle.

Acid Test Ratio

The quick (or acid-test) ratio is a more stringent measure of liquidity. Only liquid assets are taken into account. Inventory and other assets are excluded, as they may be difficult to dispose of. Quick ratio includes cash, marketable securities and accounts receivables and current liabilities. Piggle when compared to Iggle has a good acid test ratio, Piggle has an acid test ratio of 2.1:1 which means the inventory and other related assets are maintained at low level. Iggle have an acid test ratio of 0.6:1, which when compared to its current ratio shows that there is a huge inventory pile up in the organization.

Net Profit Margin

Net Profit Margin means moving down the income statement, deducting the remaining expenses and interest charges from operating profit gives the Net profit margin or EBT, (i.e., Earnings Before Tax) for the year. EBT shows the level of profitability of a company after all operating costs and expenses except tax and dividends to shareholders have been allowed for.

Both companies are maintaining a stable operating profit margin and Net profit margin. Their investment and payment of interest are almost similar. Iggle has Net profit margin of 15% and Piggle has a lesser Net profit margin of 9%. The difference is not with the interest load, but from the operating performance and sales. Even Piggle may maintain a low cost strategy to attract more customers.

Price/Earnings Ratio

The price/earnings (P/E) ratio shows how much an investor is willing to pay per dollar of reported profits. Piggle has P/E ratio of 10 which shows the firm's strong growth prospects, but this ratio is 6 for Iggle, and are at risk when compared to Piggle.

With higher P/E ratio Piggle gains greater confidence from investors and to have in the future prospects and performance of the company. A high P/E ratio indicates investors have confidence that the company will maintain and probably improve its current performance in the coming year.

Stock Holding Days

To discover how long a company's cash is tied up in inventory, the balance sheet figure for inventory is divided by Average Daily Cost to give the number of days that inventory appears to be held on an average by the company. Or it can be achieved by just dividing 365 days by Inventory turnover ratio, which is the ratio of cost of sales divided by yearend inventory.

Iggle and Piggle maintain inventory for 88 days and 21 days respectively. Iggle has highest holding days when compared to Piggle; hence the longer financial resources are tied up in a non-profit-generating item. But Piggle maintains a less inventory and hence lower holding days; thereby the faster is the turnover of the inventory. Each time inventory is turned the company makes a profit and generates cash. However, a company with a high inventory turnover may be maintaining inventory levels too low to meet demand satisfactorily, to eliminate stock out.

Part 2

Project Selection

Payback Period

Payback period is the length of time required to recover the cost of an investment. It is the ratio between Cost of project and Annual cash Inflows. All other things being equal, the better investment is the one with the shorter payback period.

There are two main problems with the payback period method,

  1. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.
  2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value, internal rate of return or discounted cash flow are generally preferred. Also we can calculate discounting type payback period.

Decision Rules

A) Mutually Exclusive Projects

In the case of two mutually exclusive projects, the one with a lower payback period is accepted, i.e. Project A is accepted because of lower payback period.

Accounting Rate of Return - ARR

ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest. ARR is used for the purposes of comparison. The major drawbacks of ARR are that it uses profit rather than cash flows, and it does not account for the time value of money.

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits. Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision. Accounting rate of return does find a place in business decision making when the returns expected are accounting profits and not merely the cash flows.

Decision Rules
  • A) Mutually Exclusive Projects
  • Select the one that offers highest rate of return.

    Here, when compared to project A, project B offers highest rate of return, hence project B is preferred.

    Net Present Value - NPV

    The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPVanalysis is sensitive to thereliability of future cash inflows that an investment or project will yield.NPV can be calculated using the formula, also can often be calculated using tables, and spreadsheets.

    NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

    Decision Rules

    A) Mutually Exclusive Projects

    Select the one with a higher NPV.

    Project B has higher NPV than project A, hence Project B may be chosen for investment.

    Internal Rate of Return

    Theinternal rate of return (IRR) on a project is the rate of return at which the projects NPV equals zero. At this point, a project's cash flows are equal to the project's costs.

    Decision Rules

    A) Mutually Exclusive Projects, select the one with higher IRR

    IRR for project A is 16% and is higher than project B, which has IRR of 13%.

    Clearly we can choose Project A of higher IRR and payback period of 4 years. These are the direct and known elements to give better visibility to select better project. Though the NPV of project B is higher, the return that we get from project A supersede project B. And the market value and confidence of customer is higher, the company Piggle has to maintain this image by earning wealth for the customer. If you have more equity then the project A with more return is preferred.

    Part 3

    Main sources of finance which are available for Piggle to finance the chosen project in Part 2 and (15%)

    A company would choose from among various sources of finance depending on the amount of capital required and the term for which it is needed. Finance sources can be divided into three categories, namely traditional sources, ownership capital and non-ownership capital.

    Traditional Sources of Finance

    Internal resources have traditionally been the chief source of finance for a company. Internal resources could be a company's assets, personal savings and profits that have not been reinvested or distributed among shareholders. Working capital is a short term source of finance and is the money used for a company's day-to-day activities, including salaries, rent, payments for raw materials and electricity bills.

    Sources of Finance: Ownership Capital

    Ownership capital is the capital owned by the shareholders of a company. A company can raise substantial funds through an IPO (initial public offering). These funds are usually used for large expenses, such as new product development, expansion into a new market and setting up a new plant. The various types of shares are:

    1. Ordinary shares: These are also known as equity shares and give the owner the right to share the company's profits and vote at the firm's general meetings.
    2. Preference shares: The owners of these shares may be entitled to a fixed dividend, but usually do not have the right to vote.

    Companies that are already listed on a stock exchange can opt for a rights issue, which seeks additional investment from existing shareholders. They could also opt for deferred ordinary shares, wherein the issuing company is not required to pay dividends until a specified date or before the profits reach a certain level.

    Unquoted companies (those not listed on stock exchanges) can also issue and trade their shares in over-the-counter (OTC) markets.

    Sources of Finance: Non-Ownership Capital

    Non-ownership capital includes funds raised from lenders, such as banks and creditors. Companies typically borrow a fixed amount from a bank, at a predetermined interest rate and with a fixed repayment schedule. Certain bank accounts offer overdraft facilities. This is used by companies to meet their short-term fund requirements, as they usually come at a very high interest rate.

    Factoring enables a company to raise funds using its outstanding invoices. The company typically receives about 85% of the value of the invoice from the factor. This method is more appropriate for overcoming short-term cash-flow issues.

    Hire purchase allows a company to use an asset without immediately paying the complete purchasing price. Trade credit enables a company to obtain products and services from another firm and pay the bill later.

    Sources of Finance: Venture Capital

    Firms in the early stages of development can opt for venture capital. This option gives the financing company some ownership as well as influence over the direction of the enterprise.

    Sources of Finance: Duration

    Depending on the date of maturity, sources of finance can be clubbed into the following:

    Long-term sources of finance: Long-term financing can be raised from the following sources:

    1. Share capital or equity share
    2. Preference shares
    3. Retained earnings
    4. Debentures/Bonds of different types
    5. Loans from financial institutions
    6. Loan from state financial corporation
    7. Loans from commercial banks
    8. Venture capital funding
    9. Asset securitization
    10. International

    Medium-term sources of finance: Medium-term financing can be raised from the following sources:

    1. Preference shares
    2. Debentures/bonds
    3. Public deposits/fixed deposits for duration of three years
    4. Commercial banks
    5. Financial institutions
    6. State financial corporations
    7. Lease financing / hire purchase financing
    8. External commercial borrowings
    9. Euro-issues
    10. Foreign currency bonds.

    Short term sources of finance: Short-term financing can be raised from the following sources:

    1. Trade credit
    2. Commercial banks
    3. Fixed deposits for a period of 1 year or less
    4. Advances received from customers
    5. Various short-term provisions

    Major budgeting techniques which can be recommended to support the running of the chosen project successfully. (15%)

    Basic Principles Before You Develop the Budget

    Something you should not do when you are developing a budget is making it up as you go along". As with most good practice in managing an organization, good practice in budgeting involves clarity of purpose, detailed planning and considerable thought. Among the questions you should be asking yourselves throughout the preparatory budgeting stages, and while you are actually developing your budget, are:

    • Could we have spent less last year and still achieved the same results, or better?
    • Have we wasted money in the past? If so, can we avoid doing so in the future?
    • In this section of the toolkit, we look at:
    • What is a budget, who should be involved in budgeting, and why do we budget?
    • The operational plans
    • Estimating costs
    • Sources of finance.

    These are all issues that you need to address before you begin developing your budget. They are an extension of the planning process on which all budgeting is based. (See also the toolkits on Overview of Planning; Strategic Planning; Action Planning)

    What is a Budget?

    A budget is a document that translates plans into money - money that will need to be spent to get your planned activities done (expenditure) and money that will need to be generated to cover the costs of getting the work done (income). It is an estimate, or informed guess, about what you will need in monetary terms to do your work.

    Why budget?

    The budget is an essential management tool. Without a budget, you are like a pilot navigating in the dark without instruments.

    • The budget tells you how much money you need to carry out your activities.
    • The budget forces you to be rigorous in thinking through the implications of your activity planning. There are times when the realities of the budgeting process force you to rethink your action plans.
    • Used properly, the budget tells you when you will need certain amounts of money to carry out your activities.
    • The budget enables you to monitor your income and expenditure and identify any problems.
    • The budget is a basis for financial accountability and transparency. When everyone can see how much should have been spent and received, they can ask informed questions about discrepancies.
    • You cannot raise money from donors unless you have a budget. Donors use the budget as a basis for deciding whether what you are asking for is reasonable and well-planned.
    Budgeting Techniques

    The two main techniques for budgeting are incremental budgeting and zero based budgeting.

    Incremental budgets

    Incremental budgets are budgets in which the figures are based on those of the actual expenditure for the previous year, with a percentage added for an inflationary increase for the new year. This is an easy method that saves time but it is the "lazy" way and is often inaccurate. This budgeting technique is only suitable for organizations where each year is very similar to the previous one in terms of activities. Very few dynamic organizations or projects are so stable that this budgeting technique really works for them.

    Zero Based Budgets

    In zero based budgets, past figures are not used as the starting point. The budgeting process starts from "scratch" with the proposed activities for the year. The result is a more detailed and accurate budget, but it takes more time and energy to prepare a budget in this way. This technique is essential for new organizations and projects, but it is also probably the best route to go in a dynamic organization that is proactive in taking on new challenges.

    Activity Based Budgets

    Activity Based Budgets is a method of budgeting in which the activities that incur costs in every functional area of an organization are recorded and their relationships are defined and analyzed.Activities are then tied to strategic goals, after which the costs of the activities needed are used to create the budget. Activity based budgeting stands in contrast to traditional, cost-based budgeting practices in which a prior period's budget is simply adjusted to account for inflation or revenue growth.As such, ABB provides opportunities to align activities with objectives streamline costs and improve business practices.

    By looking at the cost structure of an organization via theprocesses that are actually being performed, managers can more effectively analyze the profit potential of a company's products and services.Cost efficiencies can be found by comparing activities performed in different areas of the organization and consolidating or rerouting certain functions. At its essence, activity-based budgeting begins by looking at results and theactivities that created them, as opposed to cost-based budgeting, which often begins with raw input and material and works outward. ABB can also help firms create more accurate financial forecasts.

    References

    1. Prasanna Chandra, (2005), Financial Management- Theory and Practice, Tata McGraw Hill.
    2. http://www.economywatch.com/finance/sources-of-finance.html
    3. http://www.civicus.org , Budgeting
    4. Jerry Arcieri, Analysis of Financial Statements, SABA.
    5. Stephen A. Ross, Randolph Westerfield, Jeffrey Jaffe, (2004), Corporate Finance, Tata McGraw Hill.
    6. Lita Epstein,(2009), Reading Financial Reports For Dummies, John Wiley & Sons
    7. Bjarte Bogsnes, (2009), Implementing Beyond Budgeting: Unlocking the Performance Potential, John Wiley & Sons
    8. Martin T. BiegelmanandDaniel R. Biegelman, (2008), Building a World-Class Compliance Program: Best Practices and Strategies for Success, John Wiley & Sons
    9. Bob Vause, (2005), Guide to Analysing Companies, Profile Books
    10. Ruth BenderandKeith Ward, (2002), Corporate Financial Strategy, Butterworth-Heinemann.
    11. Shannon P. Pratt, (2005), The Market Approach to Valuing Businesses, John Wiley & Sons.
    12. Michael C. Thomsett, (2007), Annual Reports 101, AMACOM
    13. Lawrence W. Tuller, (2008), Finance for Non-Financial Managers and Small Business Owners, Adams Media.
    14. Matan FeldmanandArkady Libman,(2007), Crash Course in Accounting and Financial Statement Analysis, John Wiley & Sons.
    15. Peter Moles and Nicholas Terry,(1997), The Handbook of International Financial Terms, Oxford University Press

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