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Question 1 (a)

Details                                        2006                                 2005

Return on capital employed          470.7 x 100 = 183.7%                  442.5 x 100 = 160%

                                       256.2                                   276.5

Operating profit margin              470.7 x 100 = 15.2%                  442.5 x 100 = 15.5%

                                        3,106.2                             2,858.5

Gross profit margin                  468.9 x 100 = 15.1%                  440.3 x 100 = 15.4%

                                       3,106.2                              2,858.5

Total Asset Turnover                  3,106.2 = 12 times                   2,858.5 = 10 times

                                       256.2                                276.5

The Return on capital employed (ROCE) is a primary profitability ratio that should be analysed in

detail in order to evaluate the financial performance of the company. By analysing the ROCE based

on the information provided one can see that the ratio improved over time, as shown in the table

above. This indicates that management was more capable in earning profits from the capital

employed of the group.       Determining other secondary ratios, whose result is revealed in the

aforementioned table, can further substantiate this performance ratio. The operating profit margin

and gross profit margin remained quite stable over the year. However, the total asset turnover

increased. This indicates that the firm’s resources (capital employed) were utilised more effectively

in the generation of sales. Thus, if a company performs higher sales, and the profit per every £1 of

sales remained in the same range, then the overall profitability will definitely improve.

Question 1 (b)

Details                            Next Retail PLC                      Next Directory PLC

Revenue growth             (2,216.8 – 2,057.6) x 100 = 7.7%          (685 – 602.6) x 100 = 13.7%

                                      2,057.6                               602.6

Operating profit                 319.9 x 100 = 14.4%                     106.1 x 100 = 15.4%
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margin (2006)                      2,216.8                                  685

Operating profit                301.1 x 100 = 14.6%                     89.5 x 100 = 14.9%

margin (2005)                      2,057.6                                  602.6

From the ratios calculated, we can see that revenue of Next Directory PLC increased more than that

of NEXT Retail PLC. The profit generated from every £1 sales is better for Next Directory PLC

instead of Next Retail PLC, even though the revenue generated is significantly less. Thus we can

state that Next Directory PLC is more profitable than Next Retail PLC. However, Next Retail PLC

is globally performing a higher profit because they are generating more sales.

Question 1 (c)

Details                                        2006                               2005

Gearing                              303.8 x 100 = 17%                   300 x 100 = 14.2%

                                      1,783.7                              2,117.8

Earnings per share                     313.5 = £12.74                      305.4= £11.70

                                        24.6                                26.1

Next PLC is a low-geared company as indicated by the gearing ratio above. A low-geared company

is a less risky firm because the total debt is at a lower rate than the total equity. We have to

remember that debt holders demand interest payments on time and failure for the company to abide

with such requirements can lead to bankruptcy. When profits are increasing like the case presented,

the return derived from a high-geared company is substantially higher than that of a low-geared

firm. As we can see the earnings per share increase is only 8.9%. This would have been greater if

it was a high-geared company. There are indications, however, that the company is increasing the

debt amount and reducing the equity value by buying back shares as shown in the company’s cash

flow statement. This may eventually change the gearing position of the firm.

Question 2 (a)
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Cash is a very important factor for the survival of the firm. It is true to say that an organisation

needs both a sound cash flow and good profitability. However, a firm can survive without profits

for a couple of years, but if it experiences cash flow difficulties, it can perish in a few months. Cash

is frequently referred to as the lifeblood of the organisation. Without cash, the firm cannot pay the

debts due on time. The cash flow statement is thus provided in order to show the cash inflows and

outflows of the organisation.      On the contrary, the Income Statement, matches the revenue

generated versus the costs incurred, leading to a profit figure. The Income Statement is prepared on

the accruals principle. Therefore revenue that is generated in that year, but not yet received its

associated cash inflow, will still be included as part of the sales figure, leading to differences

between the profit figure and the increase in the cash and cash equivalents

Question 2 (b)

The Cash Flow Position of NEXT PLC increased by £0.4 million from 2005 to 2006.                     By

examining the Operating Position of the company, one can notice, that the net cash flow from

operating activities in 2006 improved. This is mainly due to an increase in trade payables by

adopting proper negotiations with creditors. The cash flow position of the company was also aided

in 2005 by applying proper credit control policies in order to decrease the trade receivables. It is

imperative in working capital management that the settlement period for trade receivables is always

lower than the settlement period for trade payables.

There were no investments in property plant and equipment neither in 2006 nor in 2005.

The financing activities of the firm show that management is presently performing changes in the

capital structure of the firm. Indeed a material amount of money was spent in purchasing back the

firm’s own shares. This strategy was already adopted in 2005, but the value of shares purchased in

2006 is 280% higher. This thus led in the decrease of cash and cash equivalents. The amount of

debt capital also increased in 2006 leading to cash inflows in the organisation. This diminished the
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effect of the shares redemption and affected the gearing of the company as already explained in

question 1 (c).

Overall the company is performing properly in terms of cash flow, even though there was a minor

increase in cash and cash equivalents. This is primarily due that the cash flow from operating

activities increased and the factors leading to a decrease in cash and cash equivalents, where mainly

changes in the capital structure.

Question 3

From 2005 onwards, public limited companies, were requested to commence utilising International

Accounting Standards instead of the local standards previously utilised. This led to certain changes

in the preparation and presentation of financial statements. For instance the layout of the cash flow

statement was changed drastically. The main benefit is that it will enhance harmonization of

accounting standards across Europe, thus improving comparability of financial statements. The

costs incurred by such organisations were training costs and practical problems like the adoption of

IAS 39 – Financial Instruments: Recognition and Measurement. The adoption of this standard led

to greater volatility in the profitability of the company and may thus lead to short-term adverse

effect on the firm’s share price in the capital market.

Question 4

Ratios on their own are meaningless. It is therefore important that ratios are compared over time in

the same organisation in order to see if the financial performance and position have improved or

worsened. Ideally ratios of the company should also be analysed with those of the industry by

taking the industry average. This reveals the company’s financial strengths/weaknesses in relation

to its competitors. In order to have a full picture of the firm, I would also examine the market/s the

company is operating in. Are such markets growing, steady or declining? Preferably a firm should

always enter in growing markets and appropriate product improvements or diversification strategies

should be adopted to avoid falling in deteriorating markets.
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Reference:

Randall H, A Level Accounting, Third Edition, Ashford Colour Press Ltd., Hampshire, 1996.

				
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