1 of 5 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% 2 of 5 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) 3 of 5 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 4 of 5 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. 5 of 5 Reference: Randall H, A Level Accounting, Third Edition, Ashford Colour Press Ltd., Hampshire, 1996.