Profitability Ratios
Return on capital employed (ROCE)
ROCE shows the company’s net profit before interest and tax in relation to total capital invested as a percentage. Generally a decrease in the ROCE percentage from one year to the next could signify various internal or external factors affecting their business, externally a more difficult economic climate for the company which could be caused by a general down turn in the industry or fierce competition, internally it is usually due to poor utilisation of its total assets by those entrusted to run the company, either way it is the duty of the management to utilise the assets of the company to gain maximum profits. The ROCE has decreased from 9.52% in 2005 to 5.41% in 2006, this is a very major decrease, this would normally lead one to think that the management have severely under utilised the assets of the company showing a poor performance on their part, but on closer inspection it is clear that the results have been skewed as the 9.52% figure for 2005 is largely inflated, as the PBIT of £3.472m was inflated by £1.499m of exceptional items (reduction in administration costs) in the profit calculation, and a decrease in profits in 2006 of £1.074m due to exceptional items (increase in administration costs), had these exceptional items not been considered in calculating the ROCE it would have shown a strong increase between 2005 and 2006.
Gross profit margin ratio
The gross profit margin ratio shows the gross profit as a percentage of its sales revenue. This shows that it has increased from 22.65% to 25.94%, this is a positive increase of 3.29% from 2005 to 2006.
Net profit margin ratio
The net profit margin shows the net profit before tax as a percentage of its sales revenue. It has decreased from 11.75% in 2005 to 5.32% in 2006; that is a decrease of 6.43%. This would normally be a serious issue to consider, but as explained previously the results have been skewed due to negative exceptional items in 2006 and positive exceptional items in 2005, had these items not been considered in this calculation it would have shown a positive increase.
Liquidity Ratios
Current ratio
The current ratio is one of the best measures of liquidity. It is generally accepted that a ratio of 2:1 is a strong position to be able to meet the company’s short term liability responsibilities; the higher the ratio is; the more liquidity the company has, making it more likely to be able to cover its short term liabilities. Although it has decreased from 2.41:1 in 2005 to 2.18:1 in 2006, it is still over the accepted 2:1 ratio, therefore there is no reason for investors or the company to fear liquidity problems.
Quick asset ratio
Conventional it is held; the most ideal quick assets ratio equals 1. In 2006 and 2005 the quick asset ratio was comfortably over 1, although it has decreased to some extent. It is not good to have too high a current ratio or quick assets ratio, as this would signify the under utilisation of the company assets.
Efficiency Ratios
Debtor’s Collection Period (DCP)
The debtor’s collection period ratio shows the average amount of time taken to collect debts from credit sales. In 2005 it is at 80.7 days which has decreased to 74.9 days in 2006, these positive results show that the DCP has significantly decreased from the previous year signifying an improvement in efficiency, this supports the view that its credit control system has functioned more efficiently.
Stock Holding Period (SHP)
The stock holding period ratio shows the average amount of time stock is held before being sold, it has decreased from 66.3 days in 2005 to 62.1 days in 2006, again it shows a improvement in efficiency showing that the company’s stock control systems are running more efficiently than the previous year.
Gearing Ratio
Gearing is calculated to show what proportion of a company’s total capital is provided by loans capital as opposed to equity. The greater the proportion of total capital is provided by loans the greater the vulnerability to a down turn in profits. This is because the interest on a loan must be paid regardless of the company making a profit.
33.3% gearing is conventionally accepted as medium/high gearing, although this does vary from industry to industry. The gearing ratio of 35.32% in 2005 is not considerably high, this has decreased to 31.02% for 2006; it has been brought down firmly in to the area conventionally accepted as medium gearing thus decreasing the company’s gearing vulnerability to a down turn in profits meaning it is not considered to be a high risk investment.
Part 2
a) Ratio analysis in the areas of liquidity, profitability, efficiency and gearing are very important when trying to understand the financial position of a company, all of the data required for calculating these ratios are taken from the balance sheet and income statement.
The balance sheet statement summarises the value of total assets and liabilities, as well as owner’s equity at a specific date. The balance sheet gives the user a good understanding of the company’s value as you can see what it owns and owes. The balance only provides a snapshot of this information on the date of reporting as the items in the balance sheet could change the next day, furthermore the balance sheet can be manipulated in various ways such as incorrectly valuing assets such as ‘work in progress’ inventory or incorrectly valuing buildings, plant and machinery. It is not straight forward how all items in a balance sheet are calculated. There are many ways that firms try to hide debt by not recording it on the balance sheet such as the well documented case of Enron who were keeping debts off the balance sheet by offloading the debt to ‘special purpose entities’ (SPEs). It is important to any investor to know that the company they are buying a share into actually owns tangible assets (less liabilities) that back up the value of the company’s shares; this reduces the risk of the investment.
Beyond risk to investment capital; the investor will look at profitability as this is the objective behind making an investment, for this purpose the income statement is very useful; as it shows net profit for the previous year as well as a breakdown of how this was calculated including figures for revenue, cost of sales and expenses etc. Analysis of previous income statements and the five year trading summary will help the user to get a good understanding of how well the company has been performing in the past. The income statement can also be manipulated, such as the abuse of ‘one time charges’ in the income statement when the usage of one time charges is misused to result in reported profits being lower than expected in one year, and then be seen to dramatically increase the next year, resulting in share prices rising allowing managers and related individuals to cash in on shares purchased at a lower price the previous year.
The cash flow statement shows all cash and cash equivalents entering and leaving the company for the reporting period. It allows investors to see how money is being spent and where it is coming from. It is generally held to be one of the more reliable financial statements as it is less open to manipulation as it deals with simpler and clearly tangible accounting items. Given this there are still ways to manipulate it such as dishonesty in accounts payable by counting cheques in the mail as cash in hand rather than money paid out or the choice of making payments late on purpose.
Efforts have been made by the introduction of further legislation and tightening of regulatory frameworks as well as implementation of further standards; such as international auditing standards (IASs); to counter act these problems namely the Sarbanes Oxley act 2002 in the USA and similar provisions in the UK.
By providing all three financial statements the user will be able to gain a good understanding of the company’s financial position and profitability; each of them provides different useful information. Furthermore it is more difficult to manipulate one financial statement and not result in contradictions with the others. The cash flow statement helps to back up the balance sheet and income statement. Reporting based on international reporting standards are very important, as it means that preparers of reports must treat accounting items as set out by international standards leading to more reliable and comparable financial statements for the user. Due to international auditing standards one would expect that auditors will find the cases where manipulation and fraud has taken place; which gives the investor more confidence in the financial statements that he must rely upon to make decisions. I would still advise any potential adviser to fully read all reports and notes beyond just the three financial statements.
b) In this section I will discuss how Zotefoams plc provides segmental information under IAS 14 and how this will change upon the adoption of IFRS 8 as well as consider the relevance of this information to the company’s current and potential investors.
I would like to begin by explaining IAS 14 and segment reporting. Companies often carry on several types of business or operate in many different geographical locations, with varying opportunities of growth at different levels of risk relative to the geographical location or type of business. It is very difficult for a reader of financial reports to make judgements about the nature of different activities carried out by a company or what impact each activity has on the financial situation of a company unless some segmental analysis of the financial statements are provided. Segmental reporting is required to help the users of financial statement to more thoroughly understand the past activities of the company and thus make a more informed assessment of the company’s future prospects; as well as be aware what impact will occur on the company if there are significant changes in components of the company. All of this helps to assess better the risks and potential returns for the investor.
IAS 14 was set out to standardise segmental financial reporting by companies. IAS 14 only applies to publicly quoted companies or those that are about to be. Zotefoams is a publicly quoted company and therefore should comply with the provisions of IAS 14. IAS 14 does encourage non-publicly quoted companies to report segmental information, and if they do they should comply with its provisions.
According to IAS 14 a company should report on business and geographical segments showing the groupings of products and services provided by each company segment as well as the composition of the geographical segments. One type of segmentation can be deemed as primary; chosen from either business or geographical, the second should be regarded as secondary. This is usually decided based on the company’s internal management and organisational structures as well as the internal financial reporting system for management.
Geographical or business segments can be judged to be reportable when the majority of its sales revenue is gained through sales to customers who are external, plus also:
- The revenue is 10% or above of total revenue of total segments;
- It’s profit or loss is 10% or more of the combined total of profits or losses
- It assets are 19% or above of total assets of the company (combined total of all segments).
Other segments should be reported if the total external revenue from segments that have been deemed reportable does not reach 75% of total company revenue; more segments should be recognised until 75% of the total consolidated revenue is shown as reportable segments.
The following is to be disclosed for each primary reportable segment:
- Revenue, sales to external customers and inter-segment sales disclosed separately, the basis of price setting should be disclosed for inter-segment sales.
- Profits before interest and tax for continuing operations and discontinuing operations should be disclosed separately
- Carrying amount of segment assets
- Segment liabilities
- Cost applicable to the period for acquiring property, plant and equipment as well as intangibles;
- Depreciation and amortisation charges, as well as other significant non-cash expenses or otherwise cash flows from operating, investing and financial activities in line with IAS 7 cash flow statements.
Each secondary segment should disclose:
- Revenue, disclosing separately how much is external sales and how much to other segments
- Segment assets total
- Cost applicable to reporting period for purchasing property, plant and equipment as well as intangibles
Zotefoams’ primary segment reporting is reported by business area, the company sells two main types of foam which are Polyolefins and HPP. All of the above disclosures listed above for the primary reportable segment are made in the annual report. Furthermore, the revenue from external customers, segment assets; as well as capital expenditure (on property, plant and equipment as well as intangibles) are reported in the annual report for the secondary segment report which is done by geographical location which is separated in to: UK, Europe, North America and the rest of the world. All segment reporting is in accordance with IAS 14. HPP is a new product, it can be seen that the HPP segment is making a loss, this is expected as R&D is likely to cause expense to outstrip revenue at such an early stage, you can see from the segment report that Polyolefins segment is making strong profits, this would not have been clear if segmental reporting was not provided.
I will try to only discuss the differences between IAS 14 and IFRS 8 that are relevant to Zoatfoams plc. IFRS 8 has affected three main areas of segment reporting, they are; the identification of segments, the measurement of segment information and disclosure.
In terms of identification of segments; IFRS 8 states that segments that sell primarily or exclusively to other operating segments of the company can still be deemed a operating segment if it is operated that way. This is different to IAS 14 which reduced reportable segments to be segments which gain most of their sales revenue from customers who are external, IAS 14 doesn’t oblige that the separate levels of a vertically-integrated company be deemed to be separate entities. I do not believe this will have much affect on Zotefoams plc as they do not do any inter-segment trade, nor could it be said that from their company structure that it is a vertically-integrated company with separate entities in such a vertical chain to be deemed as separate operating activities.
IFRS 8 requires that the information reported on each segment should be the same information that is provided to the chief decision maker for the activity of allocating resources to that segment and assessing its performance. This may mean for Zotefoams plc that they may be required to provide more segmental information depending on their internal reporting practices.
A major difference between IFRS 8 and IAS 14 is that IFRS 8 requires an explanation of how profit or loss, assets and liabilities are measured for each operating segment, rather than define revenue, expense, result, assets and liabilities for each operating segment. This results in companies having more control over what is included in segment profit and loss in line with their own internal reporting practices. As companies are given greater choice over disclosure this could put investors at greater risk as there will be more room for manipulation of information.
Interest revenue and interest expense must be reported for each of the reportable segments separately if they are used to calculate segment profit or loss unless the majority of the segment’s revenue is earned by interest resulting in the chief operating decision maker making decisions to allocate resources or judging the performance of the segment based on information mainly on interest revenue.
c) The aim behind revising IAS 1 was to make it easier for users to be able to understand and compare financial statements. Financial information that goes in to financial statements are to be aggregated on the basis of shared characteristics, as well as introducing a statement of comprehensive income. This is being done so that it is more visible to see the impact on the company’s equity resulting from transactions between the company and its owners in that capacity; such as share repurchases, separately from the impact caused by transactions between the company and non-owners such as third parties. Comprehensive income can be displayed in either a single statement or be separated in to two statements including a income statement and a statement of comprehensive income statement. The ICAEW as well as the ACCA have both disagreed on giving the choice between the two as they believe it will lead to confusion amongst users making comparability more difficult. The ACCA also disagrees with the decision to change the name of the balance sheet to ‘statement of financial position’ on the grounds that the definition of the balance sheet is well known; they feel this change will only result in more confusion especially when preparers are not obliged to use the new title which will result in some prepares taking it up and others not; making comparison more confusing for users. The ACCA are also of the view that the decision to include a ‘statement of financial position’ at the beginning of the reporting period is not needed and will again lead to further confusion, this information if needed could easily be looked up in the previous year’s report. These changes are not likely to have a major impact on Zotefoams other than the effort required to make these new changes, as the changes have not been made to change how accounting items are treated but rather the changes have just been put in place to affect how some information is displayed as the change in name of the balance sheet, the choice in display of comprehensive income statements and the inclusion of the balance sheet from the beginning of the reporting period, these changes just provide the information to users in a way that it is easier for them to understand the financial position of the company. In the 2006 report a ‘statement of recognised income and expense’ (SoRIE) was included, by 2009 when the IAS 1 revisions must be implemented; the annual report will have to include a ‘statement of changes in equity’ in a addition to the SoRIE or choose to combine them into a single statement. This additional information already exists in the annual report in the notes section.
Bibliography
ACCA 2.5 Financial Reporting (international stream) Study Text (2005), FTC
David Alexander and Simon Archer, Miller International Accounting/Financial Reporting Standards Guide (2006), CCH
Barry Elliott and Jamie Elliott, (2006), Financial Times/ Prentice Hall
Company Law, Jerry DeFreitas, 5th edition 2006), Castlevale Handbooks
Zotefoams plc, Annual report (2006)
Technical summary: IAS 7 Cash flow statements
Deloitte, IAS Plus, (December 2006)
IASB, press release, (6 September 2007)
APPENDICE
FTC ACCA 2.5 Financial Reporting (international stream) Study Text 2005, p315
International Financial Reporting Standards (2005)
Section 8.07 cash flow statements, ‘Miller National Accounting/financial reporting standards guide 2006’.
“We suggest that the indirect method is at the same time more complicated and less informative in terms of actual cash flows than the direct method, U.S. GAAP, like IASB GAAP, encourage but do not require the use of the direct method. U.K. GAAP now require the indirect method, on the grounds that the benefits to users of the direct are outweighed by the cost of preparing it. If one takes a user rather than a preparer perspective, it is difficult to support the U.K. view on this point.” (David Alexander and Simon Archer, 8.07:2006)
All calculations for ratio analysis can be found in the appendix.
Segment reporting, p46 2006 Zotefoams annual report.
http://www.iasplus.com/iasplus/0612ifrs8.pdf
