Introduction
The performance of a company is gauged by the evaluation of both qualitative and quantitative information regarding the company. Some of the qualitative information that is used in this evaluation of the company could be the experience of the management, macro and micro environment in which the company operates among other metrics.
In making a decision as to whether a company is doing well, an in-depth analysis of the company’s financial information is particularly important. The comparison of the company’s financial data with its previous year’s performance and also with its peers and industry at large would shade more light on how the company is doing financially.
In doing this, financial ratios are computed and compared with the known standards as well as similar ratios for the industry. A horizontal and vertical analysis of financial information can also be done on a more advanced platform to obtain a clearer picture of a company’s financial performance.
This paper attempts to carry out an evaluation of the choice company, Rolls Royse with particular emphasis on the financial ratios. These ratios will include the profitability. Liquidity, solvency and other performance ratios. An attempt will be made to compute, analyze, interpret and compare the ratio with the previous year’s results where applicable.
The overall opinion on the performance of the company after the analysis will also be included so that the overall picture of the company’s performance could be put to light. This will be done as a summary to the whole document. Notably too, other aspects of management accounting such as cash flows will also be discussed in depth
A cash flow statement is a statement that shows the companies sources and uses of funds in the organization. It’s a very important source as it shows whether the company is liquid enough to meet current financial obligations as it shows the cash available. Its important to compare cash flow from operations with operating income for the following reasons among many others.
Comparing these two sets of data, shows the sources and uses of the company’s funds . It shows how the company has been able to efficiently use the company’s funds to generate income. It also shows what segment of the income generation utilized most funds and the returns thereof.
Although a company may be generating income (profitable) it’s important that the cash flow statement is used in the planning for cash requirements in the business. This is because, being profitable may not mean that the company is generating enough cash to meet its cash needs in the period, and may be forced to borrow some funds to meet short term cash requirements besides being profitable
Comparing the income from operations with the cash flows from operations helps the accountant to be able to access the firm’s efficiency in the generation of cash inflows. This can be used to identify areas where there is a slack in efficiency and ensure that corrective actions are taken
Comparison of income and cash flows enables one to identify the non cash items that are used in arriving at the income figure so as to be able to adjust the same for a better picture of the financial statements. For instance, a company that has charged a huge figure for depreciation, on adjusting the depreciation rate will of course affect the profit figures. This means that the comparison of the two helps the accountant to identify noncash items that have an effect on the income levels
Calculate and interpret the following short-term liquidity ratios: Current Ratio, Quick Ratio or Acid Test ratio, Accounts Receivable Turnover ratio, Inventory Turnover ratio and Days Sale in Inventory ratio.
Current ratio
This is computed as current assets divided by current liabilities. This is as follows
2011 2010
£m £m
8,315 9,824
6,916 7,178
1.202285 1.368626
This ratio indicates the ability of the company to be able to meet its short term debt obligations using the current liabilities. According to the ratios above, Rolls Royce is able to meet her current liabilities 1.2 times using the current assets. In finance, a ratio of 1 is the standard, and any company that has a current ratio of more than 1 is considered ‘’safe’’. A very high ratio may however mean that the company is rather having too much capital tied in current assets.
Quick ratio/acid test ratio
2011 2010
£m £m
8,315-2561 9,824-2429
6,916 7,178
0.831984 1.030231
Quick or acid test ratio measures the ability of the company to meet its short term obligations when they fall due, using the most liquid assets This ratio excludes inventory in the premise that inventories are not very liquid and may take some time before disposal. Rolls Royse. Based on the ratios above, Rolls Royce is in good financial position, recording an 83% probability that the company would be able to settle its creditors with very liquid assets in 2011 against a 103.1% on the same issue in 2010.
Accounts Receivable Turnover ratio is computed as sales divided by average accounts receivable
2011
£m
11,124
2495
4.5 days
This ratio indicates the number of days on average, which a customer takes to pay their debts. This ratio also indicates the company’s policies and commitment with regard to debt collection is very established and the company is able to collect most of its debts.
Inventory turn over
This ratio shows how efficient a company really is in moving its inventory, or rather converting its inventory into sales. Usually computed as cost of goods sold divided by the average stock, For Rolls Royce, the ratio will be as follows:
2011
£m
8,676
2561+2421
2
= 8,676/2495
= 3.477 times
This means that Rolls Royce turns each item of inventory to a sale three times in a year
Day sales in inventory ratio
This ratio is a measure of financial performance that shows how many days it takes to turn an item of inventory, including work in progress into sale. Its computed using the formulae
=( 2,561/8676)* 365
= 107.74 days.
This is a rather long period, but looking at the nature of business that Rolls Royce is involved in, and the nature of products it sells in the market, then this number of days can be said to be reasonable. This is because; these efficiency ratios depend mostly on the industry in which the business operates.
Calculate and interpret the following long-term solvency ratios: Debt to Equity ratio and the Interest Coverage ratio.
Debt to equity ratio
This ratio compares the debt that is employed in the company with the share holders equity invested funds in the company. It shows how the company has leveraged on the mixture of debt and equity for maximum benefits.
It’s calculated as Total debt/ Total equity
= 4988/4519
=1.103
This indicates that most of the company’s assets are financed using debt. This may also mean that this debt is attracting a lot of fines and penalties for the company in the long run.
Interest coverage ratios
This ratio indicates the ease with which a company could pay its debts. Its calculated by dividing the company’s earnings before interests and tax with the interest expense
= Ebit/ Interest expense
= 1,189/84
14.15 times
This shows that Rolls Royse is in a position to service its loans with a lot of ease. This is because her EBIT is 14 times more than the interest expense
Calculate and interpret the following profitability ratios: Gross Profit Margin, Operating Profit Margin, Return on Common Stockholders' Equity, and Return on Investment.
Gross Profit Margin
This is a financial profitability ratio that indicates the amount of revenue that is left after accounting for the expenses that go directly to the business. It’s calculated as
(Gross Profit /sales)*100%
= (2,448/11,124)*100%
= 22%
This means that for each product sold, Rolls Royse has incurred direct costs amounting to 78% and therefore the remaining 22% is the gross profit margin available to the company.
Operating profit margin
This ratio shows the operating return for the investor. The operating profit is net of all other expenses and is available for distribution. The ratio is calculated as
(Operating profit/sales)*100%
(1,186/11,124)
= 10.7%
Return on equity
This ratio measures the amount of income that is a return to the money invested by the share holders. The higher the return, the better for the company’s owners. It’s calculated as follows;
Net Income/ Share holders’ equity
= 848/4519
= 18.77%
This is the return that the moneys invested by the shareholders of Rolls Royce have earned over that period of one year.
Return on investments.
This ratio is a metric that measures the returns that have accrued to the investor’s money in the business. Commonly, it’s computed as
Net profit/ total assets
For Rolls Royce, the ratio would become;
848/16,423
= 5%
This essentially means that each dollar invested in the company earns a return of about 5% each year
How are segments identified under U.S. GAAP and International Financial Reporting Standards?
IFRS 8 with segment identification and reporting and also elaborates on the factors to consider on deciding on whether a part of a business qualifies as a segment or not. This particular IFRS has a requirement that particular classes of entities ensure that they disclose all information about their operations in the segments, services and products and also the geographical areas of operations or even their major customers. The internal management usually has a upper hand in deciding what section qualifies as a segment and what to disclose in each segment.
IFFRS offers the following definition for a segment. These definitions cover the two different classes of segments which include operating segment and also reporting segment. An operating segment is a component of a given business that;
Engages in its separate business, from which revenue is earned, as well as expenses relating to the business can be quantified. These includes those transactions in which the segment has been involved in the trading with other parts of the larger business
A segment is also identified as a separate business if the operating results of that part of reviewed regularly by the top management of the business for decision making with regard to resources allocation, and also for which the business performance is to be assessed.
One of the major characteristics of a segment is however a business segment in which financial information can be made available. This will allow an independent review and decision making on the performance of any particular segment. Reportable segments on the other hand have a number of characteristics. Key among them is that its reported revenue must be at least 10% of the business combined revenue, whether internal or even external (Deloitte and Touché, 2006).
Their total asset is 10% or more compared to the overall combined assets base. Only when these are met, is the business able to identify and separately report a business as an operating segment under IFRS.
Under GAAP,
Just like the IFRS, GAAP gives management discretion as to what to classify as operating or reporting segment. Under this approach, operating segments are identified based on a number of criteria such as customer, geographic or even product based classification.
Secondly, a segment is recognized if there is an identifiable product, service customer or even a distribution method. This means that several parts of a business can be grouped into a segment.
A segment is also recognized and reported if it can produce at least 10% of the revenues, combined assets or even profit, compared to the overall business
Calculate Rolls-Royce's Return on Investment by breaking it down into the margin and turnover components. What steps can Rolls-Royce take to increase its Return on Investment?Calculate the Residual Income of Rolls-Royce. What assumptions did you make to obtain your answer?
Using the DuPont system, we can break down the return on investment into its components as follows
Operating return on assets=
= operating income * sales/Total assets
Sales
= (1186/11,124) *(11,124/16,423)
= (1186/ 16,423)100%
= 7.2%
Return on assets= (Net income/sales)*(sales/ total assets)
= (848/11,124)*(11,124/16,423)100%
= 5.15%
In order to increase the companies return in investment, Rolls Royce must endeavor to increase its operating profits and net profits at any given time. In order to increase the revenues, and by extension the profits, the company must ensure that its innovative in its product offering and also ensure investments are made in profitable business segments.
The company must also ensure that its operating expenses are significantly reduced so as to improve the margins for better returns on investment. Since the company cannot dispose its assets, its only feasible that it utilizes the assets in a better way so as to ensure a better return. The assumptions made here is that the factors of production at Rolls Royce are not at full employment, that there is extra production capacity and that the market can still accommodate more of Rolls Royce products.
Based on the ratios that you calculated above, what is your overall assessment of the company?"
Summary of assessment and conclusion
We shall begin our overall analysis of the company’s performance with the liquidity ratios which are the quick ration and the current ration. In both years, the company has attained more than average ratios thus indicating that the company is in a great position to be able to clear its debt obligations as and when they fall due, using the available current assets.
Second is the efficiency ratio where various efficiency ratios indicate that the company is quite efficient in the handling of debtors and creditors.
The solvency ratios as calculated indicate that the company is in a great position as far as debt utilization is concerned, The Company has a great mix of debt and equity and is therefore under no threat of being insolvent. The company is therefore financially sound, at least from the solvency ratios point.
In terms of profitability, the company has a gross margin of 22% and net profit margin of about 11%. This is a moderate return, considering the turbulent operating environment that the company operates in.
Lastly, in terms of returns on investment, the company reported a fair ratio of 5%. This figure is however not as is expected of a company of Roll Royce stature and management is advised to find alternative means of ensuring that the shareholders investment returns a better earning as compared to the present figures (Drake,2010).
Looking at the global picture, the company has great financial standing and brand presence in the region and is expected to continue to improve its performance for the coming days as is evident from the increased revenue in 2011. Despite the biting effects of the not so distant financial crisis, the company has been able to weather the storm and still continue to post good results. This is made possible by the strong asset base, global distribution network and also a committed and visionary management team.
References
Deloitte and Touché (2006) IFRS 8: Operating segments. IAS Plus publication. Adopted from
Rolls Royce annual report (2011). Adopted from .
Drake, P.P (2010) financial analysis.
Adopted from http://educ.jmu.edu/~drakepp/principles/module2/fin_analysis.pdf
