Ratio Analysis & Capital Budgeting

Question: Explain Ratio Analysis Capital Budgeting. Answer: Ratio Analysis is an important and useful tool for analysing financial information and statements. They condense a lot of data into simpler form in number of ratios and percentages and help the users of financial statements make sense of the financial and operating performance of the company. Ratio analysis also makes comparison between performances of companies easier. (Kothari, 2004)(Oysazar, 2012) If we look at the various profitability ratios such as Net profit margin and Return on Assets we observe that the values have hardly shown any significant deviation over the last four years hinting at the steady growth of the firm. It also hints at the fact that sales and profits are increasing by the same percentage which means expenses are also growing.(Eriotis, Frangouli, Ventoura-Neokosmides, 2012) This would have been a sign for worry had the expenses been growing at a faster rate.Net profit margin is an industry specific ratio and would be higher for a company like ABCAM which is into pharmaceuticals and life science than for a company like Tesco which is in the retail industry. On the other hand Return on Assets is a measure of how efficiently a company is using its assets.(Gibson, 2012) A company like Abcam has a lot of assets which are intangibles and goodwill which have a long pay off period, hence this ratio for them is bound to be lower than other companies operating in different sectors. Again if we look at the efficiency ratios average inventory days figure for this year of 170 is very high. Simply put it means it takes ABCAM 170 days to turn over its inventory. Again this is industry specific and while 170 might be a bad number for one industry it might not necessarily be bad for ABCAM which is in the life sciences industry.(Raoa Rao, 2009) The high current ratio through the years is testimony to the fact that ABCAM is very well off liquidity wise. One good thing is that inventory constitute roughly 20% of current assets so even if we were to take the quick ratio which is generally considered a better measure to evaluate a firms liquidity, ABCAM does very well on that front as well.(Bajkowsi, 1999) If we look at market performance of shares we can see that the company has been steadily increasing its EPS and dividend payments which is a good sign for the investors. To calculate the P/E ratio historical prices of the stock have been taken from Yahoo Finance. P/E ratio is a measure of whether a company is undervalued or overvalued by comparing this value with companies operating in the same industry. If we look at P/E ratio of OCAD Group and ASOS their P/E ratios are extremely high 141 and 76.5 respectively. Generally, such a high P/E ratio can mean two things which might be complimentary. Firstly, it is overvalued and secondly that investors are expecting higher future earnings from it. Therefore, it can be said that for ABCAM the P/E ratio is more or less steady as from its past performance investors expect steady earnings.(Wu, 2014) Next up the ratios have been derived from restated financial statements. The concept of economic different is quite different from accounting profit. Whereas accounting profit only considers the explicit costs the economic profit considers the implicit costs as well.(Li, 2012) If we look at ABCAMs profit margin calculated from restated financial statements and compare it with the profit margin calculated from financial statements that there is a huge difference between profit margins for the year 2015 with the one calculated from restated financial statements showing a marked improvement. That is mainly due to the fact that in 2015 ABCAM had significant gains from the increase in exchange price of British pound which inflated this ratio.(ABCAM PLC, 2015) Similarly, in 2014 the profit margin calculated from restated financial statements shows a sharp fall as the British pound fell whereas for 2012 and 2013 the ratio doesnt show much difference because the pound was stable. (ABCAM PLC, 2014)(ABCAM PLC, 2013)(ABCAM PLC, 2012) Net Operating assets subtracts the investment assets and adds the operating liabilities to the total assets. Since the denominator value increases that if why we observe that Return in assets and asset turnover is lower in this section than the ones calculated from the financial statements. If we look at the overall economic profit of ABCAM we see that it is the highest for all the four years as the return on net operating assets was highest for this year. Economic profit is a good indicator of how a company is creating value for the stake holders, since it is calculated by subtracting the return on net operating assets with cost of capital. (Damodaran, 2007)Hence it is taking the debt serviceability and the required rate of return for the shareholders into account before calculating the net profit. If we look at the income statement and compare the economic profit with accounting profit, we find that it is considerably less but that is because it takes the WACC into context. Simply put this is the profit left after meeting the requirements of the debt holders and the equity holders as a surplus. ABCAM Plc has two investment opportunities. The first scenario has an initial capital outlay of 5 million GBP, wherein the company invests in a machine which results in revenues of 1 million GBP for seven years. At the end of seven years the machine can be sold for 2 million GBP. The second scenario has an initial capital outlay of 8 million GBP, wherein the company buys a patent which results in revenues of 2 million GBP for 5 years and at the end of five years the patent can be sold for 2 million GBP. The patent requires an annual fee of further 0.25 million GBP. The company has a decision at hand whether to invest in the first or second scenario. Since the first option has a positive NPV the company should invest in the first option. The first option has a positive NPV of 0.8 million GBP and an IRR of 14.5% which is higher than the cost of capital whereas the second option has a negative NPV of 0.125 million and an IRR which is below the cost of capital. At the outset and IRR might produce similar results but in some cases they produce results which oppose each other. Such cases are called conflict of NPV and IRR methods. (Mackevi ius Tomaevi , 2010) There has been a long standing debate as to which is a better appraisal method. On one hand while some managers tend to prefer IRR as it gives a definitive rate of return rather than return in currency terms and managers world over have a tendency to be inclined towards ratios. They tend to find NPV less intuitive because it does not measure the amount relative to the amount invested.(Arshad, 2012) On the other hand some managers consider NPV a better approach as they consider it more flexible as it provides information regarding how much the decision increases the firms value. In these areas IRR becomes restrictive particularly when used to appraise mutually exclusive projects and in cases with alternate positive and negative cash flows.(Drake). References ABCAM PLC. (2014). Annual Report. ABCAM PLC. (2015). Annual Report 2015. Arshad, A. (2012). Net Present Value is better than Internal Rate of Return. Bajkowsi, J. (1999). FINANCIAL RATIO ANALYSIS: PUTTING THE NUMBERS TO WORK. AAII. Bajkowski, J. (1999). A LOOK AT THE CORPORATE CASH FLOW STATEMENT. AAII. Damodaran, A. (2007). Return on Capital (ROC), Return on Invested Capital (ROIC). Stern School of Business. Drake, P. P. (n.d.). Advantages and Disadvantages of the Capital Budgeting Techniques. Gibson, C. H. (2012). Financial Reporting and Analysis. Cengage Learning. Kothari, S. P. (2004). Financial Statement Analysis. MIT Sloan School of Management. Mackevi ius, J., Tomaevi , V. (2010). Evaluation of Investment Projects in Case of Conflict between the Internal Rate of Return and the Net Present Value Methods. Ekonomika, 89(4), 116-130. Oysazar, H. (2012). Advantages and Disadvantages of Financial Ratios. Wu, W.-T. (. (2014). The P/E Ratio And Profitability. Journal of Business Economics Research , 12(1).