ABC Supermarket PLC Case Analysis Ratio Analysis

ABC Supermarket PLC

Case Analysis

Ratio Analysis

The results of ABC Supermarket's financial performance are very different from the comments shared by the Chairman in the 2009 Annual report. Based on the evaluation below, the company's cash, profitability, and liquidity positions all weakened between 2006 and 2009. They also had an issue with managing inventory. However, the stock price increased successively over this period of time. This may have been a factor of raising more debt.

Return on Capital Employed (ROCE)

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the investments the shareholders have made in their company. It is also the rate of return a business is making on the total capital employed in the business. Capital will include all sources of funding (shareholders funds + debt).

The single most important indicator of the inherent excellence of a business is the return on capital employed. There is a popular statement that applies to this ratio: "it takes money to make money." Those that understand compounding know that the goal is to make as much money with as little invested as possible while avoiding the dangers of leverage.

ABC Supermarket's ROCE ratio decreased successfully over the past four years. In fact, the ratio dropped 10 points between 2006 and 2009. This is in indication that the company did not leverage investor funds appropriately.

Return on Equity (ROE)

One of the most important profitability metrics is return on equity. Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. It's what the shareholders "own." Shareholder equity is a creation of accounting that represents the assets created by the retained earnings of the business and the paid-in capital of the owner

The Return on Equity profile for ABC Supermarket is weakening. Similar to its performance with the Return on Capital Employed ratio, this suggests that management is not leveraging equity appropriately.

Stock Turnover (Days)

Stock turn over ratio and inventory turn over ratio are the same. This ratio is a relationship between the cost of goods sold during a particular period of time and the cost of average inventory during a particular period. It is expressed in number of times. Stock turn over ratio indicates the number of times the stock has been turned over during the period and evaluates the efficiency with which a firm is able to manage its inventory.

This ratio indicates whether investment in stock is within proper limit or not. Given that the number of stock turnover days increased 23% (45 days in 2006 vs. 59 days in 2009), this is indicates that there are some issues managing inventory.

Debtor Collection Period

The term Debtor Collection Period indicates the average time taken to collect trade debts. In other words, a reducing period of time is an indicator of increasing efficiency. It enables the enterprise to compare the real collection period with the granted/theoretical credit period. It is evident based on the reduction over the four-year period that the company operated efficiently in this area.

Current Ratio

The current ratio is a test of a company's financial strength. It calculates how many dollars in assets are likely to be converted to cash within one year in order to pay debts that come due during the same year. An acceptable current ratio varies by industry. Generally speaking, the more liquid the current assets, the smaller the current ratio can be without cause for concern. For most industrial companies, 1.5 is an acceptable current ratio. As the number approaches or falls below 1 (which means the company has a negative working capital), management will need to take a close look at the business and make sure there are no liquidity issues. Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash.

Normally, one would correlate the

Acid Test Ratio

The Acid Test Ratio is a stringent test of liquidity. It is also known as the Quick Ratio. The ratio is found by dividing the most liquid current assets (cash, marketable securities, and accounts receivable) by current liabilities. Inventory is not included because it usually takes a long time to convert into cash. Prepaid expenses are left out because they cannot be turned into cash and thus are incapable of covering current liabilities. In general, the ratio should at least be equal to 1. In other words, for every $1 in current debt there should be $1 in quick assets.

Over the course of the years being evaluated, there was an extreme decline in the Acid Ratio Performance. This suggests that companies were low on cash and not managing receivables efficiently.

Gearing Ratio

Shareholder's like seeing the gearing ratio, the relationship between long-term liabilities and capital employed, in their favor. This suggests that there is more equity to be had and distributed than debt. Given the high and successfully increasing Gearing Ratio profile, the company is financed mostly by debt.

In addition, it seems that they were taking on more debt each year. More debt and less cash (indicated by the liquidity ratios) is not a good operating metric.

Interest Cover Times

The interest coverage ratio is a measure of the number of times a company could make the interest payments on its debt with its earnings before interest and taxes, also known as EBIT. The lower the interest coverage ratio, the higher the company's debt burden and the greater the possibility of bankruptcy or default.

As a general rule of thumb, investors should not own a stock that has an interest coverage ratio under 1.5. An interest coverage ratio below 1.0 indicates the business is having difficulties generating the cash necessary to pay its interest obligations. The history and consistency of earnings is tremendously important. The more consistent a company's earnings, the lower the interest coverage ratio can be.

ABC Supermarket's Interest Cover Times ratio decreased about 46% (from 4.8 times in 2006 to 2.6 times in 2009). This is an indicator that the company had cash deficiencies.

EPS

Earnings per share is the portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability. Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the price-to-earnings valuation ratio.

An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company.

According to the earnings per share profile, ABC was earning substantial profit each year. But similar to a high-income wage earner with a dwindling bank account, they were not managing profits well as explained earlier.

P/E Ratio

The P/E ratio (price-to-earnings ratio) of a stock (also called its "P/E," or simply "multiple") is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. P/E is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower P/E ratio.

ABC Supermarket's stock became more expensive over the course of the evaluation period. This is not positive, given its liquidity and debt profile.

Share Price

The basic definition of share price is simply, the price of one share of stock. Normally an increase in share price is respectable. However, given the company's increasing debt load, it is reasonable to assume that the stock price was going up because they were constantly raising more capital. This is not indicative of favorable performance.

Selection of New Project: Project A or Project B

In order to evaluate which project ABC Supermarket should select for investment, we should understand each of the factors that will be used in the decision making process:

Payback Period

Accounting Rate of Return (ARR %)

Net Present Value (NPV £m in 15 years)

Internal Rate of Return (IRR %)

Payback Period

The Payback Period represents the amount of time that it takes for a Capital Budgeting project to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent projects with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive projects, the project with the quickest payback is preferred.

Project A has a payback period of 5 years; and, Project B. has a payback period of 6 years. Project A is preferred because it has the quickest payback period. However, relying solely on the payback period would be over conservative.

Accounting Rate of Return (ARR%)

The accounting rate of return (ARR) is a very simple. It consists of average profit + average investment. The profit number used is operating profit. The average investment is the book value of assets tied up (in the project). This is important as the profit figure used is after depreciation and amortization. This means that value of assets used should also be after depreciation and amortization as well.

ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organization. It is rarely used by investors, and should not be used at all, because:

Cash flows are more important to investors, and ARR is based on numbers that include non-cash items.

ARR does not take into account the time value of money -- the value of cashflows does not diminish with time as is the case with NPV and IRR.

It does not adjust for the greater risk to longer term forecasts.

There are better alternatives which are not significantly more difficult to calculate.

The accounting rate of return is conceptually similar to payback period, and its flaws, in particular, are similar. A very important difference is that it tends to favor higher risk decisions (because future profits are insufficiently discounted for risk, as well as for time value), whereas use of the payback period leads to overly conservative decisions.

Because ARR does not take into account the time value of money, and because it is wholly unadjusted for non-cash items, any method of selecting investments based on it is necessarily seriously flawed. Its only advantage is that it is very easy to calculate. It is fairly easy to construct (realistic) examples where it will lead to different choices from NPV, and the NPV led decision is clearly correct.

Project B. is preferred because it has a higher ARR. However, similar to the payback period, relying solely on this would be over conservative.

Net Present Value

The Net Present Value of a project is the difference between the sum of discounted cash flows expected and the amount that was initially invested. NPV is a calculation that expresses how much value will result from making a particular investment. This is done by measuring all cash flows over a period of time back toward the current point in present time. If the NPV amounts in a positive amount, the project should be undertaken.