The Techniques Of Measuring Profitability Finance Essay - Free Essay Example

According to the London School of business finance, Accounting ratios are defined as a kind of term which is used as describing significant relationship between figures shown in a profit and loss account, on a balance sheet, , in a budgetary control system or in any other part of accounting organization. There are five aspects of business measured by accounting ratios. Profitability of company, Liquidity of company, Asset management of company, Debts management and capital gearing of company, and Market Value of investment to ordinary shareholders / common stockholders. The profitability of company is measured by Gross Profit Markup, Gross Profit Margin, Operating Profit Margin on Sales, Profit Margin on Sales, Basic Earning Power (BEP), and Return on Common Equity (ROE). The Liquidity of company is measured by Current Ratio, Liquid Ratio. The asset management of company is measured by Inventory Turnover or Stock Turnover, Fixed Assets Turnover, Total Asset Turnover, Debtor Ratio, Debtor Payment Period and Days Sales Outstanding (DSO). Debts management and capital gearing of company is measured by Debts Ratio, Capital Gearing Ratio, Debts Equity Ratio, Time Interest Earned, Creditor Ratio, and Creditor Payment Period. Market value of investment to ordinary shareholders is measured Earnings per Share, Price/ Earnings Ratio (P/E Ratio), Dividend Cover, Earnings Yield, Dividend Yield, Price/ Cash Flow Ratio and Market Price/Book Value Ratio. The ratios should be used as a comparison to the previous years trading figures or to compare similar comp anies to analysis any problems. By ratios analysis, the firm can see the trends and be able to adjust the business strategies. The accounting ratios are compared for business performance measurement by Inter- Temporal (comparison between two periods), Inter- Firms (comparison between two companies) and Comparison with industry averages. There are two companies which are called IJM Berhad and WCT Berhad. IJM Berhad was established in 1983 with an overarching purpose of competing more effectively against bigger foreign rivals. It is one of Malaysias leading construction groups. It has involved the business activities encompass construction, property development, manufacturing and quarrying, infrastructure concessions and plantations. It is headquartered in Selangor, Malaysia. IJMs regional aspirations have seen it establish a growing presence in neighbouring developing markets with operations presently spanning 11 countries. And WCT Berhad was established in 1981 as WCT Earth works Building Contractors Sdn Bhd, the Firm became a public company in 1994. The Company assumed its present name WCT Berhad since 2008. It activities included project management, construction design, value engineering and assets management  in F1   international racing circuit, High-rise and special purpose building, International airport, Hydroelectric dam, Iconic infrastructure, Township planning development, Racecourse, Commercial property development management, Expressway Highway and BOT Toll Concessions. The comparison of two companies financial statements (refer to appendix 12) is used for analysing how the accounting ratios are used in the firms. Lets look at the ratio calculations of two companies and find how the companies should perform. 2.0 Ratios Calculation 2.1 Profitability Ratio with Formula Calculation for IJM Berhad Calculation for WCT Berhad Gross Profit Markup = 0.3115.. 100 = 31.16% = 0.8225.. 100 = 8.23% Gross Profit Margin = 0.2375.. 100 = 23.76% = 0.0759.. 100 = 7.6% Operating Profit Margin on Sales = 0.1865..100 = 18.65% = 0.0523..100 = 5.23% Profit Margin on Sales = 0.0828100 = 8.29% = 0.0315..100 = 3.15% Basic Earning Power (BEP) = 0.0596..100 = 5.96% = 0.0545..100 = 5.45% Return on Total Asset (ROA) = 0.2648..100 = 2.65% = 0.0328..100 = 3.28% Return on Common Equity (ROE) = 0. 6484..100 =6.48% = 0.1176..100 = 11.77% 2.2 Liquidity Ratio with Formula Calculation for IJM Berhad Calculation for WCT Berhad Current Ratio = 2.09 : 1 = 1.41 : 1 Acid-Test Ratio = 2.09 : 1 = 1.41 : 1 2.3 Asset Management Ratio with Formula Calculation for IJM Berhad Calculation for WCT Berhad Inventory Turnover = 5.78 times = 37.93 times Total Assets Turnover =0.32 times = 1.04 times Debtor Ratio = 0.54 : 1 = 0.32 : 1 Day Sales Outstanding = 0.54 365 Days = 197.1 Days = 0.32 365 Days = 116.8 Days 2.4 Debts Management Ratio with Formula Calculation for IJM Berhad Calculation for WCT Berhadi Debt Ratio = 0.49 : 1 = 0.67 : 1 Debts Equity Ratio = 1.19 : 1 = 2.39 : 1 Time Interest Earned or Interest Cover = 3.73 times = 4.85 times 2.5 Market Value of Investment to Stockholders Ratio with Formula Calculation for IJM Berhad Calculation for WCT Berhad Earnings Per Share = RM 0.25 = RM 0.19 Price Earnings Ratio = 19.2 times = 13.68 times Earnings Yield = 0.6944ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦.100 = 6.94% = 0.974358ÃÆ' ¢Ãƒ ¢Ã¢â‚¬Å¡Ã‚ ¬Ãƒâ€šÃ‚ ¦ 100 = 9.74% Market Price Per Book Value Ratio =1.24 : 1 = 1.61 : 1 3.0 Ratio Comparison 3.1 Profitability A) Gross Profit Markup Gross Profit Margin Gross Profit Markup and Gross Profit Margin are used to measure the firms extent of the gross profit which is earned by the firm from its sales in purchasing and the production activities effectively and efficiently. Markup percentage indicates the differences between the actual cost and the selling price. And Gross Margin percentage indicates the differences between the selling price and the firms profit. The higher Gross Profit Markup or Gross Profit Margin means that the firm is able to control its budget (purchasing the cost) effectively and efficiently. According to the calculation above, IJM Berhad had higher Gross Profit Markup and Gross Profit Margin than WCT Berhad. This calculation indicates that IJM Berhad purchased the material at lower cost from its supplier than WCT Berhad. Also IJM Berhad reduced the production cost in allocating its resources. In other words, IJM Berhad has better management in its resources than WCT Berhad. B) Operating Profit Margin on Sales Profit Margin on Sales Operating Profit Margin on Sales and Profit Margin on Sales are used to measure the firms extent of profit which is earned by the firm from the sales made due to the company expenditure control. Operating Margin is a ratio used to measure a companys strategy on pricing and the efficiency in its operating. And Profit Margin is a ratio used to measure how much the firm actually keep in earning. Higher Operating Margin and Profit Margin indicates that the firm is more profitable because it has better control overall its costs compare to its competitors. According to the calculation above, IJM Berhd has much higher Operating Margin and Profit Margin on Sales. It indicates that IJM Berhad has earned higher profit than WCT Berhad. IJM Berhad might have lower operating expenses and lower interest cost than WCT Berhad because effective controlling its expenditure and interest cost can increase the profit. C) Basic Earning Power (BEP) Return on Total Asset (ROA) Return on Common Equity (ROE) BEP, ROA, and ROE are used to measure the firms extent of generated profit from total assets which the firm has used. BEP is the percentage of Operating Profit before interest, taxation, over total asset. ROA is a percentage which shows how efficient the firms management uses its asset to generate the profit. ROE is a percentage which shows the firms profitability by revealing how much profit the firm generates with the money which the shareholders have invested. Higher BEP, ROA, and ROE indicate that the firm can generate higher profit using its asset and capital. According to the calculation above, IJM Berhads BEP is just little bit higher than WCT Berhad but ROA and ROE is lower. It indicates that IJM Berhad generated the profit lower than WCT Berhad. It could not manage its asset and capital effectively. It might purchase the material in higher cost so, fail to generate higher profit. 3.2 Liquidity A) Current Ratio Acid-Test Ratio Liquidity ratios are used to measure a firms paying ability on short-term obligations. Current ratio is used to measure the firms ability in using current asset to finance its current liabilities. Acid-Test Ratio is used to measure the firms ability in financing the current liabilities but the extent of liquid assets which can be used. Higher current ration indicates that the firm has more capable in paying obligation. According to the calculation above, IJM Berhad has higher Current Ratio Acid-Test Ratio than WCT Berhad. It indicates that IJM Berhad is more stable in its financial than WCT Berhad which means IJM Berhad has more liquidity in financing the short-term liabilities than WCT Berhad. In other words, IJM Berhad has more enough short-term assets to cover its immediate liabilities than WCT Berhad. 3.3 Asset Management of Company A) Inventory Turnover Inventory Turnover is a ratio which shows how many times a firms inventory is sold and replaced over a period. In other words, it indicates how fast the firms stocks are turned over. Higher Inventory Turnover indicates that the money tied up by the stocks in the store is less. It has implied mean that strong sales or ineffective purchasing capacity. According to the calculation above, IJM Berhad has lower Inventory Turnover Rate than WCT Berhad. IJM Berhad has larger amount of the money is kept in the stock in the store and it may show IJM Berhad has lesser sales or better purchasing capacity than WCT. B) Total Assets Turnover Total Asset Turnover is used to measure how efficiently a firm uses its asset to generate the sales. Higher Total Assets Turnover indicates that the sales are high and the firm uses its assets effectively. According to the calculation above, IJM Berhad has lower Total Asset Turnover Rate than WCT Berhad. IJM Berhad might generate the lower sales and using its asset was not effective in its activities than WCT Berhad. 3) Debtor Ratio and Day Sales Outstanding (DSO) Debtor Ratio and DSO is used to measure the size of the debtors in credit sales and how long the time of period is needed to the firm to collect the debts form the debtors. DSO shows the average number of days which a company needs to collect the revenues after the sale is made. Higher Debtor Ratio and longer DSO indicate that the firm needs to take longer time to collect the money which is made by credit sales. According to the calculation above, IJM Berhad has higher Debt Ratio and longer DSO than WCT Berhad. IJM Berhad sells its products to the customers on credit sales and let the creditors to take longer time to pay back the debts made by credit purchases than WCT Berhad. So, IJM might face the short-term financial problem in paying back the liabilities because the money is tied up longer time in debtors. 3.4 Debts Management A) Debts Ratio Debt Ratio is used to measure how much debt burden the firm has and the ability of the firm in paying back the debts. Higher D ebts Ratio indicates that the firm has large amount of debts and need to pay higher interest cost so, it has heavy debt burden. According to the calculation above, IJM Berhad has lower Debts Ratio than WCT Berhad. IJM Berhad might have lower amount of the debts and needs to pay lesser interest than WCT Berhad. So, IJM Berhad has lighter debt burden and, its finance is safer because it is able to pay back its debts. B) Debts Equity Ratio Debts Equity Ratio is used to measure how the proportion of equity and debt the firm uses to finance its assets. Higher Debts Equity Ratio indicates that the firms assets are financed with the debts so, the firm are in more risky because of high interest cost. According to the calculation above, IJM Berhad has lower Debts Equity Ratio than WCT Berhad. IJM Berhad is having debts lesser than WCT Berhad so, it has less interest cost therefore, IJM takes lesser risk than WCT Berhad. C) Time Interest Earned Time Interest Earned is used to measure that how many times of operating profit can be used to finance the interest cost. So, high Debt Equity Ratio accompanies with low time interest earned. In other words, the firm needs to pay high interest charges. As IJM Berhad has lower Debts Equity Ratio than WCT Berhad, IJM Berhad also has lower Time Interest Earned. So, IJM Berhad has lesser interest charges and it is stable than WCT Berhad. 3.5 Market Value of Investment to stockholders A) Earnings per Share Earnings per Share is used to measure the business growth of the firm because it shows the firms profitability too. Higher Earnings per Share indicates that the firm has higher growth rate and it has higher profit. So, the firm can attract the stockholders. According to the calculation above, IJM Berhad has higher Earnings per Share than WCT Berhad. Therefore IJM Berhad can attract the stockholder more effectively in their higher growth of business and profitability. B) Price Earnings Ratio Price Earnings Ratio is used to measure the period of times which is needed to recover back the common shareholders investment, by comparing the price of the firms current share with its per- share earnings. Higher Price Earnings Ratio indicates that the shareholders are needed to take longer period of time to recover back their investment. According to the calculation above, IJM Berhad has higher Price Earnings Ratio than WCT Berhad. IJM Berhad has lower earnings per share so, its shareholders are needed to take longer period of time to recover back their share investment than WCT Berhad. Therefore IJM Berhad has lesser attractiveness to the shareholders than WCT Berhad. C) Earning Yield Earning Yield is used to measure that the percentage of each dollar invested in the share which was earned by the firm. It helps to determine the optimal asset allocation. Higher Earning Yield indicates that the firm has higher net income return. It will be attractive to the shareholders. According to the calculation above, IJM Berhad has lower Earning Yield than WCT Berhad. IJM Berhad might have lower net income than WCT Berhad. Therefore, IJM Berhad has less attractiveness to its shareholder than WCT Berhad. D) Market Price per Book Value Ratio Market Price per Book Value Ratio is used to compare a stocks market values to is book value. Higher Market Price per Book Value Ratio indicates that price of the share in the market rises too high more than its real assets value. So, it cannot be attractive to the shareholders. According to the calculation above, IJM Berhad has lower Market Price per Book Value Ratio than WCT Berhad. IJM Berhads price of share in the market is lower than its real assets value. Therefore, it can be attractiveness to its shareholders. 4.0 Conclusion Accounting Ratios are used to determine how a business is performing. Analysing the accounting ratios can simplify the financial statements. And it will help the firm to make the planning more effectively because it indicates the factors associated with successful and unsuccessful firm. However, using analysis of accounting ratio has also some disadvantages. All the ratios are based on only the information which is recorded in the firms financial statements and the information might be out dated. Also, only by analysing the accounting ratio, it is hard to know the roots of the financial problem. The different companies have different financial, different policies and different business risks. So, it is difficult to get direct comparison the two different companies. Based on the accounting ratio calculations, IJM Berhad has overall better performance than WCT Berhad. In Profitability, IJM Berhad has better performance in allocating its resource but it generates the profit less er than WCT Berhad. Although WCT Berhad has better performance in Asset management than IJM Berhad, IJM Berhad has more stable financial state in company liquidity. It shows IJM Berhad has more capacity on its obligation. IJM Berhad has lesser attractiveness in taking longer period of time to recover back the shareholders investments, however, IJM can attract the shareholders in its Market Price per Book Value that the price of the stock is lower than its real value. Based on accounting ratio analysis, IJM Berhad is suggested to improve in its assets management and put more effort on reducing the period of time to recover back the shareholders investment. 5.0 Financial Market 5.1 Definition of Financial Market Financial market is the market where exchange the financial securities such as stocks and bonds, and commodities like valuable metals with efficient market prices. Trading of bonds and stocks in the financial market can be taken the palace directly between the buyers and the sellers. Or it also can be taken place by medium of stock exchange. There are many different types of financial market and, each of financial market deals in different ways from changing the prices of other assets. 5.2 Various Types of Financial Market A) Money Market Money Market is a segment of the financial market which financial instruments with very short-term, high liquidity debts securities such as certificates of deposit and U.S. Treasury notes are traded. The Participants uses the money market as borrowing and lending in the short term, or just several days under a year. B) Capital Market (Primary Market Secondary Market) The stock and bond market are parts of the capital market. The capital market composed both the primary market a secondary market. In the primary market, the bonds and stocks are newly issued and exchanged. And in the secondly market, the already existing bonds and the stocks are traded. Capital market also can be divided into two markets as bond market and stock market. Bond market is providing the finance by the bond issuance and bond trading. And stock market is providing the finance by shares or stock issuance and share trading. C) Mortgage Market The mortgage market is the market where the borrowers and the mortgage originators come together to do negotiate the terms and effectuate mortgage transition. The mortgage market involves mortgage bankers, mortgage brokers, credit unions and banks D) Consumer Credit Market Consumer credit market is the market where deals with loans such as auto (vehicles), appliances and the loan for the education, vacation and so on. In other words, it is the market which deals with the short-term loans. E) Initial Public Offering (IPO) Market The Initial Public Offering (IPO) Market is the market where deals the first sales of stock by the private company to the public company. 6.0 The three different ways to transfer the capital or fund The capital transfers are kinds of transaction that in which the ownership of an asset is transferred from one institution unit to another or in which the funds realised by the disposal of another asset are transferred or in which cash is transfer to enable the recipient to acquire another asset. There are three different ways to transfer the capital or fund. 6.1 Direct transfer from saver to borrower The direct capital transferring from the saver to borrower means that the firm issues the stocks or bonds and direct sells to the savers without any helping from the financial institutions. Figure 1 shows the way of how the capital is transferred from savers to borrowers directly. Picture1.png Figure (Diagram of Direct Capital Transfer From Savers To Borrowers) 6.2 Indirect Transfer from Savers to Borrowers through Investment Banking House Indirect capital transferring from saver to borrowers through investment banking house means that the investment bank takes the place as responsible the issuance of a firms securities. The investment bank plays the role as a middleman between the savers and the borrowers. The investment bank purchases the securities of firm and resells the same securities of firm to the savers. In this transaction, the money which paid by the savers for purchasing the firms securities is passed to the borrower thorough the investment bank. Picture2.png Figure (Diagram of Indirect Capital Transfer from Savers to Borrowers through Investment Banking House) According to the figure2 above, the business corporation plays the role as borrower, investment banking house plays the role as middleman and the saver plays the role as money lender. 6.3 Indirect Transfer from Savers to Borrowers through a Financial Intermediary Indirect capital transferring from saver to borrowers through financial intermediary means that the financial intermediary issues out the fund from the savers by issuing its own securities or certificate of deposit to saver. Then, the fund which is collected from the saver is used by the financial intermediary to purchase and to hold the other corporations securities as investment. In this case, when the savers pay the money to financial intermediary to exchange for receiving the securities or certificates of deposits issued by the financial intermediary, the fund or the capital is transferred from the savers to financial intermediary. After that, the financial intermediary will transfer this fund to the other corporation by paying money out of the fund to purchase securities of corporation. Holding the certificate of deposit and the securities of financial intermediary is the safer way to the saver and there are more liquid than mortgage loan. Picture4.png Figure (Diagram of Indirect Transfer from Savers to Borrowers through a Financial Intermediary) According to the figure 3 above, the business corporation plays the role as a borrower, financial intermediary plays the role as money lender to the corporations and the borrower form the saver, and saver plays the roles as money lender. 7.0 Investment Banking House Financial Intermediaries 7.1Investment Banking House The investment house is a kind of bank which works primarily for corporations and governments. This bank helps the clients to raise the money invested through debt and stock offerings. They advice the firms on mergers and acquisitions and helps to bring prospective to the buyers with sellers. They are also providing the advisory services to the investors but primarily to larger institutional customers like pension and mutual fund. CIMB investment bank, Maybank investment bank, and Affin investment bank are the examples of the investment banking house in Malaysia. 7.2 Financial Intermediaries The financial intermediary is financial institution which borrows from the savers and lend to individuals or firms that need resources for investment. The investments is made by financial intermediaries can be in a loan or securities. The main role of financial intermediaries is transforming the financial assets that are less desirable for a large par of the public into other financial asset which is more preferred by public. At least four economical functions are involved in this transformation; risk reduction via diversifications, providing maturity intermediation, providing a payment mechanism and reducing the costs of contracting and information processing. There are some different types of the financial intermediaries. A) Commercial Bank The commercial bank is one of the major financial institutions which is providing the services like accepting deposit and giving the business loan. The activities of commercial banking are different than those of investment banking, which include underwriting, facilitating mergers, other corporate realizations, acting as an intermediary between a securities issuer and the investing public, and also acting as a broker for institutional clients. B) Savings and Loan Associations The saving and loan association is a kind of financial institution that specialised in accepting savings, deposits and making mortgage loans. The people who deposit (depositor) earn interest in their deposits. Normally the saving and loan associations offer higher interest than commercial bank. C) Mutual Savings Fund The mutual saving fund is very similar with commercial bank and the saving and loan associations. The most of their activities are similar. However, mutual saving fund mainly deals with long-term basis clients such as house buyers and consumers. D) Credit Union The credit union is a kind of financial institution which is owned and controlled by the its own members only. And it is operated for the purpose of promoting the thrift, providing other financial services to the members and credit at reasonable rate. E) Pension Funds The pension fund is a pool of assets which is forming an independent legal entity to a pension plan for the exclusive purpose of financing pension plan benefits. It is important to the stock market where large institutional investors dominate. F) Life Insurance Companies The life insurance company is the company which collects the saving in the form of annual premiums. And it invests the fund in stocks, bonds, real estate and mortgages. At last it makes the payment to the beneficiaries of the insured parties. G) Mutual Fund The mutual fund is a kind of the investment firm that pools the money from many investors and invests the money in the stocks, bonds, other securities or even cash. Mutual fund shares are redeemable. Which means that when mutual fund investors want to sell their fund shares, they sell them back to the fund, or to a broker acting for the fund, at their current NAV per share, minus any fees the fund may charge, such as deferred sales loads or redemption fees.