Part A (1) Sterling Plc2

Date: 29 December 2014

To: Board of Directors
From: Financial Analyst
Title: Evaluation of performance using ratio analysis
Financial Highlights
The primary objective of this report is to evaluate the performance of Sterling Plc in relation
to profitability, liquidity, gearing and asset utilisation. The companys performance will cover
a two-year comparison between 2012 and 2013, with analysis of each companys profitability
ratio, liquidity ratio, gearing ratio and asset utilisation ratio. The results of the ratios are
shown in Table 1 below.

Summary of results
Table 1: Ratio analysis summary of results
2013

2012

% Variance

19,480,000 17,250,000

13%

Revenue

Gross profit margin

43

48

-5%

Selling & distribution

12

10

2%

Interest cover

times

2.54

4.76

-47%

Profit after tax margin

18

-9%

Earnings per share

0.28

0.52

-47%

Working capital cycle

days

30

650%

ROCE

27

41

-14%

ROE

20

39

-19%

Capital employed (equity)

16,545,000 12,990,000

27%

Refer Appendix 1

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Financial Analysis

Profitability
Profitability ratios measure firms ability to generate income which includes sales, assets and
equity. The ratios assist firm in accessing their ability in generating earnings, profits and cash
flows and it reflect how effectively the company is managing its profitability (Paterson Drake
and Fabozzi, 2010).

Liquidity
Liquidity ratios measure firms ability to meet its short-term borrowings when they fall due.
It shows the ability of a firm to cover its short-term debt commitment with cash and liquid
assets (Paterson Drake and Fabozzi, 2010).

Gearing
The gearing ratio indicates the financial risk of a business which represent a high and low of
gearing ratio of debt to equity of the firm (Paterson Drake and Fabozzi, 2010).

Asset utilization
This ratio measures the firms ability to fully utilise its assets to generate sales where the firm
can become more profitable by using their assets effectively (Paterson Drake and Fabozzi,
2010).

Market Indicators
This ratio measure the ability of the companys to pay dividend to its existing shareholders
(Paterson Drake and Fabozzi, 2010).

Profitability Analysis
The revenue of Sterling had increased by 13% in the current year which could be due to an
introduction of new products into the market by the company. However, the gross profit
margin has fairly dropped due to an increase in cost and consequently the profit after tax had
deteriorated. The Return of Capital Employed (ROCE) and Return on Equity (ROE) had also
shown a declined compared to the previous year ratios.

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A further analysis conducted shows that the manufacturing cost during the year had increased
most likely due to a greater production of new products, supported by the increase in revenue.
This depicted in the variable cost margin of 58% in 2013 compared to 51% in 2012. Looking
at the selling and distribution cost showed that it had increased to 12% from 10% in 2012
which is due to a higher charge of distribution cost by the suppliers to distribute the new
products. The interest payment seems to be fairly high with 9% compared to 6% in 2012.
This will be explained in details in the gearing analysis below.

A breakdown analysis shows that the company had employed a long-term capital approach
where equity and borrowings in 2013 had increased by 770,000 and 2.2 million
respectively. Consequently, the ROCE had shown a drastic decline by 14% in 2013 affected
by the lower margin of profits and an increase in long-term financing. This shows that the
company is inefficient in using its capital employed as well as its long-term financing
strategies, since a great amount profits are lost from this decision (MyAccounting Course,
n.d.). Further details of ROCE will be discussed in the Gearing and asset utilisation analysis.

Liquidity Analysis
Liquidity is unfavourable in 2013 due to cash decrease during the year. The company had put
too much reliance on the bank overdraft which had amounted to 845,000 in 2013. Over
extend of overdraft would most likely be charged an arrangement fee by the bank and a
further fee is imposed once overdraft limit exceed without authorisation. Furthermore, the
bank at any time will demand company for a repayment of the overdraft (Finance Scotland,
2013).

It seems that the combined aggressive and conservative strategy of the company is not
appropriate enough to strike a balance. Relying on short-term capital is good to the company
as it is cheaper than the long-term capital. However, the increase in short-term and long-term
borrowings during the year had caused trouble to the company, whereby the long-term
borrowing is insufficient to cover the acquisition of the long-term asset which is further
discussed below. Increase sales during the year match the increase in trade receivables by
16% in 2013. However, the receivable turnover is 65 days in 2013 as to 56 days in 2012
which is evidence for a poor management of trade receivables.

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The company is very generous in paying off its debt to suppliers as they seem to pay faster
than its credit term. The trade payables turnover shows 70 days in 2013 as to 92 days in 2012.
Not utilising the credit terms can be regards as poor payables management by the company.
However, the company could be paying its debt faster to gain trade discounts from suppliers
as to bringing the extra materials for manufacturing of new products (Athow, 2014).

Inventory management shows an improvement as inventory days in 2013 has reached to 35

days compared to 40 days in 2012. This improved of inventory days may reflect a planned
inventory build-up in the case of material shortages other than in anticipation of rapidly rising
prices from suppliers. However, this can also indicate poor liquidity, overstocking, and
obsolescence of inventories (Consultants Inc, 2009). Consequently, the Working Capital
Cycle (WCC) worsens to 30 days in 2013 from just 4 days in 2012.

Overall, dependence on the borrowing cost obviously had caused the company to a bad state
of liquidity which had also increased the financing cost as a whole.

Gearing Analysis
The gearing had worsened in 2013 as the gearing ratio for the current year is 79% compared
to 65% in 2012 which is due to the increase in the long-term borrowings. This could be an
indication of desperation from the company which is currently facing liquidity problems as
indicated above. Lower interest rates offer by banking institution may attract the company to
make the additional borrowings to cover its reduction in cash. However, the company can
save money by borrowing with lower interest rate as the actual cost of the loan can be
decrease due to the interest which can be deducted to the tax return of the company
(FindLaw, 2014).

Further analysis showed that there is no distress on interest cost which is only 9% and 6% in
2013 and 2012 respectively. However, interest cover ratio for the current year had shown that
the company is having difficulty to pay its interest expenses, where the ratio had worsened
from 4.76 times in 2012 to 2.54 times in 2013. This is due to the decrease in profitability as
mentioned above which both needs serious attention.

The additional borrowing in 2013 is supported with the increase in the long-term asset (Land
and Building) which indicates that the borrowings were to acquire this additional asset.
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However, the return on this asset should be in longer term which consequently had affected
the cash flows and the ROCE of the company.

Asset Utilisation
The increase in Land and Building in the current year had worn the ROCE which had
significantly dropped to 27% in 2013 compared to 41% in 2012. The ROA ratio also had
dropped to 1.18 in 2013 from 1.33 in 2012. This shows that the company is inefficient in
using its asset to generate profit as the increase in revenue in the current year is not in
proportion with its asset management. Further analysis shown that, the short-term asset
utilisation, mainly the WCC, Payables days and receivables days of the company had
worsened as discussed in the liquidity analysis above.

Market Indicators
Earnings per share are 0.28 and 0.52 for 2013 and 2012 respectively. There is a limitation
of information given in this regards to illustrate on the performance of the company towards
other competitors in terms of paying out its dividend. The payout dividend for 2013 is 69%
compared to 39% in 2012. It seems that the company is trying its best to obtain the
shareholders confidence as to divert their poor performance shown in the above ratio
analysis. The high payout had consequently deteriorated retained profits in 2013 and slowed
down the shareholders funds. However, shareholders had injected an additional fund of
770,000 during the year to support the acquisition of Land and Building.

Conclusion
The company appears to be weak in their financing, investment and dividend decision. The
short-term borrowing was poorly executed and inadequate long-term borrowings planning
lead the company into a bad shape which had shown in the financing cost and gearing. The
poorly managed working capital further demonstrates weakness of the company. The high
dividend payout in 2013 however, is evidence of inefficiency as it is inappropriate to make
such decision during poor performance.

Yours sincerely,

Financial Analyst

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Part A (2)
The Working Capital Cycle (WCC) is measurements of days from the purchase of raw
material to the collections of sales from receivables of the finished product whereby the lower
of days are better to improve firms performance (Rehn, 2012). According to Korankye and
Adarquah (2013), working capital management (WCM) has a positive correlation to the
profitability of the company whereby an effective WCM is essential in improving firms
profitability. However, Richards and Laughlin (1980) cited in Rehn (2012) stated that
working capital management has a significant impact to the liquidity of the company. To
illustrate the effects of WCC to the liquidity, calculation of Short-term (ST) financing cost is
shown below.

Table 2. Working capital cycle

Working capital

2013

2012

Days

Days

Inventories days

35

40

Add: Account Receivables

65

56

(70)

(92)

30

Less: Account Payables

Working Capital Cycle (WCC)

Table 3. Calculation of ST financing cost

ST financing cost

Calculation

Cost

30 days WCC

30 / 365 * 10% * 845,000

6,945.20

4 days WCC

4 / 365 * 10% * 845,000

926.03

Assuming interest rate is 10%, ST financing cost is calculated using the following formula.
ST financing cost = WCC / 365 days * interest rate p.a * WC requirement. The companys
WCC in 2013 is 30 days compared to 4 days in 2012 as in Table 2. The WCC of the company
had lengthened significantly due to poor working capital management. According to the
calculation in Table 3 above, the ST financing cost with WCC of 30 days would cost the
company 6,945.20, whereas it would only cost the company 926.03 if WCC is 4 days. The
poor management is mainly due to faster payment made to Payables and slow in collection of
Receivables which had affected the liquidity as a whole.

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Part A (3)
Cross section analysis is also known as Competitors ratios. The firms ratios are compared
with the competitors in the same industry to benchmark performances (Gillespie, Lewis and
Hamilton, 2004). The limitations of this analysis are that the measurement of the analysis is
subjective since it is dependence of the preference of the users. Some users measure gross
profit margin instead of net profit margin, therefore lead to incomparable. Lack of uniformity
of the situation will also lead to difficulty for comparison (Narotama University, 2012).
Accounting policies for two different companies may differ which may lead to different
treatment of evaluation and disclosures. In this regards, comparisons will be meaningless
since only the same basis of accounting policies will be an accurate comparison. Different of
ownership to an asset may also be an issue as some company may own a building while the
other may be renting its premises. Lastly, large organisation sometimes has multiple
industries where a quantitative breakdown of the activities is difficult to obtain to make an
analysis (Gillespie, Lewis and Hamilton, 2004).

Time series analysis is also known as past ratios. The ratio is calculated using previous
financial statement of the same company (Gillespie, Lewis and Hamilton, 2004). The greatest
limitations for this ratio analysis relates to the significant of changes in events to the company
which may distorted the comparison. Time series analysis measures the performance of the
company over time and may lead to different results as the comparison may derive from year
on year, quarter on quarter and month on month. Other than that, information is mostly
carried forward from previous period which may not be as accurate to compare results
(Gillespie, Lewis and Hamilton, 2004).

Part B (1) Grantham Ltd.

The break-even analysis is also called the Cost-volume-profit (CVP) analysis. It is a tool that
Companies use to recognize the connection among cost, volume and profit of organisation. In
the analysis, the break-even point is identified, where volume of sales is at which the
companys profit is zero (Garrison, Noreen and Brewer, 2012). The break-even analysis
results for Grantham Ltd are as follows:-

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Table 1. Summary of results

2012
Actual units

2013

Units

2,200,000

2,200,000

Sales revenue

49,500,000

61,875,000

Variable cost

40,700,000

50,875,000

Contribution

8,800,000

11,000,000

80,625

93,500

18,138,358

26,293,588

139,375

126,500

Break-even units

Units

Break-even Sales

Margin of safety units

Units

Margin of safety

63

58

Margin of safety Sales

31,361,642

35,581,412

Refer Appendix 2

Figure 1. Break-even analysis for year ended 2012

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Figure 2. Break-even analysis for year ended 2013

Grantham Ltd needs to sell 93,500 units in 2013 compared to 2012 where they only needed to
sell 80,625 units to break-even. The break-even (revenue) however, is higher in 2013
compared to 2012 which is the amount the company need to achieve to gain zero profit and
zero loss (Garrison, Noreen and Brewer, 2012). The break-even units and sales for 2013 had
both risen due to the increase in selling price per unit.

Margin of safety (MOS) measure how many sales can fall before reaching break-even point
(Garrison, Noreen and Brewer, 2012). For Grantham, sales can fall by 139,375 units in 2012
as to 126,500 units in 2013 before the company reaches its break-even point. Even though the
MOS sales had increased in 2013 compared to 2012, the MOS units for 2013 had fallen to
126,500 units from 139,375 units in 2012. This is fairly dangerous for Graham Ltd as the
safety margin has deteriorated from 63% in 2012 to 58% in 2013, which indicates the
company is more risky to breaking even and incurring a loss (Garrison, Noreen and Brewer,
2012).

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Part B (2)
According to Garrison, Noreen and Brewer (2012), assumptions associated with break-even
analysis are as follows:1. Constant selling price. As volume changes, the selling price of a product will remain
unchanged.
2. Variable cost is constant per unit and a fixed cost is constant in total over relevant
range.
3. Sales mix is constant in multiproduct companies.
4. It is assumed that in manufacturing companies, inventories are constant where
production units equal to units sold.
The above assumptions may not be applicable to todays businesses. Usually as volume
increase, economies of scale can be achieved. Production level of a company will always
change due to demand and most likely price setting of a product will increase so that
company can gain more profit margins. In terms of sales mix, sales will change according to
the sales mix. In some cases, it was found that, companies will decrease its selling price when
increasing the number of volume (ACCA, 2014).

In most companies, costs are semi-fixed. For example, telephone charges vary from call
being used to fixed monthly rental charge. Therefore, assumptions which costs can be divided
into fixed and variable components may not be true (ACCA, 2014).

Most companies have a good understanding of its business and most likely to analyse its
costs. Fixed costs for instant are usually predicted to a certain range instead of regarding it as
constant over a relevant range (ACCA, 2014).

Part C (1)
According to Garrison, Noreen and Brewer (2012), a

budget

is a detailed plan for the

future that is usually expressed in formal quantitative terms. Companies use budgets for
planning, where goals are developed and budgets are prepared to achieve the goals set. In
addition, feedbacks are gathered to make sure executed plans are in place which is part of the
control where effective budgeting system will offer an effective planning and control

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(Garrison, Noreen and Brewer, 2012). Importance of budgets as a means of planning and
controlling is discussed below.
In terms of planning, organisations plans are communicated through budgets to each
department as a mean of allocating resources to different department or decision for effective
use. Therefore, departments will have the same target set as budget coordinate activities of
the whole organisation. Through budgeting process, future plans are thought through by
managers to identify possible bottlenecks before they occur. The goals and objectives is
therefore identified which serve as a benchmark for estimating performances (Garrison,
Noreen and Brewer, 2012).

Budgeting activity is conducted by controlling the feedback of overspending across the

organisation. Usually, variance analysis is prepared by managers to evaluate the deviation
from standards for corrective action which is called budget allowance. The budgets are then
revised so that it meets it relevancy of the target plan where budgets are either cut or added.
Lastly, budgets are used as a mean of controlling people in the organisation which is set as a
basis of rewards for performances of each department when target are achieved (Garrison,
Noreen and Brewer, 2012).

Part C (2)
A company have two choices to finance its business, either by long-term finance or shortterm finance. Long-term finance cost more compared to the short-term finance and usually
less flexible. Long-term finance includes debt, venture capital, and equity finance. On the
other hand, the short-term sources of finance includes overdraft, short-term loans, trade credit
and lease finance where it is very important in everyday operations of the company especially
in paying employees salaries, order of stocks and supplies (BPP Learning Media, 2007).

Long-term sources of finance

Debt finance
One way of long-term financing is through debt finance. Before raising debt finance,
companies need to consider various types of available finances which is mostly offered
through Redeemable or Irredeemable Loan notes or Debentures which are differentiate to
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categories such as Deep discounts bonds, Zero coupon bonds, and Convertible loan notes.
Debt finance is cheaper and easier to obtain compared to equity finance which is riskier for
the company. Businesses may not wish to issue equity as it involves outside shareholders
which may have onerous requirements for them to meet. Besides this, companies may want to
inject new capitals from current shareholders which are sometimes difficult as members may
be unwilling to do so (BPP Learning Media, 2007).

Venture capital
A more risky finance is through Venture capital, where equity stake is usually asked in
return. A venture capital institution is known as venture capitalists which only desire to invest
in successful companies. Venture capitalists usually raise their money into a new business to
give it a boost, help out in a business development of new products which needs capital
injection, and a management buyouts which is to purchase the whole organisation and its
business. Companies need to consider a few factors before seeking help from venture capital
institution as the companys equity stake will be ask for. However, convincing towards
venture capitalist is needed to prove that their company will be successful, and in some cases,
venture capitalist would appoint representative to sit on companys board, usually an
independent director to look after its interest. Examples of venture institutions are 3i Group, a
UK base company (BPP Learning Media, 2007).

Equity finance
Equity financing is usually raised by the sale of ordinary shares, either by new issue of shares
or by rights issue to investors. Companies may want its shares listed in the stock market
through public offering where they can invite investors by initial public offering (IPO) which
is to sell off their shares to the public at large. However, company may want to choose a
placing instead of IPOs where it is not offered publicly but to a smaller target group which is
usually comprises from pension funds and insurance companies. Most companies prefer
placing because it is cheaper compared to IPOs, quicker, and lesser information disclosure.
Other means of equity finance is through a right issue where it is offered to existing
shareholders at a discounted price. Shareholders may prefer rights issue to obtain more shares
and it is cheaper than IPOs and in this regards, finance raised through rights issue may be
used to reduce gearing of the company and to pay off long-term debt (BPP Learning Media,
2007).

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Short-term sources of finance

Overdraft
The overdraft is most crucial source of short-term finance available to companies. It offers
flexibility and can be arranged at any time and relatively quickly. However, the overdrawn
amount will be charged interest at a base rate plus margin. Furthermore, fees are charged by
the bank for large facility of overdraft (BPP Learning Media, 2007).

Short-term loans
A term loan is a specific borrowed amount for a specific period. The bank will offer term
loan which can be drawn at the beginning of the loan period. In terms of payment, bank will
offer several schedules of repayment, usually via instalments. Furthermore, all interest
payments and capital repayments are set by the bank (BPP Learning Media, 2007).

Trade credit
Trade credit is regard as an interest free short-term loan. A trade credit is associated with raw
material that is purchased by companies on credit. The terms of credit for payments usually
vary from between 30 to 90 days. Company will benefit purchasing via trade credit during
inflation as it keeps cost down. However, with trade credit, company will incur discounts loss
for early payment offered by suppliers (BPP Learning Media, 2007).

Leasing
Another popular short-term source of finance is through leasing. The lessor and lessee will
enter a contract for a rental of a specific asset. The lessee possesses the use of the asset and is
required to pay specific rentals over a certain period while the lessor retains ownership of the
asset. A company may lease an asset instead of using its available cash or borrowings to
acquire new assets (BPP Learning Media, 2007).

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APPENDIX 1
2013

2012

% Difference

%
%
%
%
%
%
%
%

13
43
12
58
23
9
9
27
1.18
20

48
10
51
31
18
6
41
1.33
39

-5%
2%
7%
-8%
-9%
3%
14%
-11%
19%

Liquidity
Current Ratio
Quick Ratio
Receivables payment period
Inventory turnover period
Payables payment period

days
days
days

0.28
0.21
65
35
70

0.32
0.24
56
40
92

-13%
-13%
16%
-13%
-24%

Gearing
Gearing ratio
Interest cover ratio

%
times

79
2.54

65
4.76

15%
-47%

Market indicators
Earnings per share
Payout dividend

0.28
69

0.52
39

-46%
30%

Working capital
Inventories days
Add: Account receivables
Less: Account payables
Working capital cycle

days
days
days
days

35
65
(70)
30

40
56
(92)
4

-13%
16%
-24%
650%

Profitability
Sales revenue
Gross profit
Selling and distribution margin
Variable cost margin
Operating profit margin
Profit after tax margin
Interest cost margin
Return on capital employed
Return on assets
Return on equity

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APPENDIX 2
1. Year Ended (YE) 2012
Contribution per unit

Sales
Less: Variable cost
- Direct Material
- Direct Labour (20min/60min x 45/hour)
- Variable manufacturing overhead
- Variable selling expenses
- Variable administrative expenses
Total variable cost
Contribution

225.00

125.00
15.00
20.00
15.00
10.00
185.00
40.00

Fixed cost for YE 2012

000
1,100
1,450
675
3,225

Fixed manufacturing
Fixed selling and distribution
Fixed administrative
Total
Contribution / sales ratio 2012 =

40 x 100%
225
17.78%

2. YE 2013

281.25

Sales (225 x 1.25%)

Contribution / sales ratio 2012 =

Contribution/unit
Sales/unit

17.78% =

Contribution/unit
281.25

Contribution/unit for 2013 =

=

17.78% x 281.25
50

Fixed cost for YE 2013

000
3,225
1,450
4,675

Total fixed cost for 2012

Increased fixed cost in 2013
Total fixed cost
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2012
220,0000 units

Actual units sold

Sales revenue

Variable cost

Break-even (units)

Break-even (Sales)

Margin of safety (units)

Margin of safety (%)

Margin of safety
(Sales)

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225 x 220,000 units

2013
220,0000 units
=

281.25 x 220,000 units

= 49,500,000

= 61,875,000

185 x 220,000 units

231.25 x 220,000 units

= 40,700,000

= 50,875,000

3,225,000
40/unit

4,675,000
50/unit

= 80,625 units

= 93,500 units

3,225,000
17.78%

4,675,000
17.78%

= 18,138,358

= 26,293,588

= 220,000 units - 80,625 units

= 220,000 units - 93,500 units

= 139,375 units

= 126,500 units

= 139,375 units / 220,0000

units x 100%

= 126,500 units / 220,0000

units x 100%

= 63.35%

= 57.50%

= 49,500,000
- 18,138,358

= 61,875,000
- 26,293,588

= 31,361,642

= 35,581,412

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REFERENCES

ACCA, 2014. Cost-volume-profit analysis, F5 performance management [online] Available

at: <http://www.accaglobal.com/my/en/student/acca-qual-student-journey/qualresource/acca-qualification/f5/technical-articles/CVP-analysis.html> [Accessed 28
December 2014]
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Paterson Drake, P. and Fabozzi, F.J., 2010. The basics of finance: an introduction to financial
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[Accessed 17 December 2014]

Afifuddin Ramli
149090278

18
Course Instructor: H.N. Sum