Step 1: Ratio Analysis & Economic Profit
Ratio Analysis
At first I was a little confused
but I needed to go over the lectures from Maria again. Once I completed this I seemed to be ok. Excel is fairly simple to navigate through. Completing the assignment whilst watching the
lectures was of great assistance as Maria fully explained all details required
Knowing your numbers is
crucial to being a successful business owner. Financial ratios and key
performance indicators (KPIs), which are a measure of employee performance, can
be used to gauge your company's overall financial health and make informed
business decisions.
Many types of financial
ratios can be used, but some of the most popular are profitability, liquidity
and efficiency. Profitability ratios identify the company's ability to generate
a profit. Liquidity ratios gauge how
easily a company can pay its debts. And efficiency ratios analyse how well a
company uses its working assets.
Completing these activities
has demonstrated not only how useful the ratios and financial statements can
be, but it also demonstrates and highlights the importance of knowing what they
mean and ensuring that reporting is kept up to date. The financials are only as good as how they
are used however. With decision making
they are one of a number of effective tools.
At the start I believed
that Morgan Sindal (MS) was quite a profitable company however, upon looking at
the ratios and comparing to industry standards and other companies, it is evident
that it is in a low period at present.
Some of these issues have been identified in the Financial Statements
which include the economic climate at present in the United Kingdom and
Globally having an impact upon both project costs and timeframes. MS has also expanded out its business
departments in recent times to capture a greater industry in the hope of
utilising and capturing a market in progressive industries such as
environmental protection and energy efficiency.
PROFITABILITY RATIOS
NET PROFIT
MARGIN
The NPM for MS in 2014 was 0.81%. For every £1 of sales MS has generated 0.81% of
that into net profit. Obviously, my initial
reaction to this small percentage is that this is very low. I decided to look at the historical ratios
also calculated for the 2013 to 2011 financial years and this also showed quite
a small percentage however has been declining over the last few years.
|
Net
Profit Margin
|
Net
profit after tax/sales
|
0.81%
|
0.72%
|
1.50%
|
1.47%
|
I did read in the discussions in
the Financial year statements that there have been some issues with decline in
profits due to the economic climate as well as increases of costs associated
with the larger projects both running over time and excess additional costs due
to increases in prices and inflation. As
projects run overtime sometimes inflation in prices may not be considered in
the original budget and tender process.
Some of these issues have been extraneous to MS due to weather
conditions and also the nature of construction.
I have briefly discussed this in previous posts.
In saying this I was quite
interested in seeing how much this has changed over time, so did some research
and found out that the maximum NPM that MS has obtained in the previous 10
years has been 2.28%. Upon reflection of
this, it has maintained and has not dramatically dropped over time.
The next step was to look at
industry comparison. I was able to
ascertain that the industry standard median is 3.11. MS’s net Profit Margin is actually ranked
lower than 74% of the 962 Companies in the Global Engineering and Construction
industry[1]. This does not seem a very good position for
MS comparatively. 5% or greater has been
recommended for industry standard.
Benchmarking standards for the
construction industry can be located at http://www.constructionbusinessowner.com/topics/accounting/accounting-finance/construction-financial-ratios.
The profitability ratio industry standards are displayed in the following figure
taken from this website. MS has a net
profit margin of 0.81% which is lower than this 5% or greater recommendation.
Fig. 1: Profitability ratios
Nick also has a similar company
with Opus (Blog link http://nicksacct11059.blogspot.com.au/). Looking at these figures also shows that MS
does not compare favourably to Opus International which is a New Zealand based
company. Opus’s NPM for 2014 was 5.0%
which is also higher than the Industry median globally. So, this company is doing quite well given
its profitability.
RETURN ON
ASSETS
ROA identifies how profitable a company is relative to its total assets. It demonstrates the percentage return on the
use of the assets and how efficiently managed they are in generating profits,
return on investment. Therefore
ROA is affected by profit margins and asset turnover (acquisition and
disposal).
Different industries have greatly different standard ratios. Retailers should generally expect a high ROA
of over 5% and the banking industry is typically under 2%. Therefore, ROA should not be used to compare
companies in different industries. The
Industry standard for ROA for the construction industry can be seen in Figure
1.
|
Return
on Assets
|
Net
profit after tax/total assets
|
1.7%
|
1.6%
|
3.2%
|
3.3%
|
The ROA for MS in 2014 was calculated as 1.7%. This indicates that MS are getting 1.7% return
on the use of the assets. Comparatively
for the previous 4 years this has been in steady decline. Over the past 10 years, company
statistics has indicated that the highest ROA was 6% in 2005, and the lowest
has been 1.58% in 2013. In comparison to
other companies in the industry globally it has been ranked under the median industry
ROA of 2.68% at present. The industry standard is
15% or greater as seen in Figure 1 which is much higher than how MS is
performing, and is also interesting to see that this figure is also higher than
the recommendation in this case. The reduced profits that MS has seen over the past 4 years, has been a
major contributing factor to this reduced ROA.
A high ROA would be considered better for the company, however sometimes
this may not be the case and may not be physically achievable in considering
burnout of human resources. In contrast,
low percentages can also mean that assets may not be used to their full
potential in generation of income, thus wasting money if an asset is sitting
and not contributing to profits. A good
example of this in our local mining industry is where large mining companies,
such as Rio Tinto, are currently ‘parking up’ various machinery due to the
economic climate and current coal stockpile.
There are many factors that play a part in this ratio and the industry,
economic climate and the nature of the business needs to be considered. Rio Tinto is not utilising this asset, which
it uses to help extract coal. If the
company is not extracting coal then it is not producing revenue and reduces its
profits.
As a point
of interest: one of the highest ROA companies globally
is Boston Beer Inc which is the largest brewer of handcrafted beers in
America. It has been one of the largest
growing companies with a ROA of 29.7% achieved in 2011. The average comparable industry ROA was
9%. This was primarily due to net income
increases.
EFFICIENCY RATIOS
TOTAL ASSET
TURNOVER RATIO
Asset Turnover measures how
quickly a company turns over its asset through sales. This can be used as an indicator of the efficiency with which a company is deploying its assets in
generating revenue. The main difference
with ATO is that it uses sales or revenue instead of net profit as in ROA as
discussed above.
|
Total
Asset Turnover Ratio
|
Sales/total
assets
|
2.10
|
2.17
|
2.15
|
2.23
|
For every £1 of assets we are
generating 2.2 of sales for MS. Over the
past 10 years MS statistic have identified that it has maintained a stead 2.1
to 2.8 ATO ratio thus indicating that it has maintained efficiency in
utilization of its assets during this time.
Industry standards found at the
previous website mentioned in Figure 1, also show efficiency standards shown
below in Figure 2. MS’s total asset
turnover ratio is currently 2.1 with the recommendation being a ration of 5 to
7. Again this is below the Industry standard
indicating that MS is performing inefficiently in comparison to recommended
standards.
Figure 2: Efficiency ratios
Opus International, as previously
mentioned is the main comparative company with respect to other students that I
have found. Opus’ ATO for 2014 was 1.5
so MS in this instance is comparatively higher and more efficient.
LIQUIDITY RATIOS
CURRENT
RATIO
Current Ratio is a measure of
liquidity or a measure of how the company can pay off its debts and how
efficient it has the ability to turn its product into cash. This can be called its financial health. The main drivers in this are assets and
liabilities e.g. how much it owes in relation to how much it can sell. Some specific issues that can negatively
impact in the day to day operations of some companies is when they have many
outstanding and overdue receivables or have long inventory turnover.
Acceptable current ratios vary
from industry to industry and are generally between 1 and 3 for healthy
businesses. The higher the current
ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company
would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good
financial health, it does not necessarily mean that it will go bankrupt or
directed into Administration by ASIC (in Australia), as there are many ways to
access financing, but it is definitely not a good sign.
|
Current
Ratio
|
Current
assets/current liabilities
|
1.05
|
1.03
|
0.98
|
0.94
|
Morgan Sindall has a current ratio of 1.05. This measure generally indicates good
short-term financial strength. This has
increased slightly from 2011 where it was 0.9 and has been at 0.9 since 2007. This indicates that for every £1
of liabilities there is £1.05 in equity to pay for this.
The industry median of current ratio in this industry is 1.44, so again
MS is unfortunately in the lower side of the median. A snapshot of where MS is sitting can be
viewed in Figure 3.
Figure 3:
Current ratio competitive comparison
(source:
http://www.gurufocus.com/term/current_ratio/LSE:MGNS/Current+Ratio/Morgan+Sindall+Group+PLC)
FINANCIAL STRUCTURE RATIOS
DEBT/EQUITY
RATIO
Debt/Equity Ratio is used to measure a company's financial leverage, calculated by dividing a company’s total liabilities by its shareholders equity. This indicates how much debt a company is using to finance its assets relative to the amount of the shareholders’ equity.
|
Debt/Equity
Ratio
|
Debt
(total liabilities)/equity
|
-2.94
|
-2.76
|
-2.82
|
-3.23
|
The debt to equity ratio for MS
is -2.19 which indicates, that for MS for every £1 of equity that the
shareholders (owner’s equity) have put into the company, the banks have funded £2.19. This indicates that the company is funded by
a higher portion by the banks or outside the company. The ratio is negative due to the liabilities
being negative.
The higher debt/equity ratio
could indicate that a company, such as MS is using borrowed money to fund
projects. However a high debt/equity ratio generally
means that a company has been aggressive in financing its growth with
debt. These can be associated with being
high risk and can also result in added expenses through interest expense. In saying this, each individual company and
the specific ratio needs to be looked at carefully with regards to the
industry, the nature of business, the economic climate and the comparisons to
other industry standards and competition.
A lot of debt can be used
initially to finance increased operations (high debt to equity), where the
company could potentially generate more earnings than it would have without
this outside financing. In contrast, the
cost of the debt plus reduced earnings may result in limited return for the
shareholders and in some cases, bankruptcy in long term cases.
EQUITY RATIO
How much of the company’s assets
are funded by equity. In the case of MS,
the equity ratio is 0.25 which means that only 25% of the company assets are
funded by the owners. This is a small
percentage indicating that three quarters is owned by debt or outside the
company. This is a high risk situation
in most cases however it cannot be looked at individually without taking into
consideration all other aspects of the company and industry.
MS’s Equity ratio has been
maintained at this level for the past 4 years.
|
Equity
Ratio
|
Equity/total
assets
|
0.25
|
0.27
|
0.26
|
0.24
|
One discussion point with this
company is that it belongs in the Engineering and Construction industry and
relies heavily on assets (e.g. machinery, buildings) to undertake its massive
infrastructure projects. Also in the
past 5 years there has been an economic impact on the industry where slides in
project timeframes an cost of construction have occurred as well as expansion
in new areas on the company’s 5 divisions which have been heavily asset driven.
MARKET RATIOS
|
Market Ratios
|
|
2014
|
2013
|
2012
|
2011
|
|
Earnings
per Share (EPS)
£
|
Net
profit after tax/nos of issued ordinary shares
|
0.416
|
0.347
|
0.710
|
0.759
|
|
Dividends
per Share (DPS)
£
|
Dividends/number
of issued ordinary shares
|
0.27
|
0.27
|
0.41
|
0.41
|
|
Price
Earnings Ratio
|
Market
price per share/earnings per share
|
17.78
|
21.92
|
7.42
|
7.89
|
EARNINGS PER
SHARE (EPS)
Earnings per Share (EPS) is the
amount of earnings per outstanding share of the company’s stock. It is generally considered to be
the single most important variable in determining a share's price. MS’s EPS for 2014 was calculated at 0.42 which
means that the company can earn £0.42 on the shares. This has slowly decreased from £0.75 in 2011.
DIVIDENDS
PER SHARE (DPS)
In contrast to the EPS, the Dividends
per Share (DPS) is the amount that the company actually paid out of these
earnings as dividends. For MS, in 2014,
the EPS was £0.42 however
they paid £0.27 to the
shareholders.
PRICE
EARNINGS RATIO (P/E)
The P/E ratio can be related to
the number of years it will take for the company to earn back the price you pay
for the stock. It can also be expressed
as how many times greater the market price of the share is of the earning
ability of the share.
For MS, the company earns EPS £0.42 a share per year, and the stock is
traded at £7.40, therefore
the P/E ratio is 17.78. Therefore it
takes 17.78 years for the company to earn back the £0.42 that the shareholder paid for the stock.
This does not stay constant, as
is reflected in the spreadsheet figures.
As a shareholder, I want to
be paid back the amount I paid as soon as possible to get my return on my own
investment therefore MS would not be a company I would invest in given these
figures. As an investor, a lower P/E ratio
is more attractive than a higher P/E ratio.
The P/E ratio can also be applied to all stocks across all
different industries to compare a variety of companies and is widely used and a
good indicator for the valuation of stocks.
A point of
interest: I have also read about the growth rate affecting this P/E ratio in
fast growing companies with a related P/E to growth ratio also being used in
certain comparisons.
Below, in Figure 4, is a
comparison graph to indicate where MS sits within similar industry
companies. As can be seen that the
majority sit within the same line just above the 0 line on the P/E Ratio axis, although
they are spread out along the x axis, they all have similar P/E Ratios of
approximately 15. Comparatively, you can
see the following; RNHW (Renew Holdings PLC) has a P/E Ratio of 40.2, SFR
(Severfield PLC) has a P/E Ratio of 594.75, and PTSG (Premier Technical Services
Group PLC) has a P/E Ratio of 124.3. So
comparatively, MS is within the major grouping of P/RE Ratios of similar
industry companies.
Figure 4: P/E ratio competitive comparison
RATIOS
BASED ON REFOMULATED FINANCIAL STATEMENTS
RETURN ON
EQUITY (ROE)
Return on Equity (ROE) measures
the rate of return on the shareholder's equity and measures the efficiency in
generating profits. It is an indicator
of how well a company uses investment funds to generate earnings growth. An ROE between 15% and 20% are considered
desirable.
|
Return
on Equity (ROE)
|
Comprehensive
Income/shareholders' equity
|
6.5%
|
6.7%
|
12.7%
|
13.5%
|
MS’s ROE has dropped from 13.5%
in 2011 to 6.5% in 2014. As seen
previously in all other ratio calculations, MS’s financials have been reduced
and I am not surprised by this current trend.
Also as discussed there have been a number of economic factors that has
contributed to this. As comprehensive
income and shareholder equity are the drivers, both of these have been reduced
over the previous years. MS’s trend over
the past 10 years has also seen a slow decrease in ROE from 27.54% in 2005.
The industry Median is currently
at 7.3 and MS is ranked lower than 52% of the 948 Companies
in the Global Engineering & Construction industry.
Comparatively with Opus
International, MS is also below their ROE percentages of 17.88% for 2014. Interestingly, Opus International has also
seen a decrease from 22.1% in 2011.
ROE is an indicator of
profitability of the Company, the difference with this as opposed to the
profitability ratios discussed above is that ROE uses the restated financial
documents. This tells us the return on
the company regarding how profitable the company has been for the
shareholders. So for every £1 of equity
they have invested they have had 6.5% of earnings of income Comprehensive
income. This has actually halved over
the past 4 years from 13.5% in 2011. One
factor is the reduced comprehensive income over the 4 years, again at a 50%
reduction form 2011 to 2014, which would be evident from the previously
discussed reduction in profits and additional borrowings taken out in 2013 and
2014 by the company.
Comparing Opus International,
their RNOA for 2014 was 19.94% which has been fairly steady over the past 4
years. Another comparative company is
Leighton Holdings, with a RNOA of 22.4% in 2014. So comparatively MS is not dramatically lower
than in previous ratios as we have seen.
RETURN ON
NET OPERATING ASSETS (RNOA)
Return on Net Assets is a ratio that can also be used to evaluate a
company’s financial health. Fixed assets
that can be used in the production of income can be machinery and buildings,
therefore are operational. The key
drivers in this ratio are the operating income and the operating assets. It is ideal that the higher the return, the
better the profit performance of the company.
|
Return
on Net Operating Assets (RNOA)
|
Operating
income after tax (OI)/net operating assets (NOA)
|
8.8%
|
9.2%
|
14.0%
|
22.4%
|
For MS, the RNOA percentage for 2014 was 13%. This indicates that for every £1 of net operating assets the
company is generating 13% return towards operating income
NET
BORROWING COSTS (NBC)
For every $1 of obligations how
much interest is the company paying. For
MS in 2014 this was calculated at 9.3%, for 2013 it was 3.9%, for 2012 it was
-3.9% and for 2011 it was 1.7%. For 2013
and 2014, MS did take out extra borrowings in these two years which there were
no borrowings in 2011 and 2012 which could explain the differences between
these years as this additional borrowing increase the net financial obligations
for these two latter years.
|
Net
Borrowing Cost (NBC)
|
Net
fin. expenses after tax/net financial obligations
|
9.3%
|
3.8%
|
-3.1%
|
1.7%
|
Interestingly in 2012, there is a
negative figure for NBC, this can be explained as there was a positive figure
for NFE in that year, meaning that there was not an expense but a credit. This would translate to a negative NBC to be
interest MADE rather than an expense for this year.
PROFIT
MARGIN (PM)
Very similar to the Net Profit
Margin discussed above, the PM utilized the restated Operating Income (OI) as
opposed to the net profit after tax.
These percentages were fairly similar to each other, but with PM being
ever so slightly higher than NPM, for example in 2014 the PM was 1.4 as opposed
to NPM of 0.81. The PM of 1.4% means
that for every £1 of revenue or sales from MS £0.01 in turned into operating
profit. Again, the higher the PM indicates
the higher the ability to earn a profit.
With MS, this number is very low for both NPM and now again with PM over
the past 4 financial years.
|
Profit
Margin (PM)
|
Operating
income after tax (OI)/sales
|
0.93%
|
0.74%
|
1.87%
|
2.14%
|
Comparing the PM of a similar
company, with Opus International again, their PM was 5.57% so for every £1 of
sales, they turn £0.05 into operating profit.
So comparably, MS is not fairing too badly, however both are quite
low. Interestingly, Opus is a New
Zealand owned multi-national company, where as MS is a UK based company.
ASSET
TURNOVER (ATO)
As mentioned in the Efficiency
section above in Total Asset Turnover Ratio, it is the value of the sales
generated by the value of its assets and can indicate efficiency in generating
sales. For this ATO section we are using
the net operating assets instead of the total asset.
Similarly, the higher the asset turnover, the better the
efficiency and performance in generating sales per dollar of asset.
|
Asset
Turnover (ATO)
|
Sales/net
operating assets (NOA)
|
9.47
|
10.06
|
9.33
|
14.97
|
The ATO for 2014 was calculated at 9.47 whereas the total asset
turnover ratio was 2.1. The restated ATO
ratio gives us a higher ratio thus a truer value of operational profitability. This is because it utilised the operating
components only as the financing components have been removed. This was similar to
all years calculated.
Economic profit
ECONOMIC
PROFIT (EP)
Economic Profit is different to
account profit as we have calculated above as it takes into consideration the cost
of capital. Cost of capital is the cost
of the funds used for financing a company, the opportunity cost of that finance
or how much the debt cost the company.
As there can be many sources, a weighted average of all the capital
sources is used which is known as WACC, weighted average Cost of capital.
I was unable to locate the WACC
or cost of capital percentages in the financial reports but was able to find
the WACC from the internet specifically for Morgan Sindall over the years on
Guru Focus website[2].
|
Economic
profit
|
(RNOA
- cost of capital) x net operating assets (NOA) in £M
|
10.99
|
4.21
|
11.98
|
21.41
|
Calculation resulted in an EP for
MS in 2014 of £M10.99, for 2013 was £M 4.21, for 2012 was £M11.98, and for 2011 was £M21.41. This was interesting considering the
Accounting profits for the respective financial years were £M18, £M15, £M30 and
£M32.
Economic Profit v Accounting
Profit
|
COMPARISONS
|
2014
|
2013
|
2012
|
2011
|
|
Economic profit in £M
|
£
10.99
|
£
4.21
|
£
11.98
|
£
21.41
|
|
Profit in £M
|
£
18.00
|
£
15.00
|
£
30.70
|
£
32.80
|
Two main differences being in 2013 and 2014 could be contributed by a
higher cost of capital percentage, perhaps resulted in new borrowings in the
2013 year and the costs associated with this.
NOA in 2013 is also lower than 2014 thus also affecting a smaller EP
through the calculation with a higher cost of capital.
For 2011, the highest EP was
achieved of all four years. In this year
the RNOA was much greater at 22.4%. The
cost of capital was not substantially higher in comparison so resulted in a
higher (RNOA-WACC) percentage to be multiplied by the NOA. The NOA in 2011 was lower than all other
years, at £M
148 however the multiplication factor was still higher enough to gain a doubled
EP in 2011.
This shows that the RNOA is a
driver which is calculated by OI and NOA.
These have had the financing activities removed and is a true
representation of the operating activities.
The greater the OI in comparison to the NOA, the higher the RNOA, thus
efficiency of asset use, and the resulting multiplication factor, in
calculating EP. The limitation with this
is the differences in the WACC.
OTHER
QUICK COMPARISONS
|
DRIVER COMPARISONS
|
2014
|
2013
|
2012
|
2011
|
|
RNOA
|
8.8%
|
9.2%
|
14.0%
|
22.4%
|
|
NOA in £M
|
£
234.40
|
£
208.20
|
£
219.40
|
£
148.70
|
|
ATO
|
9.47
|
10.06
|
9.33
|
14.97
|
|
PM
|
1%
|
1%
|
2%
|
2%
|
|
OI in £M
|
£
20.62
|
£
19.07
|
£
30.76
|
£
33.29
|
RNOA V WACC
|
COMPARISONS
|
2014
|
2013
|
2012
|
2011
|
|
WACC
|
4.1%
|
7.1%
|
8.6%
|
8.0%
|
|
RNOA
|
8.8%
|
9.2%
|
14.0%
|
22.4%
|
RNOA percentages are higher than
the WACC percentages. This is a good
thing as this indicates that the return on net assets by MS covers the actual
cost of capital for the assets themselves.
ATO V Total
Asset Turnover Ratio
|
COMPARISONS
|
2014
|
2013
|
2012
|
2011
|
|
ATO
|
9.47
|
10.06
|
9.33
|
14.97
|
|
TOTAL ASSET TURNOVER
RATIO
|
2.10
|
2.17
|
2.15
|
2.23
|
ATO is greater than the Total
Asset Turnover Ratio due to the ATO calculations using NOA which has had the
financing activities removed from total assets the calculations thus
representing a truer operational turnover efficiency.
Profit
Margin V Net Profit Margin
|
COMPARISONS
|
2014
|
2013
|
2012
|
2011
|
|
PM
|
0.93%
|
0.74%
|
1.87%
|
2.14%
|
|
NET PROFIT MARGIN
|
0.81%
|
0.72%
|
1.50%
|
1.47%
|
Again with the PM and the NPM,
the differences with the calculations are due to the separation of the
financing activities and the operating activities in the restated
financials. With these, we see a slightly
higher ratio for the Profit Margin.
Again, due to the changes resulting in the removal of financing
activities to calculate the OI as opposed to using the net profit after
tax. This indicates are truer
representation of the PM directly due to the operation activities of the
company.
BREAKING INTO
BITS
I’ve decided to write this
section here about breaking it into bits and my key learning’s.
I was quite surprised in the
ratios of my company while undertaking this activity compared to the previous
Assignments. I thought that my Company
was doing very well given that they had an £M18 profit and paid dividends to
its shareholders. I have since found out
that due to economic issues, project issues and borrowings that the company isn’t
performing as well as I expected, and in comparison to other similar
companies. It has demonstrated lower
then median ratios than the majority of these in comparison to similar
companies globally.
The most interesting part of this
was the Economic profit calculations as this is where it all seemed to click
for me and how restating the financial statements in separating out the
financial and operating activities shows a more direct relationship to the
running and operating of the company.
In saying this, the IRR and NVP
are still a little confusing for me but undertaking Step 2 did help as I learn
from practical application of theory. I understand
that this will be developed more when I complete Financial Theory subject next semester!
(excited, I am not sure yet!)
Overall the steps in the process
of Assignment 3 have pulled all stages of the previous assignments into some
structure and it is clearly evident that the financials and restated financials
are only as good as the numbers, as well as how you use them and more importantly
understand them. I now have a much
better grasp on the factors and driver of economic profit and how operating
income, return on net investments, profit margins and net operating assets all
interrelate. I have hopefully discussed
this clearly to demonstrate this in my discussions with the ratios above.
[2]http://www.gurufocus.com/term/wacc/LSE:MGNS/Weighted%2BAverage%2BCost%2BOf%2BCapital%2B%2528WACC%2529/Morgan%2BSindall%2BGroup%2BPLC
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