(c) REPORT
To: Directors of Comparator
From: A.N. Accountant
Subject: Analysis of the financial performance of Comparator compared with the sector averages
Date: Today
Introduction
The purpose of this report is to analyse the financial performance of Comparator compared with
sector averages recently obtained from the interfirm comparison service.
The report covers 3 areas:
Operating performance
Financial position
Investment ratios
Operating performance
The high return on capital employed (ROCE) of 34.6% (compared with 22.1% for all companies)
shows that Comparator's assets are being used relatively efficiently. This is despite Comparator
having a disappointing gross profit margin (22.9% compared with 30%) and net profit margin (7.7%
compared with 12.5%). Comparator has made up for this low level of profitability by having a very
high level of asset utilisation, as shown by a net asset turnover ratio of 3.8 times, which is more than
twice the average of 1.8 times.
There are two things that complicate the analysis above:
(i) The age of Comparator's non-current assets, and
(ii) The write off of inventories.
These are discussed below:
(i) The carrying value of Comparator's non-current assets is only 15% of their cost, suggesting
that these assets are quite old. This will have boosted the ROCE compared with a companywith newer assets with a higher carrying value. However, there is not enough information to
investigate this further. Also, these assets will probably need replacing soon, and because
Comparator has no cash then it will need to borrow more money. This will be extremely
difficult (and probably expensive) as Comparator's gearing ratio is already very high (90%)
compared with the sector average (40%).
(ii) Comparator's net profit margin is distorted by the $120,000 charge for writing off inventory.
Without this the net profit margin would have been 12.6%, which is greater than the average of
12.5%. If this write-off really is a one-off not-to-be-repeated event then this suggests that the
underlying return on capital employed is 53.5%. However, the sector averages do not include
similar information on one-off costs.
Financial position
Long term
As mentioned above, Comparator's gearing ratio is already high and the need to replace old plant and equipment could push it higher. As the existing equipment cost $3.6m some years ago Comparator could expect to spend as much again today, all of it on borrowed money. This would require a gearing ratio of 1,100%, which the banks would almost certainly not tolerate. The alternative would be to raise more share capital. At the current market price of $6 a share a further 600,000 shares would need to be issued, which would double the number of shares. This also seems an unlikely prospect. However,without new loans or share capital there can be no new equipment.
Short term
Comparator's quick and current ratios are below the industry average, which suggests that there may be short term cash flow problems and poor financial management.
Although the working capital cycle is relatively good (34 days compared with 36), the individual
components are worse implying that there is poor inventory control, poor credit control, and a
shortage of cash to pay suppliers. Poor inventory control may have caused the build up of obsolete
inventory (leading to the $120,000 write-off), and poor credit control can lead to an increase in bad
debts. Delaying paying suppliers (who now have to wait 68 days to be paid) is a short term fix, but it
can back-fire if suppliers lose patience with Comparator and demand cash on delivery, or refuse to
deliver at all.
Interest cover, dividends, tax and overdraft
Although the interest cover of ten is good in terms of profits, there is no cash to pay the interest.
Likewise there is $85,000 tax to pay. We are not told what the overdraft limit is, but it appears that
Comparator can only meet its obligations if the overdraft is increased.
Investment ratios
Comparator's dividend yield of 2.5% is low compared with the average of 6%, which will dissuade
many investors from subscribing to a new share issue. On the other hand it suggests that the share
price is relatively high. This might be because investors are aware of additional information that
promises a brighter future for Comparator, or maybe the share price will drop when these results are published.
The dividend cover of 1.07 is also worrying; Comparator is paying out almost half its earnings at a
time when it needs to generate cash to pay off its liabilities and invest in new equipment.
Summary and conclusion
At first sight Comparator's operating performance appears to be good compared with its rivals, but
further analysis suggests that this might be boosted by old plant and equipment. Comparator's
financial position is worrying both in the short term and the long term, and it is difficult to see how
Comparator will be able to meet its obligations and invest in the future. Unless things improve
Comparator's going concern status must be in doubt.
