Limitations of Relying on Financial Ratios

Running head: FINANCE PORTFOLIO MANAGEMENT
Finance Portfolio Management
Name of the Student
Name of the University
Author’s Note

1FINANCE PORTFOLIO MANAGEMENT
Table of Contents
Portfolio 1...................................................................................................................................2
Introduction............................................................................................................................2
a) Calculation of Ratios..........................................................................................................2
b) Analysis of Performance, Financial Position and Investment Potential............................4
Analysis of Ratios..............................................................................................................4
Analysis of Audited Financial Statements.......................................................................10
c) Recommendations............................................................................................................11
d) Limitations of Relying on Financial Ratios to Interpret Company’s Performance.........12
Conclusion............................................................................................................................13
Portfolio 2.................................................................................................................................15
a) Advise to the Senior Management on the Selection of Project........................................15
b) Limitations of Investment Appraisal Techniques in Long-Term Decision Making........17
References................................................................................................................................19

2FINANCE PORTFOLIO MANAGEMENT
Portfolio 1
Introduction
The investors are required to analyse and assess the financial performance and
position of the companies in order to ascertain that whether the companies are viable to invest
in. They can simply gain information on the firm’s financial performance and position from
the financial statements or they can use different techniques for analysing the financial
performance and position. The main aim of this report is the analysis of the financial
performance, financial position and investment potential of two leading companies of United
Kingdom (UK); they are GlaxoSmithKline Plc (GSK) and Reckitt Benckiser Group Plc (RB).
In order to achieve this objective, ten major financial ratios are analysed and interpreted for
assessing the financial performance and position of these two companies. It needs to be
mentioned that both GSK and RB are leading companies in their respective sectors.
a) Calculation of Ratios

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4FINANCE PORTFOLIO MANAGEMENT
b) Analysis of Performance, Financial Position and Investment Potential
Analysis of Ratios
GlaxoSmithKline Reckitt Benckiser
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
0.75
0.65
0.60
0.82
Current Ratio
2018 2017
Figure 1: Comparison of Current Ratios
The current ratio of GSK has increased from 2017 to 2018 whereas the same has
declined in case of RB. In both the companies, the current ratio is less than 2:1; it means they
have poor liquidity position in the absence of adequate current assets to cover the current
liabilities. This affects the ability of these companies to repay the short-term debts in order to
carry out the business operations. However, GSK is in the way to improve its current ratio
where the same is deteriorating for RB (Oshoke and Sumaina 2015).

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GlaxoSmithKline Reckitt Benckiser
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.51 0.48
0.39
0.64
Quick Ratio
2018 2017
Figure 2: Comparison of Quick Ratios
Quick ratios are also following the same trend of current ratio because this ratio of
GSK has improved in 2018 whereas fall in it can be seen in case of RB. These companies do
not have a quick ratio more than 1:1 which is an indicator of the shortage of quick assets like
cash and others in the company to pay off the current business obligations (Jonny 2016). This
shows the poor liquidity condition of these two companies.
GlaxoSmithKline Reckitt Benckiser
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
13.13%
17.31%
7.19%
54.06%
Net Profit Margin
2018 2017
Figure 3: Comparison of Net Profit Margin

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There is a growth in the net profit margin of GSK, but a large fall in this ratio can be
seen in case of RB. This shows effective financial performance of GSK as the company has
increased its sales while decreased its overall direct and indirect expenses. In case of RB, the
main reason for this large fall in this ratio can be the increase in direct and indirect expenses
(Reynolds et al.2013).
GlaxoSmithKline Reckitt Benckiser
56.00%
58.00%
60.00%
62.00%
64.00%
66.00%
68.00% 66.77%
60.61%
65.74%
59.59%
Gross Profit Margin
2018 2017
Figure 4: Comparison of Gross Profit Margin
The gross profit ratio of both GSK and RB has registered growth in the year of 2018
as compared to 2017. This is an indication of good financial performance of both the
companies as increase in gross profit margin means increase in net sales in the presence of a
constant or reduced cost of sales. This also demonstrates the efficiency of these companies in
utilizing its direct costs and labour for generating sales (Tamulevičienė 2016).

7FINANCE PORTFOLIO MANAGEMENT
GlaxoSmithKline Reckitt Benckiser
0.00%
10.00%
20.00%
30.00%
40.00%
50.00%
60.00%
70.00%
80.00%
90.00%
100.00% 89.68%
50.76%
88.30%
55.41%
Gearing Ratio
2018 2017
Figure 5: Comparison of Gearing Ratios
There is a minor increase in the gearing ratio of GSK in 2018, but the same ratio of
RB has witnessed a fall in 2018 as compared to 2017. In both these companies, this ratio is
more than 50% that makes these companies highly geared. It means the proportion of finance
provided by debt is higher than that of equity which exposed these companies to higher risks
as the payment of interest and repayment of debt are mandatory unlike payment of dividends
(Yapa Abeywardhana 2015).
GlaxoSmithKline Reckitt Benckiser
-
5.00
10.00
15.00
20.00
25.00
30.00
35.00
40.00
45.00
20.23 20.69
42.13
8.16
P/E Ratio
2018 2017

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Figure 6: Comparison of P/E Ratios
There is a fall in the P/E ratio of GSK in 2018 where there is a growth in the P/E ratio
of RB in the current year. It is a negative aspect for GSK as the market is not willing to pay
more for its shares based on present earnings, but positive for RB because of the increase in
the expectation of the market on this company’s future performance and earnings (Marangu
and Jagongo 2015).
2018 2017
-
100.0
200.0
300.0
400.0
500.0
600.0
700.0
800.0
900.0
1,000.0
73.7 31.4
306.1
878.7
Earnings Per Share
GlaxoSmithKline Reckitt Benckiser
Figure 7: Comparison of Earnings per Share
There is decrease in the earnings per share of both GSK and RB in 2018 as compared
to 2017. This means there is decrease in the portion of these companies’ profit allocation to
each outstanding share of the common stock. This indicates towards the decreased
profitability of these two companies that has contributed towards the allocation of less profits
to their shareholders (Öztürk and Karabulut 2018). This is a major discouragement of the
shareholders of these companies.

9FINANCE PORTFOLIO MANAGEMENT
GlaxoSmithKline Reckitt Benckiser
-
0.02
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.15
0.10
0.14
0.09
Return on Capital Employed
2018 2017
Figure 8: Comparison of Return on Capital Employed
There is increase in the return on capital employed in GSK and RB in 2018 from 2017
and this indicates effective performance of these two companies in terms of effectively using
the employed capital for generating profit. It implies that both GSK and RB are using its
capital in efficient manner in order to generate profit. It makes both of these companies
suitable candidates to the investors to invest in them (Ojeka, Iyoha and Obigbemi 2014).
GlaxoSmithKline Reckitt Benckiser
-
50
100
150
200
250
195
94
196
95
Average Inventories Turnover Period
2018 2017
Figure 9: Comparison of Average Inventories Turnover Period

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Minor decrease in the average inventories turnover period can be seen in GSK and RB in
2018 as compared to 2017. However, the average inventories turnover period of RB is less
than that of GSK. This is a good indicator for RB because this means RB takes less time to
clear its inventory averagely in a year as compared to GSK (Grubor, Milicevic and Mijic
2013). This indicates towards the potential issues in the inventory management mechanism in
GSK.
GlaxoSmithKline Reckitt Benckiser
0.00%
50.00%
100.00%
150.00%
200.00%
250.00%
300.00%
108.55%
55.77%
254.78%
18.70%
Dividend Payout Ratio
2018 2017
Figure 10: Comparison of Dividend Pay-out Ratios
The dividend pay-out ratio of GSK has decreased in 2018 from 2017; but the same
has increased has increased in case of RB in the current year. In case of GSK, this fall in this
ratio is an alarming sign for the investors as this signifies that the company cannot afford to
pay such dividend. However, growth in this ratio is a positive aspect for the performance of
RB as this indicates the increase in dividend payment by the company (Ahmed 2015).
Analysis of Audited Financial Statements
The examination of the audited financial statements of both GSK and RB shows the
increase in sales of these two companies and decrease in cost of sales which contributes to the
increase in gross profit for both the companies. However, GSK has almost doubled its net

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profit in 2018 where there is more than double decrease in the net profit of RB (gsk.com
2019). This is mainly because of the increase in direct and indirect expenses of RB.
Moreover, asset position of both of these companies have increased where there is increase in
GSK’s total current assets and non-current assets along with RB’s total non-current assets.
However, total current assets of RB have decreased in the current year. Total liabilities of
GSK have increased in 2018 there the total liabilities of RB has fallen in the current year.
Total equity of both GSK and RB has increased in the current year (rb.com 2019).
c) Recommendations
It can be seen from the above analysis that both GSK and RB have certain financial
areas where they have performed poorly and appropriate recommendations are required to
improve the situation. The recommendations are provided below:
 Both GSK and RB has major liquidity issues. This can be improved through cutting
the unnecessary overhead expenses along with getting rid of the unproductive assets.
In addition, both accounts receivables and accounts payables should be managed
monitored in order to ensure their speedy collection and payment respectively
(Oshoke and Sumaina 2015).
 RB has issues in net profit margin and there are two major ways to improve this
situation; they are increase in sales revenue and decrease in operational costs. Net
products and service can be introduced that would boost the sales. Unnecessary
operational costs should also be cut.
 Both GSK and RB has high gearing ratio that needs to be reduce. The recommended
ways to reduce gearing ate sell of shares for pay down the debts, conversion of loans
through negotiating with the lenders to the company’s shares and increase in the
company’s profit. Moreover, there should be increase in the accounts receivable

12FINANCE PORTFOLIO MANAGEMENT
collection, reduction in the level of inventory, increase in the days for paying the trade
payable and others (Yapa Abeywardhana 2015).
 GSK has problem in price earnings ratio. This can be improved through reinvesting
the earnings, developing new production plants and expanding the business
operations. These need to be done because most of the investors are enthusiastic to
buy the stock at higher share price out of the expectation of a high future payoff from
the investment in the company.
 RB has major issues with the Earnings per share. This can be improved through the
increase in revenue that will enable flowing down more pounds to the earnings. It is
also recommended to decrease the costs as this enables the flow down of greater
portion of revenue to the earnings. Lastly, share count needs to be decreased that will
split the total earnings in less shares.
 Both GSK and RB has witnessed decrease in average inventory days. The
recommendation to the company is to turn to automated inventory management
system with the aim to keep track of the inventories in effective manner. Moreover,
the pricing strategy of the companies needs to be reviewed as the current price many
not be working for the companies to increase the demand. Most importantly, the
overall costs associated with the inventories need to be reduced (Ahmed 2015).
d) Limitations of Relying on Financial Ratios to Interpret Company’s Performance
Followings are the limitations of depending in financial ratios for understanding the
financial performance of the companies:
 The financial information used in ratio analysis is based on the past results published
by the firm; the metrics in ratio analysis do not essentially represent the future
performance of the firm (Faello 2015).

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 There are differences in time in the financial statements as they are published
periodically. In case there is occurrence of inflation in the time lag, the information
presented in the financial statements fails to reflect the same. Therefore, it become
impossible to obtain the real price. Thus, the numbers across different financial period
are not comparable until there is adjustment of inflation (Faello 2015).
 Changes in accounting policies of a firm create major impact on financial reporting of
the firms. Different companies tend to have different accounting policies. In this
situation, it is not possible in comparing the ratios of two companies having different
accounting policies since ratio analysis does not consider the changes in accounting
policies.
 Financial analysts need to be aware of the seasonal factors that can possibly lead to
the limitation of the ratio analysis. Ratio analysis is unable in adjusting the seasonality
effects which can contribute to false interpretation of financial results (Faello 2015).
Conclusion
As per the above discussion, both the companies have positive and negative aspects
associated with the financial performance and position; but the positives of GSK are stronger
than RB. Both the companies have liquidity issues, but GSK is showing the sigh of
improving where the liquidity of RB is deteriorating. Both the companies have high gearing
ratio and this can be to accommodate any business expansion plan or introduction of new
product line. Significant improvement in the earnings per share of GSK is evident from the
analysis which is a major positive for the investors as GSK is allocating more profit to the
investors. GSK has also improved its efficiency in using its employed capital for generating
sales and profit. Decrease in the dividend pay-out ratio is an indicator that the company is
paying less dividend to the investors and undertaking any new expansion plan could be the
possible reason and this increases the scope of future profitability of GSK. Most importantly,

14FINANCE PORTFOLIO MANAGEMENT
GSK has been able in increasing its profitability in terms of both net profit and gross profit
where the same has deteriorated for RB and this is the most important indicator of the
company’s good financial performance. It means the company is adequately profitable to
provide the investors with healthy return. Therefore, based on the whole analysis, it is
recommended to invest in GSK as this is a more viable option to invest in.

15FINANCE PORTFOLIO MANAGEMENT
Portfolio 2
a) Advise to the Senior Management on the Selection of Project
It can be seen from the provided scenario that the management of Harris Private
Limited is considering the investment opportunity in two potentially and mutually exclusive
projects. The purchase of a new machine is involved in case of each project. There are five
major investment appraisal methods that are used for appraising Project A and Project B.
These are discussed below.
Net present value (NPV) undertakes calculating the disparity between present value of
cash flows and outflow of a project. It is possible for the management to tell whether a
project is worth investing by the fact the derived NPV is positive or negative. A positive NPV
denotes that the future cash flows associated with the project are superior than the
preliminary cost (Gallo 2014). As per the above table, both project A and project B generates
positive NPV; but the NPV of project A is larger than project B.
IRR refers to the minimum discount rate used by the management for the
identification of capital investments or future projects with acceptable return. This is used for
assessing the viability of two investment proposals or projects (Patrick and French 2016). The
investment option with higher IRR will be acceptable by the management (Gorshkov et
al.2014). In case of Harris Private Limited, the IRR of project A is greater than the IRR of
project B and this must be considered while making decisions.

16FINANCE PORTFOLIO MANAGEMENT
Payback period is a key capital budgeting method used for calculating the required
number of days for an investment project for generating cash flows equal to the actual
investment cost. The management of Harris Private Limited needs to use payback period
calculation for assessing how speedily the money can be got back on the investment, the
faster the better. As per the above table, project A provides the money back in fewer years as
compared to project B.
PI involves in computing the present value of the expected cash flow that can be
generated by the investment. In case PI is larger than 1, management should undertake the
project. In case PI is less than 1, the project should not be undertaken. In case the PI is equal
to 1, the project is indifferent which accepting the project will not make any difference
(Nekrasova, Leventsov and Axionova 2016). The above table shows that both the projects
have PI of more than 1.
ARR is used for calculating the amount of return that would be made by the investors
from an investment. Therefore, projects with higher ARR are acceptable. It can be seen in the
case of Harris Private Limited that Project A has higher ARR as compared to project B
(Brdulak and Zakrzewski 2013).
It can be seen from the above discussion that Project A is superior in every aspect as
compared to the project B. First, despite of NPV of both the projects as positive, Project A
has more NPV than Project b. Second, the IRR of Project A is superior to Project B. Third;
the payback period of Project A is lesser than Project B which means this will take less time
to recover the investment money. Fourth, despite of PI of both the projects is greater than 1,
Project A has greater PI than Project B. Lastly, the ARR of Project A is greater than Project
B. Therefore, the management is advised to select Project A.

17FINANCE PORTFOLIO MANAGEMENT
b) Limitations ofInvestment Appraisal Techniques in Long-Term Decision Making
The above-used five investment appraisal techniques have certain limitations in
helping in the long-term decision making process and these are discussed below:
NPV – The main limitation associated with NPV method is the requirement to guess about
the future cash flows along with the estimation of the cost of capital of the firm. This method
cannot be applied at the time of comparing investment projects with dissimilar investment
amount. In addition, it is hard to apply NPV method at the time to compare two investment
projects having different life durations (San Ong and Thum 2013).
IRR – The major limitation of IRR is that it assumes that there is reinvestment of earnings at
the IRR for the project’s outstanding duration. In case the average rate of return earned by the
company is not close to the IRR, there is no reasonableness in the profitability of that
particular project. This method does not take into account economies of scale and the
presence of impractical implicit assumptions associated with reinvestment can be seen in this
(El Tahir and El Otaibi 2014).
PBP – The greatest limitation of PBP in long-term decision making is its failure in taking
into consideration the time value of money in order to adjust the cash flows consequently. At
the same time, this method also fails to consider the cash inflows take place further than the
payback period which leads to the failure in comparing one project’s overall profitability to
another (Kim, Shim and Reinschmidt 2013).
PI – One main limitation of PI is that the generated information is based on estimations rather
than facts. The use of best-guess estimation in PI fails to provide any guarantee. One crucial
aspect that is sunk cost is ignored under this method. Sunk costs are the costs that are
incurred before the commencement of the projects which form a crucial part of the capital
investment appraisal decision. At the same time, the managements have to face major

18FINANCE PORTFOLIO MANAGEMENT
difficulties in the estimation of opportunity cost under PI technique (Daunfeldt and Hartwig
2014).
ARR – One greatest limitation of ARR is that this does not consider the time factor that
causes problems in the selection of alternative use of the funds. In case return on investment
(ROI) is different from ARR, major problem is created in the long-term decision making.
Different external factors are not considered under this method while making long-term
decisions (Beck, Raj and Britzelmaier 2013).

19FINANCE PORTFOLIO MANAGEMENT
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