Financial Ratios and Firm Performance

This assignment explores the connection between book-to-market (B/M) value and profitability ratios of companies listed on the Tehran Stock Exchange. It examines research papers that investigate the impact of various financial ratios on a company's profitability, using empirical analysis and case studies from diverse industries like food & beverages, cement, and steel. The assignment emphasizes understanding how working capital management, debt-equity choices, R&D investment, and inventory turnover contribute to overall firm performance.

ACCOUNTING AND
FINANCE

Table of Contents
INTRODUCTION......................................................................................................................1
Q.1. Comparative analysis..........................................................................................................1
Financial performance......................................................................................................1
Non-financial performance measure.................................................................................3
Presenting data through column charts.............................................................................3
Recommendation to Asol Ltd. CFO.................................................................................8
Recommendation to Hennes and Mauritz.........................................................................8
Limitation of financial ratios............................................................................................9
Q.2. Uses of Capital Investment Appraisal Techniques.............................................................9
2a................................................................................................................................................9
Net Cash Flows of the project.........................................................................................10
Payback period................................................................................................................11
Project NPV....................................................................................................................11
Project ARR....................................................................................................................12
2b..............................................................................................................................................12
Limitations of Investment appraisal techniques.............................................................12
CONCLUSION........................................................................................................................13
REFERENCES.........................................................................................................................14
..................................................................................................................................................16

INTRODUCTION
Next plc is a UK cloth, footwear and home products retailer company established in
the year 1864 and headquartered in Enderby, Leicestershire. Hennes and Mauritz, often
known as H & M is the world second largest cloth retailer organization which was found in
the year 1947 in Swedish. Both the organizations have worldwide presence and serve a large
customer base. Currently, Asol ltd being a large fashion retailing firm is choosing these two
well established companies for investing funds in the form of share capital. Henceforth,
comparative analysis of both the financial and non-financial performance will be done for
effective investment decisions. Along with this, capital budgeting tools will be used to assist
senior management of Hilltop Ltd for acquiring new machine for enhancing its total
production. In the present report, both the discounted and non-discounted cash flow methods
will be used for taking strategic decisions.
Q.1. COMPARATIVE ANALYSIS
Financial performance
 Profitability ratios: The surplus of total sales over the cost is called GM whilst the
excess of GM over total operating expenses is called NM. In 2011, GM of Next plc
was 29.27% while in H & M, it was 62.93% in year 2010, and thus, it was higher in H
& M business. However, in 2015, Next Plc GM went up by 33.59% whereas in H &
M, it got reduced to 58.81% in 2014. Thus, upward trend of Next plc business is a
good sign of its performance (Khan and Khokhar, 2015). Moreover, NM of Next Plc
turned out from 11.93% to 15.87% in 2015. On the contrary, H & M generated less
NM from 17.22% to 13.19%. Thus, it can be said that although H & M is a good
profit earning organization but still its declined trend is not good so there is a great
chance of lowering potential operational performance in the future period (Hosseini
and Mehregan, 2015). This in turn, it can be concluded that Next Plc will be more
suitable for share acquisition by Asol Ltd.
 Management effectiveness: Return on assets and return on equity measure the
manager’s efficiency to earn profits. In Next Plc, ROA has been increased from
22.55% to 28.68% whilst in H & M; it has been dropped from 32.91% to 28.28% in
2014. However, Next Plc ROE got reduced from 214.98% to 208.75% whereas in H
& M it has been declined from 44.07% to 41.27%. Thus, ROE in Next plc is
approximately 5 times higher than H & M. On the other hand, ROA is witnessing an
upward movement due to high profitability. Thus, it became clear that manger's
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effectiveness is good in Next Plc business which indicates that Asol Ltd's CFO should
purchase this company's shares (Sharma, Sharma and Arif, 2015).
 Financial strength: Current ratio and acid test ratio are the indicators of business
liquidity (Perinpanathan, 2015.). Next Plc CR shows an increasing trend as it got risen
from 1.28 to 1.82 in 2015 on contrary, in H &M, it prevails an declined from 2.96 to
2.11. Therefore, high WC is available in Next plc for doing its daily functions. In
2011, It was 234400 got improved to 729400 in 2015 whereas in H & M, it shows an
significantly decreases as it got reduced from 2472996 to 1915437 in 2014. Moreover,
QR in Next plc is 1.16 while in H & M it is 1.07 in 2014. Thus, it can be said that
Next Plc is managing its liquidity position and pay-off their short term obligations in
an effective manner (Ibrahim, 2015). However, declined trend in H & M business will
impact its operating functions adversely.
Moreover, debt equity ratio in Next Plc shows an little bit increases from 2.57 to 2.61.
However, in H&M, debt/equity ratio is nil because it is funding itself through using
only the equity capital. Debt funds is unavailable in the firm hence, it will affect
organization in an adverse manner because business will not be able to take the
advantageous of trading on equity (Lewis and Tan, 2016). Furthermore, excessive use
of equity capital will diversify its control in the hand of shareholders so that it can be
said that capital structure is well designed in Next Plc.
 Efficiency ratio: Inventory turnover ratio indicate the time period in which stock will
be converted into cash (Lee, Zhou and Hsu, 2015). In Next Plc, it went fall from 6.89
to 6.62 in 2015 on the other hand, in H&M, it got reduced from 3.70 to 3.46 in 2014.
Stock using efficiency prevails an declined in both the firms however, in Next Plc, it
is almost 2 times greater than H & M. Thus, it can be concluded that Next Plc is
quickly converting its inventory into sales for cash collection purpose. Furthermore,
inventory days in Next Plc is 55.13 however, in H &M, it is 105.63 which indicate
that H&M is stuck its cash in stock for longer time period. On contrary, in Next plc, it
is approximately half to 55.13 conclude that it is using inventory in more efficient
manner.
 Valuation ratios: FCF/share in Next plc got improved from 1.83 to 4.14. However,
in H&M, it got reduced from 0.93 to 0.76. On the other hand, operating cash
flow/share got enhanced from 2.49 to 4.86 in Next Plc whereas in H&M, it shows an
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little bit increase from 1.20 to 1.25. Thus, it became clear that Next plc is generating
high cash flows on the shares and will be able to gain high shareholder satisfaction
(Barua and Saha, 2015). Thus, it became clear that Asol Ltd should consider this
company for investment in share capital.
Non-financial performance measure
Revenue/employees in Next plc got improved from 114727 to 135729 whereas in
H&M, it went fall from 166639 to 138467 in 2014. Moreover, in Next Plc, EBITDA for
employees got declined from in H&M business, it got reduced from 42580 to 28008 in 2014.
Therefore, upward movement in Next plc indicated that more earnings is available for their
workers which is a sign of better company's performance.
Presenting data through column charts
Gross margin 2010 2011 2012 2013 2014 2015
Next Plc - 29.27 30.38 31.48 33.16 33.59
H & M 62.93 60.13 59.5 59.13 58.81 -
Next Plc
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2011 2012 2013 2014 2015
27
28
29
30
31
32
33
34
29.27
30.38
31.48
33.16
33.59

Hennes and Muritz
Net margin 2010 2011 2012 2013 2014 2015
Next Plc - 11.93 12.62 14.34 14.79 15.87
H & M 17.22 14.38 13.96 13.3 13.19 -
Next Plc
Hennes and Muritz
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2010 2011 2012 2013 2014 2015
56
57
58
59
60
61
62
63
64
62.93
60.13
59.5 59.13 58.81
2011 2012 2013 2014 2015
0
2
4
6
8
10
12
14
16
18
11.93 12.62
14.34 14.79
15.87

Current
ratio
2010 2011 2012 2013 2014 2015
Next plc - 1.28 1.54 1.48 1.76 1.82
H & M 2.96 2.71 2.66 2.25 2.11 -
Next Plc
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2010 2011 2012 2013 2014
0
2
4
6
8
10
12
14
16
18
20
17.22
14.38 13.96 13.3 13.19

Hennes and Mauritz
Quick
ratio
2010 2011 2012 2013 2014 2015
Next plc 0.72 0.91 0.97 1.18 1.16
H & M 2.06 1.69 1.49 1.22 1.07
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2011 2012 2013 2014 2015
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
1.28
1.54 1.48
1.76 1.82
2010 2011 2012 2013 2014
0
0.5
1
1.5
2
2.5
3
3.5
2.96
2.71 2.66
2.25 2.11

Next plc:
Hennes and Mauritz
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2011 2012 2013 2014 2015
0
0.2
0.4
0.6
0.8
1
1.2
1.4
0.72
0.91 0.97
1.18 1.16

Recommendation to Asol Ltd. CFO
On the basis of above analysis, it can be recommended to CFO of Asol Ltd that he
should make purchase of Next Plc shares. This is because its financial strength is
comparatively better than H&M business. High profit margin, better liquidity position, high
stock turnover ratio, good working capital management, well-designed capital structure,
improved managers effectiveness and high cash flow on shares interpreted that Next Plc
business will be more worthy for Asol ltd for investment objectives (Campbell, Galpin and
Johnson, 2015). Moreover, non-financial measure also presents that Next plc is performing
well and generate high revenues for the employees. Therefore, through investing money in
Next Plc, Asol Ltd can generate more yield and return on their investment.
Recommendation to Hennes and Mauritz
To
The directors of H & M
On the basis of financial analysis, it has been derived that operational performance of
the company is got reduced over the period. Therefore, managers need to pay focus on
improving their profitability. It can be done through maximizing revenues and minimizing
spendings. It will also assist to enhance return on assets and equity. Moreover, to strengthen
its financial status, management has to ensure better working capital management through
improving their liquid availability in the business. It can be done through receiving their
receivables quickly and paying delayed to the suppliers. Another, company has to improve
their inventory turnover ratios which make firm able to increase their cash inflows. It
provide assistance to operate effectively and remove operational difficulties. Furthermore,
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2010 2011 2012 2013 2014
0
0.5
1
1.5
2
2.5
2.06
1.69
1.49
1.22
1.07

H&M business has to use debt funds in its capital structure so that they can take benefits of
trading on equity and maximize their shareholders return. In addition to it, it will provide
advantageous for securing business controlling rights in the hand of owners. By doing this,
firm will be able to maintain its financial position as previous years and ensure business
growth.
Limitation of financial ratios
Even ratio analysis is a good technique for making comparative study between two or
more companies but still it contains several limitations, described below:
 Ratio provide information about past performance and do not helpful for determining
future business performance. However, investors as well as potential investors are
more interested to assess company's performance for FY. Thus, it will not satisfy their
objectives which is its limitation.
 Accounting rules, convention, policies and principles also plays an major role in
financial statement preparation. Any different in these adopted policies will provide
different results so ratios will be changed accordingly (Ratio Analysis: Applications,
Limitations and Dangers-A perspective, n.d.). Therefore, it is also its drawback which
may contributes to harmful decisions.
 Interpretation of ratio is very difficult task because there is not a set idle measurement
for all kind of ratios. Henceforth, it can not be said that computed ratio is good or bad
(Ratio analysis- Limitation, 2008). Furthermore, idle ratio also may also tends to very
from industry to industry thus, interpretation will be varied accordingly.
 Ratio computation do not consider the market factors which are outside the firm
control. Although, in the present changing market environment, these factors such as
inflation and fluctuation in interest rate affects organization in a great extent hence, it
is also its limitation.
Q.2. USES OF CAPITAL INVESTMENT APPRAISAL
TECHNIQUES
2A
Capital budgeting techniques helps to assess worthiness of the available potential
investment project in which business is planning to invest. The techniques entail in-depth
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evaluation and analysis of all the alternative investment proposals and take decisions that
which project they should accept. Present scenario indicated that a medium sized
manufacturing firm, Hilltop Ltd has the opportunity to invest in two potential and mutually
exclusive projects for purchasing new machinery. Thus, capital budgeting tools will greatly
assist its senior management to take qualified investment decisions.
Net Cash Flows of the project
It has been identified through combining all the cash flows and eliminating all the
non-cash based transactions such as depreciation.
Year
Machine 1
(profits) Depreciation
Sale of
machine
New
Machine
purchase Cash inflow
2016 £40000 £33000 £73000
2017 £40000 £33000 £73000
2018 £40000 £33000 £21000 (£50000) £44000
2019 £30000 £10000 £40000
2020 £30000 £10000 £40000
2021 £20000 £10000 £30000
Total £200000
Working note:
Depreciation on machine sold on 31st December, 2008
= (Initial investment-scrap value)/project life
= (£120000-£21000)/3 = £33000
Depreciation on new machine purchased
= £50000/5 = £10000
Year Machine 2 (profits) Depreciation Cash inflow
2016 10000 20000 30000
2017 20000 20000 40000
2018 30000 20000 50000
2019 60000 20000 80000
2020 70000 20000 90000
2021 55000 20000 75000
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Total 245000
Working note:
Depreciation on Machine 2
= £120000/6 = £20000
Payback period
It is a simple method which indicates that how much time the project will take to
recover its initial cash investment, also known as recovery period (White and Miles, 2015).
Project which will generate its initial cash outlay earlier will be considered better for Hiltop
Ltd.
Year Project A (£) CCI (£) Project B (£) CCI (£)
2016 73000 73000 30000 30000
2017 73000 146000 40000 70000
2018 44000 190000 50000 120000
2019 40000 230000 80000 200000
2020 40000 270000 90000 290000
2021 30000 300000 75000 365000
Machine 1 = 1 year + (£120000-£73000)/£73000 = 1.643 year
Machine 2 = Cumulative cash inflows in year 2018 is equal to initial investment of £120000.
Thus, its PP will be 3 year.
Project NPV
Discounted cash flow method seems to be more effective for project evaluation
because it takes into consideration the time value concept of the money. In this method, all
the future cash flows associated with the project will be discounted to compensate for the
market uncertainties (Saxena, 2015). However, NPV is the surplus of total discounted cash
inflows over the project cost.
Year Project A
(In £)
Discounted
value of £1
DCF (In £) Project B (In £) DCF (In £)
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@20%
2016 73000 0.833 60809 30000 24990
2017 73000 0.694 50662 40000 27760
2018 44000 0.579 25476 50000 28950
2019 40000 0.482 19280 80000 38560
2020 40000 0.402 16080 90000 36180
2021 30000 0.335 10050 75000 25125
Total 182357 181565
Less: Initial
investment (120000) (120000)
NPV 62357 61565
Project ARR
ARR is the rate of net earnings which can be generated through investing funds in
available proposals.
ARR = Average annual profits/Average investment*100
Machine 1 = (£200000/6)/(£120000)*100 = 27.78%
Machine 2 = (£245000/6)/(£120000)*100 = 34.03%
Recommendations: From the above computation, it can be recommended that senior
management team of Hilltop Ltd has to purchase Machine 2. The reason behind this decision
is that project B will recover its project cost of £120000 earlier than project A. Along with
this, rate of net profit is also higher to 34.03% while in project A, it is only 27.78%. On
contrary to it, DCF presents that NPV of both the projects will be £62357 and £61565
respectively. It is higher by £792 in project B henceforth, it can be suggested that project B
will be more worthy for Hilltop Ltd so senior management has to invest funds for acquiring
Machine 2. It will increase company's production so that firm will be able to acquire more
profits in the business.
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2B
Limitations of Investment appraisal techniques
Investment appraisal techniques are helpful for the investment decisions but still each
method consists of several limitations, described below:
 Pay-back or recovery period: It is very basic and easier method whereas its
limitation is it do not take into consider the time value concept of money. Moreover, it
avoids the profitability beyond the payback period (DeFusco and et.al., 2015).
Although, it might be possible that a project which has longer pay-back period still
provide high post profitability. Therefore, it can be said that it is not a good method
and judgement cannot be made on this basis.
 Accounting rate of return: It is also a non-discounted method henceforth; evaluate
profits without determining their future values. Another drawback is that it evaluates
net profits after adjusting depreciation and other non cash affecting transaction rather
than cash flows (Brzozowska, 2015).
 Net Present value: The success of this method greatly depends upon the correct
estimation of discount rate. However, it will be very difficult for Hilltop Ltd to
forecast an accurate cost of capital which is its limitation (Sims, Powell and Vidgen,
2015). Thus, incorrect discount rate may lead in taking harmful business decisions for
long term period.
CONCLUSION
Presented project report concluded that Asol Ltd should buy Next Plc company's
shares for investing purpose. Growth in profitability margin, liquidity, manager's efficiency,
and financial strengthness are the reason behind this. Along with this, non financial
performance is also good in Next Plc so it became clear that through investing share capital in
Next Plc, Asol ltd can earn maximum profits on their investment. Besides this, capital
investment tools have concluded that Hilltop Ltd management has to buy Machine 1 for
investment in production.
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REFERENCES
Barua, S. and Saha, A.K., 2015. Traditional Ratios vs. Cash Flow based Ratios: Which One is
Better Performance Indicator?.
Brzozowska, K., 2015. Cost-Benefit Analysis in Public Project Appraisal. Engineering
Economics. 53(3).
Campbell, T.C., Galpin, N. and Johnson, S.A., 2015. Optimal inside debt compensation and
the value of equity and debt. Journal of Financial Economics.
DeFusco, R.A. and et.al., 2015. Quantitative investment analysis. John Wiley & Sons.
Hosseini, S.M. and Mehregan, M.J., 2015. ANALYZING THE RELATIONSHIP
BETWEEN BOOK TO MARKET (B/M) VALUE AND PROFITABILITY RATIOS
OF TEHRAN STOCK EXCHANGE COMPANIES. Economic and Social
Development: Book of Proceedings. p. 86.
Ibrahim, K.A., 2015. Working Capital Management and Profitability of Food and Beverages
Companies in Nigeria. International Journal of Management & Behavioural Sciences
(IJMBS). 6. p. 147.
Khan, M.N. and Khokhar, I., 2015. THE EFFECT OF SELECTED FINANCIAL RATIOS
ON PROFITABILITY: AN EMPIRICAL ANALYSIS OF LISTED FIRMS OF
CEMENT SECTOR IN SAUDI ARABIA. Quarterly Journal of Econometrics
Research. 1(1). pp. 1-12.
Lee, H.H., Zhou, J. and Hsu, P.H., 2015. The role of innovation in inventory turnover
performance. Decision Support Systems. 76. pp. 35-44.
Lewis, C.M. and Tan, Y., 2016. Debt-equity choices, R&D investment and market timing.
Journal of Financial Economics.
Perinpanathan, R., 2015. Using Altman's Model and Current Ratio to Assess the Financial
Distress of Listed Companies in the Default Board of Colombo Stock Exchange.
Scientific Research Journal (SCIRJ). 3.
Saxena, A.K., 2015. CAPITAL BUDGETING PRINCIPLES: BRIDGING THEORY AND
PRACTICE. EDITORIAL REVIEW BOARD. p. 31.
Sharma, D., Sharma, J. and Arif, M., 2015. CORPORATE PROFITABILITY AND
WORKING CAPITAL MANAGEMENT: A CASE STUDY OF STEEL
AUTHORITY OF INDIA LIMITED (SAIL). Indian Journal of Accounting. 47. p. 1.
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Sims, J., Powell, P. and Vidgen, R., 2015. Investment appraisal and evaluation: preserving
tacit knowledge and competitive advantage. International Journal of Business and
Systems Research. 9(1). pp. 86-103.
White, J.B. and Miles, M.P., 2015. A Proposed Capital Budgeting Technique for Liquidity
Constrained Small Businesses. Journal of Small Business Strategy. 1(2). pp. 36-46.
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