Question-   Gross Margin Analysis

Solution-

Part A: Further Guidance

 

1. Introduction
 

This guidance complements the detailed marking scheme to be found in the Assignment section on Bb.


First, just to clarify, you are writing your report as if the date is (say) February 14th 2034.  In other words you have the 2033 results but your business has not yet made its decisions for 2034.  You should not, therefore, refer to the actual decisions or results for your business from 2034 onwards.

 

Second your report for Task 1 should go beyond merely describing what has happened to the financial health of your business.  ‘Analysis’ requires you to explain why the changes in the ratios have occurred, to comment on the significance of the changes or otherwise, and to offer some recommendations for improvement. 


 

2. Structure

 

We recommend you adopt the following structure:

 

Report Heading

 

Please use the following heading at the top of your report:

To:  Board of Directors

From: [Your Candidate Number]

Date: 14th February 2034

Subject: Financial Analysis of [World X; Your Company Name] at 31st December 2033

 

Introduction

 

Financial Performance

            Profitability

            Efficiency

 

Financial Position

            Liquidity

            Stability

 

Limitations of the Analysis

 

Conclusions / Summary

 

 

 

Appendix

            Include a table showing detailed workings for all 12 ratios for 2033 only:

Profitability:

    1. Return on capital employed
    2. Operating profit margin
    3. Gross margin
    4. Operating expenses to sales

Efficiency:

    1. Revenue on capital employed
    2. Inventory holding period
    3. Receivables days
    4. Payables days

Liquidity:

    1. Current ratio
    2. Acid test

Stability:

    1. Gearing ratio
    2. Interest cover

 

3. Recommended Approach

We recommend the following approach:

  • Organise your ratios into financial performance (profitability and efficiency) and financial position (liquidity and stability).

 

  • For each category of ratios (profitability, etc.), explain the meaning of the category (profitability, etc.) and provide an overall assessment of your business’ financial health with respect to this category (e.g.: ‘The business’ profitability declined in 2033 and is a cause for concern’).

 

  • Then introduce and explain a specific ratio which supports your analysis.

 

  • Briefly describe the movement year-on-year (and/or the comparison with industry / averages / conventional target values).  In other words has it improved or deteriorated?  (Use charts, graphs or tables to help the reader understand the movement in the ratios year on year and/or comparison with industry averages / conventional target values).

 

  • Comment on the significance of the movement or comparison.

 

  • For ratios which themselves are explained by others (e.g. through the ‘ROCE tree’ relationships), explain the relationship with those other ratios, and move to those ratios to continue your analysis.

 

  • For ratios which are not themselves explained by others, explain the business factors and/or business decisions which explain the movement in the ratio.  (Please avoid ‘mathematical explanations’ such as ‘…the ROCE increased because the operating profit increased by $300m and the capital employed remained the same’.  This might be correct but is not very helpful).

 

  • Where appropriate provide recommended actions for improving this ratio

Part B: Extracts from Past Students’ Work for Review

 

Critically review the following financial analysis extracts and taking each in turn, identify strengths and areas for improvement:

 

  1. Analysis of gross margin – Version 1

 

“The gross margin % is calculated as follows:

Gross margin % = gross profit / revenue x 100.

The gross margin % increased during 2033 because the gross profit increased by 15% and the revenue increased by 10%.   The gross margin is affected by the selling price per unit and the unit cost of production”.

 

 

  1. Analysis of gross margin – Version 2


 

“The gross margin ratio measures the business’ ability to generate a gross profit from its revenue, and is calculated before the deduction of operating expenses. 

The gross margin increased from 12.3% to 22.5% which can be explained by the increase in the net sales price during the year which was implemented to reflect an expected increase in demand following a significant increase in advertising, which as anticipated, resulted in an increase in brand awareness”.

 

  1. Profitability – Version 1

 

The return on capital employed has deteriorated as the operating profit margin has decreased. It is affected by a change in operating profit margin and sales revenue on capital employed. The operating margin had also deteriorated as it is affected by a change in the gross margin and by a change in the operating expenses to sales ratio. The gross margin has deteriorated as it is affected by a change in the sales price, a change in unit cost, relating to the cost of materials, labour and production overheads and to a change in product mix. The selling price remained the same during the years, but the unit cost increased which affected the gross profit. The operating expenses to sales improved as it is affected by a change in the operating expenses, such as selling, general and administrative costs, relative to the level of sales revenue achieved. The management team should drive an increase in operating profit by decreasing cost and improve the operating expense to sales ratio”.

 

 

 

 

  1. Profitability – Version 2


 

 “Profitability is a measurement of how good the company is to generate profit based on the revenue it has and the resources it use. As mentioned before 2032 was a year of heavily investments for A, these investments generated increased turnover for 2033. The return of capital employed (Ratio 1 – Appendix) measure the relationship between profit and resources used (equity plus Loan) which for A is really good compared to industry average. This is due to two main reason; decrease of total equity and improvement of profit. The retained profit from earlier year is low due to historically investments which affect the total equity. Also, the capacity and fixed costs remained in the same level as 2032 the profit increased heavily. These two combined improved the ROCE heavily”. 

 

 

  1. Stability


 

“Stability refers to the measurement of the Company’s ability to meet its longer-term obligations, notably those that are interest bearing such as debt. The stability of the Company appears to have improved during the year with the proportion of debt in the capital structure of the business reducing, as shown by the gearing ratio improving from 27.5% in FY32 to 25.2%. An increased level of profitability over a stable level of debt significantly enhances the interest cover from 8.5x in FY32 to 18.1x.

Bionic’s gearing is marginally better than the industry average (26.9%) and significantly ahead of the industry conventional target of 50%. This coupled with the Company’s industry best interest cover (nearest competitor 12.6x) continues to make the Company’s stability attractive, therefore stability should not be considered a threat to the business. Given this, the Company should consider negotiating a lower interest rate with the bank on its long-term and short-term debt”.

 

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