Financial Decision Making in assessing company growth

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b) Performance appraisal of Capello Designs PLC

Return of Capital Employed (ROCE) is often considered to be the best measure of profitability in order to assess the overall performance of the business (McLaney & Atrill, 2009). The year 2009/10 has seen a decrease of 4.5% from 24.6% to 20.1% in the ROCE ratio compared to the previous year, operating profit between the two years are similar, the difference in ROCE is due to the large change in capital employed. The decrease in ROCE suggests a poor efficiency and profitability of the company's investments. Capello Designs' ROCE is significantly lower than the typical ROCE of 27% of other companies in the hair care products sector. Capello Designs should strive to maximise the return of capital employed by finding the optimum mix between mix of unit profitability and capital utilisation. The decrease in Return of Shareholders' funds suggests management is less efficient in utilizing its equity base and giving a better return to its investors than it was in the previous year.

Gross profit from the year 2008/09 to 2009/10 has declined by 2.4% from 30.8% to 28.4%, this suggests an increase in costs without any corresponding increase in selling price, or/and selling prices have declined due to competition, or the range of goods may have changed to include more products with lower margins. The facts show that the sales revenue has increased by 7% compared to the cost of sales that has increased by 11%; the divergence of figures has contributed significantly to the decline in gross profit. The decrease in net profit by only 0.5% suggests that overheads have been tightly controlled during 2009/2010. Capello Designs' profitability margin figures are falling below the typical profitability gross margin figure of 35% and net margin of 13%. The company can however increase its profitability by reducing costs, increasing turnover, productivity and increasing efficiency, to increase the overall performance of the company.

Working capital cycle days has decreased from 81 days to 77 days, trade receivables have decreased by 13 days, while inventory have increased by 13 days which means there has been a reduction in the time taken to collect amounts owed by credit customers, but there has also been a raise in the time inventory is held for, this could also suggest the reason for the difference in current ratio of liquidity in comparison to acid test ratio of liquidity. Trade payables are taking longer to settle in 2009/10 compared with the previous year and has increased for a period of 4 days from 71 days to 75 days. Net Asset Turnover is a measure of the effectiveness with which assets are being used to generate sales and a company would ideally expect to see an increasing trend. However the ratio has actually declined as the growth in sales (7%) has not kept pace with the growth in assets (26%), with particular references to the increases in non-current assets, inventory and trade receivables.

The current ratio measures liquidity and solvency, essentially a measure of the business's ability to meet its current obligations. A generally acceptable current ratio of current assets to current liabilities is 2:1 (Gill & Chatton, 2003). The current ratio of Capello Designs has fallen from 1.9:1 to 1.7:1. A lower ratio means that the company may not be able to readily pay off its short-term liabilities or take advantage of any discounts available, overall a weaker liquidity position than the previous year. Current ratios tend to overstate the current liquidity position of a company, therefore the acid-test ratios need to be compared.

The acid-test ratio is also a liquidity indicator that further refines the current ratio with the exclusion of inventory (Loth, 2010), a more conservative ratio than the current ratio because of its exclusion of inventory which is more difficult to turn into cash. Therefore, a higher ratio means a higher liquidity position. The acid-test ratio has declined by 25% from 1.2:1 to 0.9:1, the ratio is now less than one, which would suggest that the company cannot meet it's current liabilities and that the liquidity of the business is now cause for concern. Furthermore, the acid-test ratio is much lower than the current ratio, which would suggest that current assets are highly dependent on inventory.

The combination of ratios would suggest that the liquidity position of the company needs to improve. Various methods in which Capello Designs could do so is by increasing the current assets from loans or other borrowings with a maturity of more than one year, converting non-current assets into current assets as well as increasing current assets from new equity contribution, or perhaps investing profits back into the business.

Gearing Ratio (1) has increased quite considerably from 38.9% to 59.2%. The gearing ratio has increased by over a third, this is a consequence of the significant additional loan taken out during the year. The increase in gearing (leverage) means the company is considered to be more risky than before; because it is more vulnerable to downturns in the business cycle as the company must continue to service its debt regardless of how bad sales are. Interest cover has decreased from 11.3 times to 6.6 times, a reduction of 4.7, which amounts to almost 40%, the gearing of this company needs to be closely reviewed going forward. Capello Designs could consider reducing its loan and maximise the use of its overdraft facility which would help its short term liquidity problem without unduly increasing its gearing ratio.

The earnings per share have decreased by 1.1 pence from 27.7 to 26.6 pence which is discouraging. The dividend per share and dividend payout rate has remained constant throughout both years. The dividend yield has reduced by 1.1 however the P/E ratio has increased by 2.6 times from 14.1 to 16.7, giving Capello Designs a greater price/earnings ratio than its main UK competitor. A high P/E ratio is one that has a high price compared with its recent earnings (McLaney, 2009), this implies that investors are more confident this year in the growth of future earnings. However the dividend yield has decreased by 0.5% to 3.6% compared to its main UK competitor with a dividend yield of 4.9%, which is more than a third of an increase of Capello Designs. This comparison suggests that the shareholders of Capello Designs' main UK competitor can be more confident that dividends will be maintained as opposed to Capello Designs.

Overall the company's performance seems to be deteriorating, in comparison to the typical figures of other companies in the same sector, Capello Designs is not performing as well as it should be, in comparison to the previous year, this year has taken a turn for the worst. Profitability as a whole has declined and there is cause for concern when it comes to the liquidity of the business, gearing, activity and investment. This company needs to be closely monitored over the next few years.

Appendix

Profitability Ratios

Return on Capital Employed

Profit before interest and tax x 100

Total assets less current liabilities

Return on Shareholders' Funds

Profit after taxation x 100

Shareholders' funds

Gross Profit Margin

Gross Profit x 100

Turnover

Net Profit Margin

Operating Profit x 100

Turnover

Activity Ratios

Trade Receivable Days

Trade receivables x 365

Turnover

Inventory Days

Inventory held x 365

Inventory used (cost of sales)

Trade Payables

Trade payable days x 365

Credit purchases (cost of sales)

Net Asset Turnover

Turnover x 365

Total assets less current liabilities

Working Capital Cycle

Trade receivables plus Inventory days less Trade receivable days

Capital Gearing Ratios

Gearing Ratio (1)

Long term debt x 100

Shareholders' funds

Gearing Ratio (2)

Long term debt x 100

Shareholders' funds plus long term debt

Gearing Ratio (3)

Net Debt x 100

Shareholders' funds

Interest Cover

Profit before interest and tax

Net interest payable

Liquidity Ratios

Current Ratio

Current assets___

Current liabilities

Acid Test Ratio

Current assets less inventory

Current liabilities

Investor Ratios

Earnings per share

Profit after tax

Number of ordinary shares issued

Dividend per share

Total ordinary dividend

Number of ordinary shares in issue

Price/Earnings Ratio

Current market share price

Earnings per share

Dividend Cover

Profit after tax

Number of ordinary shares issued

Dividend Yield

Net dividend per share x 100/90

Current market price

Dividend Payout Ratio

Dividend per share

Earnings per share