Question

Question Four: Saddam Ltd is considering the possibility of diversifying its operations and has identified three firms in the same industrial sector as potential takeover targets. The following information in respect of the companies has been exacted from their most recent financial statements. Ali Baba Camel Ratios 22.10 23.70 25.00 Return on Capital Employed before tax% Net Profit % 12.00 12.50 3.75 Asset turnover ratio 1.45 1.16 3.73 Gross profit % 20.00 25.00 10.00 Sales/Non-current Assets 4.80 2.20 11.60 Sales/Current Assets 2.10 5.20 5.50 Current Ratio 3.75 1.40 1.50 Acid test ratio 2.25 0.40 0.90 Average number of weeks' receivables outstanding! 5.60 6.00 4.80 Average number of weeks' inventory held 12.00 19.20 4.00 Ordinary dividend% 10.00 15.00 30.00 Dividend cover 4.30 5.00 1.00 Required: 1). prepare a report for the directors of Saddam Ltd, assessing the performance of the three companies from the information provided (profitability, liquidity and dividend). (15 marks) 2). Identify areas which you consider require further investigation before a final decision is made. (5 marks)

Answer 1

1.

Profitability: It can be seen that net profit and gross profit is lowest for Camel, however, its’ ROCE is highest. Net profit is Earnings after tax / Sales and ROCE before tax is Earnings before Interest and Tax / Capital employed (Equity+Debt). High net profit is mostly attributed to higher numerator, i.e., profit and ROCE means how well a company’s capital is used, higher ROCE means that company is generating more revenues for every dollar invested in it. Thought gross profit and net profit for Camel is extremely low (which indicates higher cost of goods sold, other mismanaged expenses and probably interest expenses which may be due to large portion of debt), its ROCE is highest, which indicates it is employing capita efficiently. Asset turnover ratio (which is Net Sales / Average total assets) is highest for Camel, which indicates assets are effectively employed. Further, Sales/Current assets and Sales/ Non-current assets is also highest for Camel which also indicates that Camel is using its current assets and non-current assets most effectively out of the three.

Liquidity : Current ratio (Current assets/ Current liabilities) is above 1.5 for all three companies (1.5 being a safe zone implying current assets are >= current liabilities). Though, Ali has the highest current ratio, but highest current ratio may not always be the best since it may indicate idle cash lying which is not invested to employ maximum benefits out of the company’s assets. Further, acid test ratio (Current assets less inventory and receivables / Current liabilities) is highest for Ali but less than 1 for Baba and Camel. An acid test ratio of 1 and slightly above it is good since it implies that in case the Co. needs to pay its current liabilities, it has sufficient quick assets to pay them off. Acid test ratio of 0.9 of Camel (means that current liabilities are only 90% covered by quick assets) is slightly worrisome but a ratio of 0.4 of Bali is huge worry since only 40% of its current liabilities are secured by quick assets. As for Ali, a ratio of 2.25 may imply excessive cash which can be put to better use.

Further, receivables outstanding (lower the better, since it implies debtors are quickly converted to cash) are lowest for Camel. Also, inventory held is lowest for Camel which means it is quickly converting its inventory to sales. Excessively high inventory implies longer operating cycle and therefore poor turnover.

Dividend : Camel pays the highest dividend to shareholders. Generally, good-performing companies share a higher proportion of their earnings with shareholders in the form of dividend because of their higher earnings (higher ability to share) and lesser transfer to retained earnings (expectations of higher earnings in the future too). Dividend cover, which is ratio of company’s earnings per share to dividend per share, implies how much is the dividend covered by its net earnings. It is higher for Ali and Baba (partially due to lower dividends declared by them) and lower for Camel (may be due to lower EPS due to high debt) but not less than 1.

Considering all above factors, I feel that Camel is making best use of its assets for generating returns and has better turnover ratios too though it looks like the company may need to manage certain expenses to improve its gross and net profitability. Further, it is paying very good dividends, which is a benchmark for a good company in the market. Nevertheless, further probing needs to be done why gross profit and net profit is so low than ROCE.

2. As mentioned in the above answer, further probing needs to be done majorly on why gross profit and net profit is so low than ROCE for Camel, when its assets are put to best use and its turnover on assets is so good, idle inventory is low, receivables are low,etc. It needs to be ascertained what portion of its capital is equity and what portion is debt (whether there are huge interest expenses which are impacting net profit). Further, its quick ratio is less than 1, so it needs to be seen why current assets other than inventory and receivables are so low.