Financial Ratios Overview
Financial ratios indicate a firm’s financial position and financial performance. They are used to predict a company’s financial position in the future and to compare a firm’s financial position with other firms. These ratios are not only important to the firm but also to financing institutions and stakeholders. Financial ratios are classified according to the information they provide. The most frequently used ratios are profitability ratios, liquidity ratios and investment ratios. The following essay will analyze the three ratios in addition to efficiency ratio and gearing ratio in relation to Barney bakes plc company.
Financial ratios directly relate to profitability. If not well evaluated they could result in unnecessary losses even when a company is well financed. Financial ratios can be used to predict impending failure and avoid it. An example is the use of liquidity ratios to predict bankruptcy.
The liquidity ratio measures the company’s solvency and ability to meet its short term obligations. The most frequently used liquidity ratios are the current ratio and the working capital ratio. The current ratio is calculated by dividing the current assets with current liabilities. The current ratio indicates a company’s strength. A ratio of 2 is considered healthy. It implies that for every unit of current liability there are two units of current assets available. It is advisable that the current assets always exceed the current liabilities.
A current ratio of less than one is a warning sign of impending danger. It indicates that a company’s debts exceed its assets. In this case the current ratio over the years has been too low and is decreasing over time. This indicates that they have no working capital and are operating on debt. Such a ratio raises a red flag to financing institutions and they are not likely to finance them.
Working capital is the difference between current assets and current liabilities and is the cash used to settle daily expenses. This company has no working capital indicating that they operate on debt most of the time. This is a dangerous way for a company to run their activities. It indicates that they lack liquid assets and they risk bankruptcy due to the high level of insolvency.
Profitability ratios include three main ratios; gross profit margin, return on assets and return on equity. The gross profit margin refers to the gross profits earned on goods. Return on assets measures how diligently a firm’s assets are being used to generate income. It is a result of the firm’s net income divided by its total assets. Return on Equity measures the profits earned for each unit of currency invested in the firm by shareholders. Return on assets in Barney bakes plc is very low. It indicates poor investment decisions for the company’s assets which will directly result in low incomes.
Profitability ratios indicate a firm’s level of profitability in comparison to capital invested. Barney Bakes plc’s profitability ratios indicate low profits further showing that shareholders earn little or no dividends and their level of saving and reinvesting is pretty low.
The efficiency ratiomeasures a firm’s productivity. It measures how much capital the firm needs to invest to generate each unit of profit. It is calculated by dividing noninterest expense by revenue. The less the efficiency ratio the better off the firm is. An increasing efficiency ratio shows the firm is spending more money on expenses. A decreasing efficiency ratio on the other hand indicates that the firm is cutting back on costs. Noninterest expenses are the fixed operating costs a company must incur that bring no returns.
Gearing ratiomeasure a firm’s capital structure and financing position. It analyzes how much of a firm’s capital is financed from owners equity and how much is financed by debt. The gearing ratio affects a firm’s capacity to maintain a healthy and constant dividend policy. The higher the level of gearing or borrowing the riskier it is for the firm. However if a company has strong cash flows gearing could be an advantage. Gearing ratio is calculated by dividing earnings before interest and taxes divided by total equity.
Return on investment ratio is calculated by dividing the net profits before tax by shareholders equity. This ratio shows how much is generated from each unit of investment. Barney bakes plc’s investment ratio is low which could lead to dissatisfaction from shareholders.
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Improvements that can be made by the company to improve the ratios
The company should consider evaluating its variations in short and long term debt as a means of financing. They have very little working capital if any and this places the company’s liquidity dangerously low. It indicates that the company is highly insolvent and risks bankruptcy. However the working capital can be reduced by ensuring the bigger percentage if not all of debt is long term. This would greatly reduce current liabilities increasing the difference between current assets and short term liabilities.
Poor investment ratios imply something is amiss with management. It shows slow response or lack thereof to emerging opportunities and threats. The efficiency and investment ratios need to be among the highest ratios as they are a direct result of how the firm’s assets and resources are being used to generate profit. In the case of Barney bakes plc the department in charge of this needs to be analyzed. Poor performance could be due to genuine reasons like too much bureaucracy in decision making hence lack of quick response to emerging threats and opportunities or could be a lack of motivation among workers.
This can be improved by motivating the department to be performance oriented and recruiting innovative people to steer investments in the right direction. Education and on job training is also important to ensure workers are in tune with market trends. The company should take the responsibility of readily availing and circulating information. A knowledgeable staff is more productive and can avoid pitfalls that cause losses.
The company needs to revise its investment options its efficiency ratio can be improved. This can also lead to less borrowing hence lower the gearing ratio.
Corporate Governance and Budgeting
Remuneration is the compensation received from an employer by an employee for services provided. Remuneration can be in the form of deferred compensation, monetary rewards, commission or fees. Total managerial remuneration payable to a company’s directors must not exceed 11 percent of the company’s net profits.
In accordance to the UK Corporate Governance Code 2010, a director in full time employment may be remunerated by way of a specified percentage of the net profits or by way of monthly payment or partly by one and partly be the other. Unless the Central government approves such remunerations should not exceed 5 percent. In the case where the Central Government approves it is the case of one director and such get 10 percent.
For directors and managers who are neither full time employees nor managing directors, they may be paid remuneration by way of monthly, quarterly or annual payments. Such remunerations cannot exceed one percent if the company has a full time manager or director and three percent otherwise. These resolutions should remain in force for five years after which they can be renewed. Managers and directors holding managerial office or in full time employment of the company they may receive compensation for loss of office or retirement from office.
Remuneration is extracted directly from net profits. It is therefore important that it be linked to performance.
Beyond budgeting was established with the objective of replacing budgeting with other steering mechanisms and to make organizations more adaptive to change. Beyond budgeting as the name suggests involves other growth and management mechanisms besides budgeting. It causes a company to critically analyze its management model to establish factors like whether it ensures all resources follow current opportunities, whether it gives warning signs, whether it encourages creativity and passion at work among others.
Beyond budgeting implies that it takes more than planning and budgeting to successfully run a company. It encourages managers to apply a lot of creativity in management activities. To implement it there has to be revolutionary thinking. It is important to get on board people of similar ideas who can build a strong and convincing case for the board.
A team of designers can be charged with the responsibility of application of the principals involved in beyond budgeting. This team should include accountability members, support services team, value centre team and executive team. Designing the right governance and accountability models will help make the implementation clearer and organized. These new teams need to be trained and educated to operate with the new model. They need to learn how to identify quick wins in order to maintain credibility and build momentum.
The problem with budgeting
They are too rigid and are not designed to respond quickly to unpredictable events. Change is the only constant in life and as a company it is important that they are flexible enough to quickly respond and adapt to it as it occurs. Budgeting takes too much time, leads to bureaucracy and is too expensive. In view of unavoidable change budgets become outdated really fast and following them regardless could rob the company of lucrative opportunities. Budgeting is more concerned with managing people and expenses as opposed to continuous improvement, performance and fast response. (Moeini, 2007)
Budgeting israrely based on strategy. It is more concerned with departments and their functions. Budgeting encourages a dictatorship or authoritarian kind of governance that stifles creativity and innovation. Budgeting does not analyze value added by costs and more often than not causes the company to incur non value adding costs. Budgeting also has a way of demotivating people and encouraging unethical behavior. When there are strict set targets that must be achieved and authority that cannot be questioned people learn to just get by achieving the minimum required and leaving it at that. They may also be pushed to fake sales and costs in order to hit set targets.
Under budgeting there is too much power allowed for too few decision makers. Workers are more concerned with pleasing authority and following rules rather than meeting customer needs and improving in their work. There is a lot of unutilized talent and innovation under budgeting.
Beyond budgeting’s vision
The problems caused by budgeting can over time be rectified by adopting to make decisions immediately when the occasion arises. It also aims at prioritizing customer needs and making the most of workers creative abilities. The focus is on pleasing consumers, encouraging and rewarding performance, encouraging innovation and improving accountability among workers. (shim, 2008)
Beyond Budgeting Principals
Thefirst couple of principles involve devolution of responsibility to people in the front line enabling them to respond fast to events as they emerge and making them accountable for continuous performance improvement and customer outcomes. The rest involve performance management strategies that encourage front line people to respond quickly and positively to competition and customer needs. Different companies emphasize different elements of the model at different times. There are twelve principles involved in beyond budgeting. These principles can be placed into four main categories.
Governance and transparency
Principals involved in this category are value, transparency and governance. This involves governance through sound judgment and shared values as opposed to strict rules and regulations. Therefore information is open and transparent compared to its restriction in budgeting. This kind of governance aims at binding people to a common cause as opposed to a central plan.
It entails the principles of teams, accountability and trust. It requires delegating teams with responsibility and allowing them to manage themselves. It involves trust and encourages accountability among team members. Micromanagement has also proved to be more effective and less time consuming.
Goals and rewards
In accordance to the two principles here; goals and rewards, people are encouraged to set ambitious goals and to be passionate about them instead of turning goals into fixed contracts. They are then rewarded according to performance not fixed targets.
Planning and control
This last category entails the principles of control, planning, coordination and resources. Planning in this case is not a onetime annual event but a continuous and interactive process throughout the year. Co ordinations are directed dynamically not through set budgets. Resources are availed in time when needed not beforehand just in case they are needed. Controls are based on fast and frequent feedback instead of budget variances.
In summary these principles aim at ridding the company of rigid plans and bureaucracy and encouraging spontaneity and creativity in the day to day running of the company. The contribution of workers to the improvement of the company is more as a result of willingness and dedication on the part of the workers as opposed to fixed guidelines and contracts. There is a general feeling of being a part of the team among workers since there are no set performance contracts.
Benefits of Beyond Budgeting to the Organization
Beyond budgeting organizations operate faster and with less complexity. One of its advantages is the fact that it enables faster response. This is achieved by giving front line people or people in leadership positions the scope to act immediately and make quick decisions within strategic boundaries and clear principles. Beyond budgeting has the effect of reducing rigidity and increasing flexibility. As a result employees respond quickly to situations by reconfiguring processes. Making strategy an adaptive process enables people respond fast to threats and opportunities as they emerge instead of being constrained to a rigid out of date plan. In summary it has the effect of reducing bureaucracy which is unnecessarily time consuming.
Under Beyond budgeting people work in an open, self managed society. There is a trusting atmosphere as the company moves away from performance targets rigidly set in a plan to rewards based on performance. This encourages innovation and creativity. Targets are set by and within a team which encourages creativity and innovation among team members. It also allows them to commit and own their work.
Beyond budgeting lowers costs. Eradicating budgets motivates people to question fixed costs and seek to reduce costs in the long run. Requests made for resources are based on need and value added to customers rather than being viewed as entitlements. This eradicates non value adding costs.
As a result of placing customer needs and their satisfaction as the priority the company gets more loyal customers. The fast response to situations and requests and the eradication of bureaucracy attracts customers and keeps customers. The ability of front line people to make quick decisions and manage their own bit of business works positively for the company and assures customers of quick response to their needs.
More micromanagement encourages more accountability and effective control. Beyond budgeting attracts the best and most dedicated employees. This is mainly because creative people do not fancy being constrained to rigid rules and regulations but thrive in conditions where they think and try new ideas. They therefore need to be allowed to make decisions under strategic principles and a trusting encouraging atmosphere.
Beyond budgeting encourages ethical behavior and effective governance. It eventually exposes non performers more easily. Beyond budget focuses on the consumer rather than the company rules and regulations and provides an open forum for workers to contribute whatever they can to the achievement of this goal.
Adoption of beyond budgeting by Barney Bakes plc will ensure remunerations are based on performance since performance is the outcome of beyond budgeting.
Decision making exercise
In view of the above findings decisions on investment ratios and resource usage need to be made. The main objective of a company usually is profit maximization and cost minimization. The larger percentage of profits results from product sales. Production and factors affecting it need to be analyzed because they are directly linked to profitability. For companies with different products it becomes necessary to evaluate their production versus profitability ratios. That is, they need to evaluate what products to invest more into and what products they should cut back costs on. Hence the product mix theory.
Product mix is the total composite of products produced by a company. Product lines are defined as closely related groups of products within the product mix due to similar functions, price ranges, similar target markets etc. Product mix decisions concern the combination of product lines produced by the company. These decisions involve reviewing existing product lines and adding to or deleting existing product lines. they also involve analyzing the effects of making such changes . The product or brand manager is responsible for making these decisions. (Assel, 1985)
They need to make a plan that outlines advertisement expenditures, price levels, distribution facilities and all the factors pertaining to changing the product mix. Most of these changes affect the product’s target market. The most widely used method for determining the product mix is Boston consulting Group (BCG) analysis.
Qualitative factors to be considered when deciding on product mix
Factors to be considered include high opportunity that can be taken advantage of by introducing new products or expanding the production of existing products to steer future growth. Another factor is the strength of the market position. This indicates for the firm to strengthen its current production to acquire current profits. If high opportunity arises and the company is not in a position to take advantage of it the result could either be attempting to find the required resources or deciding not to pursue the opportunity. On the other hand weak market position and low opportunity result in decreasing production for such markets or avoiding them all together. (Bernhardt, 1983)
The above issues provide the basis for evaluation of both new and existing products in the product mix. The most widely used analysis method, the (BCG) analysis evaluation criteria include the evaluating the product’s market share and the product’s market growth rate. These two criteria closely relate to profitability hence offer effective results. Market growth rate could be an indicator of the product’s level of competitiveness in the market. After analysis has been made using the two criteria products are placed in one of four categories;
These are products with large market shares and high growth rates. Such products have high profitability potential and hence should be given priority in financing and distribution.
These products have a large market share but low growth rate. They generate more cash than is needed for their production and marketing. Such production should be maintained and the extra cash used to finance the stars. Emphasis should be on sustaining them rather than expanding them. This is because their expansion would require investment hence reducing the existing cash flow.
These products have low market share but high growth rate. Their eventual outcome is not clear. Some may have the potential of becoming stars and such should be financed and invested in. Others however may end up becoming dogs and finances should not be wasted on them. It however takes a lot of research and careful analysis to determine their future direction.
Such products have low market share and low or no potential for growth. Such products should be deleted and their finances invested in stars or promising problem children. In the short run there are strategies that could make dogs profitable such as selling them to loyal customers who will purchase even in the absence of marketing and advertising. In the long run however it is best to eliminate them altogether.
In general products are evaluated either as generators or spenders of cash. The plan is to finance products with positive cash flows and reinvest the cash in the growth of stars in the hope that they become cash cows, and in the development of problem children in the hope that they become stars. Dogs continually receive the least funding and are eventually done away with. Coming up with the right product mix involves constant attention and alertness to the product’s trend, market changes and overall improvement opportunities.
Barney Bakes PLC’S Product Mix
The small and large birthday cakes have the highest demand and market share but relatively low and average profit margins respectively. They are the company’s cash cow and it would be advisable to maintain their production without seeking to expand or reduce their production. The cash flow is positive and could be used to finance the star. The celebration fruit has the highest profit margin and a relatively high demand. It could well be the company’s star and needs to be financed in terms of advertisement, research, distribution and production. Extra cash generated by the birthday cakes can be invested in the celebration fruit with the hope of making it a cash cow too.
The celebration sponge has the lowest demand but a relatively high profit margin. It is the company’s problem child however with potential to become a star. With strategic marketing the market share can be improved and it could bring in a lot of profits. It is fortunate that the company does not have dogs because they are an expense that adds little or no value.
This decision however is open for revision should market trends change. For example changes in consumers’ tastes and preferences may alter a product’s demand. A product that had high demand and a large market share may suddenly not have as much demand while a product that has a small market share may suddenly be in demand. In such cases prompt revision in response to market changes is called for.