Post on 15-Aug-2020
transcript
Assignment Stage 3 – Ratio Analysis & Capital Budgeting
ACCT11059
USING ACCOUNTING FOR D-MAKING
6 June 2016
Prepared by
Kym Chisholm
S0244760
1
Step 1 – Ratios..........................................................................................................................4
1.1 The Holy Grail........................................................................................................4
1.1.1 Net Profit Margin (NPM)........................................................................5
1.1.2 Return on operating assets (ROA)..........................................................7
1.1.2 Return on operating assets (ROA)..........................................................7
1.2 Turning Over..........................................................................................................9
1.3 Three dollars........................................................................................................11
1.4 In Debt We Trust..................................................................................................14
1.6 Other People’s Money.........................................................................................16
1.7 To Market, To Market..........................................................................................17
1.7.1 Earnings per share (EPS).......................................................................17
1.7.2 Dividends per share (DPS)....................................................................18
1.7.3 Price to earnings (PE)...........................................................................18
1.8 Love, actually....................................................................................................................19
1.8.1 Return on equity (ROE).....................................................................................19
1.8.2 Return on net operating assets (RNOA)............................................................20
1.8.3 Net borrowing costs (NBC)................................................................................21
1.8.4 Profit Margin (PM)............................................................................................22
1.8.5 Asset Turnover (ATO)........................................................................................23
1.9 Economic Profit.................................................................................................................24
Step 2 – Capital Investment....................................................................................................27
Step 3 – Feedback...................................................................................................................28
3.1 I provided feedback to:........................................................................................28
3.2 I received feedback from:....................................................................................28
3.3 Feedback reflectionsReferences..........................................................................28
References.................................................................................................................29
2
Step 1 – Ratios
1.1 The Holy Grail
"King Arthur: Go and tell your master that we have been charged by God with a sacred quest. If he will give us food and shelter for the night, he can join us in our quest for the Holy Grail.French Soldier: Well, I’ll ask him, but I don’t think he will be very keen. Uh, he’s already got one, you see.King Arthur: What?Sir Galahad: He said they’ve already got one!King Arthur: Are you sure he’s got one?French Soldier: Oh yes, it’s very nice!”
- Monty Python
Monty Python spends 91 hilarious minutes telling the story of King Arthur and his search
for the Holy Grail. The Holy Grail is something that you want very much but that is very
hard to get or achieve (Merriam-Webster, 2015). Profitability is the holy grail that Clarius
Group are searching for but in the last few years it has been very elusive. Clarius Group
haven’t had to deal with the Black Knight, Knights who say Ni or the Castle of Aaaaargh
but their annual reports do tell a story of an inability to rise to challenges it has faced in the
past few years.
Profitability ratios help evaluate the financial health of a business (Hofstrand, 2009) and
after looking at Clarius Group’s net profit margin and return on assets, I would have to say
they that it might be time to call the doctor.
3
1.1.1 Net Profit Margin (NPM)
NPM is supposed to show how well a firm can convert its revenue into profits. It answers
the question of how much profit can be extracted for every dollar earned by a firm. Clarius
Group’s NPM shows that for the last four years, they lost money on each sale:
Table 1 - Net profit margin trend
2015 2014 2013 2012-6.3% -0.9% -18.7% -3.5%
So what affects NPM?
Net profit after tax (at a basic level revenue less expenses)
Sales (after allowing for any returns and/or refunds)
Below is a summary of trends for sales, expenses, NPAT and NPM (where the benchmark
is the 2012 figures).
Figure 1 - Trends of NPM drivers
2013 was a year of economic and political instability, leading to market uncertainty and a
decrease in business confidence. I address this in greater detail in The Perfect Storm blog
post. Harsher conditions triggered impairment of goodwill, which was a rather large once
off expense. However, a reduction in other operating costs plus a restructuring (leading to
salary savings) meant expenses decreased from 2012 levels.
Pricing was affected, as there was reduced demand for recruitment services and pressure
was placed on margins from existing major accounts as they also re-negotiated terms.
Clarius Group also walked away from a major client they provided with managed services
and there was also a reduction in contractor margins which are Clarius Group’s main
revenue source. Unsurprisingly, all these factors contributed to a drop in sales compared
to 2012.
4
Unfortunately, the drop in sales was much larger than the reduction they had managed in
expenses. Clarius Group posted the worst NPM in 2013 and lost almost 19 cents for each
$1 of sales.
NPM actually improved dramatically in 2014 (although still negative) but this isn’t because
sales went up. Sales dropped another 16.8% from 2013. Clarius Group focused on
reducing cost base and operational efficiency which had a major affect in reducing on hired
labour costs.
In 2015, Clarius Group got a new CEO and went through a period of transformation. I
cover that a bit more closely in the Road to Perdition. Clarius Group held on grimly to
NPM by the tips of their fingers and ultimately steadied things, showing only a small NPM
decrease in 2014. Sales looked to have stabilised and reached a new level of “normal” but
still dropped a minor amount. Expenses blew out and caused another negative NPAT
because of more one-off costs from restructuring and software impairment losses. The
bad and doubtful debts allowance was also considerably higher in 2015. These factors
provided the second worst NPM result. Clarius Group lost 6 cents for each $1 of sales it
made.
Examining the NPM ratio leaves me with one question I am constantly asking. How long
can Clarius maintain a business that has not seen a profit in four years?
5
1.1.2 Return on operating assets (ROA)
We continue our Holy Grail hunt with another profitability ratio, this time, the ROA.
ROA shows how efficiently a firm manages its assets to produce a profit during a certain
period of time. We have previously seen that cash flow from operations can be used to
invest in operating assets. Investments in operating assets are generally the biggest
investments a firm makes so ROA helps managers to see if the money the are pouring into
the firm is making a difference by providing a return on asset investment.
Clarius Group have a negative ROA for each of the four years so it is not doing very well in
converting its investment in assets into profits. For 2015, Clarius Group lost 24 cents for
every dollar of assets they held!
Table 2 - Return on operating assets trend
2015 2014 2013 2012-24.0% -2.8% -72.7% -8.7%
As we saw with NPM, 2013 and 2015 are the worse performing by a large order of
magnitude. We saw with NPM that while revenue has trended steadily downwards,
expenses fluctuated greatly in 2013 and 2015 due to one-off costs. These same issues
are having an effect on ROA because it also uses the net profit after tax (NPAT) in its
calculation.
The reason ROA is larger than NPM is because total assets are used as the denominator
and these amounts are much smaller than the sales figures used in NPM. As a
denominator decreases the answer is divided by fewer parts so its size gets larger.
Figure 2 - Trend of Total Assets
2014 was again a little ray of hope in a fairly bleak outlook because Clarius Group
managed to stop the decline in assets. It was also the year expenses reduced at a faster
rate than revenue decreased, meaning a positive NPAT figure and a very small negative
NPM (less than one cent was lost per dollar of sales).
2013 annual report states that goodwill impairment reflected the uncertainty and market
turbulence that hit in that year. This was due to two reasons:
6
Clarius Group acquired two businesses during the peak of the market and it looks
like the economic issues of 2013 triggered the need to revalue them
Clarius Group needed to take into account the impact of brand consolidation that
had taken place since they had acquired certain recruitment brands. This sounds
like a loss in reputation to me.
The goodwill impairment is shown in the balance sheet as a staggering 94% drop in
intangible assets. Trade and other receivables dropped almost 20% due to less sales and
a 20% drop in deferred tax assets (DTAs) was because Clarius had to derecognise tax
losses (check out my comments on Sue’s blog about DTAs and why de-recognition is
necessary).
Cash made the difference in 2014 along with an increase in DTAs and intangible assets.
Don’t get too excited though! Cash from operating activities reduced further. It was more
the fact that investing activities reduced in the form of purchasing less plant and equipment
and spending less on software development. Financing activities were eliminated all
together which also helped. Clarius Group also received a $1.2M tax refund and kept a
tight control on receivables, meaning they pulled in as much cash as they could from
accounts.
Intangible assets went up 21% due to capitalised software costs. This is because Clarius
completed a full implementation of new back end systems to help automate their
processes and improve technology.
Things went a bit pear shaped in 2015 and every single asset decreased in value. The
main culprit in ratio changes was once again intangible assets. This time, due to software
impairment, meaning the revaluation almost completely wiped out what was left of
intangible assets. Restructuring costs also affected cash and the annual report stated that
changing superannuation payments from quarterly to monthly also had an impact.
It looks like Clarius Group is struggling and that the new CEO and management team have
actually made things worse since they started. I hope this is a case of just taking an initial
hit to try and improve the situation for the future.
While looking at NPM and ROA, I have started to wonder if I should be removing the
figures for impairment losses, restructuring losses and de-recognition of tax losses. These
items look like they are skewing the trends and maybe should not be included as they are
not everyday operational items that occur every single year in the business.
7
1.2 Turning Over"22 May 2016Weight: 136 lbCigarettes: 42Alcohol units: 50You only get one life. I’ve just made a decision to change things a bit and spend what’s left of mine looking after me for a change.Am enjoying a relationship with two men simultaneously, the first is called Ben, the other, Jerry"
- Bridget Jones’s Diary
The first thing that comes to mind when thinking about turnover is turning over a new leaf
or making a fresh start. Bridget Jones’s Diary is a quintessential movie about starting
anew and has an entertaining love triangle as part of the plot. I love complicated
relationships, after all, isn’t that what ratios really are?
Unlike when Bridget Jones records her weight, cigarette and alcohol units – the total asset
turnover ratio is generally better when the number is bigger. Maria stated she would at
least like to see a 1:1 occurring. A bigger number is generally better because it measures
how efficient a firm is at using its assets to produce sales.
Table 3 - Total asset turnover trend
2015 2014 2013 2012
3.80 3.03 3.88 2.53
The 2015 result shows that each dollar of assets generated $3.80 of sales.
The first thing that springs to mind when looking at the trend is 2013 and 2015 are now the
best performing years instead of the worst! Therefore, asset turnover must have an
inverse relationship with NPM and ROA.
I would like to think the Clarius Group has finally performed outstandingly well in one ratio
calculation but total asset turnover is quite dependent on the type of industry your
company is in (Merritt, 2016). A company like Clarius, that runs more on “brain power”
(therefore having a small asset base) is expected to have higher ratios (Merritt, 2016).
This is because it makes the denominator smaller which means the answer is divided by
fewer parts so its size gets larger (as addressed in the section on ROA).
The total asset turnover trend is a bit haphazard but the ratio has definitely improved all
three years from 2012. However, the ratio did not improve because of increased sales, in
8
fact, sales dropped repeatedly each year and total assets declined two of the three years.
This does not inspire confidence at all!
There are many ways to improve total asset turnover (eFinance Management, n.d),
including:
Increasing sales
Liquidating obsolete or unused assets
Leasing assets instead of buying
Improving asset usage and productivity (efficiency improvements)
Better collection of accounts receivable
Improve inventory management
Clarius Group has talked about improving technology to gain efficiency. They are also
extremely focused on collecting accounts receivable (only 2% was overdue by 90 days)
and lease a lot of their premises. I have no doubt the trend shows an improvement in
operational efficiency but I still feel the company is in a bit of trouble if they cannot increase
sales.
I did find it interesting that the total asset turnover ratio can sometimes be too high, which
is just as bad as being too low. Maria mentions she would be concerned this would not be
sustainable and a sign of assets overworking or stretched to capacity.
One final point to note about total asset turnover ratio is how similar I found it to be to the
ROA ratio. When I started calculating asset turnover I thought, ‘hang on a minute, haven’t
I just done this?’ However, the ROA measures how well a firm uses assets to generate
profit whereas asset turnover measures how well a firm uses assets to generate sales.
Just like with RNOA, that Martin mentioned in chapter four, ‘it is the interaction of profit
margins with efficiency that is critical’.
9
1.3 Three dollars
Poor Eddie, he had a stable and happy life working as a public servant while living in his
own home with his family. He was able to pay his mortgage and other financial obligations
each month and remained financially sound. When the forces of economic and social
change threaten this, Eddie realises just how fragile his reality and security is. He loses
his job and finds he has three dollars left in the bank. How will he pay his debts?
Sounds a bit like the Clarius Group, although their situation is not so drastic yet. Forces of
economic change have shown their business reality and security may be a bit more fragile
than they realised. How do we know if they can pay off debts and remain financially
sound?
The current ratio is used to keep track of liquidity and measures if the Clarius Group can
pay off short term debts or other financial obligations lasting less than a year (current
liabilities) with the current assets it has on hand.
Table 4 - Current ratio trend
2015 2014 2013 20122.07 2.27 2.47 2.12
These numbers tell us Clarius Group’s current assets are two and bit times larger than
current liabilities. If they needed to pay off all their debts within a year, they could manage
this and still have current assets to spare. Here, finally, is a ratio that the Clarius Group
may be excelling at! A firm is generally deemed to have good short term financial strength
if the current ratio is 1.5 – 3 (Boundless.com, n.d).
The current ratio trend is different again to what I have seen while analysing the previous
trends. Now 2012 and 2015 are the worst years! While the ratio stays higher than the
benchmark (2012) for 2013 and 2014, it is starting to trend down.
Figure 3 - Current ratio trend and drivers
10
In 2013, trade receivables decreased. We know this is due to a drop in sales as the
economy worsened. However, current tax receivables significantly increased because
Clarius Group did not have to pay any tax and were due a tax refund. This meant that
while current assets dropped, they did so at a lower rate than might otherwise have been
expected.
Current liabilities dropped in 2013 due to a large change in trade payables (a result of on
hired labour costs reducing and not having the same number of contractors in paid
work?). There were no current tax liabilities (as mentioned above there is a tax refund
due) and no interest bearing liabilities. The bank overdraft, however, sneakily went up and
shows it was more heavily used in 2013 (a sign of not enough cash coming in?).
The interesting thing to note about the interest bearing liabilities is they came from a
Receivables Purchases Facility set up by Clarius. This means they sold trade receivable
invoices to their finance providers at a discounted rate. In 2013, they utilised only a non
recourse agreement, meaning the finance provider bears the full loss if the customer does
not pay. If the facility was provided under recourse then Clarius Group would have had to
pay some of their financing back. Being able to get non-recourse funding is probably due
to their good management of accounts receivable.
In 2014, current assets stayed relatively stable. While current tax receivables dropped,
Clarius Group’s cash increased due to a large tax refund. The bank overdraft was not
utilised in 2014 (due to the big influx in cash?) but trade payables increased enough to
slightly affect the current ratio. I cannot see the reason why trade payables increased;
however, I am not too concerned in the downward movement for 2014.
Trade receivables dropped again in 2015, which is starting to become a bit concerning
because I would think the economic downturn has steadied but they are still struggling to
make sales. Cash dropped due to timing differences in superannuation payments and
also major restructuring costs (feels like management in 2014 were on the right track so it
starts to look like they prematurely fired and hired and maybe this was not a good use for
their cash?). This left current assets at their lowest level seen in four years.
Trade payables reduced in 2015 which meant current liabilities decreased overall.
However, the decrease was at a slower rate than the drop in current assets meaning the
current ratio decreased again. Clarius Group did not use their Receivables Purchase
Facility in 2015 but they did dip into their bank overdraft as their overall cash flow became
negative. They also have a new current liability, in the form of finance leases, to help
Clarius finance software licenses over the next three years.
11
It is great that Clarius Group has a healthy looking current ratio but I think this is out of
necessity rather than good management. With such low cash balances, Clarius Group
would be hard pressed to pay back any significant ongoing interest payments. I think
Clarius Group’s management realise that if they don’t keep themselves lowly geared they
could edge more quickly towards troubled waters. With the way the recruitment industry is
at the moment, management cannot afford to take on any more risk.
If Clarius Group continue to struggle with revenue and cash and cannot obtain any
significant debt financing, while also making losses to the point where no one wants to buy
any more shares issued (equity financing), how are they going to grow and develop?
12
1.4 In Debt We Trust
Unlike personal debt, debt in a business environment is not always a bad thing. As I look
at the debt to equity ratio, through management eyes, I need to constantly repeat this
mantra to myself. This is because my experience in life has always been focused on
paying down and eliminating debt, like my credit card and car loan, as this kind of debt is
not helpful in any way.
Debt financing is an inexpensive source of capital compared to equity, improves the return
on equity and can produce tax savings (Way, 2016). Therefore, having a very low debt to
equity ratio is not always a good thing and neither is having it too high. You want it just like
Goldilocks wanted her porridge – not too hot, not too cold, “just right”.
Debt to equity ratio shows how much debt a firm is using for finance relative to the total
value of shareholder’s equity. So for every dollar a shareholder put in, Clarius Group
received 92 cents from creditors in 2015 or another way to phrase it, would be, Clarius
Group used debt financing equal to 92.2% of shareholder’s equity.
Table 5 - Debt to Equity Trend
2015 2014 2013 2012
92.2% 66.9% 56.9% 37.4%
100% or 1 would indicate that equity investors and creditors have equal stakes in Clarius
Group’s assets. Debt to equity ratio is an indicator of risk and a higher ratio normally
shows a firm is more aggressive with debt (or potentially is a start up trying to grow
rapidly). This is confusing to me as I know that Clarius Group is focused on having a low
amount of financial leverage. The figure for 2015 seems to indicate they are taking on
more risk and being aggressive, so I did some more research about this ratio, as I am not
convinced Clarius Group are displaying these qualities.
It seems the debt to equity ratio can be calculated a number of ways and one of those
ways are to exclude liabilities from the calculation that are non interest bearing (Gallo,
2015). If we ignore trade payables (which the notes say are non interest bearing), tax
obligations and provisions then we get an extremely different result which more aligns with
what I know about the Clarius Group.
13
Table 6 - Debt to Equity excluding non-interest bearing liabilities
2015 2014 2013 2012
3.5% 0.0% 2.0% 3.4%
Either way, shareholders of the Clarius Group own more than it owes for all four years,
which is a good sign. The trend of this ratio fluctuates a bit which shows that their debt
management is not consistent (sometimes they need the overdraft or to sell invoices and
sometimes they don’t. Clarius also started using finance leases in 2015 which previously
was not seen).
Maria also looked at the trend in profit margin to relate it to the debt to equity ratio. This is
because, if you have to pay interest to external debt providers you would assume you will
have less profit. This assumption does not hold for 2014. If we look at the debt to equity
ratio of 66.9% (Table 1) this is an increase from 2013 but net profit margin also increased.
The explanation behind this is that while liabilities rose in 2014, none of them were interest
bearing liabilities.
If you look at Table 2, you can see the discrepancy happens in the year 2013 instead.
Debt to equity improves to 2% but net profit margin gets worse anyway. I think this is
explained by the fact that equity drops almost 50% in size in 2013 and is the denominator
in the ratio calculation.
For a firm like Clarius Group that has a volatile revenue stream (dependent on economic
activity and cyclical business environment) or has a large portion of business tied up in just
a few customers (40% of revenue from just two customers) it should have a low debt to
equity ratio (Accounting-simplified.com, 2013). Otherwise it may find a sudden loss in
revenue means it cannot support all its financial obligations.
If I look at the ratio calculated in Table 2, I would be happy to see low risk (although this
probably also means less efficiency). If I look at the ratio in Table 1, I think I would be
fairly concerned as the trend shows increasing risk in the business (from an investor
perspective, Clarius are definitely risky to put your money into). However, at this stage,
each yearly debt to equity ratio sits under 1:1 which is considered acceptable for most
industries (Accounting for Management, 2015).
14
1.5 Other People’s Money
Money contributed by shareholders and creditors falls under the definition of other people’s
money. The acronym (OPM) actually sounds the same as opium, which is fitting,
considering the drug like power that other people’s money can exert on people managing
that money.
One way to measure how much of a company’s assets are funded through other people’s
money is by calculating the equity ratio. The equity ratio shows how much a firm’s total
assets are owned outright/financed by equity investors, that is, after all liabilities are paid
off how many remaining assets will they end up with. The inverse of this calculation shows
how much creditors finance the firm’s assets (1-Equity ratio).
Table 7 - Equity ratio trend
2015 2014 2013 2012
Equity 52.0% 59.9% 63.7% 72.8%Table 8 - (1 - Equity) Trend
There is a definite downward trend and a larger and larger portion of assets is being
funded externally rather than through shareholders. This is not surprising considering total
assets and total equity also show a clear downwards trend as well.
Clarius Group have less and less assets, mainly due to accounts receivable reducing over
four years (not being able to make consistent sales) and intangible assets suffering
impairment losses and needing their carrying values adjusted (due to economic
environment and potential reputation damage?). They also have less and less equity
because their accumulated losses have steadily increased over the last four years as well.
A higher equity ratio is generally better as it shows a more sustainable and less risky firm.
It also intimates that a firm has more free cash on hand as it does not have to pay so much
in interest costs. Clarius Group is an established firm, so it is expected that equity should
be higher than debt. While this is currently the case, if we continue following the trend,
their equity ratio will fall under 50% next year. This is a cause for concern and backs up
my initial thoughts on Clarius Group being a risky business.
2015 2014 2013 2012
Debt 48% 40.1% 36.3% 27.2%
15
1.6 To Market, To Market
To market, to market, to buy a fat pig,Home again, home again, dancing a jig;To market, to market, to buy a fat hog;Home again, home again, jiggety-jog;To market, to market, to buy a plum bun,Home again, home again, market is done.
- Mother Goose Rhymes
Market ratios are used in valuing a firm’s stock (Reference for Business, 2016). They help
to show current market perception, regarding future profit potential, to both internal and
external interested parties (Baskerville, 2016). With this being the case I would have to
say my perception of Clarius Group, from looking at the market ratios, would be something
like a train wreck!
Table 9 - Earnings per share
2015 2014 2013 2012-$ 12.65 -$ 1.87 -$ 47.12 -$ 10.56
1.6.1 Earnings per share (EPS)
EPS was negative all four years. EPS shows the amount of money that is potentially
available to distribute for each outstanding share (it is not the actual amount paid out).
However, in Clarius Group’s case it shows the amount of money lost per share.
EPS gives an indication of profitability, or lack thereof and can also be a measure of how
management is performing (Ready Ratios, 2016). A negative EPS decreases the value of
Clarius Group and can be a factor in reducing the share price.
In some situations a negative EPS is not a huge drama – these include biotechs, startups
and established companies incurring major one off expenses (Merritt, 2016). Sadly,
Clarius Group does not fall into those categories (still performing poorly and has had a
couple of years of what were supposed to be one off larger expenses). There is a definite
downward trend showing (despite the better 2014 result) indicating signs of trouble at
Clarius Group. Not surprisingly, as EPS uses the net profit after tax (NPAT) figure, it
follows the same trend as net profit margin (NPM).
16
The EPS figures for 2015 and 2014 are exactly spot on to what is shown in Clarius
Group’s annual reports. This is because the amount of shares issued did not change in
those years. The slight discrepancy in 2012 and 2013, I attribute to the fact that I used the
share balance as at end of financial year while Clarius Group would have used a weighted
average of shares in their calculation.
1.6.2 Dividends per share (DPS)
DPS is quite similar to EPS with the only difference being that the DPS shows the actual
profit amount paid out to each outstanding share.
Table 10 - Dividends per share
2015 2014 2013 2012$0 $0 $0 $0.03
In 2012, Clarius Group paid out 3 cents to each outstanding share. Considering that
Clarius made a loss in 2012, this meant they would have had to use debt to distribute this
payment to shareholders. With Clarius Group’s lack of cash and profits and no retained
earnings, they seem to have wised up and stopped issuing dividends. With no plans to
reinstate dividends, this shows a lack of confidence in being able to produce future profits.
1.6.3 Price to earnings (PE)
PE compares share price to EPS. From an investor’s point of view it shows how long it will
take to get paid back if they invest in a firm’s shares. It also provides an indication on
whether buying at the current share price is a good opportunity (Investopedia, 2016). A
manager tries to ensure the PE ratio looks as good as possible because it provides
confidence in the company.
While I have calculated the PE ratio, I don’t think it particularly means anything because
my EPS was negative which means my PE ratio is negative. While a negative PE is
mathematically possible, I imagine it is hard to compare and make sense of negative PE
ratios and the financial community normally does not show them and instead marks them
as not applicable (Investopedia, 2016). What runs through my head when I see a negative
PE ratio is the Lost in Space robot flashing his red light and saying, “Danger, Will
Robinson, danger!”.
17
1.7 Love, actually
When I think of ratios, I think of relationships. If a ratio had a Facebook profile I imagine it
would put, “It’s complicated” in their status profile. When I think of relationships, I think of
the movie ‘Love, actually’. It is a tale that revolves around eight different couples and
shows their complicated and sometimes interrelated relationships. I thought it was fitting
to use this movie as my title for looking at the family of ratios based on restated financial
statements. Indeed, three of these ratios are interrelated with ratios previously discussed.
1.7.1 Return on equity (ROE)
The first couple’s relationship that we examine is comprehensive income and
shareholder’s equity. They make up ROE which is an important profitability indicator.
ROE shows how well a firm generates a return on the funds invested into the company
from an owner and also show how well a firm uses its equity. Clarius Group is doing
neither of those things well as is clearly shown by a negative ROE for all four years.
Table 11 - Return on Equity trend
2015 2014 2013 2012-44.7% -4.2% -113.1% -12.0%
2013 and 2015 were years of large impairment losses and one-off costs but even in the
years where it was “business as usual” it still did not generate a return for shareholders.
The ratio for 2015 shows Clarius Group lost almost half of total shareholder equity in that
year. I fear a divorce is on the horizon for this rocky relationship!
If I was an investor or a manager I would be fairly appalled at the trend of negative
returns. I cannot fathom how the new CEO could have sat down and looked at the
possible projections, based on his decisions for the year, and still gone ahead with all the
restructuring. I am also confused as to what triggered the 2015 software impairment when
it is never previously mentioned, in other annual reports, that their technology was aging.
Management look like they were starting to get back on track in 2014 and then the CEO
seems to have pushed out or fired a lot of them (he was fairly derogatory in his
assessment of the past CEO and executive). He tries very hard in the 2015 annual report
to sell this decision and talk about what a wonderful experienced team he now has, but I
am not sure I am buying it.
18
1.7.2 Return on net operating assets (RNOA)
RNOA is a relative of the return on assets (ROA) ratio, which I previously discussed in the
Holy Grail section. The difference between them is that RNOA shows how well a firm is
managing its operating assets to produce an income during a certain period of time. I
thought the ROA was trouble but his relation RNOA is even worse!
Table 12 - Comparison of ROA and RNOA trends
2015 2014 2013 2012
ROA -24.0% -2.8% -72.7% -8.7%RNOA -43.5% -4% -112.6% -11.4%
So what causes the negative amount to increase? This is due to the denominator used,
which is NOA. The operating assets (OA) and liabilities (OL) are isolated from financial
ones and then OL is taken away from OA. This leaves a much smaller denominator which
makes the result bigger as previously discussed. The result would have been even worse
except for the fact that the operating income is used, rather than the larger net profit after
tax (NPAT) amount. The RNOA really focuses on operating activities and magnifies
Clarius Group’s losses even further because the financial activities have been taken out of
the equation.
19
1.7.3 Net borrowing costs (NBC)
NBC shows Clarius Group’s cost of debt. You can think of the NBC as the “interest rate”
Clarius Group is paying on financing. Maria mentions that this is a more true cost of debt
then what they might show in the annual report. This is because we are isolating just the
financing activities and using them for the calculation.
Table 13 - Net borrowing costs trend
2015 2014 2013 201232.4% 14.7% – 6.7%
There is no result for 2013 as Clarius had no net financial obligations that year and you
cannot divide by zero. However, the other years tell an interesting story, in that the cost of
debt is trending upwards. In personal finance, creditors generally raise the interest rate
the more they see you as a credit risk. Think of pawn shops and ‘payday loan’ businesses
that charge outrageous rates compared to personal loans from a bank. The same thing
happens in a business setting and this supports my assumption that Clarius Group is
becoming increasingly risky.
Forgive my relationship stories; they are a bit more depressing than those in the actual
Love, actually movie!
20
1.7.4 Profit Margin (PM)
Profit margin is almost the twin to net profit margin and I did not expect to see much of a
difference between these two ratios. PM still shows how much profit can be extracted for
every dollar earned by a firm but it just uses operating income instead of net profit after
tax. This allows us to focus on operating activities and ensure they are actually generating
returns rather than them coming from financial activity.
Table 14 - NPM and PM trend comparison
2015 2014 2013 2012
Net Profit Margin -6.3% -0.9% -18.7% -3.5%
Profit Margin -6.05% -0.77% -18.48% -3.39%
The reason I did not expect to see much difference was because Clarius Group did not
have many financial activities and only one item from other comprehensive income that
was deemed operational. However, this other comprehensive income (from foreign
currency translation differences) being added in was enough to make the operating loss
smaller. As the operating loss is the numerator in the ratio, this infers the result will be
smaller (which is good as we are dealing with losses) while the denominator is sales which
stays constant across both ratios. The tax expense and exclusion of net financial
expenses also made a slight difference in the operating loss figure.
You can find a more in depth discussion about what financial statement items affected
these ratios in the Holy Grail section.
21
1.7.5 Asset Turnover (ATO)
Another set of twins are the total asset turnover ratio and the asset turnover ratio from the
restated financial statements. The only difference being that ATO shows how efficient a
firm is at using net operating assets to produce sales rather than total assets.
Table 15 - Comparison of ATO and total asset turnover
2015 2014 2013 2012
Total Asset Turnover 3.80 3.03 3.88 2.53
Asset Turnover 7.19 5.16 6.09 3.36
The results for the ATO are higher because net operating assets are a much smaller figure
than total assets. As previously discussed, a smaller denominator leads to a larger ratio
result. The ATO shows that assets are being used even more efficiently because the
turnover rate has increased. As a manager you would have to be happy to see these ATO
figures, although, I start to wonder if the 2013 and 2015 ATO are starting to stray into the
“abnormal” zone.
The ATO also has an inverse relationship to the profit margin, just like the total asset
turnover has with the net profit margin. You can see a further discussion on this in the
above Turning Over section.
22
1.8 Economic Profit
Economic profit introduces us to the concept of cost of capital. I am pleased to say that
my accounting "paint by numbers" has been filled in a bit more, while investigating cost of
capital and the four drivers of economic profit.
Cost of capital is an opportunity cost and as Martin has explained, an opportunity cost
reflects the benefits you could have received if you had pursued an alternative action
rather than taking the path you went down. In business, it is the rate of return the Clarius
Group gives up, in order to use its assets and money to follow the path it has taken, rather
than putting resources into a potential alternative investment (with a similar risk profile).
How is the cost of capital turned into a number we can use in an equation? Well, there are
two types of people interested in how a business is performing. These are debt and equity
investors who provided funds and are hoping to get a return on them. So we work out the
cost of debt and the cost of equity and combine them into a rate of return that will satisfy
both investor types. This return (earned from existing assets) then represents the
minimum acceptable return that is needed for value creation.
So if cost of capital is the minimum acceptable return, we want to be able to compare that
to the actual return on net operating assets (RNOA) received from the investments Clarius
Group are pursuing. This is where the economic profit calculation comes in.
Economic profit actually deducts opportunity costs (as well as normal costs seen in profit
and loss) from revenue earned to show if a firm has truly created value through running its
business. Economic profit shows an amount that is left over to reward debt and equity
investors for investing and supporting the firm.
Accounting profit only focuses on deducting normal money expenses from revenue. While
your firm might make an accounting profit (which then provides cash for dividends or to
pay back creditors), if it still makes a negative economic profit then the firm still has not
truly created any value because it could have done something different with its assets and
made more money pursuing an alternative.
Economic profit is made up of RNOA, cost of capital and net operating assets (NOA).
Simple right? Not quite. It's a bit like the movie Inception where we now have to step down
into another level and then another (something, inside of something, inside of something).
RNOA is then made up of profit margin (PM) and asset turnover (ATO). PM is then made
up of operating income (OI) and sales while ATO is sales and NOA. Because PM and
23
ATO have an inverse relationship, the sales amounts are going to cancel each other out
leaving us with OI and NOA. Inception moment!
Table 16 - Drivers of economic profit and those affecting calculation
2015 2014 2013 2012
Economic Profit-
$14,343.99
-$6,289.17 -$46,844.38 -$18,265.47
RNOA -43.5% -4% -112.6% -11.4%Cost of capital 14.09% 14.09% 14.09% 11.06%
PM -6.05% -0.77% -18.48% -3.39%ATO 7.19 5.16 6.09 3.36NOA $24,902 $34,782 $36,980 $81,459
With 2012 as our benchmark we can see that 2013 was a mess. I am not sure it is even a
good thing that ATO increased because it is due to the denominator in the ratio (NOA)
dropping just over 50%. This shows that while ATO is a driver of economic profit, it is not
a very strong one as ATO almost doubled but still lead to a rather large decrease of
economic profit. You might then make the assumption, in 2015, where ATO is at its
highest, it should lead to another large decrease in economic profit. However, the
economic profit result is nowhere as bad as 2013 so you would have to surmise ATO is a
weaker driver.
If ATO is a weaker driver then this would mean that PM must have more of an effect as it
is the other half of RNOA. PM dropped 15% which seems to be fully reflected in the
increased economic loss. This makes sense as both PM and economic profit are
profitability measures. A drop in PM corresponds with a worse economic loss and an
increase in PM shows an improvement in the economic loss. Therefore, I would say PM is
a primary driver in economic profit. However, the scale of the drops and increases in PM
do not fully explain the magnitude of the drop and improvements of the economic loss.
This is where RNOA comes into it.
RNOA follows the same trend as the economic loss. We can see when RNOA drops
101%, in 2013, that this is fully reflected in the 150% drop in economic loss. The cost of
capital is subtracted from RNOA so the higher the RNOA loss, the worse the result of the
economic loss. This shows that RNOA is also a primary driver of the economic profit
ratio. However, there is another factor that seems to be at play here because a combined
24
decrease in PM and RNOA, in 2013, does not reflect the full 150% increase in the
economic loss.
NOA is this final factor in the economic profit equation. NOA decreases each and every of
the four years but we do not see a corresponding continual increase of economic loss
each year. I believe this is because NOA is more of a multiplier that is used to reflect the
total return for the number of assets your firm holds. So it helps contribute to the economic
loss but is not a primary force like PM and RNOA are. In 2014, we see that while PM and
RNOA increased dramatically, leading to an 87% improvement in economic loss, NOA still
dropped. This did not stop economic loss from making an improvement but did reduce the
overall improvement of the amount.
2015 is interesting because RNOA and PM are much worse than back in 2012, however,
the economic loss was larger in 2012. This was a year where sales steadied but Clarius
Group still made a decision to spend more which blew out operating income. NOA was
also a much smaller figure in 2015 (compared to 2012) which supports it having a
multiplier effect on economic loss.
Economic profit makes us look at the balance sheet as well as the income statement,
which encourages managers to think about assets as well as expenses in their decisions
(Investing Answers, 2016). Economic profit can be improved when (Cashfocus, 2016):
a firm invests in new capital that earns more than cost of capital
a firm diverts or gets rid of capital being used in the business that do not cover the
cost of capital
a firm manages to improve RNOA without changing the capital being used
It looks like Clarius Group were trying to improve RNOA in 2014 by drastically reducing
expenses and may have ended up with a positive result if revenue had not also dropped.
A new CEO has then come in 2015 and has decided to let Clarius take a hit while trying to
change strategies. I found a news announcement recently on the ASX stating that local
New Zealand business operations will be closed and moved back to be run from Australia.
Maybe this is the start of diverting capital to try and improve their return. They certainly
need to try something because if they continue to make an economic loss, risk will
increase, investors will go elsewhere and there would not seem much point in staying in
business and flogging a dead horse!
25
Step 2 – Capital Investment DecisionOne of Clarius Group’s goals is to recapture a leading position in traditional recruitment
services. This will involve continuing expansion as Clarius Group strives to improve its
market share. Clarius Group are experiencing positive growth in their New Zealand and
China investments and are considering an opportunity to open a new recruitment office in
Guiyang, China and/or Auckland, New Zealand. This will provide Clarius Group with the
opportunity to generate more revenue in growing economic areas.
Guiyang is the economic and commercial hub of Guizhou province and is ranked in the top
10 for GDP growth and consumer spending. Its economy is forecast to grow 12% and its
five year job growth is 47.18%. Guiyang is quickly becoming known as a ‘big data’ centre
which is attracting cloud computing services and telecommunications along with building a
new science park.
Clarius Group already has an office in Auckland but this New Zealand city is a standout for
GDP and population growth. It also has a partner city relationship with Guangzhou which
is a Chinese city that Clarius Group already has a presence in. Auckland attracts highly
skilled workers in business and finance, ICT and health.
For new recruitment offices, Clarius Group initially negotiates a five year lease for office
space and assesses performance at the end of this period. Therefore, we will use a project
length of five years and assume Clarius will then make a decision on whether to renew a
lease, move location or close down if the location is still unprofitable. At the end of the
lease Clarius Group would incur costs to restore office space back to its original fitout.
Cash flows for Guiyang are expected to grow rapidly based on economic forecasted
figures. However, it is a much narrower market as Clarius Group would be focusing solely
on the IT sector along with the fact that permanent recruitment is far more popular in
China, rather than contractor recruitment which provides a larger margin.
Cash flows in Auckland are expected to grow more slowly as Clarius Group establishes a
second office. However, the Auckland office would focus more on lucrative contractor
services and can attract a wider market of finance, IT and health recruitment.
All amounts are expressed in Australian dollars. The WACC is assumed to be 10%.
26
Guiyang office Auckland Office
Original cost1$1,065,000 $2,450,000
Estimated useful life25 years 5 years
Residual value3-$21,286 -$51,148
Estimated future cash flows4
2017 $880,000 $1,200,000
1 Includes rent for the five year period, all outgoings including body corporate and rates, capital investments including fitout at start of lease, signage, etc. Auckland’s commercial rate of vacancy is quite low so office space is more in demand and more expensive. Guiyang is a tier 3 city at this stage and is not as expensive as counterparts in Beijing or Shanghai. A softening property market in China also means the investment is not as high as Auckland.2 Original lease term for both offices3 Clarius Group will need to spend money removing signage and restoring office space to original condition4 Sales are spread over six offices in China but only four offices in NZ. I am assuming the Auckland office will have a slower start as it needs to establish itself as a second office. Sales are forecast based on 3.5% economic growth rate for Auckland and 8% economic growth rate for Guiyang, with Auckland’s sales leveling out as market saturation is reached.
27
2018 $986,000 $1,240,000
2019 $1,100,000 $1,300,000
2020 $1,230,000 $1,300,000
2021 $1,380,000 $1,300,000
28
Step 3 – Feedback
3.1 I provided feedback to:
3.2 I received feedback from:
3.3 Feedback reflections
29
References
Accounting for Management. (2015). Debt to equity ratio. Retrieved from
http://www.accountingformanagement.org/debt-to-equity-ratio/
Accounting-simplified.com. (2013). Debt-to-equity-ratio. Retrieved from http://accounting-
simplified.com/financial/ratio-analysis/debt-to-equity.html
Baskerville, P. (2016). What are the key financial ratios to know when going through financial
statements of any company? Quora. Retrieved from https://www.quora.com/What-are-the-
key-financial-ratios-to-know-when-going-through-financial-statements-of-any-company
Boundless.com, (n.d). Current ratio. Retrieved from
https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/reporting-
of-current-and-contingent-liabilities-9/reporting-and-analyzing-current-liabilities-64/current-
ratio-302-3754/
Boundless.com, (n.d). Current ratio. Retrieved from
https://www.boundless.com/accounting/textbooks/boundless-accounting-textbook/reporting-
of-current-and-contingent-liabilities-9/reporting-and-analyzing-current-liabilities-64/current-
ratio-302-3754/
Cashfocus. (2016). Analyze financial results for economic profit. Retrieved from
http://cashfocus.com/economic-profit-analysis/
Gallo, A. (2015, July 13), A refresher on debt-to-equity ratio, Harvard Business Review. Retrieved
from https://hbr.org/2015/07/a-refresher-on-debt-to-equity-ratio
Hofstrand, D. (2009). Understanding Profitability, Iowa State University. Retrieved from
https://www.extension.iastate.edu/agdm/wholefarm/html/c3-24.html
Investing Answers. (2016), Economic profit. Retrieved from
http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/
economic-profit-2927
30
Investopedia. (2016). Can a stock have a negative price-to-earnings ratio? Retrieved from
http://www.investopedia.com/ask/answers/05/negativeeps.asp
Merritt, C. (2016a). What does the company’s asset turnover ratio mean? Chron. Retrieved from
http://smallbusiness.chron.com/companys-asset-turnover-ratio-mean-60811.html
Merritt, C. (2016b). What does a negative eps mean? The nest. Retrieved from
http://budgeting.thenest.com/negative-eps-mean-31095.html
Ready Ratios. (2016). Earnings per share retrieved from Reference for Business. (2016). Financial
ratios retrieved from http://www.referenceforbusiness.com/management/Ex-Gov/Financial-
Ratios.html
Reference for Business. (2016). Financial ratios retrieved from
http://www.referenceforbusiness.com/management/Ex-Gov/Financial-Ratios.html
Way, J. (2016). The advantages of using debt as capital structure. Retrieved from
http://smallbusiness.chron.com/advantages-using-debt-capital-structure-22011.html
31