Business Performance Analysis
The report would deal with analysing the business performance of ABC Consulting LLP, which is a reputed organisation providing professional services in London, UK. It operates as a limited liability partnership since 2001 and it has gained popularity for being a popular provider of consultancy support for aiding in transforming businesses operating in different industrial sectors. In order to conduct its business performance analysis, ratio analysis is deemed fit for the purpose to analyse its various financial statements like income statement, balance sheet statement and cash flow statement.
By using Exhibit 1 provided in the case study, the statement of profit or loss of ABC Consulting LLP has been evaluated with the help of the following ratios.
The three ratios that have been considered to be significant for the organisation include net margin, return on capital employed (ROCE) and return on equity. Net margin is a ratio that generally assists the investors and the analysts in measuring the ways through which an organisation is managed efficiently and estimating future profitability depending on the sales projections of the management. For ABC Consulting LLP, net margin is observed to decline from 25.81% in 2017 to 22.79% in 2018, which has declined by 11.69%. This is not a good sign, as the organisation has not managed to increase its profit level over the year despite increase in revenue. From the income statement, it is evident that there is increase in revenue margin over the year; however, this is outweighed by the considerable increase in operating expenses. The operating costs that significantly increased over the year include staff costs and marketing, as the organisation might have recruited additional staffs and focus has been kept on attracting more clients for ensuring further rise in revenue. As a result, this has resulted in fall in net margin of the organisation.
A higher return on capital employed (ROCE) is always desirable, as it implies that additional profits are earned from each unit of money employed (Benedict and Elliott 2011). In case of ABC Consulting LLP, the return has fallen drastically from 89.13% in 2017 to 62.74% in 2018 and the decline is by -29.61%. The primary reason identified behind the fall in ROCE is that the organisation does not have adequate cash balance to invest in assets, as they are utilised for settling off the existing dues and obligations. If this ratio is declining, it is an early signal for the investors to sell the shares that they hold in order to avoid losses.
Statement of Profit or Loss:
Return on equity (ROE) gauges the efficacy of an organisation in using the money from the shareholders for generating profits along with ensuring business growth (McClaney and Atrill 2014). In case of ABC Consulting LLP, the ROE of the organisation has fallen from 132.19% in 2017 to 87.23% in 2018 and the decline is by 34.01%. This implies for every pound of shareholders’ equity, earnings have been £1.32 in 2017 and £0.87 in 2018. This ratio is considered to be significantly high for the organisation, even though decline could be observed in the current year. Thus, ABC Consulting LLP has managed a stable growth over the years. Finally, operating margin has fallen by 10.45% in 2018 due to the rise in operating costs and hence, adequate profit level is not maintained despite the rise in revenue in 2018.
Based on the above evaluation, it could be stated that the organisation is experiencing decline in its profitability aspect.
By using Exhibit 1 provided in the case study, the statement of financial position of ABC Consulting LLP has been evaluated with the help of the following ratios, which are demonstrated briefly as follows:
The current ratio and quick ratio have identical figures, as both the ratios have declined from 1.74 in 2017 to 1.61 in 2018. The ideal current ratio is considered as 2, while the ideal quick ratio is considered as 1. The two ratios have remained identical due to the fact that the organisation does not maintain any inventory or incur prepaid expenses in conducting its business operations (Collier 2015). These two ratios help in measuring the liquidity position of an organisation by assessing its efficiency in clearing off its short-term dues with the existing short-term asset base available. Since the quick ratio is above 1, it denotes that ABC Consulting LLP has huge amount of idle working capital, which has remained unutilised, since trade receivables are observed to increase from £1,179 in 2017 to £1,194 in 2018. However, there is significant decline in cash balance over the year from £214 in 2017 to £75 in 2018, due to which a slight decline could be observed in 2018.
Hence, in terms of liquidity, ABC Consulting LLP is not placed in a favourable position due to the declining trend of current ratio and quick ratio owing to huge amount of idle cash stuck in the hands of the clients.
In terms of efficiency ratios, the two ratios that have been taken into consideration include receivables turnover period and payables turnover period. It is noteworthy to mention that in order to compute the payables turnover period, cost of revenue is needed to arrive at the desired figure. However, in case of ABC Consulting LLP, the staffs costs are taken into consideration as cost of sales for calculating payables turnover period. In addition, inventory turnover period could not be calculated, as the organisation does not maintain any inventory level, since it is mainly involved in providing consultancy services (Thomas and Ward 2015).
Statement of Financial Position:
From the above figure, it could be clearly seen that there is a slight decline in receivables turnover period of ABC Consulting LLP from 125 days in 2017 to 121 days in 2018. Receivables collection period gauges the ability of a business organisation to collect receivables in an efficient manner. A lower period in terms of days is always favourable, since it implies that the organisation is collecting amounts from the debtors more frequently in a year. For ABC Consulting LLP, it has managed to minimise such period to a certain extent in 2018, as it huge amount of idle cash stuck with the clients. Moreover, since the sales are made on credit, ABC Consulting LLP needs to wait 121 days in 2018 to collect the amount from the debtors from those sales in contrast to 125 days in 2017.
The payables turnover period signifies the capability of an organisation in paying off its vendors, which is used by the creditors as well as the suppliers to determine whether to grant credit terms to any business organisation. If the period is higher in terms of days, it implies that the organisation makes frequent and timely payments to the creditors and the suppliers. However, clearing the amount before the stipulated time might lead to cash shortage for the concerned organisation. For ABC Consulting LLP, payables turnover period is observed to fall from 184 days in 2017 to 171 days, as the creditors are unwilling to extend their terms due to slight fall in market demand causing the creditors to implement stringent terms and policies on the organisation.
Thus, in terms of efficiency, ABC Consulting LLP needs to undertake efforts for minimising the settlement period of debtors to further, since the creditors have reduced their collection period for receiving payments.
The four ratios that have been chosen to conduct the solvency analysis of ABC Consulting LLP include debt-to-equity ratio, debt ratio, equity ratio and interest cover ratio and their detailed calculations
It is evident that there is decline in debt-to-equity ratio from 1.75 in 2017 to 1.31 in 2018; however, the ideal standard is considered to be 1. This is because this standard implies that an organisation has maintained an appropriate mix of debt and equity in its capital structure for funding its capital projects. In case of ABC Consulting LLP, the ratio is well above 1, even though it has declined in 2018 due to significant rise in long-term loan of the organisation. As a result, the capital structure of the organisation is highly leveraged.
Liquidity analysis:
This is supported further by debt ratio and equity ratio, as these two ratios indicate the percentage of funds that are obtained through debt and through equity respectively. The debt ratio is observed to decline by 7% in 2018 coincided with rise in equity by 7% in the same year. This implies that the organisation has started to raise more funds via equity, which could be observed from significant increase in members’ reserves from £671 in 2017 to £940 in 2018. However, it is still not sufficient, as ABC Consulting LLP has to find some ways to minimise its overall debt further in order to avoid drainage of working capital in future. However, interest cover ratio is significantly high despite the drastic decline in 2018. The organisation has adequate capability of clearing its interest expenses with the operating income earned, as it has not undertaken adequate bank loans.
Henceforth, in terms of solvency, the organisation is not placed in a favourable position in the industry due to more reliance on obtaining funds through debt financing.
Reasons behind drop in cash:
Based on the provided cash flow statement of ABC Consulting LLP, it could be found that the organisation has purchased property, plant or equipment for which it has to incur £525 in 2018. Moreover, the working capital of the organisation has declined from £222 in 2017 to £34 in 2018. Hence, a considerable amount of cash has been invested to buy this asset, which has resulted in negative investing cash flows. Another reason that could be identified behind the significant decline in cash balance is the payment made to the members of the organisation. These payments are made due to the collection from them for raising equity capital and hence, the organisation has to pay a portion of its profits earned in the year 2018. Due to these reasons, there has been significant decrease in cash and cash equivalents resulting in adverse figure, which has been offset partially by the positive cash balance in the previous year. As a result, the closing cash balance of ABC Consulting LLP has been £75 in 2018, which was lower in contrast to the cash balance of £214 in the past year.
Operating cash cycle is the time needed to convert purchases into cash receipts from the customers. This helps in disclosing the use of working capital in an organisation. For ABC Consulting LLP, the operating cash cycle has been negative in both the years, even though a slight improvement could be observed by reduction of 9 days in 2018. This is not a sound trend, as negative operating cash cycle implies that a business organisation clears its supplier payments after cash receipts from the customers and hence, this minimises the chance for debt repayment or additional purchases. Therefore, it needs to take care of its debtor settlement period further for minimising its operating cash cycle to increase the working capital base.
Efficiency analysis:
Based on the provided case study, it could be observed that ABC Consulting LLP provides a portion of the profits to its partners based on the amount earned. The Executive Board of the organisation decides the amount of profit to be earned based on their performance. However, in 2018, it has been found that the payments of the members have dropped by 17.50% due to fall in profit margin over the year. This decision is rightly justified, as it would help the organisation in increasing its retained earnings. Moreover, it has been found that ABC Consulting LLP is observed to increase its equity funding for maintaining balance in its capital structure. Once adequate return on investment is generated, it would help in generating additional profit and this, in turn, would increase the payments of the members. Therefore, it could be stated that ABC Consulting LLP has made the right decision of minimising the final payments to the partners.
After evaluating the segment wise performance of ABC Consulting LLP for the two years, it has been found that the revenue base of the organisation has declined in Australian market by £132 million; however, considerable increase could be observed in the US market and the UK market by £229 million and £64 million respectively.. However, the expenses and disbursements of the organisation has increased in UK and Australia, while such expenses have declined in US market despite the rise in revenue. As a result, considerable increase in gross margin could be seen in US market, while the margin in both Australian and UK markets has declined. In addition, despite the operating loss suffered by the US segment, it has managed to turn around its position significantly in 2018 and the operating margin is highest for this segment in 2018 to 35.52%, which was -7.84% in 2017. However, the other two segments have experienced downfalls in their operating margins in 2018.
For the UK market, ABC Consulting LLP could follow market penetration strategy that would intention to draw the customers by offering lower prices for its services. After considerable penetration, it could increase its prices again for better reflection of the state of its market position. For the Australian market, ABC Consulting LLP could follow economy pricing strategy for reducing the marketing costs in order to minimise the service prices. As a result, the customers could buy the services without any frills. Finally, for the US market, the organisation could adopt price skimming strategy by setting rates, since their services are in the introductory phase. However, with the passage of time, it could minimise prices gradually, since the products of the competitors appear to gain popularity in the market.
Solvency analysis:
ABC Consulting LLP is planning to expand its business in the US market, for which it has decided to adopt the investment appraisal methods by making certain forecasts. However, it is to be borne in mind that forecasts are made on certain assumptions, which could change eventually and investment appraisal techniques are not an exception to this fact as well. The management forecast of ABC Consulting LLP could be challenged by considering the following points:
- Investment appraisal decisions are based on long-term and therefore, they could not be reversed in future. It is evident from the provided information that the US segment has doubled its net revenue in 2018 from 2017 and it is expected that the same would continue for the next year as well and then it is expected by grow 25% in the next two years. This indicates that the management has forecasted strong revenue growth in future for the US segment. Hence, The US project is designed for five years and hence, any decision that would be taken by ABC Consulting LLP in the initial stage would be irreversible in nature in future.
- As these techniques are dependent on assumptions and projections, uncertainty tends to prevail in future. Thus, if the forecasts for the three years suddenly change due to factors like inflation and interest rate, revenue base is likely to decline in future.
- Investment appraisal is still introspective, since the discounting factor and risk factor remains subjective to the perceptions of the managers of ABC Consulting LLP.
- If inaccurate investment appraisal decision is undertaken, the long-term durability of the organisation could be influenced and therefore, the professionals of ABC Consulting LLP need to conduct it judiciously by having effective understanding of the expansion requirements of the organisation.
The following investment appraisal techniques are considered for the expansion project of ABC Consulting LLP in the US market:
Payback period is the time needed where the initial cash outflow of investment is expected to be generated from the cash inflows over the economic life of the project. A lower period is always favourable from an organisational perspective, as the initial outlay would be recovered in shorter timeframe. In case of US expansion project, the payback period is computed as 2 years and 7 months, which is much lower in contrast to the economic life of the project. The most significant advantage of this method is its universal use along with easy understanding and interpretation. Moreover, this method provides significance on liquidity in order to undertake decision regarding the investment proposal. By considering all these factors for the US expansion project, it is recommended to ABC Consulting LLP to undertake the project for maximising its return on investment. However, some significant drawbacks of this method include non-recognition of the time value of money, more importance on liquidity by ignoring profitability completely and before payback period cash flows are only taken into consideration.
This method gauges the amount of return or profit expected on a particular investment. A higher ARR is desirable for maximising the overall rate of return. Some significant benefits of this method include the recognition of net earnings concept along with providing clear overview of the project profitability. In case of ABC Consulting LLP, the rate is obtained as 100%, which is way too higher than the cost of capital. Therefore, the organisation could accept this investment proposal; however, this technique suffers from certain drawbacks. Some significant limitations include ignorance of time value of money and determination of fair rate of return.
This method could be explained as the variation between the cash inflows generated and initial outlay of the project. The significant benefits of this method include consideration of time value of money, priority to project risks and profitability and consideration of both before tax and after tax cash flows. A higher NPV is always desirable and in case of ABC Consulting LLP, NPV is computed as £886 million, which suggests the acceptance of the project. However, this method could not provide accurate decision, if two mutually exclusive projects have varied economic lives and it is complex to compute the appropriate discount rate.
For this particular investment, the two source from which ABC Consulting LLP could raise funds include debt financing and equity financing. It has already been observed that the organisation has relied on raising more funds by obtaining loans from the market. Hence, for this particular expansion programme, the organisation could raise £600 million by raising equity shares in the market and the remaining £200 million by obtaining loans from any reputed US bank. This would help in reducing the leverage of the organisation by maintaining an appropriate mix of debt and equity. Hence, if ABC Consulting LLP decides to progress with the expansion programme, it needs to raise additional funds through equity so that the overall leverage of the organisation does not increase in future.
Along with considering financial factors, ABC Consulting LLP needs to take into consideration certain non-financial factors, which are represented briefly as follows:
- Matching the industrial yardsticks and effective practice, as the organisation has to comply with the standard wage rate in US (about $857 per week for 40 hours a week) and safe environment or its staffs, which might lead to additional expenses
- Boosting the morale of the staffs in order to make the retention of the staffs much easier by providing incentives and promotions for superior performance so that any staff associated with the US project did not leave before project completion (Weetman 2006)
- Enhancement of relationships with the suppliers as well as the customers by providing timely payments to the suppliers and ABC Consulting LLP could offer discounts to its customers for bulk purchases to guarantee additional revenue generation in the future years (Weetman 2006)
References:
Benedict, A. and Elliott, B., 2011. Financial Accounting: An Introduction. Financial Times/Prentice Hall.
Collier, P.M., 2015. Accounting for managers: Interpreting accounting information for decision making. John Wiley & Sons.
McClaney, E. and Atrill, P., 2014. Accounting and Finance for non-Specialists. 9th ed. Harlow: Pearson.
Thomas, A. and Ward, A.M., 2015. Introduction to Financial Accounting. McGraw-Hill Education.
Weetman, P., 2006. Financial Accounting: An Introduction. Financial Times Prentice Hall.
Weetman, P., 2006. Financial and Management Accounting: An Introduction. Financial Times Prentice Hall.
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