Profit is the lifeblood of business
Lonza Pharmaceuticals is a pharmaceutical, biotech, and nutrition company. It mostly produces Nucleofectors Technology MODA-EMTM Paperless QC Microbiology and Electronic Logs module.
Profit is the lifeblood of business. To survive in the competitive market, every company is required to generate profit. Therefore, making a profit is the main objective of the company and they make a strategy to generate positive profit in the future.
In 2019, the gross profit ratio of Lonza was 29.07%. which increases to 40.99% in 2020 and 39.01% in 2021. The net operating profit of the company was 19.61% in 2019 which increased to 19.99% in 2020 and in 2021, which decreases to 15.73%. The analysis clearly indicates that the gross profit ratio has increased in 2020 and 2021 as compared to 2019 but in 2021, profit decreased as compared to 2020. On the other side, the operating profit in 2021 is decreased as compared to 2019 and 2020. The objective to achieve higher profit in 2021 is not achieved.
The net sales are an increase in 2021 as compared to 2019 and 2020 but the Net operating profit decreases in 2021 due to increases in operating expenses.
The failure of efficiency of the mechanisms utilized to implement management decisions regarding the profit objective.
The trend of gross profit of Lonza is negative in the year 2021 compared to 2020 and 2019 but in 2020 trend is positive as compared to 2019. In the same way, operating profit is in a negative trend as compared to 2020 and 2019 and it is trend marginal positive in 2020 as compared to 2019. The below graph shows the linear gross profit ratio.
The gross profit trend of competitor company Tianjin ZX USD is positive in 2021as compared to 2020 but it is a negative trend as per 2019 records. The trend of operating profit is positive in 2021 as compared to 2020 and 2019 respectively.
Lonza’s performance against the Tianjin Zhong Xin Pharmaceutical group corporation limited (Tianjin ZX USD)
When comparing the Lonza with their competitors Tianjin ZX USD, it found that in 2021 gross profit trend of Lonza is negative but the trend gross profit of Tianjin ZX USD is positive. The trend of operating profit of Lonza is negative in 2021 but Tianjin ZX USD trends are positive.
The return of equity of Lonza increases in 2021 to 30.19% by comparing to 12.75% and 9.93% in the years 2021 and 2019 respectively. An increase in ROE indicates that Lonza has increased its efficiency to generate more profit by utilizing its existing assets. Higher ROE is better for the company.
The debt ratio of Lonza decreased in 2021to16.70% as compared to 26.43% and 25.6% in the year 2020 and 2019 respectively. The lower debt ratio (below 0.4) is good for the company because it indicates a stable business with long sustainability in the competitive market. A lower debt ratio also indicates that the company has overall low debt and they can take more debt from the market.
Analysis of Gross Profit and Net Operating Profit
The earnings per share of Lonza are stable in 2021 and 2020 at 3.8%. EPS is increased in 2021 as compared to 2019 which is 3%. An increase in earnings per share indicates that the company is earning better profit and distributing it to its shareholders. An increase in EPS also shows that the efficiency of the company in respect of business is good (Elearnmarkets 2022).
The overall analysis of return on equity, debt ratio, and earnings per share indicates the current performance of the company Lonza is better. Total debt in the year 2021 is decreased from 1065 million and the debt ratio is also below 0.4. Therefore, the Lonza company is able to take more debt from the market.
As per the above analysis of return on equity, debt ratio, and earnings per share, Lonza is able to take more debt from the markets. After taking the debt, their total debt is increasing. The increase in total debt will cause the performance of the company. It increases the leverage ratio like the debt ratio of the company as well as it also impacts the interest coverage ratio and debt level requirements. If the additional debt is taken by equity financing, then it increases the outstanding shares of the company.
The capital structure of the company indicates the debt and equity of the company which are used to generate the assets of the company by utilizing the debt and equity. An ideal capital structure contains 40% long-term debt, 10% preferred stock, and 50% of common stocks (CFA Institute, 2022). The capital structure of Lonza for the year 2021 is = CHF12226 (2,234+169+9,750+73). If the additional debt is taken then it increases the total capital structure of the Lonza. For example, if a long-term debt of CHF 500 million is taken then a new capital structure will be CHF12,726 (500+2,234+169+9,750+73). Therefore, this additional debt will change the capital structure which impacts the cost of capital, the leverage ratio of the company, net income for the financial year, and the liability of the company is increases (CSH 2022).
As per the net income approach, if the company decreases its debt, then it decreases the capital structure of the company. It also increases the weighted average cost of capital (WACC). In Lonza, the debt (current and non-current) is decreased by CHF 1177 million in 2021. Therefore, the capital structure is also decreased in 2021. The total capital structure is CHF12226 (2,234+169+9,750+73) in 2021. The debt ratio for 2021 is fallen to 16.70% from 26.43% in 2020.
Debt repayment so that finance costs would reduce and therefore, the profit available to common shareholders would increase. That extra fund would be required to repay the debt as well as to continue to manage the working capital requirements of the company, which would be fulfilled by raising funds from equity participation.
The common strategies and methods such as profit maximization and maximization of the present value of the expected future return will help the company to maximize the wealth of the shareholders. Boosting the stock price means the maximization of the wealth of shareholders. To increase the value of shareholders, the company is required to increase return on investment, and market shares and improve the performance of the business (Roe 2000).
Lonza’s Performance Against Tianjin Zhong Xin Pharmaceutical Group Corporation Limited
The net income for the year 2021 is increased by CHF 2076 million as compared to 2020 and 2019. It indicates that the company is focusing on profit maximization. The earnings per share of the company increased in 2021 to 39.68 which was 11.70, and 8.68 in the year 2020 and 2019 respectively. The return on assets of the company has been increasing as compared to the previous years which shows the resource utilization from the assets and better returns generated over the years. In the same fashion, the return on equity is improved from 12.75% to 30.19% in the year 2021 as compared to the year 2020 these factors indicate the performance improvements as compared to what the company had in the past and if the company could be able to reduce the debt, then the financial outcome of this would enhance the profits available for equity shareholders by giving more earnings in the future. It indicates that the corporate executives are working to increase their company’s wealth, they are essentially seeking to increase the stock price of the company. The increase in stock price rises means the wealth of the shareholders are finally maximized.
The wealth of shareholders is maximized by the maximization of profit of the company. The profit has been increased by CHF 2076 million in the year 2021. The earnings per share have been also increased from 11.70 to 39.68 in the year 2021. The total debt has also reduced in 2021 from CHF 3649 to CHF 2476. This helps the company to enhance its profit.
The dividend valuation model: Under this model, the value of shares is carried by the shareholders with the expectation of a future dividend. It uses to determine the value of share price by using the dividend (Moyo, and Mache 2018).
The Gordon growth model: This model will assist the causes of dividend growth. The intrinsic value of a firm is calculated using this approach (Lytvynenko 2021).
Modigliani and Miller’s dividend irrelevancy theory: This theory will explain that the pattern of dividends has not provided any effect on share values (Udobi,and Iyiegbuniwe 2018).
Reserves: Reserves are required to run the company. It uses for the depreciation, bad debt, taxation of working capital, and the redemption of various shares. Lonza pay its dividend of CHF 3 per share in 2021 by using the reserve of the company (Your Article Library 2022).
A company’s cash requirements: When it comes to deciding whether or not it should pay a dividend, the cash balance is crucial. A company needs cash for a number of reasons. As a consequence, the dividend policy should be decided after a thorough examination of the company’s financial situation (Your Article Library 2022).
Government Taxation Policy: Corporation taxes are an important factor to consider when deciding on a dividend. To meet its revenue needs, the government levies a high level of taxation on enterprises.
Increased dividends provide a positive message to investors and analysts, indicating that the company can continue to grow and generate profit in the future. However, in this instance, the company’s gross profit and operating profit declined in 2021. If a corporation pays more dividends, it has a direct impact on its cash flow and profitability. As a result, the corporation continues to follow the former dividend policy.
Return on Equity and Debt Ratio
(i) Payback Period: The payback period is the time it takes for a project’s cash flow to pay back its initial investment. It’s a quick and simple method for determining the risk of a project.
If the payback time is short, go with the project. In other words, investments with shorter payback periods are more enticing, whereas those with longer payback periods are less so. (Bragg 2022).
The investment policy of the company is clear that if the initial outlay of the project is recovered within 5 years, then the company accepts the policy. In this case, the payback period of project P is 3.84 years, the payback period of project Q is 4.85 years, the payback period of project R is 3.25 years and the payback period of project S is above 6 years. The payback period of Project r is lower as compared to the projects P, Q, and S. The payback period of project R is lower than the 3.5 years which is required as per the company policy. Hence project R is best as per the investment policy of the company.
(ii) Net Present Value (NPV): The present value of cash flow is subtracted from the present value of cash outflow to arrive at the net present value. It’s used to figure out whether a project will be profitable or not and how much money would be needed. If the project’s net present value (NPV) is more than zero, the project is acceptable; however, if the NPV is less than zero, the project should be rejected. Sometimes, when there are alternative non-monetary factors, a project that is unprofitable may be adopted by a business. As a result, when evaluating different investment possibilities, the project with the greater NPV is predicted to provide superior financial returns. In other words, if the NPV of the project is highest then must choose the project (Cdaaudit.com 2022).
In this case, after 6 years the NPV of project P is $86357.19, the NPV of Project Q is $184645.7, the NPV of project R is $72701.25%, and the NPV of Project S is -$1731.97. Here only project S is a negative NPV and projects P, Q, and R have positive NPV. Project Q has the highest NPV as compared to projects P, R, and S. Hence project Q is good from the point of view of investment.
(iii) Internal rate of return (IRR): Internal rate of return indicates that the net present value of the project is zero. Only if the IRR exceeds the interest rate at which you may borrow money, then the project is acceptable. When comparing different projects, the one with the highest IRR succeeds. IRR should never be used to compare projects that are mutually incompatible. IRR can assist you to decide whether or not to pursue a project or make an investment (Propel(x) 2022). IRR aids in determining the cost of a project and comparing it to the cost of capital, as well as taking into account the time value of money.
In this case, the IRR of project P is 29.66%, the IRR of Project Q is 28.43%, the IRR of project R is 31.67%, and the IRR of project R is 14.27%. The discounting rate is 15%. If we assume that the interest rate at which the company is borrowing is 15% then the project whose IRR is more than 15% is acceptable. Here the IRR of project R is lower than 15% so, reject project R. The IRR of projects P, Q, and S has more than the interest rate of 15%. The IRR of project R is the highest among all projects. Therefore, the company should go with project R.
Capital Structure and Debt Repayment
Within capital planning, IRR, payback time, and NPV all have various applications. When comparing numerous projects or in instances where determining a discount rate is problematic, IRR comes in useful. The payback period indicates how long it will take you to recoup your investment costs. When there are various discount rates or different directions of cash flow over time, NPV is preferable. The IRR, payback period, and NPV may all be used to assess whether a project is desired and will bring value to the organization. Whereas the IRR is given as a percentage, the payback period reflects the investment’s recovery period, and the NPV is represented as a dollar amount. Although some people use IRR as a capital planning metric, it has drawbacks since it ignores changing elements like discount rates. However, NPV has certain drawbacks, such as the inability to evaluate project sizes and the requirement for upfront rate estimates (Corporate Finance Institute 2022).
Popularity and superiority of the Internal Rate of Return (IRR) methodology as compared to the Payback Period and the Net Present Value (NPV) method:
To calculate the discounting rate at which cash flows reach zero, the IRR approach is utilized. On the other hand, the payback period is used to calculate the time during which the initial capital investment will be recovered, and the net present value (NPV) is used to evaluate the project’s net benefit.
IRR is more popular since it aids in determining the project’s cost, which can then be compared to the cost of capital and the time value of money. The payback period gives the estimated time required to recover all investments, and the net present value (NPV) allows for comparison with approximate real-time data when it is available, taking into account all cash flows.
IRR is better than payback period and net present value (NPV) because it may be used to compare numerous projects or in instances where determining a discount rate is challenging. IRR is simple to compute and provides you with the benefit of determining the real returns on your current investment (The Strategic CFO™ 2022).
The reason why a specific investment appraisal tool is preferred in practice
IRR, NPV, and the payback period are significant for investors because they are a type of essential research that may demonstrate to an investor whether such stock or a business has a long-term platform for the profitability of its upcoming initiatives and endeavors.
The NPV (Net Present Value) is computed in terms of cash, whereas the Payback approach specifies the time it will take for the investment to pay off. The NPV technique analyses temporal value and provides a direct estimate of the project’s financial advantage to the firm’s shareholders on a present value approach. The best single metric of profitability is the net present value (NPV). As a result, we believe that the NPV technique is the best.
References
Bragg, S., 2022. Payback method | Payback period formula — AccountingTools. [online] AccountingTools. Available at: <https://www.accountingtools.com/articles/2017/5/17/payback-method-payback-period-formula> [Accessed 12 April 2022].
Cdaaudit.com, 2022. How NPV and IRR Help in Financial Feasibility Study | CDA. [online] Cdaaudit.com. Available at: <https://www.cdaaudit.com/blog/how-npv-and-irr-help-in-financial-feasibility-study> [Accessed 12 April 2022].
CFA Institute, 2022. Capital Structure, Level I. [online] CFA Institute. Available at: <https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/capital-structure#:~:text=Capital%20structure%20refers%20to%20the,capital%20with%20greater%20financial%20flexibility.> [Accessed 12 April 2022].
Corporate Finance Institute, 2022. NPV vs IRR. [online] Corporate Finance Institute. Available at: <https://corporatefinanceinstitute.com/resources/knowledge/valuation/npv-vs-irr/> [Accessed 12 April 2022].
CSH, 2022. How capital structure affects business valuation – CSH. [online] CSH. Available at: <https://www.cshco.com/articles/how-capital-structure-affects-business-valuation/> [Accessed 12 April 2022].
Elearnmarkets, 2022. Earning Per Share – Formula, Factors, & Importance. [online] Elearnmarkets – Learn Stock Market, trading, investing for Free. Available at: <https://www.elearnmarkets.com/blog/earning-per-share/#:~:text=A%20higher%20or%20increasing%20earnings,efficiency%20on%20its%20business%20prospects.> [Accessed 12 April 2022].
Moyo, V. and Mache, F., 2018. Inferring the cost of equity: Does the CAPM consistently outperform the income and multiples valuation models?. Journal of Applied Business Research (JABR), 34(3), pp.519-532.
Propel(x), 2022. What is the Internal Rate of Return (IRR) and why does it matter when investing in startups? – Propel(x). [online] Propel(x). Available at: <https://www.propelx.com/blog/internal-rate-of-return-and-importance-when-investing-in-startups/> [Accessed 12 April 2022].
Roe, M.J., 2000. The shareholder wealth maximization norm and industrial organization. U. Pa. L. Rev., 149, p.2063.
The Strategic CFO™, 2022. NPV vs Payback Method – The Strategic CFO™. [online] The Strategic CFO™. Available at: <https://strategiccfo.com/articles/investment-shareholders/npv-vs-payback-metho/> [Accessed 12 April 2022].
Udobi, P.I. and Iyiegbuniwe, W.I., 2018. A Test of Miller and Modigliani Dividend Policy Irrelevance Theory in Nigerian Stock Market. American Finance & Banking Review, 2(2), pp.1-13.
Your Article Library, 2022. Top 9 Factors Affecting the Dividend Policy of a Company. [online] Your Article Library. Available at: <https://www.yourarticlelibrary.com/company/dividend-policy/top-9-factors-affecting-the-dividend-policy-of-a-company/74187> [Accessed 12 April 2022].
Lytvynenko, I., 2021.An Extension Of The Gordon Growth Model With Currency Fluctuations. The Journal of Theoretical Accounting Research, 16(2), pp.67-81.
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