Review of SSPs financial performance and position
Profitability
Overall SSP plc has increased turnover by nearly 15%, however, this appears to be at the expense of operating profit which has fallen by 20%.
The companys Return On Capital Employed (ROCE), which indicates how well the business has used the financial resources which have been invested in it, has fallen from 31.9% to 23.3%. Although the ROCE for 2004 in absolute terms appears quite satisfactory (it is certainly higher than the cost of capital), this ratio shows a decline from the previous years and must be further investigated.
The gross profit margin (which effectively compares the cost of goods sold with the selling price) has been maintained at 60%. However, the net profit ratio (which measures operating profit as a proportion of sales) has fallen from 12.1% to 8.5%. This indicates that the fall in profitability is due to a disproportionate rise in expenses in relation to turnover. In particular, administrative expenses have increased by 26% which is more than the increase in sales. This overall drop in the profit margin will be a major factor in the drop in the ROCE and further analysis must be undertaken to ascertain what specific expenses were responsible.
Liquidity
All firms need liquid assets to meet day to day payments. Cash is the life-blood of any business, no matter how large or small. If a business has no cash and no way of getting any cash, it will have to close down. The liquidity ratios highlight the ability of the firm to convert its assets to cash. SSPs current ratio (which compares current assets with current liabilities) has improved from 1.56 to 1.78. However, the acid test ratio, which excludes stock values (which are seen as less liquid than other current assets) has dropped from 0.76 to 0.64.
It is not the absolute value of this ratio which might cause concern but the fact that it has fallen over the year. An examination of the constituent parts of this ratio reveals that the main factor driving the figures down is the decrease in cash balance by £386,000. The cash flow statement indicates that, encouragingly, the company is still generating significant cash flow from normal operating activities, however, it appears that new fixed assets have been acquired without any injection of new long term finance resulting in a bank overdraft where there was a healthy cash balance previously. If this situation is allowed to continue the overall liquidity of the organisation could be threatened.
Efficiency
Managing liquidity is part of the management of working capital as a whole if debtors pay timeously there will be a steady inflow of funds to meet payments to creditors. If stock levels are controlled there should be less need for capital to be tied up in stock and its associated costs.
The debtors collection period for SSP plc (which is an indication of how long the average credit customer took to pay the business) has increased by 3 days. Although the calculated collection periods look quite acceptable any period under 30 days seems quite short, management should still seek to find out why, on average, customers are taking longer to pay.
The companys creditor payment period (which indicates the extent to which a firm is using suppliers to finance its business) has dropped from 42 days to 27 days. Suppliers credit should be maximised where possible as it is free (unless early settlement discounts are lost) therefore, it would be interesting to know why SSP plc have paid their creditors more quickly this year.
To ensure the efficient use of funds tied up in stock, the level should be kept to a minimum consistent with the requirement to meet customer demand. The companys stock turnover period has increased from 47 to 54 days. As with all ratios, there is no one yardstick by which this may be measured. Different sectors have different norms but the movement is in the wrong direction (holding stock costs money). The difference, however, is not great and could be explained if the company is stocking up for meeting extra demand generated by increased advertising.
Capital structure
The capital structure of an organisation is important, especially to shareholders and suppliers of long term loan finance. They will need to assess the risk they are taking with their investment.
Capital gearing is concerned with the proportion of the long term capital employed by the company which is fixed interest capital (all loan capital and preference share capital). The higher the level of gearing the greater the financial risk associated with the company. By taking on loan capital, the company takes on a commitment to pay interest and make capital repayments at agreed times. If there are insufficient funds available to meet these commitments the consequences for the company may be very serious indeed.
The capital gearing ratio of SSP plc (2003 35%, 2004 32%) indicates that the company is not a highly geared company it has not borrowed more long term finance over the last year.
Although there is considerable debate over whether certain levels of gearing are good/bad one way of looking at the financial risk is to consider the interest cover (the number of times we can cover interest payable with available profits) a company provides.
As operating profits have fallen the interest cover for SSP has decreased from 6 to just under 5 however this is still generally regarded as a fairly safe level.
Conclusions
The company appears to have increased turnover at the expense of profitability during 2004. This may well have been deliberate in order to capture an increased market share, however attention should be given to the increase in expenses in relation to sales in order to identify the specific reasons for this. The companys capital structure seems stable although the increased reliance on short term debt cannot continue in the longer term.
The planned expansion will result in a need for both increased working capital and new fixed assets. New long term sources of finance must be sought to finance this.
Recommendations
The recommendations to the companys management are as follows:
1 Investigate and identify the administrative expense(s) which have risen sufficiently to cause a drop in the operating profit.
2 Investigate and identify the reason for the early payment of suppliers. If there is none, make more use of this source of short term finance.
3 When considering the funding of the expansion programme, the following points should be borne in mind:
i No more fixed assets should be bought using short term sources of finance. The company should match the requirement for long term assets with long term sources of finance such as a new share issue or more loan finance (debentures).
ii In relation to a possible new share issue, unfortunately the current share price is low, perhaps a rights issue, after informing the shareholders of the advantages to be gained from the expansion, could be successful.
iii With regards to possible new loan capital, the company is currently low geared and could certainly support new debt finance. It is, however, important to keep a watch on interest cover.
iv Additional requirements for working capital will also arise as a result of the expansion. Use should be made of credit facilities where available and extra requirements met from long term sources.
v Consideration should be given to leasing rather than purchasing some of the fixed assets. Perhaps this option should have been considered in the year just passed. Leasing allows the company to benefit from the use of new technology without having to pay out large capital sums at the outset. It is a form of finance particularly suited to areas where new technology has yet to be proved efficient and effective.