The Techniques of Measuring Profitability Finance Essay

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According to the London School of business & finance, Accounting ratios are defined as a kind of term which is used as describing significant relationship between figures shown in a profit and loss account, on a balance sheet, , in a budgetary control system or in any other part of accounting organization. There are five aspects of business measured by accounting ratios. Profitability of company, Liquidity of company, Asset management of company, Debts management and capital gearing of company, and Market Value of investment to ordinary shareholders / common stockholders. The profitability of company is measured by Gross Profit Markup, Gross Profit Margin, Operating Profit Margin on Sales, Profit Margin on Sales, Basic Earning Power (BEP), and Return on Common Equity (ROE). The Liquidity of company is measured by Current Ratio, Liquid Ratio. The asset management of company is measured by Inventory Turnover or Stock Turnover, Fixed Assets Turnover, Total Asset Turnover, Debtor Ratio, Debtor Payment Period and Days Sales Outstanding (DSO). Debts management and capital gearing of company is measured by Debts Ratio, Capital Gearing Ratio, Debts Equity Ratio, Time Interest Earned, Creditor Ratio, and Creditor Payment Period. Market value of investment to ordinary shareholders is measured Earnings per Share, Price/ Earnings Ratio (P/E Ratio), Dividend Cover, Earnings Yield, Dividend Yield, Price/ Cash Flow Ratio and Market Price/Book Value Ratio.

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The ratios should be used as a comparison to the previous years’ trading figures or to compare similar companies to analysis any problems. By ratios analysis, the firm can see the trends and be able to adjust the business strategies. The accounting ratios are compared for business performance measurement by Inter- Temporal (comparison between two periods), Inter- Firms (comparison between two companies) and Comparison with industry averages. There are two companies which are called IJM Berhad and WCT Berhad. IJM Berhad was established in 1983 with an overarching purpose of competing more effectively against bigger foreign rivals. It is one of Malaysia’s leading construction groups. It has involved the business activities encompass construction, property development, manufacturing and quarrying, infrastructure concessions and plantations. It is headquartered in Selangor, Malaysia. IJM’s regional aspirations have seen it establish a growing presence in neighbouring developing markets with operations presently spanning 11 countries. And WCT Berhad was established in 1981 as WCT Earthworks & Building Contractors Sdn Bhd, the Firm became a public company in 1994. The Company assumed its present name WCT Berhad since 2008. It activities included project management, construction design, value engineering and assets managementA in F1A & international racing circuit, High-rise and special purpose building, International airport, Hydroelectric dam, Iconic infrastructure, Township planning & development, Racecourse, Commercial property development & management, Expressway & Highway and BOT Toll Concessions.A The comparison of two companies’ financial statements (refer to appendix 1&2) is used for analysing how the accounting ratios are used in the firms. Let’s look at the ratio calculations of two companies and find how the companies should perform.

Gross Profit Markup and Gross Profit Margin are used to measure the firm’s extent of the gross profit which is earned by the firm from its sales in purchasing and the production activities effectively and efficiently. Markup percentage indicates the differences between the actual cost and the selling price. And Gross Margin percentage indicates the differences between the selling price and the firm’s profit. The higher Gross Profit Markup or Gross Profit Margin means that the firm is able to control its budget (purchasing the cost) effectively and efficiently. According to the calculation above, IJM Berhad had higher Gross Profit Markup and Gross Profit Margin than WCT Berhad. This calculation indicates that IJM Berhad purchased the material at lower cost from its supplier than WCT Berhad. Also IJM Berhad reduced the production cost in allocating its resources. In other words, IJM Berhad has better management in its resources than WCT Berhad.

Operating Profit Margin on Sales & Profit Margin on Sales

Operating Profit Margin on Sales and Profit Margin on Sales are used to measure the firm’s extent of profit which is earned by the firm from the sales made due to the company expenditure control. Operating Margin is a ratio used to measure a company’s strategy on pricing and the efficiency in its operating. And Profit Margin is a ratio used to measure how much the firm actually keep in earning. Higher Operating Margin and Profit Margin indicates that the firm is more profitable because it has better control overall its costs compare to its competitors. According to the calculation above, IJM Berhd has much higher Operating Margin and Profit Margin on Sales. It indicates that IJM Berhad has earned higher profit than WCT Berhad. IJM Berhad might have lower operating expenses and lower interest cost than WCT Berhad because effective controlling its expenditure and interest cost can increase the profit.

Basic Earning Power (BEP) & Return on Total Asset (ROA) & Return on Common Equity (ROE)

BEP, ROA, and ROE are used to measure the firm’s extent of generated profit from total assets which the firm has used. BEP is the percentage of Operating Profit before interest, taxation, over total asset. ROA is a percentage which shows how efficient the firm’s management uses its asset to generate the profit. ROE is a percentage which shows the firm’s profitability by revealing how much profit the firm generates with the money which the shareholders have invested. Higher BEP, ROA, and ROE indicate that the firm can generate higher profit using its asset and capital. According to the calculation above, IJM Berhad’s BEP is just little bit higher than WCT Berhad but ROA and ROE is lower. It indicates that IJM Berhad generated the profit lower than WCT Berhad. It could not manage its asset and capital effectively. It might purchase the material in higher cost so, fail to generate higher profit.

Liquidity

Current Ratio & Acid-Test Ratio

Liquidity ratios are used to measure a firm’s paying ability on short-term obligations. Current ratio is used to measure the firm’s ability in using current asset to finance its current liabilities. Acid-Test Ratio is used to measure the firm’s ability in financing the current liabilities but the extent of liquid assets which can be used. Higher current ration indicates that the firm has more capable in paying obligation. According to the calculation above, IJM Berhad has higher Current Ratio & Acid-Test Ratio than WCT Berhad. It indicates that IJM Berhad is more stable in its financial than WCT Berhad which means IJM Berhad has more liquidity in financing the short-term liabilities than WCT Berhad. In other words, IJM Berhad has more enough short-term assets to cover its immediate liabilities than WCT Berhad.

Asset Management of Company

 Inventory Turnover

Inventory Turnover is a ratio which shows how many times a firm’s inventory is sold and replaced over a period. In other words, it indicates how fast the firm’s stocks are turned over. Higher Inventory Turnover indicates that the money tied up by the stocks in the store is less. It has implied mean that strong sales or ineffective purchasing capacity. According to the calculation above, IJM Berhad has lower Inventory Turnover Rate than WCT Berhad. IJM Berhad has larger amount of the money is kept in the stock in the store and it may show IJM Berhad has lesser sales or better purchasing capacity than WCT.

Total Assets Turnover

Total Asset Turnover is used to measure how efficiently a firm uses its asset to generate the sales. Higher Total Assets Turnover indicates that the sales are high and the firm uses its assets effectively. According to the calculation above, IJM Berhad has lower Total Asset Turnover Rate than WCT Berhad. IJM Berhad might generate the lower sales and using its asset was not effective in its activities than WCT Berhad.

Debtor Ratio and Day Sales Outstanding (DSO)

Debtor Ratio and DSO is used to measure the size of the debtors in credit sales and how long the time of period is needed to the firm to collect the debts form the debtors. DSO shows the average number of days which a company needs to collect the revenues after the sale is made. Higher Debtor Ratio and longer DSO indicate that the firm needs to take longer time to collect the money which is made by credit sales. According to the calculation above, IJM Berhad has higher Debt Ratio and longer DSO than WCT Berhad. IJM Berhad sells its products to the customers on credit sales and let the creditors to take longer time to pay back the debts made by credit purchases than WCT Berhad. So, IJM might face the short-term financial problem in paying back the liabilities because the money is tied up longer time in debtors. 3.4 Debts Management A) Debts Ratio Debt Ratio is used to measure how much debt burden the firm has and the ability of the firm in paying back the debts. Higher Debts Ratio indicates that the firm has large amount of debts and need to pay higher interest cost so, it has heavy debt burden. According to the calculation above, IJM Berhad has lower Debts Ratio than WCT Berhad. IJM Berhad might have lower amount of the debts and needs to pay lesser interest than WCT Berhad. So, IJM Berhad has lighter debt burden and, its finance is safer because it is able to pay back its debts.

Debts Equity Ratio

Debts Equity Ratio is used to measure how the proportion of equity and debt the firm uses to finance its assets. Higher Debts Equity Ratio indicates that the firm’s assets are financed with the debts so, the firm are in more risky because of high interest cost. According to the calculation above, IJM Berhad has lower Debts Equity Ratio than WCT Berhad. IJM Berhad is having debts lesser than WCT Berhad so, it has less interest cost therefore, IJM takes lesser risk than WCT Berhad.

Time Interest Earned

Time Interest Earned is used to measure that how many times of operating profit can be used to finance the interest cost. So, high Debt Equity Ratio accompanies with low time interest earned. In other words, the firm needs to pay high interest charges. As IJM Berhad has lower Debts Equity Ratio than WCT Berhad, IJM Berhad also has lower Time Interest Earned. So, IJM Berhad has lesser interest charges and it is stable than WCT Berhad.

Market Value of Investment to stockholders

Earnings per Share

Earnings per Share is used to measure the business growth of the firm because it shows the firm’s profitability too. Higher Earnings per Share indicates that the firm has higher growth rate and it has higher profit. So, the firm can attract the stockholders. According to the calculation above, IJM Berhad has higher Earnings per Share than WCT Berhad. Therefore IJM Berhad can attract the stockholder more effectively in their higher growth of business and profitability.

Price Earnings Ratio

Price Earnings Ratio is used to measure the period of times which is needed to recover back the common shareholder’s investment, by comparing the price of the firm’s current share with its per- share earnings. Higher Price Earnings Ratio indicates that the shareholders are needed to take longer period of time to recover back their investment. According to the calculation above, IJM Berhad has higher Price Earnings Ratio than WCT Berhad. IJM Berhad has lower earnings per share so, its shareholders are needed to take longer period of time to recover back their share investment than WCT Berhad. Therefore IJM Berhad has lesser attractiveness to the shareholders than WCT Berhad.

Earning Yield

Earning Yield is used to measure that the percentage of each dollar invested in the share which was earned by the firm. It helps to determine the optimal asset allocation. Higher Earning Yield indicates that the firm has higher net income return. It will be attractive to the shareholders. According to the calculation above, IJM Berhad has lower Earning Yield than WCT Berhad. IJM Berhad might have lower net income than WCT Berhad. Therefore, IJM Berhad has less attractiveness to its shareholder than WCT Berhad.

Market Price per Book Value Ratio

Market Price per Book Value Ratio is used to compare a stock’s market values to is book value. Higher Market Price per Book Value Ratio indicates that price of the share in the market rises too high more than its real assets value. So, it cannot be attractive to the shareholders. According to the calculation above, IJM Berhad has lower Market Price per Book Value Ratio than WCT Berhad. IJM Berhad’s price of share in the market is lower than its real assets value. Therefore, it can be attractiveness to its shareholders.

Conclusion

Accounting Ratios are used to determine how a business is performing. Analysing the accounting ratios can simplify the financial statements. And it will help the firm to make the planning more effectively because it indicates the factors associated with successful and unsuccessful firm. However, using analysis of accounting ratio has also some disadvantages. All the ratios are based on only the information which is recorded in the firm’s financial statements and the information might be out dated. Also, only by analysing the accounting ratio, it is hard to know the roots of the financial problem. The different companies have different financial, different policies and different business risks. So, it is difficult to get direct comparison the two different companies. Based on the accounting ratio calculations, IJM Berhad has overall better performance than WCT Berhad. In Profitability, IJM Berhad has better performance in allocating its resource but it generates the profit lesser than WCT Berhad. Although WCT Berhad has better performance in Asset management than IJM Berhad, IJM Berhad has more stable financial state in company liquidity. It shows IJM Berhad has more capacity on its obligation. IJM Berhad has lesser attractiveness in taking longer period of time to recover back the shareholders’ investments, however, IJM can attract the shareholders in its Market Price per Book Value that the price of the stock is lower than its real value. Based on accounting ratio analysis, IJM Berhad is suggested to improve in its assets management and put more effort on reducing the period of time to recover back the shareholders’ investment.

 

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The Techniques Of Measuring Profitability Finance Essay. (2017, Jun 26). Retrieved November 26, 2022 , from
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