Case Study

Ratio Analysis & Capital budgeting

Ratio Analysis & Capital budgeting

Nere Supermarket Plc

Chairman's report from Nere's annual report in 2009:

'The company's financial position has never been stronger. Turnover has risen 209% and the share price has almost doubled during the last four years. The board of the company has decided to build a number of new supermarkets in the UK and, our objective is to become the largest retailing group in the UK within five years.'

Relevant ratios calculated from its financial statements are shown below:

Financial Ratios

Ratios

2006

2007

2008

2009

Return on Capital Employed

25%

24%

21%

15%

Return on Equity

17%

16%

13%

10%

Stock turnover (days)

45

44

52

59

Debtor collection (days)

63

51

56

50

Current ratio

0.85

0.73

0.68

0.68

Acid test ratio

0.50

0.40

0.36

0.32

Gearing

83%

72%

117%

109%

Interest cover (times)

4.8

4.4

3.3

2.6

EPS (pence)

6.0

7.0

7.0

8.2

P/E ratio

13.7

14.9

17.1

19.4

Share price (pence)

82

104

120

159

Part A

As a financial analyst, by using ratios analysis, you are required to evaluate the company's business performance and appraise whether you agree with the chairman.

Answer Part A

Yes, I agree with the chairman to open new markets as the turnover has been increased up to 209% in last four years anticipating that in coming year demand for the supermarket will in increase with faster pace. Assuming that the sales will be increasing in the future we consider the following rationales for the decision taken:

Rational for the decision:

Average collection period

Quality of the account receivables is measured by this ratio. The shorter the collection time exhibits faster payments by the. The ratio decreases the potential of being bad debts. Similarly, a longer collection period implies too liberal and inefficient credit collection performance but the company in this aspect is efficient as this ratio has been decrease since 2006. In 2006 it was 63 days that mean the company collects its average debts in 63 days but in 2009 average debt collection period has been reduced up to 50 days. This will help the company in opening new supermarket in managing credits.

Stock turnover (days)

The stock turnover ratio of the company exhibits that the company is becoming inefficient in managing and selling their inventory. In 2006 it had been 45 days but as time has been passed stock turnover (in days) has went up to 59 days that means the company now takes longer time to make a sale of average inventory . Opening new supermarket will help the in maintaining the inventory and make it efficient in selling its product as new opportunities will be explored.

Current ratio

Current ratio measures the short term liquidity of the company. That means how much current assets a company has to meet its short term operating obligation. Nere Supermarket Plc has low current ratios throughout given four years which is alarming to get into new place for business. The company should be concerned about its short term liquidity by developing effective credit policies and increasing the inventory turnover to overcome this issue. The supermarket should focus on the tools that would improve the current ratio.

Acid test ratio

Acid test ratio measures the short term cash need of the company. That means how much cash and other liquid assets a company has to meet its short term cash requirements. Nere Supermarket Plc has low acid test ratios ...