What does profitability mean? And how can we use it to understand the financial situation of a company? How can we judge the financial structure of a company? What kind of financial ratios can be used to answer such questions?
The purpose of this article is to present a case study that critically evaluate the Profitability two companies; DEBENHAMS and NEXT using ROCE (Return on Capital Employed) and their Financial Structure using Gearing and Interest Cover ratios.
DEBENHAMS and NEXT are two retails UK-based companies with international multi-channels orientation. An overview of their products and markets is shown below.
In the next section, the financial performance will be evaluated based on the calculations presented in the below table.
ROCE is a profitability ratio shows how the company is good in terms of using its capital employed to generate a return. It is calculated by dividing Operating Profit by Capital Employed (which is equal Equity plus Net Borrowing).
Both companies managed to improve their ROCE ratios between 2014 and 2015, where DEBENHAMS increased it by 0.35% and NEXT increased it by 3.34%.
ROCE in NEXT is much higher than DEBENHAMS which means it is more profitable and more efficient in using its capital employed to generate returns for the benefit of their shareholders.
Gearing ratio is a financial structure ratio that shows whether the financing of the company changed or not. It is calculated by dividing Net Borrowing by Equity. This is a measure of financial leverage, i.e., shows the degree to which a company’s fund is coming from the owners versus borrowings. The lower the number, the greater the financial stability for the company.
In all cases, it should be compared to industry standards where it is expected to be high in clothing industry due to uncertainty in demand, and high potential variability in profit (Walker 2009, p.194).
Both companies managed to improve their ROCE between 2014 and 2015, where Debenhams reduced it by 20.44% and NEXT reduced it by 5.15%.
20% reduction in DEBENHAMS means a big change in its financial structure from being dependable on Net Borrowing to Equity, and the lower ratio comparing to NEXT (37.48% versus 175.68%) means it is more stable from a financial point of view.
Second: Interest Cover
Interest Cover is another financial structure ratio that shows how many times the company can pay its Financial Costs within its current earnings. It is calculated by dividing Operating Profit by Finance Costs.
DEBENHAMS did not manage to improve its Interest Cover between 2014 and 2015 and decreased it by 7.73% while NEXT Company managed to improve it and increased it by 3.56%.
The higher Interest Cover in NEXT means it is more capable to pay off its interest.
The main drivers for the above results are shown in the below two figures.
The previous analysis showed a comparison between DEBENHAMS and NEXT. As mentioned earlier, due to the short product life cycle and uncertainty in such industry, it is expected to see high financial risks.
2015 Revenue in NEXT was £3,999.8m, while it was £2,322.7m in DEBENHAMS. With 539 stores for NEXT comparing to 248 stores in DEBENHAMS, and with the support of ROCE calculations in section 1.2.1, it can be concluded that NEXT is larger and a more profitable company. Given that both are competing in the same market, DEBENHAMS is advised to continue the investment in its multi-channel international growth plan so they can increase their revenues and profit.
In terms of the financial structure, Debenhams is a more stable company and has a bigger improvement in managing their financial risks as supported by Gearing Ratio calculations in section 1.2.2. However, the Interest Cover calculations showed that NEXT is more capable to pay off its finance costs from its operating profit. NEXT company is advised to re-study its financial structure to reduce the current risk.
As a conclusion, the above calculations should be conducted regularly to understand the trends and to be compared with industry standards so decision makers can have better insights about the future.
DEBENHAMS Company, 2015. DEBENHAMS Annual Report. Available at: http: //media.corporate-ir.net/media_files/IROL/19/196805/agm2015/2015_Annual_Report.pdf.
NEXT PLC Company, 2015. NEXT PLC Annual Report. Available at: http: //www.nextplc.co.uk/~/media/Files/N/Next-PLC-V2/documents/reports-and-presentations/2014/next-annual-report-2015-final-web.pdf.
Walker, J., 2009. Accounting in a nutshell: accounting for the non-specialist 3rd ed., London : Elsevie.