a) Gross profit shows the difference between a firm's sales revenues and its direct cost of sales (COGS). Net profit, however, is calculated after deducting overheads (expenses) from the gross profit figure, i.e. it considers both indirect and direct costs in the calculation of profit. Gross profits will, therefore, always be greater than Net profits.
b) Note: SL students are not expected to use the Earnings Per Share ratio in this question.
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Ratio
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Firm
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Commentary
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GPM
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Pia
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Gross profit has fallen by 20% (from GPM of 50% to 40%).
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Hayman
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Gross profit has fallen by just 10% (from GPM of 50% to 45%); therefore Hayman has performed better in terms of its ability to control COGS.
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NPM
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Pia
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NPM is stable at 20% but this means with a reduced GPM that overhead control is improving; overhead accounted for a 30% differential (comparing GPM and NPM) but only 20% by the Year 3.
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Hayman
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NPM has improved by 5.2% and is quite stable. Hayman's ability to control overheads has also improved but Pia performed better.
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ROCE
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Pia
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Fall in ROCE of 6.7% but the rate is still quite attractive at 14% return.
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Hayman
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Improved by 25% thereby seems very attractive if performance can be maintained. Hayman's ROCE overtakes that of Pia in 3rd year and seems attractive at 15% return.
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Quick ratio
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Pia
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High acid test ratio in Years 1 and 2; seems to have improved with the ratio falling to 1.5 (although we have no information about the type of industry that Pia operates in).
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Hayman
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Fluctuating acid test ratio that is close to the minimum recommended of 1:1 so liquidity issues at Hayman could be a concern for some investors.
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EPS (HL)
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Pia
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Improving EPS ratio will tend to attract investors (Pia's EPS has increased by 40% in the given time period).
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Hayman
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Declining EPS ratio may drive away investors in the long term, especially since the EPS has fallen by 33%.
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- Award a maximum of 4 marks for the analysis of up to two of the given economical ratios.
- For SL candidates, at least 3 ratios should be analysed (at least 4 ratios for HL candidates) for 5-7 marks.
- For 8-9 marks, there should be a justified conclusion as to which firm is the better investment based on the given analysis.
c) It is important for potential investors to consider non-financial factors when making investment decisions because not all options are made on quantitative grounds. For example:
- There is no information concerning the type of industries in which Pia and Hayman operate; indeed the two firms might not even operate in the same industry!
- Factors and Labour turnover such as the level of staff motivation can affect the firm's long term profitability and costs.
- Past financial performance is not essentially indicative of future performance so caution should be taken when making investment decisions
- Financial/quantitative analysis may not be consistent due to window dressing of historical data and accounts being used, i.e. the current situation for both firms is likely to have changed.
- Consumer confidence levels will also affect investment decisions, irrespective of what financial ratios might disclose, e.g. a looming recession might be sufficient to put off investors
- The state of the economy - investment decisions tend to be additionaly reserved during a period of recession or when the level of consumer and business confidence is declining
- The reputation of the two firms is likely to have an persuade on investors' decisions since corporate ethics and social responsibility are increasingly factors that affect the customer's perception (and hence sales) of a firm
- objectives and Aims of the two firms are likely to be considered, e.g. Pia might be expanding which accounts for its failing quick ratio.