Financial analysis: Paul Prendergast shows how a "modified DuPont approach" to ratio analysis can be used to drill down to the true cause of financial performance problems.
| Author | Prendergast, Paul |
| Position | Accounting |
It's year-end reporting time at Make-or-Break plc, a video cassette and CD manufacturer. The firm's chief executive, Sir Alex, has a problem. Its share price has been in the doldrums recently and the corporate announcement is likely to make things worse: earnings per share, return on equity and return on capital employed have all declined on the previous year and it's not dear what is causing the problem. Service companies with high off-balance-sheet intellectual capital sometimes find that traditional ratios don't give a true picture of their performance, but Sir Alex is well aware that CEOs of manufacturing firms need to give the media a satisfactory explanation.
"Our ad campaign was poor this year. It was bound to affect our profits," declared Peter, the production director. "I'm not blaming anyone, but the agency we used last year was better."
Jane, the marketing director, glared at him before reminding Sir Alex that the sales turnover was up ten per cent on the previous year. "This is a cost issue," she insisted. "I'm not blaming Peter--maybe the machines are old or something--but the costs are out of control."
"Don't talk about something you know nothing about," Peter retorted. "We bought new machines two years ago. Anyway, Look at the accounts: our gross profit has increased, for pity's sake."
"Calm down, everyone," Sir Alex said. "I think I see the problem: it's those overheads again. Our expenses have risen by ten per cent and are pulling down our profits. We really need the financial controller in here, but he's on sick leave."
"I knew it," Peter groaned. "They keep hiring more accounting and admin people just to push paper around."
Jane agreed: "We're killing ourselves here doing the important work, but the overheads keep dragging us down."
Half an hour later, Hark, the firm's part-qualified management accountant, listened intently as Sir Alex strode up and down his office and told him what he was going to do.
"Tomorrow I'll tell the press that everything's going to plan: both revenue and gross profit have risen as expected. I'll stress that we've started a cost-cutting p[an to get our overheads back in line and that our bottom line will improve soon. I hope that'll be enough to stop any carping about our EPS and hold the stock price. I need you to take a quick took at the numbers--never my thing, I must admit--in case any smart-aleck journalist tells me I'm talking rubbish. Sorry to put you on the spot, but it's urgent and none...
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