Assessing the Expansion Opportunity using Financial Ratios

To assess whether the business should proceed with the expansion, we need to consider how the expansion will affect its financial ratios. We'll focus on the impact on profitability and solvency.

Profitability Analysis: The current profit margin is 10%. The projected annual profit increase is £30,000. We can calculate the new profit margin after the expansion:

New Profit Margin = (Current Profit Margin + (Projected Annual Profit Increase / Total Revenue))

Without knowing the current total revenue, we can't calculate the exact new profit margin. However, we can assume that the expansion will increase revenue. If the expansion is successful, the profit margin should increase. A higher profit margin is always desirable.

Solvency Analysis: The current debt-to-equity ratio is 0.6. This means that for every £1 of equity, the business has £0.6 of debt. The expansion requires a £200,000 investment. We need to consider how this investment will affect the debt-to-equity ratio. If the business finances the expansion with debt, the debt-to-equity ratio will increase. If it finances the expansion with equity, the debt-to-equity ratio will remain the same. The impact on the debt-to-equity ratio depends on the financing method.

Decision:

Based on the information provided, it's difficult to definitively say whether the business should proceed with the expansion. However, the projected annual profit increase of £30,000 is a positive indicator. To make a more informed decision, the business needs to:

• Estimate the total revenue increase resulting from the expansion.
• Determine how the expansion will be financed (debt or equity).
• Calculate the new debt-to-equity ratio after the expansion.
• Compare the new profit margin and debt-to-equity ratio to industry averages.

If the expansion is financed with equity and the new profit margin is higher than the industry average, and the debt-to-equity ratio remains manageable, then the business should proceed with the expansion. If the expansion is financed with debt and the debt-to-equity ratio becomes too high, or the profit margin does not improve, then the business should not proceed.

It is not appropriate to simply compare the PBIT figures of Alpha Ltd and Beta Co. to determine profitability because PBIT is influenced by the company's asset base. A higher PBIT doesn't necessarily mean higher profitability if the company has significantly more assets. A company with more assets might have a lower profit margin.

To make a more informed comparison, the student should consider other financial ratios that account for the size of the company. Two suitable ratios are:

• Profit Margin: This ratio measures the percentage of revenue that remains as profit after all expenses are deducted.

  Calculation: (PBIT / Revenue) x 100. Comparing profit margins allows for a more accurate assessment of how efficiently each company generates profit from its sales, regardless of its asset size.

• Return on Assets (ROA): This ratio measures how effectively a company uses its assets to generate profit.

  Calculation: (PBIT / Total Assets) x 100. ROA indicates how much profit a company generates for every pound invested in its assets. A higher ROA suggests better asset utilization and therefore greater profitability.

Absolute figures are the raw numerical values presented in a financial statement. They represent the actual amounts of money involved. Relative figures are calculated by expressing absolute figures as a percentage or ratio. They are useful for comparing different companies or different periods for the same company.

Using only absolute figures can be misleading when comparing two companies because it doesn't account for differences in size or scale. Example:

If we only look at the absolute revenue figures, it might seem like Company B is significantly larger than Company A. However, without further analysis, we cannot determine which company is more successful. Company A might have a higher profit margin, making it more profitable despite having lower revenue. Relative figures, such as market share or profit margin, would provide a more accurate comparison.