Page 16 - CIMA SCS Workbook February 2019 - Day 1 Suggested Solutions

CIMA FEBRUARY 2019 – STRATEGIC CASE STUDY

Asset turnover and operating profit margin

Breaking down the ROCE into asset turnover and operating profit margin often helps to identify
where the main problem lies.

The amount of revenue generated from the capital employed (asset turnover) has actually
increased slightly (from 6.6 times to 6.8 times).

The main problem is that the operating profit margin is very small and has fallen significantly.
However, the gross profit margin has actually risen in 2018 - partly because the average selling
price per unit sold has increased. The main reason for the dramatic fall in ROCE and operating
profit margin is actually that “other operating expenses” are much higher in 2018 than in 2017.

We are told in the notes to the accounts that research and development (R&D) expenses
increased by N$ 354 million in 2018, due to a planned increase in R&D headcount etc. Overall,
“other operating expenses” rose by N$ 455 million year on year, so the planned increase in R&D
makes up the vast majority of this increase. Indeed, if we remove the planned N$ 354 million
increase in R&D costs from “other operating expenses” the adjusted ratios would show the
following:

N$ 000 2018 2017
ADJUSTED Return (ADJUSTED operating (54,259 + 68.8% (153,550 / 28.1%
on Capital profit / Capital 354,000 / 547,047)
Employed (ROCE) Employed) x 100% 593,542) x100% x100%
ADJUSTED (ADJUSTED operating (54,259 + 10.2% (153,550 / 4.3%
operating profit profit / Revenue) x 354,000 / 3,588,843)
(%) 100% 4,006,768) x100%
x100%

This gives a very different (and much more positive!) impression of Vita’s performance.

In this high-technology, fast-moving industry it is to be expected that companies will spend huge
amounts on R&D, but Vita’s policy of expensing all its R&D costs (rather than capitalising some if it
can be shown that a future economic benefit will follow) means that the company’s profit appears
to be volatile even when the underlying operating performance is not. This could create problems
for Vita since it is a listed company and therefore its share price will be impacted whenever new
information is released to the market. If the new information being released gives an impression
that the company’s performance is volatile, this could cause the share price to fluctuate
considerably.

This last point links into the calculation of Return On Equity (ROE) too. ROE has fallen dramatically
year on year, so it may be that the shareholders will be alarmed by the information shown in the
financial statements of Vita, even though the underlying operating performance has arguably
improved.

56 KAPLAN PUBLISHING