Assignment Stage 2 – Restated Financial Statements



Assignment Stage 3 – Ratio Analysis & Capital Budgeting

ACCT11059

USING ACCOUNTING FOR D-MAKING

6 June 2016

Prepared by

Kym Chisholm

S0244760

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Step 1 – Ratios 4

1.1 The Holy Grail 4

1.1.1 Net Profit Margin (NPM) 5

1.1.2 Return on operating assets (ROA) 7

1.1.2 Return on operating assets (ROA) 7

1.2 Turning Over 9

1.3 Three dollars 11

1.4 In Debt We Trust 14

1.6 Other People’s Money 16

1.7 To Market, To Market 17

1.7.1 Earnings per share (EPS) 17

1.7.2 Dividends per share (DPS) 18

1.7.3 Price to earnings (PE) 18

1.8 Love, actually 19

1.8.1 Return on equity (ROE) 19

1.8.2 Return on net operating assets (RNOA) 20

1.8.3 Net borrowing costs (NBC) 21

1.8.4 Profit Margin (PM) 22

1.8.5 Asset Turnover (ATO) 23

1.9 Economic Profit 24

Step 2 – Capital Investment 27

Step 3 – Feedback 28

3.1 I provided feedback to: 28

3.2 I received feedback from: 28

3.3 Feedback reflectionsReferences 28

References 29

Step 1 – Ratios

1.1 The Holy Grail

"King Arthur: Go and tell your master that we have been charged by God with a sacred quest. If he will give us food and shelter for the night, he can join us in our quest for the Holy Grail.

French Soldier: Well, I’ll ask him, but I don’t think he will be very keen. Uh, he’s already got one, you see.

King Arthur: What?

Sir Galahad: He said they’ve already got one!

King Arthur: Are you sure he’s got one?

French Soldier: Oh yes, it’s very nice!”

- Monty Python

Monty Python spends 91 hilarious minutes telling the story of King Arthur and his search for the Holy Grail.  The Holy Grail is something that you want very much but that is very hard to get or achieve (Merriam-Webster, 2015).  Profitability is the holy grail that Clarius Group are searching for but in the last few years it has been very elusive.  Clarius Group haven’t had to deal with the Black Knight, Knights who say Ni or the Castle of Aaaaargh but their annual reports do tell a story of an inability to rise to challenges it has faced in the past few years.

Profitability ratios help evaluate the financial health of a business (Hofstrand, 2009) and after looking at Clarius Group’s net profit margin and return on assets, I would have to say they that it might be time to call the doctor.

1.1.1 Net Profit Margin (NPM)

NPM is supposed to show how well a firm can convert its revenue into profits.  It answers the question of how much profit can be extracted for every dollar earned by a firm.  Clarius Group’s NPM shows that for the last four years, they lost money on each sale:

Table 1 - Net profit margin trend

|2015 |2014 |2013 |2012 |

|-6.3% |-0.9% |-18.7% |-3.5% |

So what affects NPM?

• Net profit after tax (at a basic level revenue less expenses)

• Sales (after allowing for any returns and/or refunds)

Below is a summary of trends for sales, expenses, NPAT and NPM (where the benchmark is the 2012 figures).

Figure 1 - Trends of NPM drivers [pic]

2013 was a year of economic and political instability, leading to market uncertainty and a decrease in business confidence.  I address this in greater detail in The Perfect Storm blog post.  Harsher conditions triggered impairment of goodwill, which was a rather large once off expense.  However, a reduction in other operating costs plus a restructuring (leading to salary savings) meant expenses decreased from 2012 levels.

Pricing was affected, as there was reduced demand for recruitment services and pressure was placed on margins from existing major accounts as they also re-negotiated terms.  Clarius Group also walked away from a major client they provided with managed services and there was also a reduction in contractor margins which are Clarius Group’s main revenue source.  Unsurprisingly, all these factors contributed to a drop in sales compared to 2012.

Unfortunately, the drop in sales was much larger than the reduction they had managed in expenses. Clarius Group posted the worst NPM in 2013 and lost almost 19 cents for each $1 of sales.

NPM actually improved dramatically in 2014 (although still negative) but this isn’t because sales went up.  Sales dropped another 16.8% from 2013.  Clarius Group focused on reducing cost base and operational efficiency which had a major affect in reducing on hired labour costs.

In 2015, Clarius Group got a new CEO and went through a period of transformation.  I cover that a bit more closely in the Road to Perdition.  Clarius Group held on grimly to NPM by the tips of their fingers and ultimately steadied things, showing only a small NPM decrease in 2014.  Sales looked to have stabilised and reached a new level of “normal” but still dropped a minor amount.  Expenses blew out and caused another negative NPAT because of more one-off costs from restructuring and software impairment losses.  The bad and doubtful debts allowance was also considerably higher in 2015.  These factors provided the second worst NPM result. Clarius Group lost 6 cents for each $1 of sales it made.

Examining the NPM ratio leaves me with one question I am constantly asking. How long can Clarius maintain a business that has not seen a profit in four years? 

1.1.2 Return on operating assets (ROA)

We continue our Holy Grail hunt with another profitability ratio, this time, the ROA.

ROA shows how efficiently a firm manages its assets to produce a profit during a certain period of time.  We have previously seen that cash flow from operations can be used to invest in operating assets.  Investments in operating assets are generally the biggest investments a firm makes so ROA helps managers to see if the money the are pouring into the firm is making a difference by providing a return on asset investment.

Clarius Group have a negative ROA for each of the four years so it is not doing very well in converting its investment in assets into profits.  For 2015, Clarius Group lost 24 cents for every dollar of assets they held!

Table 2 - Return on operating assets trend

|2015 |2014 |2013 |2012 |

|-24.0% |-2.8% |-72.7% |-8.7% |

As we saw with NPM, 2013 and 2015 are the worse performing by a large order of magnitude.  We saw with NPM that while revenue has trended steadily downwards, expenses fluctuated greatly in 2013 and 2015 due to one-off costs.  These same issues are having an effect on ROA because it also uses the net profit after tax (NPAT) in its calculation.

The reason ROA is larger than NPM is because total assets are used as the denominator and these amounts are much smaller than the sales figures used in NPM.  As a denominator decreases the answer is divided by fewer parts so its size gets larger.

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Figure 2 - Trend of Total Assets

2014 was again a little ray of hope in a fairly bleak outlook because Clarius Group managed to stop the decline in assets.  It was also the year expenses reduced at a faster rate than revenue decreased, meaning a positive NPAT figure and a very small negative NPM (less than one cent was lost per dollar of sales).

2013 annual report states that goodwill impairment reflected the uncertainty and market turbulence that hit in that year.  This was due to two reasons:

• Clarius Group acquired two businesses during the peak of the market and it looks like the economic issues of 2013 triggered the need to revalue them

• Clarius Group needed to take into account the impact of brand consolidation that had taken place since they had acquired certain recruitment brands.  This sounds like a loss in reputation to me.

The goodwill impairment is shown in the balance sheet as a staggering 94% drop in intangible assets.  Trade and other receivables dropped almost 20% due to less sales and a 20% drop in deferred tax assets (DTAs) was because Clarius had to derecognise tax losses (check out my comments on Sue’s blog about DTAs and why de-recognition is necessary).

Cash made the difference in 2014 along with an increase in DTAs and intangible assets.  Don’t get too excited though! Cash from operating activities reduced further. It was more the fact that investing activities reduced in the form of purchasing less plant and equipment and spending less on software development.  Financing activities were eliminated all together which also helped.  Clarius Group also received a $1.2M tax refund and kept a tight control on receivables, meaning they pulled in as much cash as they could from accounts.

Intangible assets went up 21% due to capitalised software costs.  This is because Clarius completed a full implementation of new back end systems to help automate their processes and improve technology.

Things went a bit pear shaped in 2015 and every single asset decreased in value.  The main culprit in ratio changes was once again intangible assets.  This time, due to software impairment, meaning the revaluation almost completely wiped out what was left of intangible assets.  Restructuring costs also affected cash and the annual report stated that changing superannuation payments from quarterly to monthly also had an impact.

It looks like Clarius Group is struggling and that the new CEO and management team have actually made things worse since they started. I hope this is a case of just taking an initial hit to try and improve the situation for the future.

While looking at NPM and ROA, I have started to wonder if I should be removing the figures for impairment losses, restructuring losses and de-recognition of tax losses.  These items look like they are skewing the trends and maybe should not be included as they are not everyday operational items that occur every single year in the business.

1.2 Turning Over

"22 May 2016

Weight: 136 lb

Cigarettes: 42

Alcohol units: 50

You only get one life. I’ve just made a decision to change things a bit and spend what’s left of mine looking after me for a change.

Am enjoying a relationship with two men simultaneously, the first is called Ben, the other, Jerry"

- Bridget Jones’s Diary

The first thing that comes to mind when thinking about turnover is turning over a new leaf or making a fresh start.  Bridget Jones’s Diary is a quintessential movie about starting anew and has an entertaining love triangle as part of the plot.  I love complicated relationships, after all, isn’t that what ratios really are?

Unlike when Bridget Jones records her weight, cigarette and alcohol units – the total asset turnover ratio is generally better when the number is bigger.  Maria stated she would at least like to see a 1:1 occurring.  A bigger number is generally better because it measures how efficient a firm is at using its assets to produce sales.

Table 3 - Total asset turnover trend

|2015 |2014 |2013 |2012 |

|3.80 |3.03 |3.88 |2.53 |

The 2015 result shows that each dollar of assets generated $3.80 of sales.

The first thing that springs to mind when looking at the trend is 2013 and 2015 are now the best performing years instead of the worst!  Therefore, asset turnover must have an inverse relationship with NPM and ROA.

I would like to think the Clarius Group has finally performed outstandingly well in one ratio calculation but total asset turnover is quite dependent on the type of industry your company is in (Merritt, 2016).  A company like Clarius, that runs more on “brain power” (therefore having a small asset base) is expected to have higher ratios (Merritt, 2016).  This is because it makes the denominator smaller which means the answer is divided by fewer parts so its size gets larger (as addressed in the section on ROA).

The total asset turnover trend is a bit haphazard but the ratio has definitely improved all three years from 2012.  However, the ratio did not improve because of increased sales, in fact, sales dropped repeatedly each year and total assets declined two of the three years.  This does not inspire confidence at all!

There are many ways to improve total asset turnover (eFinance Management, n.d), including:

• Increasing sales

• Liquidating obsolete or unused assets

• Leasing assets instead of buying

• Improving asset usage and productivity (efficiency improvements)

• Better collection of accounts receivable

• Improve inventory management

Clarius Group has talked about improving technology to gain efficiency.  They are also extremely focused on collecting accounts receivable (only 2% was overdue by 90 days) and lease a lot of their premises.  I have no doubt the trend shows an improvement in operational efficiency but I still feel the company is in a bit of trouble if they cannot increase sales.

I did find it interesting that the total asset turnover ratio can sometimes be too high, which is just as bad as being too low.  Maria mentions she would be concerned this would not be sustainable and a sign of assets overworking or stretched to capacity.

One final point to note about total asset turnover ratio is how similar I found it to be to the ROA ratio.  When I started calculating asset turnover I thought, ‘hang on a minute, haven’t I just done this?’ However, the ROA measures how well a firm uses assets to generate profit whereas asset turnover measures how well a firm uses assets to generate sales.  Just like with RNOA, that Martin mentioned in chapter four, ‘it is the interaction of profit margins with efficiency that is critical’.

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1.3 Three dollars

Poor Eddie, he had a stable and happy life working as a public servant while living in his own home with his family.  He was able to pay his mortgage and other financial obligations each month and remained financially sound.  When the forces of economic and social change threaten this, Eddie realises just how fragile his reality and security is.  He loses his job and finds he has three dollars left in the bank.  How will he pay his debts?

Sounds a bit like the Clarius Group, although their situation is not so drastic yet.  Forces of economic change have shown their business reality and security may be a bit more fragile than they realised.  How do we know if they can pay off debts and remain financially sound?

The current ratio is used to keep track of liquidity and measures if the Clarius Group can pay off short term debts or other financial obligations lasting less than a year (current liabilities) with the current assets it has on hand.

Table 4 - Current ratio trend

|2015 |2014 |2013 |2012 |

|2.07 |2.27 |2.47 |2.12 |

These numbers tell us Clarius Group’s current assets are two and bit times larger than current liabilities.  If they needed to pay off all their debts within a year, they could manage this and still have current assets to spare.  Here, finally, is a ratio that the Clarius Group may be excelling at!  A firm is generally deemed to have good short term financial strength if the current ratio is 1.5 – 3 (, n.d).

The current ratio trend is different again to what I have seen while analysing the previous trends.  Now 2012 and 2015 are the worst years!  While the ratio stays higher than the benchmark (2012) for 2013 and 2014, it is starting to trend down.

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Figure 3 - Current ratio trend and drivers

In 2013, trade receivables decreased. We know this is due to a drop in sales as the economy worsened.  However, current tax receivables significantly increased because Clarius Group did not have to pay any tax and were due a tax refund.  This meant that while current assets dropped, they did so at a lower rate than might otherwise have been expected.

Current liabilities dropped in 2013 due to a large change in trade payables (a result of on hired labour costs reducing and not having the same number of contractors in paid work?).  There were no current tax liabilities (as mentioned above there is a tax refund due) and no interest bearing liabilities. The bank overdraft, however, sneakily went up and shows it was more heavily used in 2013 (a sign of not enough cash coming in?).

The interesting thing to note about the interest bearing liabilities is they came from a Receivables Purchases Facility set up by Clarius.  This means they sold trade receivable invoices to their finance providers at a discounted rate.  In 2013, they utilised only a non recourse agreement, meaning the finance provider bears the full loss if the customer does not pay.  If the facility was provided under recourse then Clarius Group would have had to pay some of their financing back.  Being able to get non-recourse funding is probably due to their good management of accounts receivable.

In 2014, current assets stayed relatively stable. While current tax receivables dropped, Clarius Group’s cash increased due to a large tax refund.  The bank overdraft was not utilised in 2014 (due to the big influx in cash?) but trade payables increased enough to slightly affect the current ratio.  I cannot see the reason why trade payables increased; however, I am not too concerned in the downward movement for 2014.

Trade receivables dropped again in 2015, which is starting to become a bit concerning because I would think the economic downturn has steadied but they are still struggling to make sales.  Cash dropped due to timing differences in superannuation payments and also major restructuring costs (feels like management in 2014 were on the right track so it starts to look like they prematurely fired and hired and maybe this was not a good use for their cash?).  This left current assets at their lowest level seen in four years.

Trade payables reduced in 2015 which meant current liabilities decreased overall.  However, the decrease was at a slower rate than the drop in current assets meaning the current ratio decreased again.  Clarius Group did not use their Receivables Purchase Facility in 2015 but they did dip into their bank overdraft as their overall cash flow became negative.  They also have a new current liability, in the form of finance leases, to help Clarius finance software licenses over the next three years.

It is great that Clarius Group has a healthy looking current ratio but I think this is out of necessity rather than good management.  With such low cash balances, Clarius Group would be hard pressed to pay back any significant ongoing interest payments.  I think Clarius Group’s management realise that if they don’t keep themselves lowly geared they could edge more quickly towards troubled waters.  With the way the recruitment industry is at the moment, management cannot afford to take on any more risk.

If Clarius Group continue to struggle with revenue and cash and cannot obtain any significant debt financing, while also making losses to the point where no one wants to buy any more shares issued (equity financing), how are they going to grow and develop?

1.4 In Debt We Trust

Unlike personal debt, debt in a business environment is not always a bad thing.  As I look at the debt to equity ratio, through management eyes, I need to constantly repeat this mantra to myself.  This is because my experience in life has always been focused on paying down and eliminating debt, like my credit card and car loan, as this kind of debt is not helpful in any way.

Debt financing is an inexpensive source of capital compared to equity, improves the return on equity and can produce tax savings (Way, 2016).  Therefore, having a very low debt to equity ratio is not always a good thing and neither is having it too high.  You want it just like Goldilocks wanted her porridge – not too hot, not too cold, “just right”.

Debt to equity ratio shows how much debt a firm is using for finance relative to the total value of shareholder’s equity.  So for every dollar a shareholder put in, Clarius Group received 92 cents from creditors in 2015 or another way to phrase it, would be, Clarius Group used debt financing equal to 92.2% of shareholder’s equity.

Table 5 - Debt to Equity Trend

|2015 |2014 |2013 |2012 |

|92.2% |66.9% |56.9% |37.4% |

100% or 1 would indicate that equity investors and creditors have equal stakes in Clarius Group’s assets.  Debt to equity ratio is an indicator of risk and a higher ratio normally shows a firm is more aggressive with debt (or potentially is a start up trying to grow rapidly).  This is confusing to me as I know that Clarius Group is focused on having a low amount of financial leverage.  The figure for 2015 seems to indicate they are taking on more risk and being aggressive, so I did some more research about this ratio, as I am not convinced Clarius Group are displaying these qualities.

It seems the debt to equity ratio can be calculated a number of ways and one of those ways are to exclude liabilities from the calculation that are non interest bearing (Gallo, 2015).  If we ignore trade payables (which the notes say are non interest bearing), tax obligations and provisions then we get an extremely different result which more aligns with what I know about the Clarius Group.

Table 6 - Debt to Equity excluding non-interest bearing liabilities

|2015 |2014 |2013 |2012 |

|3.5% |0.0% |2.0% |3.4% |

Either way, shareholders of the Clarius Group own more than it owes for all four years, which is a good sign.  The trend of this ratio fluctuates a bit which shows that their debt management is not consistent (sometimes they need the overdraft or to sell invoices and sometimes they don’t.  Clarius also started using finance leases in 2015 which previously was not seen).

Maria also looked at the trend in profit margin to relate it to the debt to equity ratio.  This is because, if you have to pay interest to external debt providers you would assume you will have less profit.  This assumption does not hold for 2014.  If we look at the debt to equity ratio of 66.9% (Table 1) this is an increase from 2013 but net profit margin also increased.  The explanation behind this is that while liabilities rose in 2014, none of them were interest bearing liabilities.

If you look at Table 2, you can see the discrepancy happens in the year 2013 instead.  Debt to equity improves to 2% but net profit margin gets worse anyway.  I think this is explained by the fact that equity drops almost 50% in size in 2013 and is the denominator in the ratio calculation.

For a firm like Clarius Group that has a volatile revenue stream (dependent on economic activity and cyclical business environment) or has a large portion of business tied up in just a few customers (40% of revenue from just two customers) it should have a low debt to equity ratio (Accounting-, 2013).  Otherwise it may find a sudden loss in revenue means it cannot support all its financial obligations.

If I look at the ratio calculated in Table 2, I would be happy to see low risk (although this probably also means less efficiency).  If I look at the ratio in Table 1, I think I would be fairly concerned as the trend shows increasing risk in the business (from an investor perspective, Clarius are definitely risky to put your money into).  However, at this stage, each yearly debt to equity ratio sits under 1:1 which is considered acceptable for most industries (Accounting for Management, 2015).

1.5 Other People’s Money

Money contributed by shareholders and creditors falls under the definition of other people’s money.  The acronym (OPM) actually sounds the same as opium, which is fitting, considering the drug like power that other people’s money can exert on people managing that money.

One way to measure how much of a company’s assets are funded through other people’s money is by calculating the equity ratio.  The equity ratio shows how much a firm’s total assets are owned outright/financed by equity investors, that is, after all liabilities are paid off how many remaining assets will they end up with.  The inverse of this calculation shows how much creditors finance the firm’s assets (1-Equity ratio).

Table 7 - Equity ratio trend

| |2015 |2014 |2013 |2012 |

|Equity |52.0% |59.9% |63.7% |72.8% |

Table 8 - (1 - Equity) Trend

| |2015 |2014 |2013 |2012 |

|Debt |48% |40.1% |36.3% |27.2% |

There is a definite downward trend and a larger and larger portion of assets is being funded externally rather than through shareholders.  This is not surprising considering total assets and total equity also show a clear downwards trend as well.

Clarius Group have less and less assets, mainly due to accounts receivable reducing over four years (not being able to make consistent sales) and intangible assets suffering impairment losses and needing their carrying values adjusted (due to economic environment and potential reputation damage?).  They also have less and less equity because their accumulated losses have steadily increased over the last four years as well.

A higher equity ratio is generally better as it shows a more sustainable and less risky firm.  It also intimates that a firm has more free cash on hand as it does not have to pay so much in interest costs.  Clarius Group is an established firm, so it is expected that equity should be higher than debt.  While this is currently the case, if we continue following the trend, their equity ratio will fall under 50% next year.  This is a cause for concern and backs up my initial thoughts on Clarius Group being a risky business.

1.6 To Market, To Market

To market, to market, to buy a fat pig,

Home again, home again, dancing a jig;

To market, to market, to buy a fat hog;

Home again, home again, jiggety-jog;

To market, to market, to buy a plum bun,

Home again, home again, market is done.

- Mother Goose Rhymes

Market ratios are used in valuing a firm’s stock (Reference for Business, 2016).  They help to show current market perception, regarding future profit potential, to both internal and external interested parties (Baskerville, 2016).  With this being the case I would have to say my perception of Clarius Group, from looking at the market ratios, would be something like a train wreck!

Table 9 - Earnings per share

|2015 |2014 |2013 |2012 |

|-$ 12.65 |-$ 1.87 |-$ 47.12 |-$ 10.56 |

1.6.1 Earnings per share (EPS)

EPS was negative all four years.  EPS shows the amount of money that is potentially available to distribute for each outstanding share (it is not the actual amount paid out).  However, in Clarius Group’s case it shows the amount of money lost per share.

EPS gives an indication of profitability, or lack thereof and can also be a measure of how management is performing (Ready Ratios, 2016).  A negative EPS decreases the value of Clarius Group and can be a factor in reducing the share price.

In some situations a negative EPS is not a huge drama – these include biotechs, startups and established companies incurring major one off expenses (Merritt, 2016).  Sadly, Clarius Group does not fall into those categories (still performing poorly and has had a couple of years of what were supposed to be one off larger expenses). There is a definite downward trend showing (despite the better 2014 result) indicating signs of trouble at Clarius Group.  Not surprisingly, as EPS uses the net profit after tax (NPAT) figure, it follows the same trend as net profit margin (NPM).

The EPS figures for 2015 and 2014 are exactly spot on to what is shown in Clarius Group’s annual reports.  This is because the amount of shares issued did not change in those years.  The slight discrepancy in 2012 and 2013, I attribute to the fact that I used the share balance as at end of financial year while Clarius Group would have used a weighted average of shares in their calculation.

1.6.2 Dividends per share (DPS)

DPS is quite similar to EPS with the only difference being that the DPS shows the actual profit amount paid out to each outstanding share.

Table 10 - Dividends per share

|2015 |2014 |2013 |2012 |

|$0 |$0 |$0 |$0.03 |

In 2012, Clarius Group paid out 3 cents to each outstanding share.  Considering that Clarius made a loss in 2012, this meant they would have had to use debt to distribute this payment to shareholders.  With Clarius Group’s lack of cash and profits and no retained earnings, they seem to have wised up and stopped issuing dividends.  With no plans to reinstate dividends, this shows a lack of confidence in being able to produce future profits.

1.6.3 Price to earnings (PE)

PE compares share price to EPS.  From an investor’s point of view it shows how long it will take to get paid back if they invest in a firm’s shares.  It also provides an indication on whether buying at the current share price is a good opportunity (Investopedia, 2016).  A manager tries to ensure the PE ratio looks as good as possible because it provides confidence in the company.

While I have calculated the PE ratio, I don’t think it particularly means anything because my EPS was negative which means my PE ratio is negative.  While a negative PE is mathematically possible, I imagine it is hard to compare and make sense of negative PE ratios and the financial community normally does not show them and instead marks them as not applicable (Investopedia, 2016).  What runs through my head when I see a negative PE ratio is the Lost in Space robot flashing his red light and saying, “Danger, Will Robinson, danger!”.

1.7 Love, actually

When I think of ratios, I think of relationships.  If a ratio had a Facebook profile I imagine it would put, “It’s complicated” in their status profile.  When I think of relationships, I think of the movie ‘Love, actually’.  It is a tale that revolves around eight different couples and shows their complicated and sometimes interrelated relationships.  I thought it was fitting to use this movie as my title for looking at the family of ratios based on restated financial statements.  Indeed, three of these ratios are interrelated with ratios previously discussed.

1.7.1 Return on equity (ROE)

The first couple’s relationship that we examine is comprehensive income and shareholder’s equity.  They make up ROE which is an important profitability indicator.  ROE shows how well a firm generates a return on the funds invested into the company from an owner and also show how well a firm uses its equity.  Clarius Group is doing neither of those things well as is clearly shown by a negative ROE for all four years.

Table 11 - Return on Equity trend

|2015 |2014 |2013 |2012 |

|-44.7% |-4.2% |-113.1% |-12.0% |

2013 and 2015 were years of large impairment losses and one-off costs but even in the years where it was “business as usual” it still did not generate a return for shareholders.  The ratio for 2015 shows Clarius Group lost almost half of total shareholder equity in that year.  I fear a divorce is on the horizon for this rocky relationship!

If I was an investor or a manager I would be fairly appalled at the trend of negative returns.  I cannot fathom how the new CEO could have sat down and looked at the possible projections, based on his decisions for the year, and still gone ahead with all the restructuring.  I am also confused as to what triggered the 2015 software impairment when it is never previously mentioned, in other annual reports, that their technology was aging.

Management look like they were starting to get back on track in 2014 and then the CEO seems to have pushed out or fired a lot of them (he was fairly derogatory in his assessment of the past CEO and executive).  He tries very hard in the 2015 annual report to sell this decision and talk about what a wonderful experienced team he now has, but I am not sure I am buying it.

1.7.2 Return on net operating assets (RNOA)

RNOA is a relative of the return on assets (ROA) ratio, which I previously discussed in the Holy Grail section.  The difference between them is that RNOA shows how well a firm is managing its operating assets to produce an income during a certain period of time.  I thought the ROA was trouble but his relation RNOA is even worse!

Table 12 - Comparison of ROA and RNOA trends

| |2015 |2014 |2013 |2012 |

|ROA |-24.0% |-2.8% |-72.7% |-8.7% |

|RNOA |-43.5% |-4% |-112.6% |-11.4% |

So what causes the negative amount to increase?  This is due to the denominator used, which is NOA.  The operating assets (OA) and liabilities (OL) are isolated from financial ones and then OL is taken away from OA.  This leaves a much smaller denominator which makes the result bigger as previously discussed.  The result would have been even worse except for the fact that the operating income is used, rather than the larger net profit after tax (NPAT) amount.  The RNOA really focuses on operating activities and magnifies Clarius Group’s losses even further because the financial activities have been taken out of the equation.

1.7.3 Net borrowing costs (NBC)

NBC shows Clarius Group’s cost of debt.  You can think of the NBC as the “interest rate” Clarius Group is paying on financing.  Maria mentions that this is a more true cost of debt then what they might show in the annual report.  This is because we are isolating just the financing activities and using them for the calculation.

Table 13 - Net borrowing costs trend

|2015 |2014 |2013 |2012 |

|32.4% |14.7% |– |6.7% |

There is no result for 2013 as Clarius had no net financial obligations that year and you cannot divide by zero.  However, the other years tell an interesting story, in that the cost of debt is trending upwards.  In personal finance, creditors generally raise the interest rate the more they see you as a credit risk.  Think of pawn shops and ‘payday loan’ businesses that charge outrageous rates compared to personal loans from a bank.  The same thing happens in a business setting and this supports my assumption that Clarius Group is becoming increasingly risky.

Forgive my relationship stories; they are a bit more depressing than those in the actual Love, actually movie!

1.7.4 Profit Margin (PM)

Profit margin is almost the twin to net profit margin and I did not expect to see much of a difference between these two ratios.  PM still shows how much profit can be extracted for every dollar earned by a firm but it just uses operating income instead of net profit after tax.  This allows us to focus on operating activities and ensure they are actually generating returns rather than them coming from financial activity.

Table 14 - NPM and PM trend comparison

| |2015 |2014 |2013 |2012 |

|Net Profit Margin |-6.3% |-0.9% |-18.7% |-3.5% |

|Profit Margin |-6.05% |-0.77% |-18.48% |-3.39% |

The reason I did not expect to see much difference was because Clarius Group did not have many financial activities and only one item from other comprehensive income that was deemed operational.  However, this other comprehensive income (from foreign currency translation differences) being added in was enough to make the operating loss smaller.  As the operating loss is the numerator in the ratio, this infers the result will be smaller (which is good as we are dealing with losses) while the denominator is sales which stays constant across both ratios.  The tax expense and exclusion of net financial expenses also made a slight difference in the operating loss figure.

You can find a more in depth discussion about what financial statement items affected these ratios in the Holy Grail section.

1.7.5 Asset Turnover (ATO)

Another set of twins are the total asset turnover ratio and the asset turnover ratio from the restated financial statements.  The only difference being that ATO shows how efficient a firm is at using net operating assets to produce sales rather than total assets.

Table 15 - Comparison of ATO and total asset turnover

| |2015 |2014 |2013 |2012 |

|Total Asset Turnover |3.80 |3.03 |3.88 |2.53 |

|Asset Turnover |7.19 |5.16 |6.09 |3.36 |

The results for the ATO are higher because net operating assets are a much smaller figure than total assets. As previously discussed, a smaller denominator leads to a larger ratio result.  The ATO shows that assets are being used even more efficiently because the turnover rate has increased.  As a manager you would have to be happy to see these ATO figures, although, I start to wonder if the 2013 and 2015 ATO are starting to stray into the “abnormal” zone.

The ATO also has an inverse relationship to the profit margin, just like the total asset turnover has with the net profit margin.  You can see a further discussion on this in the above Turning Over section.

1.8 Economic Profit

Economic profit introduces us to the concept of cost of capital.  I am pleased to say that my accounting "paint by numbers" has been filled in a bit more, while investigating cost of capital and the four drivers of economic profit.

Cost of capital is an opportunity cost and as Martin has explained, an opportunity cost reflects the benefits you could have received if you had pursued an alternative action rather than taking the path you went down.  In business, it is the rate of return the Clarius Group gives up, in order to use its assets and money to follow the path it has taken, rather than putting resources into a potential alternative investment (with a similar risk profile).

How is the cost of capital turned into a number we can use in an equation?  Well, there are two types of people interested in how a business is performing.  These are debt and equity investors who provided funds and are hoping to get a return on them.  So we work out the cost of debt and the cost of equity and combine them into a rate of return that will satisfy both investor types.  This return (earned from existing assets) then represents the minimum acceptable return that is needed for value creation.

So if cost of capital is the minimum acceptable return, we want to be able to compare that to the actual return on net operating assets (RNOA) received from the investments Clarius Group are pursuing.  This is where the economic profit calculation comes in.

Economic profit actually deducts opportunity costs (as well as normal costs seen in profit and loss) from revenue earned to show if a firm has truly created value through running its business.  Economic profit shows an amount that is left over to reward debt and equity investors for investing and supporting the firm.

Accounting profit only focuses on deducting normal money expenses from revenue.  While your firm might make an accounting profit (which then provides cash for dividends or to pay back creditors), if it still makes a negative economic profit then the firm still has not truly created any value because it could have done something different with its assets and made more money pursuing an alternative.

Economic profit is made up of RNOA, cost of capital and net operating assets (NOA).  Simple right? Not quite.  It's a bit like the movie Inception where we now have to step down into another level and then another (something, inside of something, inside of something).  RNOA is then made up of profit margin (PM) and asset turnover (ATO).  PM is then made up of operating income (OI) and sales while ATO is sales and NOA.  Because PM and ATO have an inverse relationship, the sales amounts are going to cancel each other out leaving us with OI and NOA.  Inception moment!

Table 16 - Drivers of economic profit and those affecting calculation

| |2015 |2014 |2013 |2012 |

|Economic Profit |-$14,343.99 |-$6,289.17 |-$46,844.38 |-$18,265.47 |

|RNOA |-43.5% |-4% |-112.6% |-11.4% |

|Cost of capital |14.09% |14.09% |14.09% |11.06% |

|PM |-6.05% |-0.77% |-18.48% |-3.39% |

|ATO |7.19 |5.16 |6.09 |3.36 |

|NOA |$24,902 |$34,782 |$36,980 |$81,459 |

With 2012 as our benchmark we can see that 2013 was a mess. I am not sure it is even a good thing that ATO increased because it is due to the denominator in the ratio (NOA) dropping just over 50%.  This shows that while ATO is a driver of economic profit, it is not a very strong one as ATO almost doubled but still lead to a rather large decrease of economic profit.  You might then make the assumption, in 2015, where ATO is at its highest, it should lead to another large decrease in economic profit.  However, the economic profit result is nowhere as bad as 2013 so you would have to surmise ATO is a weaker driver.

If ATO is a weaker driver then this would mean that PM must have more of an effect as it is the other half of RNOA.  PM dropped 15% which seems to be fully reflected in the increased economic loss.  This makes sense as both PM and economic profit are profitability measures.  A drop in PM corresponds with a worse economic loss and an increase in PM shows an improvement in the economic loss. Therefore, I would say PM is a primary driver in economic profit.  However, the scale of the drops and increases in PM do not fully explain the magnitude of the drop and improvements of the economic loss.  This is where RNOA comes into it.

RNOA follows the same trend as the economic loss. We can see when RNOA drops 101%, in 2013, that this is fully reflected in the 150% drop in economic loss.  The cost of capital is subtracted from RNOA so the higher the RNOA loss, the worse the result of the economic loss.  This shows that RNOA is also a primary driver of the economic profit ratio.  However, there is another factor that seems to be at play here because a combined decrease in PM and RNOA, in 2013, does not reflect the full 150% increase in the economic loss.

NOA is this final factor in the economic profit equation.  NOA decreases each and every of the four years but we do not see a corresponding continual increase of economic loss each year.  I believe this is because NOA is more of a multiplier that is used to reflect the total return for the number of assets your firm holds.  So it helps contribute to the economic loss but is not a primary force like PM and RNOA are.  In 2014, we see that while PM and RNOA increased dramatically, leading to an 87% improvement in economic loss, NOA still dropped. This did not stop economic loss from making an improvement but did reduce the overall improvement of the amount.

2015 is interesting because RNOA and PM are much worse than back in 2012, however, the economic loss was larger in 2012.  This was a year where sales steadied but Clarius Group still made a decision to spend more which blew out operating income.  NOA was also a much smaller figure in 2015 (compared to 2012) which supports it having a multiplier effect on economic loss.

Economic profit makes us look at the balance sheet as well as the income statement, which encourages managers to think about assets as well as expenses in their decisions (Investing Answers, 2016).  Economic profit can be improved when (Cashfocus, 2016):

• a firm invests in new capital that earns more than cost of capital

• a firm diverts or gets rid of capital being used in the business that do not cover the cost of capital

• a firm manages to improve RNOA without changing the capital being used

It looks like Clarius Group were trying to improve RNOA in 2014 by drastically reducing expenses and may have ended up with a positive result if revenue had not also dropped.  A new CEO has then come in 2015 and has decided to let Clarius take a hit while trying to change strategies.  I found a news announcement recently on the ASX stating that local New Zealand business operations will be closed and moved back to be run from Australia.  Maybe this is the start of diverting capital to try and improve their return.  They certainly need to try something because if they continue to make an economic loss, risk will increase, investors will go elsewhere and there would not seem much point in staying in business and flogging a dead horse!

Step 2 – Capital Investment Decision

One of Clarius Group’s goals is to recapture a leading position in traditional recruitment services. This will involve continuing expansion as Clarius Group strives to improve its market share. Clarius Group are experiencing positive growth in their New Zealand and China investments and are considering an opportunity to open a new recruitment office in Guiyang, China and/or Auckland, New Zealand. This will provide Clarius Group with the opportunity to generate more revenue in growing economic areas.

Guiyang is the economic and commercial hub of Guizhou province and is ranked in the top 10 for GDP growth and consumer spending. Its economy is forecast to grow 12% and its five year job growth is 47.18%. Guiyang is quickly becoming known as a ‘big data’ centre which is attracting cloud computing services and telecommunications along with building a new science park.

Clarius Group already has an office in Auckland but this New Zealand city is a standout for GDP and population growth. It also has a partner city relationship with Guangzhou which is a Chinese city that Clarius Group already has a presence in. Auckland attracts highly skilled workers in business and finance, ICT and health.

For new recruitment offices, Clarius Group initially negotiates a five year lease for office space and assesses performance at the end of this period. Therefore, we will use a project length of five years and assume Clarius will then make a decision on whether to renew a lease, move location or close down if the location is still unprofitable. At the end of the lease Clarius Group would incur costs to restore office space back to its original fitout.

Cash flows for Guiyang are expected to grow rapidly based on economic forecasted figures. However, it is a much narrower market as Clarius Group would be focusing solely on the IT sector along with the fact that permanent recruitment is far more popular in China, rather than contractor recruitment which provides a larger margin.

Cash flows in Auckland are expected to grow more slowly as Clarius Group establishes a second office. However, the Auckland office would focus more on lucrative contractor services and can attract a wider market of finance, IT and health recruitment.

All amounts are expressed in Australian dollars. The WACC is assumed to be 10%.

| |Guiyang office |Auckland Office |

|Original cost[1] |$1,065,000 |$2,450,000 |

|Estimated useful life[2] |5 years |5 years |

|Residual value[3] |-$21,286 |-$51,148 |

|Estimated future cash flows[4] | | |

|2017 |$880,000 |$1,200,000 |

|2018 |$986,000 |$1,240,000 |

|2019 |$1,100,000 |$1,300,000 |

|2020 |$1,230,000 |$1,300,000 |

|2021 |$1,380,000 |$1,300,000 |

Step 3 – Feedback

3.1 I provided feedback to:

3.2 I received feedback from:

3.3 Feedback reflections

References

Accounting for Management. (2015). Debt to equity ratio. Retrieved from

Accounting-. (2013). Debt-to-equity-ratio. Retrieved from

Baskerville, P. (2016). What are the key financial ratios to know when going through financial statements of any company? Quora. Retrieved from

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Cashfocus. (2016). Analyze financial results for economic profit. Retrieved from

Gallo, A. (2015, July 13), A refresher on debt-to-equity ratio, Harvard Business Review. Retrieved from

Hofstrand, D. (2009). Understanding Profitability, Iowa State University. Retrieved from

Investing Answers. (2016), Economic profit. Retrieved from

Investopedia. (2016). Can a stock have a negative price-to-earnings ratio? Retrieved from

Merritt, C. (2016a). What does the company’s asset turnover ratio mean? Chron. Retrieved from

Merritt, C. (2016b). What does a negative eps mean? The nest. Retrieved from

Ready Ratios. (2016). Earnings per share retrieved from Reference for Business. (2016). Financial ratios retrieved from

Reference for Business. (2016). Financial ratios retrieved from

Way, J. (2016). The advantages of using debt as capital structure. Retrieved from

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[1] Includes rent for the five year period, all outgoings including body corporate and rates, capital investments including fitout at start of lease, signage, etc. Auckland’s commercial rate of vacancy is quite low so office space is more in demand and more expensive. Guiyang is a tier 3 city at this stage and is not as expensive as counterparts in Beijing or Shanghai. A softening property market in China also means the investment is not as high as Auckland.

[2] Original lease term for both offices

[3] Clarius Group will need to spend money removing signage and restoring office space to original condition

[4] Sales are spread over six offices in China but only four offices in NZ. I am assuming the Auckland office will have a slower start as it needs to establish itself as a second office. Sales are forecast based on 3.5% economic growth rate for Auckland and 8% economic growth rate for Guiyang, with Auckland’s sales leveling out as market saturation is reached.

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