Fundamental of corporate finances

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Corporations use financial ratios to measure elements of the company’s operating efficiency. Some components considered include performance, profitability and solvency (Sarngadharan & Kumar, 2011). The article will use three measures, namely return on asset ratio, profit margin and asset turnover ratios, to evaluate whether Denver Corp can retain its current products or consider introducing a new product line targeting a wide range of consumers. The first section will include tabulated computations, while the second portion will include a description of the computations. More than that, the paper aims to examine the consequences of the use of these ratios in the management decision. Return on Assets
Return on Assets = Net income/ Total Assets
(In thousands)
Current Results
Proposed Results without Cannibalization

Proposed Results with Cannibalization

Net Income

$12,000

$13,000

$12,000

Average total assets

$100,000

$100,000

$100,000

Return on Assets

0.12 or 30 %

0.13 or 13 %

0.12 or 12 %

Profit Margin = Net Income / Net Sales

(In thousands)

Current Results

Proposed Results without Cannibalization

Proposed Results with Cannibalization

Net Income

$12,000

$13,000

$12,000

Sales Revenue

$45,000

$60,000

$50,000

Profit Margin

0.27 or 27 %

0.22 or 22 %

0.24 or 24 %

Asset Turnover = Revenue/Total Assets

(In thousands)

Current Results

Proposed Results without Cannibalization

Proposed Results with Cannibalization

Sales Revenue

$45,000

$60,000

$50,000

Average total assets

$100,000

$100,000

$100,000

Asset Turnover

0.45 or 45 %

0.6 or 60 %

0.5 or 50 %

Implications on Denver’s Decision

Based on the three ratios above, it is evident that the management should consider a proper mix of the new product and existing product line. This rationale is explained in the following paragraphs:

First, relying on results from return on assets, it is clear that the management will consider maintaining the current line of products. Denver’s management would therefore chose to maintain the existing line of products and do away with the proposed new line of product. To begin with, using the return on assets methodology, the current results reflect a ratio of 0.12. In contrast, the proposed results without cannibalization turns out to be 0.13. Upon introduction of the new product (also known as cannibalization), the return on assets ratio remains at 0.12; despite increase in productivity as well as introduction of a new line. In explaining the implications of the above results, it is essential to understand return on assets and how it may impact on the company’s financial statement. Return on assets is a pure measure of efficiency of a company’s assets in generating earnings. An ROA of 0.12 or 12 percent means that the company produces $ 1 for every $ 8 it has invested in its assets. Therefore it gives a quick indication on whether the company will make profits with each increased in a dollar.

It is clear that the efficiency of the assets will decrease upon cannibalization. The impact on Denver’s decision may vary depending on the management’s psychology or strategic objectives of the company. Maintaining the current product line will not only increase the return on assets but also improve on quality and lower the costs. Identification and developing a good relationship with existing clients will be enhanced through offering high quality products at the existing prices. This will in turn promote loyalty as well lower the chances of excessive obsolete goods (Sarngadharan & Kumar, 2011). More so, it is evident from the data, the revenues will increase when the current production rates are maintained. More so, the same amounts of assets will be utilized for production purposes. Inventory is also an asset and therefore, the less inventory that the company has sitting around unsold, the lower the total assets, which in turn increases the Return on assets (Sarngadharan & Kumar, 2011). Effective inventory control would be reducing the need for fixed assets which also increase the return on assets.

However, based on the profit margin, the company could chose to explore the cannibalization decision. From the results, it is evident that there is high profitability and therefore the profit margin would be higher. The profit margin directly measures the percentage of profits produced as a result of certain amounts of sales. The current results show a profit margin of 27 percent. The predicted results puts the profit margin at 22 percent. While upon cannibalization, the company’s profit margin will be 24 percent. For that reason, it is logical for the company to consider bringing a new product into the mix. The rationale for introducing a new product would be attribute to a number of reasons. For instance, Denver’s production manager has mentioned that the company’s production components are not operating on full capacity (Sarngadharan & Kumar, 2011). Therefore, considering cannibalization would not increase profitability but also ensure maximum utilization of production capacity. This will act as a cost reduction initiative as well as effective service to extensive segments of the customers.

Based on the calculated results on asset turnover, it would be wise for Denver Corp to maintain the current line of production. The current results show an asset turnover ratio of 45 percent, while the propose results depict a turnover ratio of 60 percent. Upon cannibalization, the asset turnover margin drops to 50 percent. Based on the numbers, maintaining the existing customers and existing products would be a wise move. The rationale for this decision is that a declining return on assets ratio would mean that’s the company would be over-investing its assets, which should not be the case (Sarngadharan & Kumar, 2011). Also, it might mean that that the firm has too much added capacity in terms of fixed assets. It is seen from the product manager’s view that Denver Corp has excess operating capacity. In fact, to further improve this ratio, the management would consider selling some of the under-utilized assets or divesting such resources.

Other Option

Outsourcing Production

To improve on quality and minimize costs, the company could consider maintaining the two products by outsourcing some of the less efficient production functions. Usually, change in demand and production means that the company’s production capacity would be operating at full capacity but other functions would be strained (Bellgran & Säfsten, 2010). For that reason, the organization may require additional resources, making outsourcing the most reliable initiative. For instances, this approach minimizes labor costs because real savings can be achieved. There would little need for more employees upon expansion of the company. More so, outsourcing fuels innovation because there will be quick prototyping without reallocation of internal resources (Bellgran & Säfsten, 2010). Thirdly, inefficient production processes will be done away with. Other than the mentioned production and financial benefits, outsourcing will ensure strategic optimization especially when the management would like to improve its mission and strategy for operations. Among other benefits of this option includes employment of up to date technology, enhancement of market discipline, flexibility and better management of the outsourced productivity functions.

Outsourcing will reduces the cost of production which in turn increases profitability. As such, the profit margin will increase substantially. Similarly, this option will increase sales revenue and lower the assets available for production purposes. For that reason the asset turnover ratio will increase, which bears well with the firm’s management (Sarngadharan & Kumar, 2011). Its impact on return on assets ratio will be the same as the other two. The two components of return on assets ratio are net income and average total assets. Outsourcing lower expenses in the income statement which automatically increases income. Similarly, the company will have to do away with certain property, plant and equipment, which therefore lowers the average total assets. Ultimately, the ratio will increase, which will be a good reflection of management’s performance.

Conclusion

To conclude, the paper analyses the three ratios: asset turnover, return on assets and profit margin. The ratios are applied in coming up with a variety of solutions to Denver Corp’s management on whether to incorporate a new and cheaper product to the market. The paper concludes that a proper mix of new product and existing one would suit both the production and marketing departments, as well as the management. The last option considered would be outsourcing some of the production functions.

References

Bellgran, M., & Säfsten, K. (2010). Production development: Design and operation of production systems. London: Springer.

Sarngadharan, M., & Kumar, R. S. (2011). Financial analysis for management decisions.

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