Question

Discuss the possible causes and effects of changes in the ratios that have been calculated below:

UNITED UTILITIES GROUP PLC (UU.)
Profitability Ratio Calculation	2015-03	2016-03	2017-03
Profit before Tax and Interest	639	557	582
Equity	2434	2706	2822
Long term borrowing	6067	6509	7058
Return on Capital employed	7.52%	6.04%	5.89%
Profit after Tax	271	398	434
Equity	2434	2706	2822
Return on Equity	11.13%	14.71%	15.38%
Operating Profit before Interest and Taxes	639	557	582
Revenue	1720	1730	1704
Net operating Profit Margin	37.15%	32.20%	34.15%
Gross Profit	1720	1730	1704
Revenue	1720	1730	1704
Net Gross Profit Margin	100%	100%	100%

Liquidity Ratio Calculation	2015-03	2016-03	2017-03
Current Assets	639	626	658
Current Liabilities	1002	844	690
Current Ratio	0.64	0.74	0.95
Inventories	40	29	22
Current Assets - Inventories	599	597	636
Current Liabilities	1002	844	690
Quick Ratio	0.6	0.71	0.92

Answer 1

For each ration we will first explain what the ratio means in crisp sense and then discuss the cause and effect for the changes.

1. Return on Capital Employed (ROCE) = (Profit Before Tax and Interest) / (Equity + Long Term Borrowing)
A company can deploy only majorly two types of capital i.e. Equity & Debt. Profit Before Taxed and Interest (PBIT/EBIT) defines a figure for checking a company's efficiency. The ratio simply means the returns that the company has produced after having deployed its total capital.
There has been a decrease in ROCE. The company has taken more debt (6067 to 7058) and equity (2434 to 2822). However the company would not have rationalized on the costs related to goods sold, . The sales of the company would have been impacted. Thus the company has not been able to use the capital raised and deployed judiciously to improve its ROCE.

2. Return on Equity = Profit After Tax / Equity
This is basically an equity holder return measure. Net Profit is something that an Equity holder waits for as it shows the return one gets on his sharehoding.
The company has been able to capitalise on interest paid and thus even though EBIT is decreasing, the company has shown increasing Net Profit. The rate of growth of Net Profit is more than rate of growth of Equity. This has helped in increase in Return on Equity. The shareholders would definitely have been happier.

3. Net Operating Profit Margin = Operating Profit Before Interest and Taxes / Revenue

Sales - COGS - SG&A Expenses = EBITDA (Operating Profit Before Interest and Taxes)

This ratio helps us determine the operating profitability of the company before we subtract all the depreciation and other items. This ratio also helps us determine the level of Cost of Goods Sold, Selling General and Administration expenses and their impact.
As is visible there is a decrease in Operating Profit before Interest and Taxes. All this while the revenue has decreased a bit but has more or less been in the stagnant reason. Thus the reason for Operating Profit to decrease might be because of increase in Cost of goods sold i.e. raw material cost, Selling General and Administrative Expenses. From 2015 to 2016 there has been a major drop. However the company has recovered from 2016 to 2017.

4. Net Gross Profit Margin = Gross Profit/ Revenue
Sales - COGS = Gross Profit

Thus this ratio helps us tell what is the level of COGS i.e. raw material cost/ cost of goods sold. Thus we can see that since Gross Profit and Revenue is the same therefore COGS = 0

5. Current Ratio = Current Assets/ Current Liabilities
This ratio gives us the explanation about the readiness/ ability of the company to service its immediate debt i.e. short term debt ( payable within 1 year). The company can repay such a short term debt/liability by selling current assets i.e. Cash, Inventory etc.
Thus there has been an increase in the Current Ratio which is favourable for the company. It reinforces the fact that the company is now more ready in the event it would have to service its short term debt if any.
There has been a decrease in Current Liabilities consistently from 2015 to 2017. Current Assets have slightly decreased from 2015 to 2016 and then slighly increased from 2016 to 2017.

6. Quick Ratio = (Current Assets - Inventory) / Current Liabilities
This ratio is basically a stricter version of Current Ratio. It neglects inventories in its calculation. Cash/ Marketable Securities/ Account Receivables is something which can be liquidated within a shorter time and faster. Inventory liquidation depends on the current market condition and also demand.
Thus there has been an increase in the Quick Ratio which is highly favourable for the company. It reinforces more the fact that the company is now highly ready in the event it would have to service its short term debt if any. It has all the ammunition to repay off its short term liabilities in a smoother fashion.
Decrease in inventory is one of the major reasons for this ratio to increase. Also current liabilities have declined making the ratio stronger.