Question

Zara and Ackerman’s compete in the market for apparel for the fashion-conscious professional woman. Zara targets the ‘better price’ and the ‘upper moderate price’ categories whereas Ackermans has a broader target audience. Financial data for the two companies is presented below in columns labelled company 1 and company 2 (Note: the amounts are in R’million for one column and R10 millions for the other.)

	Company 1	Company 2
Sales	R1,084	R 977
COG Gross profit margin	(536)	(644)
	R 548	R 333
Operating expenses Operating Profit	(414)	(241)
	R 134	R 92

Total Assets Company 1: R 765, Company 2: R 413

Total Equity Company 1: R 550, Company 2: R 220

Total Liabilities Company 1: R 215, Company 2: R 193

Annexure A at the end of this paper contains formulas for the ratios

REQUIRED

(a)	Prepare common size financial statements for company 1 and company 2.
		(b)	Calculate ROE for each company, and disaggregate ROE and comment.
(c)	Using information from part (a) and part (b) above, identify which company is Zara and which is Ackermans. Justify the choice.
(d)	Explain how financial data computed in part (a) and (b) above reflect company’s competitive edge.

Answer 1

(a) Common Size Financial Statements:

A common size financial statement displays line items as a percentage of one selected or common figure. Creating common size financial statements makes it easier to analyze a company over time and compare it with its peers. Using common size financial statements helps investors spot trends that a raw financial statement may not uncover.

Following are the common size financial statements of Company A and Company B:

Company A
Common Size Income Statement
Particulars	Income Statement	Common Size Income Statement
Sales Revenue	1084	100
Cost of Goods Sold	536	49
Gross Profit	548	51
Operating Expenses	414	38
Operating Profit	134	12
Common Size Balance Sheet
Particulars	Amount	Percent
Assets	765	100
Total Assets	765	100
Equity	550	72
Liabilities	215	28
Total Equity and Liability	765	100

Company B
Common Size Income Statement
Particulars	Income Statement	Common Size Income Statement
Sales Revenue	977	100
Cost of Goods Sold	644	66
Gross Profit	333	34
Operating Expenses	241	25
Operating Profit	92	9
Common Size Balance Sheet
Particulars	Amount	Percent
Assets	413	100
Total Assets	413	100
Equity	220	53
Liabilities	193	47
Total Equity and Liability	413	100

(b) ROE of the company:

ROE is a measure of the profitability of the firm. The ROE is the net income from the firms most recent income statement, divided by the total equity at the end of the period. The income statement is measured over a period of time (e.g. one year), whereas equity is measured at a single point in time.

Formula for ROE: ROE = 100% * (net income / total equity)
where total equity = total assets - total liabilities

Thus, ROE of Company A = 100* (134/550) = 24.36%

ROE of Company B = 100* (92/220) = 41.81%

Disaggregation of ROE:

The basic premise of the model implies that management has two options to increase its ROE and thus increase value to its shareholders:

• Increase the company's equity turnover and use equity more efficiently
• Become more profitable and subsequently increase the company's net profit margin

Let us break the ROE into three parts:

ROE​= Net Income/Common Equity

Split as ---> Net Income/Sales​ X Sales/Total Assets X Total Assets/Common Equity​​
This reveals that ROE equals net profit margin times the equity turnover.

Thus Disaggregated ROE of Company A =

Net Income/Sales = 134/1084 = 0.123616236

sales/total assets = 1084/765 = 1.416993464

Assets/ Equity = 765/550 = 1.390909091

Disaggregated ROE of Company B =

Net Income/Sales = 92/977= 0.094165814

sales/total assets = 977/413 = 2.365617433

Assets/ Equity = 413/220 = 1.877272727

Comment:

Company A's net profit margin is higher than that of Company B's: Companies strive for higher profit margin ratios which means that their profits will exceed their expenses. They accomplish these higher ratios by either lowering expenses or increasing revenues. Though generating more revenue would be a preferred solution, it is often more difficult than reducing spending budgets. Therefore, most companies cut expenses in order to improve their profitability.

Company B has better usage of Total assets when compared to Company A: A measure of a company's efficiency in managing its assets in relation to the revenue generated. The higher this ratio, the smaller the investment required to generate sales revenue and, therefore, the higher the profitability of the company.

Company B has higher Asset/Equity Ratio: A relatively high ratio (indicating lots of assets and very little equity) may indicate the company has taken on substantial debt merely to remain its business but a high asset/equity ratio can also mean the return on borrowed capital exceeds the cost of that capital.

c) Company A is Zara whereas Company B is Ackermans. As Zara is all about better pricing, it has wider customer base plus no target audience. Thus, that results in higher turnover. As Ackermans has target audience, the opposite holds good.

d) ZARA has more Competitive Edge:

Zara, along with generating more profit also has higher equity when compared to the assets. That means it comparitively has lower debt than ACKERMANS.