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ACCT11059 Accounting, Learning & Online Communication ASS#2

Stuart HentschkeAssignment 2 – Step 7, 8, 9 & 10

Step 7 - Contribution margins

Incitec Pivot (IPL) have two distinct business operations: - Incitec Pivot Fertilisers: Australia’s largest supplier and manufacturer of fertilisers.- Dyno Nobel: A global leader in the commercial explosives industry.

Four of their products contribution margins are shown in the table below.

IPL subsidiary

Product Images Product Selling Price per Unit

Estimated Variable Costs per

unit

Contribution Margin per

unit

Contribution Margin Ratio (Contribution

Margin / Selling Price)

Incitec Pivot Fertilisers

Granulock Z: A granular fertilizer for broadacre wheat and barley (per tonne)

$700 $588 $112 16%

Incitec Pivot Fertilisers

Easy N: Concentrated liquid nitrogen fertiliser (per litre)

$1.15 $1.07 $0.08 7%

Dyno Nobel

Dyno42: Anti vibration control blasting software (per copy)

$1000 $250 $750 75%

Dyno Nobel

Dynobulk: Providing explosive formulations titan blend (per tonne)

$3500 $2765 $735 21%

I found some historical prices on the Internet for Incitec Pivot Fertilisers products, the prices of the other products have been estimated along with the variable costs to calculate the contribution margin. The contribution margin can be calculated by subtracting the variable costs per unit from the selling price per unit, and it represents the amount each unit can contribute towards the fixed costs of the business. The contribution margin per unit should be a positive number as a negative contribution margin takes more from the business than they return in sales and this should be avoided. It is important to understand the contribution margins for each product as the amount that they are greater than the fixed costs (associated with the production of the unit) will add to your overall profit. If the contribution margin for a product is equal to the fixed costs for a product, the company will break even on sales of that product and won’t make any profit from its sales.

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The different products offer very different contribution margins for example Dyno42 offers $750 per copy versus Easy N at just $0.08 per litre. The occurs because each product has different variable costs associated with its production and the selling prices of each item differ due to competition, market demand and the availability of substitute products. It is common for higher turnover items and those that can be supplied in larger quantities (such as Easy N) to have a lower contribution margin than those that sell infrequently and in limited amounts (such as Dyno42). This is because businesses are willing to accept a lower contribution margin and turnover the items quicker to generate profits. Dyno42 has a contribution margin ratio of 75% (the closer to 100% the better) because once the software has been created it doesn’t have very high variable costs associated with its setup. Products such as Granulock Z and Dynobulk have contribution margins ratios of 16% and 21% delivering $112 and $735 per tonne of product sold. If the variable costs can be reduced or the selling price increased, these products will benefit from increased contribution margins.

It is important to produce a range of different products to help diversify the business, appeal to customers, generate stable returns and prevent specific product risk. IPL have done this by offering a range of different products through two separate business entities. Multiple products allow the company to appeal to more customers by offering them greater choice and may eliminate the need for their customers to shop elsewhere. Generally, returns will be more stable over the long term as when sales decline in one product they might increase in another product, offsetting part of the loss. If the company only offered one product with the highest contribution margin they are unlikely to appeal to a broad range of customers, returns would be more irregular due to changes in volume of sales for that single product and the company would be more susceptible to competition.

Given that IPL operate their mines are in remote parts of Australia a resource constraint might include the availability of labour. Attracting and retaining employees becomes more difficult as there are less people in the area and it may influence total production. To overcome this potential constraint IPL might hold larger inventories prior to the anticipated increase in sales to offset the reduced output due to staff shortages. Another resource constraint IPL may face would be the shortage of equipment. For example, a shortage of explosive trucks or shortage of fertiliser producing equipment such as conveyer belts and loading equipment. When services are in high demand all available resources might be allocated (all trucks booked out) and all fertiliser production equipment operating 24/7, resulting in production that can’t satisfy the demand. The ideal situation is that all equipment is running at capacity and the company can generate enough products to satisfy the customer’s needs. IPL may decide to increase purchases of equipment relating to products with the higher contribution margins such as Dynobulk to generate more sales and make more profits in this situation.

Market constraints would also affect IPL as mining can be a cyclical business and the levels of fertiliser farmers purchase can vary depending on seasonal conditions. IPL would have faced a reduction in sales of their Dynobulk and Dyno42 because of the Global Financial Crisis and the end of the mining boom. Dyno42 production wouldn’t be impacted as the software has been

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created but sales would be reduced as less mining activities translate to less demand for their products. During this time the company must maintain their fixed costs even if they aren’t generating any money from sales. IPL would also face a lower demand for Easy N when seasonal conditions are unfavourable as lower rainfall translate to lower crop growth, lower yield potential and a lower demand for Easy N fertilisers. Market constraints such as a long-term drought would lower the overall demand for fertiliser as farmers cut back on their input costs and rely on the previous year’s inputs. Therefore, during these times IPL should reduce the amount of production of fertiliser to avoid holding inventories for long periods of time.

Step 8 – Ratio Analysis

I found that IPL had a different total number of shares in the 2015 report compared to the 2016 report. I found it interesting that they would be out by three shares.

2015 Report: 2016 Report:

IPL had only listed the company’s share price as a range, high, low, year-end and financial year end, this was consistent throughout their reports. I used the ASX to obtain the closing share price for IPL on 30th September each year to match the date the number of shares was recorded.

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I searched for the weighted average cost of capital and while it was referenced in the annual report it wasn’t specifically stated

I also noticed that they have mentioned a rate of 8.5% and 9%, I’m unsure if this is their calculation of weighted average cost of capital so I will use 10% as stated in the study guide.

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Profitability Ratios

Net Profit MarginI choose to link to revenue only (not including the financial and other income) as the footnote shows Revenue = External Sales.

2018 2017 2016 20150.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

Profitability Ratios

Net Profit Margin Return on Assets

The net profit margin is shown as a percentage and it means that for every dollar of sales IPL made between 2.7 cents and 10.4 cents profit over the 2015 to 2018 period. No real trend can be determined from the graph, but it appears in 2016 something pulled the value down to 2.7%. A closer look at the figures reveals revenue has been very similar over the four years but total comprehensive income in 2016 was significantly lower, leading to the lower result. The 2016 annual report states that it has been a difficult year and the fertiliser business suffered from the impact of lower global commodity prices and their explosive business suffered from a cyclical oversupply.

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Return on assetsThe return on assets follows a similar pattern as the net profit margin due to the poor net profit after tax in 2016. It is calculated by net profit after tax divided by total assets. The return on assets gives a percentage showing how efficient a company can manage its assets to produce a profit, the higher the better. Some further research mentioned that this ratio is best used to compare companies in similar industries as some are more asset intensive. I thought that the overall figure was quite low but reading further suggests that anything over 5% is considered adequate. IPL’s average over the four years was 3.2%, if 2016 was omitted the return was 4%.

Efficiency (or Asset Management) Ratios

Days of inventoryI understand the days of inventory to be how long it takes to sell all the company’s remaining inventory if they stopped producing today. The lower the number the better up until a certain point as you don’t want inventory to run out, else your customers might buy from your competitors. The number was negative as the “Raw materials and consumables used and finished goods purchased for resale” each year was a negative number (as expected because it was an operating expense), I have converted the ratios to become a positive number. The days of inventory for IPL appear to be very consistent over the four years ranging from 92.24 to a high of 99.82 with no real trend.

Total asset turnover ratioThe total asset turnover ratio is a measure of how much is the company turning into sales from every dollar in the business’s assets. The higher the number the better and to improve this number the company could do so by increasing their revenue (sales) or reducing their total assets or a combination of both. Again, IPL’s ratios appear to be consistent with no real trend throughout the four years.

Liquidity Ratio

Current ratioThis ratio is a measure of the company’s ability to pay short term debt obligations. For example, for every dollar of current liabilities the company has, do they have a dollar of current assets to pay for them? Ideally the ratio will be around one or slightly more. A high current ratio relative to the sector might indicate that the company isn’t using their assets efficiently, maybe they have a lot of cash that isn’t being used. In 2015 IPL had a low current ratio of 0.71 due to an increase in “interest bearing liabilities.” As the current ratio was less than one it indicates that if all the company’s short-term debt were due at the same time the company wouldn’t have

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enough money to pay them. As the ratio is calculated at a single point in time it does have limitations, as money owed to the company may be due soon and improve the result.

Financial Structure Ratios

Debt/equity ratioThe debt to equity ratio is a ratio that shows the level of debt relative to the percentage of the company that is funded by debt. IPL have between 85 and 96 cents of debt for every dollar that an equity owner is providing for the business. If a company has a high debt/equity ratio they are considered to have a higher level of risk when compared to a company with a lower debt/equity ratio.

Equity RatioThe equity ratio is the percentage of the business that is funded by equity. For IPL it has remained relatively consistent over the four years with 53% funded by equity and 47% funded by debt in 2018.

Market Ratios

Earnings per shareEarnings per share (EPS) ratio shows how much net profit was earnt per share on issue. IPL has had relatively constant earnings per year (apart from the 2016 year due to lower total comprehensive income for the year). When I compared my EPS of $0.22 to IPL’s annual report in 2018 it was quite different at 12.5 cents per share,

looking to the footnotes

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revealed that they had calculated their basic earnings per share (including individually material items), when compared to basic earnings per share (excluding individually material items) the numbers where a lot closer (20.9 cents with my 22 cents). The slight discrepancies possibly being due to the weighted average number of shares being slightly different.

Dividends per shareThe dividends per share is the total amount that is paid out to shareholders for each share they hold during the financial year. Dividends are usually paid twice a year. In 2016 IPL paid out 11 cents in dividends per share and only earnt 5 cents per share. They might have done this to be keep a consistent trend of dividends of approximately 10 cents per share to avoid disappointing their shareholders who might have considered selling their shares due to reduced profits and reduced dividends.

Price Earnings ratioThe price to earnings ratio gives a quick overview of the company, displaying how many years it would take of current earnings to cover the current share price. Different investors have different ideas on how to best use this ratio, some believe a high price earnings ratio can be a good thing as the market might be pricing in the anticipation of future profits. It appears that in 2016 IPL had a very high price earnings ratio of 53.40, this wasn’t due to expectation of future profits, this was due to low earnings.

Ratios Based on Reformulated Financial Statements

Return on equityThe return on equity shows that for every dollar of shareholders equity IPL have turned between 7 and 8.1 cents into net profit (ignoring 2016 at 1.95 cents) and there appears to be no trend.

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Return on Net Operating Assets (RNOA)

2018 2017 2016 20150.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Return on Assets vs Restated RNOA

Return on Assets Return on Net Operating Assets (RNOA)

As the return on net operating assets (RNOA) has been calculated from only the operating income divided by the net operating assets, I assumed that it would be a larger return. This is because the cost of net financial expenses has been ignored (making the numerator larger) and it only includes the net operating assets (making the denominator smaller) rather than total assets. RNOA gives a better picture of the operating side of the business. The trend of RNOA seems to follow the return on assets quite closely, just a few percent higher.

Net Borrowing CostShows the cost of the company’s debt. IPL’s net financial obligations didn’t change very much over the last four years. The results were affected by fluctuations amounts of net financial expenses (which were mainly affect by changes in cash flow hedges). The results were up and down with 2015 4.5%, 2016 1.6%, 2017 4.4%, 2018 2.6% and there appears to be no trend to the cost of borrowing increasing or decreasing.

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Profit Margin

2018 2017 2016 20150.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Net Profit Margin vs Restated Profit Margin

Net Profit Margin Profit Margin (PM) Restated

The restated profit margin is the operating income after tax divided by sales. IPL’s restated profit margin does closely track their original net profit margin with a 1-2% increase in all years. This is because operating income doesn’t include the cost of the financial expenses and makes the numerator larger increasing the result.

Asset turnover

2018 2017 2016 20150.30

0.35

0.40

0.45

0.50

0.55

0.60

0.65

Total Asset Turnover vs Restated Asset Turnover

Total Asset Turnover Ratio Asset Turnover (ATO)

The asset turnover ratio is showing sales divided by net operating assets. As net operating assets are smaller when compared to the total assets (which the total asset turnover ratio uses)

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the results in all years are higher values. The asset turnover ratio is showing that for IPL every dollar they have in net operating assets they are making between 54 and 62 cents in sales. Looking at the graph there appears to be an increasing trend which is positive for the business.

Economic profitThe economic profit formula includes the cost of capital and thereby looks not only if the company is making a profit but are they making enough profit over and above the cost of the funds. For example, a company might have a profit at the end of the year but is that profit enough to justify continuing the business and meeting shareholder expectations.

Economic Profit = (RNOA – WACC) x NOA

Return on Net Operating Assets (RNOA): Is a measure of how much operating income after tax is being earnt for every dollar of net operating assets that have been invested into the business.

Weighted-average cost of capital (WACC): The WACC is a measure of the average cost of funding the business and represents the cost of capital. This percentage tells us the return that the shareholders and lenders expect to receive by investing in the company and it represents their opportunity cost. As if their money wasn’t invested in this business it could be invested elsewhere. It also represents the company’s opportunity cost of investing in the business as capital can only be used in one area at a time.

Net Operating Assets: Is the amount of total operating assets minus the total operating liabilities to return the overall figure of dollars invested in the business to generate returns. For IPL the net operating assets haven’t change a lot over the four years (relatively stable around 6,250 million), but it is possible that during the year the amount of net operating asset could have differed to the amount used within the formula, as the information for this formula has been taken on a specific date, the balance sheet date 30th September.

2018 2017 2016 2015

(600.00)

(500.00)

(400.00)

(300.00)

(200.00)

(100.00)

-

Economic Profit IPL using 10% WACC (millions)

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As IPL had a low RNOA (varying between 1.85% and 7.1%) it was expected that their economic profit would also be negative in each year as it is less than the WACC of 10% and when multiplied by the NOA it would be a negative dollar value.

This is not what you would like to see as an investor, lender or an employee of IPL as it shows that overtime they are destroying value, approximately 200 million per year and up to 500 million in 2016.

As 5.44% is the average of RNOA over the four years. If it was used as the WACC it shows that IPL would on average have made close to $0 over the four years in terms of economic profit. This is different to breaking even as the cost of capital has been taking into consideration.

Overall the ratios tell a story about IPL’s performance over the last four years by breaking it down into different pieces. While IPL have made a profit over the last four years (ranging from 89 to 379 million) that haven’t made enough profit. This is clearly shown by looking at the economic profit when using 10% as the cost of capital. There appears to be no trend of increasing earnings, only 2016 showed an anomaly were profits were significantly lower than the other three years. I believe that IPL need to focus on ways to increase their low net profit margins. Their current ratio and days of inventory ratio appear to be consistent with appropriate benchmarks. They are paying out quite high amounts of dividends compared to earnings per share, but this seems appropriate given that they aren’t generating high returns on their own assets. Over the years not much has changed and it appears that if changes aren’t made or the company can’t increase their profits they will have unhappy shareholders. I wouldn’t consider investing in IPL.

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Comments with others on ratio – Still to come

I will compare my ratios to those I leave feedback for and make comparisons here

Step 9 – Capital Investment Decision

IPL are looking at expanding their mining operations and have two scenarios that they would like to explore.

Option One: Expanding the Moranbah mines production by 50% to increase production of ammonium nitrate to approximately 519 thousand tonnes per year. This would be achieved through a significant infrastructure investment of $600 million. Due to the highly corrosive environment of ammonium nitrate the mine would have a lifespan of ten years and a demolition cost of $20 million.

Option Two: Expanding the Phosphate Hill mines production by 30% to increase production of Ammonium Phosphates to 1214 thousand tonnes per year. With an initial cost of $450 million a flexible temporary mining setup could be purchased. After ten years this setup could be redeployed at another nearby mine, with a residual value of $100 million.

The estimated future cash flows are shown in the table below for the two options that company is contemplating. The company wishes to calculate the net present value (NPV), the internal rate of return (IRR) and the payback period for each option. To proceed with the investment decision all the company conditions must be met.

Company Conditions- Net Present Value: must be positive (assume a discount rate of 10%).- Internal Rate of Return: must be greater than a 10% required return.- Payback Period: must be less than 8 years.

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All figures in millions AUD Moranbah Mine Phosphate Hill MineOriginal cost ($600) ($450)Estimated life 10 years 10 yearsResidual value ($20) $100Estimate future cash flows30/5/2020 (Time period = 1 year) ($50) ($25)30/5/2021 (Time period = 2 years) ($30) $6030/5/2022 (Time period = 3 years) ($20) $7030/5/2023 (Time period = 4 years) 20 $8030/5/2024 (Time period = 5 years) 50 $9030/5/2025 (Time period = 6 years) 100 $10030/5/2026 (Time period = 7 years) 200 $10030/5/2027 (Time period = 8 years) 300 $10030/5/2028 (Time period = 9 years) 400 $10030/5/2029 (Time period = 10 years) 500 $100

The results can be summarised in the table below.

The Phosphate Hill mine met all the company’s conditions and I would recommend proceeding with the capital investment decision. The NPV added value to the firm as it was a positive number, the IRR was greater than their pre-determined limit of 10% and the payback period was less than 8 years.

The Moranbah Mine only met two of the company’s conditions and therefore the recommendation is not to proceed. While NPV and IRR satisfied the conditions the payback period was greater than 8 years (only just).

The strengths of the analysis would be the ability to discount the future cash flows back to todays dollars (for NPV and IRR). Another strength would be the ability to use all three capital investment decision tools to provide an overall analysis on the project rather than just relying on one method.

The major weakness of the analysis is that estimating future cash flows accurately in the future (up to ten years) is very difficult and it is likely that the actual with vary greatly from the

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projections. Another weakness is the company’s blunt conditions for accepting a project. For example, the Moranbah Mine won’t proceed due to not meeting one of the company’s three investment decision tools. The payback period criteria states that the money from the initial investment must be returned within 8 years and it’s estimated to be 8 years and one month. The payback period also doesn’t make any allowance for the residual value of assets, so this should be considered by the company when making decisions.

IPL should proceed with the Phosphate Hill mine only.

Overall, I have found steps 7-9 helpful in developing a further understanding of contribution margins, ratios and capital investment decisions. I’m looking forward to the next accounting units in my degree!

Step 10 – Individual Feedback

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