(ii) Discussion of financial performanceIt is clear that 2006 has been a difficult year for Merton plc. There are very few areas of interest to shareholders whereanything positive can be found to say.ProfitabilityReturn on capital employed has declined from 14·4% in 2005, which compared favourably with the sector average of12%, to 10·2% in 2006. Since asset turnover has improved from 1·5 to 1·6 in the same period, the cause of the declineis falling profitability. Gross profit margin has fallen each year from 27·5% in 2004 to 25% in 2006, equal to the sectoraverage, despite an overall increase in turnover during the period of 10% per year. Merton plc has been unable to keepcost of sales increases (14% in 2006 and 10% in 2005) below the increases in turnover. Net profit margin has declinedover the same period from 9·7% to 6·2%, compared to the sector average of 8%, because of substantial increases inoperating expenses (15·4% in 2006 and 10·6% in 2005). There is a pressing need here for Merton plc to bring costof sales and operating costs under control in order to improve profitability.Gearing and financial riskGearing as measured by debt/equity has fallen from 67% (2005) to 63% (2006) because of an increase inshareholders’ funds through retained profits. Over the same period the overdraft has increased from ￡1m to ￡8m andcash balances have fallen from ￡16m to ￡1m. This is a net movement of ￡22m. If the overdraft is included, gearinghas increased to 77% rather than falling to 63%.None of these gearing levels compare favourably with the average gearing for the sector of 50%. If we consider the largeincrease in the overdraft, financial risk has clearly increased during the period. This is also evidenced by the decline ininterest cover from 4·1 (2005) to 2·8 (2006) as operating profit has fallen and interest paid has increased. In each yearinterest cover has been below the sector average of eight and the current level of 2·8 is dangerously low.Share priceAs the return required by equity investors increases with increasing financial risk, continued increases in the overdraftwill exert downward pressure on the company’s share price and further reductions may be expected.Investor ratiosEarnings per share, dividend per share and dividend cover have all declined from 2005 to 2006. The cut in the dividendper share from 8·5 pence per share to 7·5 pence per share is especially worrying. Although in its announcement thecompany claimed that dividend growth and share price growth was expected, it could have chosen to maintain thedividend, if it felt that the current poor performance was only temporary. By cutting the dividend it could be signallingthat it expects the poor performance to continue. Shareholders have no guarantee as to the level of future dividends.This view could be shared by the market, which might explain why the price-earnings ratio has fallen from 14 times to12 times.Financing strategyMerton plc has experienced an increase in fixed assets over the last period of ￡10m and an increase in stocks anddebtors of ￡21m. These increases have been financed by a decline in cash (￡15m), an increase in the overdraft (￡7m)and an increase in trade credit (￡6m). The company is following an aggressive strategy of financing long-terminvestment from short-term sources. This is very risky, since if the overdraft needed to be repaid, the company wouldhave great difficulty in raising the funds required.A further financing issue relates to redemption of the existing debentures. The 10% debentures are due to be redeemedin two years’ time and Merton plc will need to find ￡13m in order to do this. It does not appear that this sum can beraised internally. While it is possible that refinancing with debt paying a lower rate of interest may be possible, the lowlevel of interest cover may cause concern to potential providers of debt finance, resulting in a higher rate of interest. TheFinance Director of Merton plc needs to consider the redemption problem now, as thought is currently being given toraising a substantial amount of new equity finance. This financing choice may not be available again in the near future,forcing the company to look to debt finance as a way of effecting redemption.OvertradingThe evidence produced by the financial analysis above is that Merton plc is showing some symptoms of overtrading(undercapitalisation). The board are suggesting a rights issue as a way of financing an expansion of business, but it ispossible that a rights issue will be needed to deal with the overtrading problem. This is a further financing issue requiringconsideration in addition to the redemption of debentures mentioned earlier.ConclusionOrdinary shareholders need to be aware of the following issues.1. Profitability has fallen over the last year due to poor cost control2. A substantial increase in the overdraft over the last year has caused gearing to increase

3. It is possible that the share price will continue to fall4. The dividend cut may warn of continuing poor performance in the future5. A total of ￡13m of debentures need redeeming in two year’s time6. A large amount of new finance is needed for working capital and debenture redemptionAppendix: Analysis of key ratios and financial information