QUESTION 2 Pelangi Sdn Bhd is trying to determine its efficiency in managing the costs associated with production of goods and sales support. Presented below are three (3) years Statement of Financial Performance of the company for a financial year ended December 31: 2021 (RM) 2020 (RM) 2019 (RM) Sales 950,600 706,200 411,950 Cost of goods sold 627,264 370.049 215,862 Gross profit 323,336 Q1 : 196,088 Operating expenses 143,554 137,003 79,918 Interest 53,000 26.000 16.000 Earnings before taxes 126,782 173,148 100,170 Taxes (10%) 12,678 17,315 10,017 Earnings after taxes 114,104 155,833 90,153 Evaluate the company's performance using common size percent over the three (3) years periods. Identify the strengths and weaknesses and suggest the relevant strategies to deal with the weaknesses. (10 marks)

Since we're working on a high-level data, recommendations are general and assumptions are also made. Please comment if you need further explanation on some items.

Refer to explanation section for the table of analysis and basis of narratives below (i.e., Key Points).

Abbreviations used include:

• y-o-y = year-on-year or the change from year 1 to year 2
• COGS = cost of goods sold
• OpEx = operating expense
• EBIT = Earnings before interest and taxes
• EBT = Earnings before taxes

Key Points:

1. Although gross profit margin was the same from 2019 to 2020 at 48%, there's been a notable decline in gross profit margin from 48% in 2019 and 2020 to 34% in 2021. It is noted that even if sales increased from RM706,200 in 2020 to RM950,600 in 2021 or 35%, this was offset by the larger increase in COGS of 70% from 2020 to 2021. Management should consider the following:
   • Evaluate sales strategies to boost revenues while maintaining COGS at a certain level.
   • Analyze COGS component. There might be an unusual line item or one-off transaction that resulted to significant increase in COGS. If so, we can eliminate the effects of these unusual or one-off transactions in the analysis and evaluate if gross profit margin is following the normal trend. If not, then Management should understand the cause of the increase in COGS and find a way to lower or eliminate some of this (e.g., look for other suppliers with lower cost but the same quality, etc.).
2. In terms of OpEx, Management was doing good maintaining the OpEx at 19% of sales in 2019 and 2020 and even better in 2021 with OpEx at 15% of sales. Looking at the y-o-y change, we can also see that compared to the increase of 71% from 2019 to 2021, Management was able to lower the increase from 2020 to 2021 at only 5%. If they're able to maintain this, this will result to higher profit.
3. EBIT, excluding effects of interest and taxes which are dependent on other factors, is a better way to analyze profitability. Even if EBIT increased by 71% from 2019 to 2020, there's been a significant decline of 10% from 2020 to 2021. This resulted from the decrease in gross margin (refer to 1 since these are correlated). EBIT is a factor of all the line items above it so even if the company was able to minimize OpEx, due to the lower increase in sales, EBIT was affected. Refer to 1 for recommendations.
4. Interest expense significantly increased by 63% from 2019 to 2020 and 104% from 2020 to 2021. Interest expense can result from many transactions but the most common one would be from debt. Other than looking at the impact it could have in the Earnings after interest, Management should deep dive on their indebtedness. While incurring debt is good at a certain level, if left unmanaged, this could have potential implications not just on the profitability but in their ability requesting debt in the future. Management should look at if they're able to pay their debts on time and analyze further why their interest expense is growing at a significant level.
5. Tax expense is usually not analyzed at a higher level since this is government-mandated and for corporations or companies, these are fixed at a certain percentage (in this case, 10%) of earnings before taxes.
    

Step-by-step explanation

Vertical Common-Size Horizontal Common-Size Amount Percentage of Sales (%) Year-on-year change (RM) Year-on-year change (%) 2019 2020 2021 2019 2020 2021 2019 to 2020 2020 to 2021 2019 to 2020 2020 to 2021 Sales 411,950.00 706,200.00 950,600.00 100 100 100 294,250.00 244,400.00 71 35 Cost of goods sold (215,862.00) (370,049.00) (627,264.00) (52) (52) (66) (154,187.00) (257,215.00) 71 70 Gross profit 196,088.00 336, 151.00 323,336.00 48 48 34 140,063.00 (12,815.00) 71 (4) Operating expenses (79,918.00) (137,003.00) (143,554.00) (19) (19) (15) (57,085.00) (6,551.00) 71 5 EBIT 116, 170.00 199,148.00 179,782.00 28 28 19 82,978.00 (19,366.00) 71 (10) Interest (16,000.00) (26,000.00) (53,000.00) (4) (4) (6 (10,000.00 (27,000.00) 63 104 Earnings before taxes 100,170.00 173,148.00 126,782.00 24 25 13 72,978.00 (46,366.00) 73 (27) Taxes (10%) (10,017.00) (17,315.00) (12,678.00) (2) (2) (1) (7,298.00) 4,637.00 73 (27) Earnings after taxes 90,153.00 155,833.00 114,104.00 22 22 12 65,680.00 (41,729.00) 73 (27)

Percentage of sales (%) = Line item amount / Sales

Year-on-year change (RM) from 2019 to 2020 = 2020 amounts / 2019 amounts

Year-on-year change (RM) from 2020 to 2021 = 2021 amounts / 2020 amounts

Year-on-year change (%) from 2019 to 2020 = Year-on-year change (RM) from 2019 to 2020 / 2019 amounts

Year-on-year change (%) from 2020 to 2021 = Year-on-year change (RM) from 2020 to 2021 / 2020 amounts

NOTE:

Common-size analysis can be made by:

• Analyzing the figures as a percentage of sales (i.e., vertical common-size analysis)
• Analyzing the changes from one period to another, i.e., time period analysis or horizontal common-size analysis)