Profitability
Tillinton Co’s chief executive is correct in saying that the absolute increase in revenue and gross profits on all products was greater in 20X3 than 20X2, but the % increase in revenue was smaller on all products, and the % increase in gross profit on toys was also lower. The % increase on the electronic toys shows the biggest fall, possibly indicating greater competition.
The improvements in operations mentioned by the chief executive seem to have maintained gross and operating profit margins and resulted in the absolute overall increases in gross and operating profits. However, this aspect of performance is almost all attributable to Tillinton Co’s older products. The gross profit on electronic toys has hardly increased and the gross profit margin has fallen over the last two years. Although the margin remains higher than on the other products, even the 20X3 margin may not be sustainable. If competitors are starting to catch up with Tillinton Co, then the profit margin on the current range of electronic toys may continue to fall in future years, as prices fall to maintain market share.
Despite the emphasis on developing the products, the revenue generated by electronic toys is still below the revenue generated by non-electronic toys.
Asset turnover and return on capital employed have risen significantly over the last two years. However, part of the reason for the 20X3 increases was the significant increase in current liabilities. The further amount of investment which the chief executive appears to be contemplating suggests that asset turnover and return on capital employed may fall in future years, particularly if profit margins on electronic toys cannot be sustained.
Liquidity
The figures for other current assets seem to support the chief executive’s contention that working capital is being managed better, as other current assets are falling as revenue and gross profits are rising.
However, the fall of the current ratio from 1·52 to 0·64 is significant, and the biggest reason for the fall in 20X3 was the large increase in current liabilities. Cash balances have remained at a low level, despite higher revenues and profit. Possibly there is now a bank overdraft, which could have contributed to the significant increase in finance costs between 20X2 and 20X3. It would seem that cash reserves have been exhausted by the combination of investment in non-current assets and the payments to finance providers (both interest and dividends), and Tillinton Co is more dependent on short-term liability finance. Slowdown in any product area, particularly electronic toys, may result in significant liquidity problems.
Solvency
Gearing has fallen over the last two years, but this is due to share price increases which may not be sustainable. If book values rather than market values are used to calculate gearing, the fall in gearing is much smaller. More information is needed about why finance costs have increased so much, leading to the deterioration in interest rate cover. Tillinton Co has only taken out an additional $30 million in long-term loans. Although costs on these may be higher than on its current loans, this would not account for all the increase in finance costs. As discussed above, Tillinton Co may be making use of overdraft finance. The fact that current liabilities have increased much more than non-current liabilities could be an indication that Tillinton Co is having problems raising all the longer term loan finance which it requires.
The figures suggest that Tillinton Co’s board needs to review future financing carefully if the company wants to make further investment in electronic products. At some stage, the board will have to consider raising further finance, either through an issue of shares or through selling off parts of its operations.
Investor ratios
Both earnings and dividends per share have risen since 20X1, which could help explain the significant increase in share price. Dividend cover has remained around 2·0 despite an increase in earnings. Although dividends have increased, dividend yield has fallen since 20X1. The increase in total shareholder return is due solely to the increases in share price, which have also resulted in the price-earnings ratio increasing in 20X3. The current rate of share price increase does not appear to be warranted by the most recent results and may be partly due to generous dividend levels, which may not be sustainable if more cash is required for investment.
Conclusion
Despite the chief executive’s optimistic message in the annual report, the benefits from the electronic toys development may be short-lived. There appears to be a mismatch between investment, dividend and financing policies. As discussed, margins on current products may fall further and there is no guarantee that margins on new electronic toys or other products will be higher if competition generally is increasing.
Further significant investment in electronic toys or other goods may be difficult to finance. Increased reliance on short-term finance is clearly not sustainable, but obtaining more debt may be problematic, particularly if gearing levels rise as share prices fall. Tillinton Co seems reluctant to take advantage of high share price levels to issue equity capital. This, plus the increase in dividends, may indicate Tillinton Co’s board is unwilling to risk upsetting shareholders, despite the large increases in share price. The chief executive may be right in saying that funds may have to be obtained by selling off one of the other parts of the business, but revenue and profits from the older products may be more sustainable. An increased concentration on electronic products may be a high-risk strategy. Possibly, if investors become less positive towards the electronic goods sector, they may realise this, resulting in an increase in cost of capital and a fall in share price.
​​​​​​​Note: Credit will be given for relevant, alternative approaches to the calculations and discussion.
Appendix​​​​​​​

Tillinton Co’s shares may be overvalued because share prices generally are too high. The situation may be a stock market bubble. Share prices have been rising consistently recently and this could be encouraging investors to buy more shares, further increasing share prices.
The bubble could be more localised. Tillinton Co seems to be positioning itself as much in terms of producing technologically-advanced electronic products as manufacturing toys. The electronic goods sector may be more likely than other sectors to attract investors on the basis of future profit potential, with investors possibly following a herd instinct, investing because others have been investing in the expectation of future gains.
Possibly, investors are more persuaded by the chairman’s confident language and future promises than they are by the concerns the figures suggest. They may also be paying excessive attention to the most recent set of results, rather than seeing them in the context of whether they can be sustained in the future.
If investors are attempting to make a valuation, they could prefer using a model which confirms what they believe the shares are worth (confirmation bias), rather than one which gives a more reliable indication of value. As discussed above, shareholders may be basing their estimates of value on the recent increases in dividend, even though it may be doubtful whether this is sustainable.