Expansion programmes in business - Free Essay Example

Executive Summary Hobart plc is a small and sedately growing UK based company, engaged in the business of productions and sales of soft drinks. The company has recently embarked upon a major expansion programme, through acquisitions, as well the setting up of manufacturing facilities in the emerging markets of East Europe. Both the asset base and the long-term borrowing of the company have increased significantly in the last year. The expansion initiative has also resulted in increases in overheads, without any corresponding enhancement in sales, and has caused a drop in profitability and strain on working capital resources. A detailed financial analysis, based upon examination and analysis of operating parameters and financial ratios reveals that while the current profitability of the company is under pressure, the situation should improve significantly as the returns from the recent investments start coming in and the expansion plans gain traction. The shares of the company are currently trading below book value, primarily because of the reduced profitability of the company in 2006. The fundamentals of the company, and their overall operating parameters, however, continue to be strong and the share should show marked improvement in the medium term, as recent investments start yielding results. While there is little chance of the shares of the company improving sharply in the near future, prospects for inv estors willing to hold the shares for a period of at least two years appear to be extremely attractive. 1. Introduction Hobart plc is a UK based manufacturer of soft drinks, active mostly in the small institutional market. While the majority of its customers are in the pub and restaurant segment, the company also tries to reach retail customers through small supermarkets. In recent years, the company has attempted to grow through acquisitions in the UK, as well as in Eastern Europe, with the establishment of a production unit, in Poland, in 2006. This report attempts to analyse the working of Hobart through (a) a study of its financial figures for the last two years, (b) its key ratios for a further two year period and (c) a comparative analysis with a local competitor, a company which is also small in size and operates in similar markets, in order to determine the suitability of investing in the company. The report is for the specific use of prospective investors. It ma kes use of financial statements and attempts to come to conclusions, mainly through ratio analyses, of relevant financial, capital and operational parameters. The report has sequential sections that describe the prospective users of this report, discuss the general limitations of ratio analysis, contain the financial analysis, and finally detail the findings, conclusions and recommendations. The appendices contain details of the mathematical working, used in computing the ratios. 2. Users Users of financial analyses primarily comprise of two distinct segments, internal, and external, to the company. Internal users include members of the management, as well as other employees. The list of external users is of course much larger and consists primarily of stakeholders who have personal interests in the performance of the company. Shareholders, suppliers, customers, lenders, investors and concerned regulatory bodies are members of this list of external users. Apart from these grou ps, other external users include industry watchers, analysts, policy makers, members of economic and financial think tanks, and of course competitors. (Osteryoung, Constand, and Nast, 1992) This particular exercise, as stated earlier, makes use of competitor data for arriving at conclusions. Corporate performance becomes relevant for these users for different reasons, with different users looking at diverse parameters for their individual assessment purposes. Lenders, for example, may, primarily look at the extent of interest cover provided by earnings, as well as information on the extent of borrowing, currently in use by a company. Gearing and Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s ratios will be able to provide these users important information on the relationship between borrowed and owned funds, and the adequacy of capitalisation. Investors may find it worthwhile to analyse the Earning per Share and the Price/Earning ratios in order to decide on buying and selling decisions, and to assess whether the analysis reveals any information that could lead to profitable investment decisions. Comparison of P/E ratios, with other firms in the same business would provide information about under or overvaluation of the scrip in the equity market and help in decision-making regarding to buying or selling shares. Long-term shareholders would on the other hand look at fundamentals, corporate performance and prospects for the future, in order to assess the worth of their investments. Members of the management would need to analyse financial statements, primarily to assess corporate performance, and to set targets for the future. This user group would mainly examine operational ratios, vis-ÃÆ'  -vis profitability and liquidity, and use their findings as a base for carrying out improvements in efficiency and setting targets. (Osteryoung, Constand, and Nast, 1992) It is probably in their hands that its use becomes most beneficial, for the progress and well-being of the corpor ation. 3. Limitations of Ratio Analysis Ratio Analysis continues to be one of the most basic tools in use for financial analysis. Business schools and professional accountancy courses deem its usage to be intrinsic to analytical exercises in finance, and parameters abound for acceptable limits for the different ratios in common use. Ratios help in analysing the operational and financial health of companies, especially with regard to issues like solvency, leverage, liquidity, operational efficiencies, and profitability. Ratios of related figures, for example, stocks of finished goods and sales, or current assets and current liabilities, are determined and tracked over time to assess the financial health or operational efficiency of particular companies. However, ratio analysis also has many serious limitations, which, if unattended, can invalidate its conclusions. These limitations have come to be widely accepted by financial experts, who now use ratios in conjunction with a host of other information. Ratio analysis primarily depends upon an analysis of published figures; any inaccuracies in the preparation of these figures will automatically affect the validity of the inferences provided by its usage. (Wells, 2001) In an era distinguished by creative accounting and corporate scams, illustrated by the demise of Enron and the collapse of Arthur Anderson, financial statements are looked at with scepticism. Notwithstanding the requirements of Sarbanes Oxley and the convergence of international accounting practices, the first limitation of ratio analysis stems from the questionable reliability of accounting statements. Ratios again depend upon financial figures that pertain to either revenue or capital items, which can, in turn, be subject to completely different influences, depending upon the size of the company and the nature of its business. While a weak current ratio could denote liquidity problems in a small company, it could just be an indicator of s upplier exploitation in the case of large and financially strong companies, which have the muscle to extract longer payment periods from their suppliers. The same ratio may thus need to be analysed differently for organisations of different sizes. To give another illustration, debt equity ratios are generally far larger for capital-intensive businesses like cement than for FMCG companies like Unilever, where working capital needs are significant, and investments in plant and machinery are remarkably low. It is also important to consider that ratios reflect the financial status of a company at a particular point of time. These analyses will thus not be able to reflect the effect of any subsequent developments, positive or negative. The reliability of accounting documents, the essentiality of different ratios to reinforce and not contradict each other, the size of the business, the nature of the business or industry, and the date of preparation of the analysis are capable of influe ncing the interpretation of ratios, thus need particular attention. (Giacomino, and Mielke, 1993) 4. Financial Analysis This exercise is predominantly dependent upon the use of ratios in key operational areas for its findings, conclusions and recommendations. While other information available on data pertaining to earlier years as well as on a competing company, namely Adelaide plc helps in the analysis, the validity of the exercise is subject to the limitations of ratio analysis, elaborated in some detail in the previous section. The analysis pertains to five significant financial and operational areas, namely, (a) profitability, (b) asset utilization, (c) liquidity, (d) capital structure, gearing and risk and (e) investments. The appendix contains details about the premises involved and the calculations undertaken for the preparation of these ratios. The table, provided below gives a snapshot of the various ratios used for the analysis. While computation of ratios for Hob art for 2006 and 2005 are from available financial information, the ratios for Hobart for 2004, as well as for Adelaide, for 2006 and 2005 are from directly obtained data. While a few ratios are unavailable, as is evident from the empty grids on the table, the available data is sufficient for some detailed preliminary analysis. Ratio Group Ratio Hobart 2006 Hobart 2005 Hobart 2004 Adelaide 2006 Adelaide 2005 Profitability Operations Return on Capital Employed 6% 20% 18% 17% 19% Asset Turnover 1.36 1.45 Gross profit Margin 38% 40% 41% 36% 39% Net Profit Margin 5% 14% 13% 13% 15% Trade Receivables Period 50 days 41 days 37 days 29 days 28 days Asset Utilisation Asset Turnover 1.13 1.48 Stock Turnover 49 44 Liquidity Current Ratio 1.43 2.79 1.7 2.3 2.0 Quick Ratio 0.89 1.68 1.3 1.5 1.4 Capital Structure, Gearing Risk Gearing Ratio 44 % 36% 32% 25% %24 Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Ratio 56% 64% Interest Cover 1.55 times 6.25 times Investment Earnings per Share 0.04 GBP 0.24 GBP Price/ Earnings 17.5 times N/A A preliminary financial analysis of Hobartà ¢Ã¢â€š ¬Ã¢â€ž ¢s performance does not make for very happy reading. The first problem relates to sales growth, which is growing excruciatingly slowly, creeping up at a rate of less than 10 % per annum. The last year, which saw a growth of less than 5 % was exceptionally poor. Considering that sales figures also include the effect of price rises, it is possible that volume growth was even poorer than that reflected by financial figures. The year 2006 has been poor in terms of net profitability, despite a marginal increase in sales, and little change in gross margins. While the Gross profit margin has dipped marginally from 40% to 36%, the net profit margin has crashed from 14% to 5%, with a corresponding dip on the Return on Capital, which has dipped from 20 % to 6%. This drop in profitability has occurred because of a sharp increase in administrative expenses, which have gone up by 2000 GBP, practically 6.7 % of revenues. Other than this, the other major cause for worry with regard to operational efficiencies arises from the increase in trade receivables, which have been increasing steadily during the last three years. Trade receivables in 2006 were at 50 days of sales, compared to 37 days in 2004. This could possibly be due to an increase in terms of payment and needs investigation in detail. Prima facie, the ratios denote a sharp fall in profitability, because of an increase in administrative expenses, and this could certainly be a cause for concern. This expense, along with a few other factors evident from a perusal of the accounting statements, needs analysis in the context of recent acquisitions, and the installation of manufacturing facilities in Poland. Capital structuring figures and ratios indicate a significant increase in long-term assets, as well as funding, through the issue of debentures. However, the increase in the value of long-term assets is significantly higher than the funds obtained from debe ntures. This factor, compounded by the increase in administrative expenses, which have eaten up much of the yearà ¢Ã¢â€š ¬Ã¢â€ž ¢s operational profits, has led to the balance of the increase in long term assets having to be funded from the internal funds of the company. The ratios pertaining to short-term liquidity, i.e. current ratio and quick ratio have worsened accordingly. In comparison to Adelaide, Hobart appears to be a significantly larger company with both sales and assets that are practically four times the former. The wisdom of comparing the ratios of these two companies is thus questionable. However, the key operational ratios of both companies were reasonably similar before 2006, when Hobart put its expansion plans into motion. Adelaide follows a practice of revaluing its long-term assets, and as such may have an even smaller asset base than that evident from the financial records. 4. Conclusions and Recommendations Hobart is in the middle of a major expansion exercise, in the UK and in Eastern Europe, through acquisitions, and installation of manufacturing facilities. These activities have obviously resulted in a strain on current operations and profitability, as expenses, including interest costs, have increased without a corresponding increase in sales or gross profits. Even though the price of the share is currently trading at less than its book value, the PE ratio of 17.5, compared to the industry average of 11, indicates that the companyà ¢Ã¢â€š ¬Ã¢â€ž ¢s plans have the approval of investors and market watchers. The company should see a sharp increase in revenues and earnings as its investment plans bear fruit. Even otherwise, Hobart is adequately capitalized and financially and operationally strong enough to ride out the current drop in profitability, until sales increase in response to investments. The price of the share, at 70 p appears to be extremely attractive for investing, if bought with an intention to hold for at least tw o years. While there appears to be little chance of the share price appreciating in the immediate future, it should certainly appreciate strongly in the medium and long term. Long-term investors, if they buy at current market prices, should find their investment in Hobart to be extremely rewarding. Appendix This appendix contains details regarding the computation of various ratios used in the report. A. Profitability Ratios 1. Return on Capital Employed = Profit before Interest and Tax/ Capital Employed at the beginning of the year Details 2006 2005 Capital Employed at the beginning of the year is equal to Total assets less Current Liabilities 22000 20000 Profit before Interest and Tax 1400 4000 Return on Capital Employed 0.06 0.2 2. Asset Turnover Ratio = Sales/ Capital Employed at Start of the Year Details 2006 2005 Capital Employed at the beginning of the year is equal to Total assets less Current less Current Liabilities 22000 20000 Sales 30000 29000 Asset Turnover Ratio 1.36 1.45 3. Gross Profit Margin = Gross Profit/ Sales * 100 Details 2006 2005 Gross Profit 11400 11600 Sales 30000 29000 Gross Profit Margin 0.38 0.40 4. Net profit Margin = Net Profit (Profit before Interest and Tax) / Sales * 100 Details 2006 2005 Net Profit 1400 4000 Sales 30000 29000 Net Profit Margin 0.050 0.14 B. Asset Turnover Ratios 5. Fixed Asset Turnover = Sales/ Fixed Assets Details 2006 2005 Fixed Assets (Non Current Assets) 26560 19600 Sales 30000 29000 Net Profit Margin 1.13 1.48 6. Stock Turnover Ratio = Inventory/ Cost of Sales X 365 Details 2006 2005 Inventory 2500 2100 Cost of Sales 18600 17400 Stock Turnover Ratio 49 44 C. Liquidity Ratios 7. Current Ratio = Current Assets (Inventory and Trade Receivables)/ Trade Payables Details 2006 2005 Current Assets 2500 + 4100 =6600 2100 + 3200 = 5300 Trade Payables 4600 1900 Current Ratio 1.43 2.79 8. Quick Ratio = Trade Receivables/ Trade Payables Details 2006 2005 Trade Receivables 4100 3200 Trade Payables 4600 1900 Current Ratio 0.89 1.68 D. Capital Structure, Gearing and Risk Ratios 9. Gearing Ratio = (Total Liability à ¢Ã¢â€š ¬Ã¢â‚¬Å" Current Liability) / Capital Employed Details 2006 2005 Total Liability à ¢Ã¢â€š ¬Ã¢â‚¬Å" Current Liability 18000-6000 = 12000 11000 à ¢Ã¢â€š ¬Ã¢â‚¬Å" 3000 = 8000 Capital Employed = Total Assets less Current Liabilities 26560 + 6600 à ¢Ã¢â€š ¬Ã¢â‚¬Å" 6000 = 27160 19600 + 5400 à ¢Ã¢â€š ¬Ã¢â‚¬Å" 3000 = 22000 Gearing Ratio 0.44 0.36 10. Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Ratio = Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Funds/ Capital Employed Details 2006 2005 Shareholders Funds 15160 14000 Capital Employed 27160 22000 Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Ratio 0.56 0.64 11. Interest Cover = Net Profit before Interest and Tax/ Interest Details 2006 2005 Profit before Interest and Tax 1400 4000 Interest 900 640 Shareholderà ¢Ã¢â€š ¬Ã¢â€ž ¢s Ratio 1.55 6.25 H. Investment Ratios 12. Earnings per Share = Earnings/ Number of Shares Details 2006 2005 Profits after Tax 350 2360 Number of Shares 10000 10000 Earnings per Share (GBP) 0.04 0.24 13. Price/ Earnings Ratio = Price per Share/ EPS Details 2006 2005 Price per Share (GBP) 0.70 N/A Earnings per Share 0.04 0.24 Price/ Earnings Ratio 17.5 N/A Bibliography Giacomino, D. E., Mielke, D. E., 1993, Cash Flows: Another Approach to Ratio Analysis. Journal of Accountancy, 175(3), 55+. Osteryoung, J., Constand, R. L., Nast, D.,1992, Financial Ratios in Large Public and Small Private Firms. Journal of Small Business Management, 30(3), 35+. Pettis, M., 2001, The Volatility Machine: Emerging Economies and the Threat of Financial Collapse. New York: Oxford University Press. Retrieved March 21, 2007, from Questia database: https://www.questia.com/PM.qst?a=od=104937007 Riahi-Belkaoui, A. ,1998, Financial Analysis and the Predictability of Important Economic Events. Westport, CT: Quorum Books. Sannella, A. J., 1991, The Impact of GAAP on Financial Analysis: Interpretations and Applications for Commercial and Investment Banking. New York: Quorum Books. Wells, J. T., 2001, Irrational Ratios. Journal of Accountancy, 192(2), 80.