Business Performance for Severn Trent - Case Study Example

Financial reporting and analysis: severn trent al Affiliation) Key words: financial ratios, leverage, fiscal and monetary policy, business performance Business Performance for Severn Trent Global Financial Situation The company’s performance has been significantly influenced by the subdued growth that the world economy has experienced. In addition, the world economy has worsened due to inappropriate monetary and fiscal policy actions among the developed countries. In the recent past, signs of improvements have been noted, specifically in the euro area. Most developed countries continue to register growth in their Gross Domestic Product. The World Gross Product (WGP) has set a 3.0% and 3.3% growth baseline for 2014 and 2015. The baseline forecast will be influenced by the monetary and fiscal policy actions, the exchange rates, and the international oil prices. All companies are expected to take advantage of the policy actions to achieve the WGP. In addition, there exists a sense of harmonization among different companies that dictate the cyclical movements in growth (World economic situation and prospects 2014). Severn Trent The current ratio and quick ratio indicate that Severn Trent can pay its current debts using either the current assets or assets that can be readily converted into cash. However, the liquidity ratios indicate a downward trend from 2013 to 2014. The trend can be attributed to the current monetary policy action to reduce the cost of borrowing by lowering the interest rates. The company’s liabilities increased from £581.0m to £655.7m to indicate the incorporation of leverage in the capital structure. In addition, additional leverage means that creditors are aware of the current financial situation, and acknowledges the liquidity status for Severn Trent. Investors may seek an explanation for the trend depicted by the cash ratio. Besides the company adding a significant amount of leverage in its capital structure, the cash and cash equivalents have reduced within the two year period. This indicates that the company does not keep most of its retained earnings in form of cash and cash equivalents. The company might be using liquid cash to offset expenses and pay off short-term debt. With the current rate of inflation that is being experienced worldwide, it may be unwise to stock cash and cash equivalents. This is a good sign for the investors as it is clear that the company protects the value of its cash and cash equivalents by offsetting debt to accommodate for ‘new’ debt to strengthen its capital structure. The asset turnover ratio is an efficiency ratio that indicates how a company uses its assets to generate sales. The ratio is relatively low (0.23 for both years). The company’s net sales seem to be affected by the monetary and fiscal policy actions that have made cash readily available; significantly reducing its value. The increase in total assets reported in the statement of financial position is a sign that the company attaches value to investments, only that the current fiscal and monetary policy actions do not allow for a balance between the forces of supply and demand. The recent economic recession affected the capital structure for companies because investors were not willing to invest during that period. The current fiscal and monetary fiscal policy actions have been significant in the fight against economic recession. Severn Trent has resolved to debt financing to make investments. The debt ratio (0.86, 0.89) is a clear indication that the company resolved to debt financing after the recent economic recession. However, investors should not be worried since the ratio only indicates that the company has incorporated debt capital to obtain assets. The downward trend may be attributed to the fact that the company is keen to offset its debts, which is evident in the statement of financial position. The total assets have reduced from £8,019.4 million to £7,889.2 million, 2013 to 2014, to indicate that most of the cash and cash equivalents were used to offset debt rather than investing in assets. The debt to equity ratio is an important measure for business performance in terms of the balance between investors and creditors. The ratios for 2014 and 2013; 6.24 and 8.5 respectively, hold some important information about the performance of the company. Though the ratios are high, they indicate a downward trend between the two years. Business performance might be inhibited by a weak capital structure, but the financial operations indicate that the company is heading towards achieving a stable capital structure. The ratio reduces in 2014 since equity increases and liabilities are offset. Favourable monetary policy actions have enabled investors to borrow cash at a lower cost. This means that more investors can invest in companies like Severn Trent, which will boost their capital structure. The equity ratio is used to indicate how the components of working capital fund investments in assets. Severn Trent has registered equity ratios of 0.14 and 0.11 for 2014 and 2013 respectively. The ratio might be lower than the reasonable rate. However, it indicates an upward trend to signify the increased interest among investors to invest in the company. The increase in shareholder equity can be attributed to the favourable monetary policy actions, which have improved the accessibility of cash for investors. The trend indicates that Severn Trent will soon be able to finance its assets using shareholder equity. The existing and prospective shareholders should consider the trend as an indicator of stable business performance. A higher return on assets (ROA) ratio is favourable to investors as it indicates that the company’s assets are generating high amounts of net income. Severn Trent registered 5.5% and 2.2% return on assets for 2014 and 2013 respectively. Favourable monetary and fiscal policy actions, which increased the supply of funds to borrowers, encouraged investments in major companies. Severn Trent recorded a 29.34% increase in shareholder equity. In addition, the more stable capital structure, compared to 2013, encouraged the company to invest in assets. The company recorded a 1.1% increase in average total assets from 2012 to 2014. The increase in total assets had a positive effect on net income. Existing and potential investors should view this result as a sign of positive business performance attributable to the favourable monetary and fiscal policy actions. Severn Trent registered a return on capital employed (ROCE) of 0.06 and 0.03 for 2014 and 2013 respectively. The ratio is relatively low indicating that the company is losing money because it is borrowing at a higher percent than it is generating a return on employed capital. Such a result can be attributed to the recent economic recession, which had a significant effect on the returns that companies generated. On the contrary, the ratio indicates an upward trend from 2013 to 2014. The trend indicates that the company will achieve higher returns with a stable capital structure composed of shareholder equity. Existing and prospective investors may use this result to invest in the company since it indicates that returns will be higher as fiscal policy actions become stable. Investors use the return on equity ratio to evaluate how the company utilizes the shareholder equity to generate profits and enhance business growth. Severn Trent has indicated a reasonable return on equity; 0.40 and 0.20 in 2014 and 2013 respectively. This means that the company generated 40cents for every dollar of shareholder equity invested. The move by governments and central banks to formulate favourable exchange rates, monetary and fiscal policy actions, and stable international oil prices has played a significant role in combating the effects of the recent recession. Lending rates have reduced significantly to increase the supply of money. In addition, the availability of money has increased the level of investments. Investors should be encouraged to invest in Severn Trent as its return on equity ratio indicates a stable business, which can maximize their wealth. Comments according to the table (see appendix) As the interest cover indicates, the cost for obtaining leverage significantly reduced prompting the company to incorporate debt into its capital structure. The favourable monetary and fiscal policy actions lowered the cost for obtaining credit. Interest charges increased from £186.8m to £206.9m from 2013 to 2014 to indicate that the company obtained more leverage and ended up incurring a higher interest charge. Increased debt resulted in a cause-and-effect relationship with the other financial ratios. It is important to note that the business performance for Severn Trent is attributable to the current global economic situation. Monetary policy and fiscal policy actions have a material effect on the business performance for the company. Investors can base their investment decision on the gearing ratio. The ratio reduced from 41% in 2013 to 38% in 2014. The reduction is attributable to a 29 % in equity. Long-term debt increased, but with a smaller margin (13%). The investment on assets was not significant (2.3%) but it was a clear indication that the company was set to use a significant portion of the capital structure to invest in assets. This is visible in the ROA that indicates an increase on the return on assets from 2.2% to 5.5% in 2013 and 2014 respectively. Severn Trent still suffers from a slow asset turnover rate. The ratio is constant between the two years. However, the flat rate is attributable to the minimal investment in assets due to the previous economic crisis affecting business performance. Form the solvency ratios; it is evident that the company used most of its cash and cash equivalents to pay the short-term debts. The total assets reduce by 1.6% whereas total liabilities reduce by 5.2%. Overall, SEVERN TRENT appears to be on an expansion plan. The increase in leverage in the company’s capital structure has been met by a significant rise in shareholder equity. The company is clearly on an expansion plan because it offsets its current obligations using the current cash and cash equivalents. Although the trend in sales appears to be stagnant, the company is set to have a 19% increase in sales over the next three years. The company is worth investing in because the financial ratios indicate that more investors will turn the capital structure from debt financing to a nearly whole shareholder equity financing. Aerts and Walton (2013) argue that ratio analysis provides a useful tool for evaluating organizational performance. However, it ignores essential factors shaping an organization. Financial ratios are quantitative indicators of business performance. In addition, business performance is influenced by both qualitative and quantitative factors. Financial ratios are not meaningful if they are not integrated with the internal factors that affect business performance (Aerts, & Walton, 2013). Qualitative Factors that Shape an Organization Business model According to Standfield, (2005), investors ought to indentify the main business operations for a company rather than relying on the financial statements only. The business model is concerned with how a company makes money; that is, the main line of operation. Investors should first analyze the overview of the company to identify whether it is a viable business venture worth investing in. Financial ratios fail to explain the business model for an organization (Standfield, 2005). Competitive advantage A successful organization should be able to create and maintain a competitive advantage in the industry. Financial ratios fail to indicate an organization’s ability to maintain a competitive advantage within the respective industry. Investors ought to analyze the competitive advantage of an organization to establish how shareholders are rewarded from such qualities. Management An organization’s management structure defines the investment options available within the organization, and in the industry. Investors might be convinced to invest in an organization if they are aware of the investment options that are available to the management. Financial ratios do not indicate the investment options that management intends to undertake. Corporate governance Financial ratios are an indication of an organization’s financial operations. However, they do not indicate the policies that govern the roles and responsibilities between directors, managers, and shareholders. Corporate governance defines how efficiently business operations are conducted to achieve the desired financial status. Reference List Aerts, W., & Walton, P. 2013. Global Finanical Accounting and Reporting 3rd Edition ed., p. 544. Stamford, CT: Cengage Learning. Dunn, J. 2010. Financial Reporting and Analysis. Chichester: Wiley. Elliot, B., & Elliot, J. 2013. Financial Accounting and Reporting 16th Edition ed.. Harlow: FT/Prentice Hall. Financials: Severn Trent PLC STRNY.PK. n.d.. Retrieved November 5, 2014, from http://uk.reuters.com/business/quotes/financialHighlights?symbol=STRNY.PK Top of Form Bottom of Form Melville, A. 2012. International Financial Reporting: A Practical Guide. Harlow: FT/Prentice Hall. Top of Form Bottom of Form Top of Form Bottom of Form Morgan, G. n.d.. Purposes, activities and beneficiaries: Assessing the use of accounting narratives as indicators of third sector performance. Qualitative Research in Accounting & Management, 295-315. Our history. (n.d.). Retrieved November 6, 2014, from http://www.severntrent.com/about-us/our- history Severn Trent. 2014. Annual Report and Accounts Top of Form Bottom of Form Top of Form Bottom of Form Standfield, K. 2005. Intangible finance standards advances in fundamental analysis & technical analysis. Burlington, MA: Elsevier Academic Press. Top of Form Bottom of Form World economic situation and prospects 2014. 2014. Place of publication not identified: United Nations Pubns. Appendix Number of words: 1954 On the Severn Trent Plc annual report and accounts, 2014: Chairman’s statement on page 6-7 Chief Executive’s statement on page 8-9 Chairman’s letter on page 49 Governance report on page 50-54 Director’s report on page 81-85 Auditors report, financial statements and notes on page 84-92 Industry benchmarks available on http://uk.reuters.com/business/quotes/financialHighlights?symbol=STRNY.PK Financial ratios (Severn Trent Plc Annual Reports and Accounts, 2014) (see table below) Company SEVERN TRENT                     Finanical ratios                             2013     2014       A. Profitability ratios           Industry Average     Industry Average   Gross operating margin     Sales less cost of sales/Sales [1,831.6-1,340.5]/1831.6 0.268 or 27% 25.44% [1,856.7-1,384.3]/1,856.7 0.25 or 25% 28%   Net operating margin     Net Profit before interest and tax/Sales 218.9/1,831.6 0.1195 or 12% 15.26% 434.9/1,856.7 0.23375 or 23% 28.28%   ROE     Net income(attributable to owners of equity)/Equity 168.7/833.2 0.20 or 20% 12.62% 434.3/1,077.6 0.4 or 40% 35.33%   ROA     Net income/Average total assets 172.1/7,867.3 0.022 or 2.2% 6.96% 434.4/7,954.3 0.055 or 5.5% 6.75%   ROCE     Net PBIT/Total Assets-Current liabilities 218.9/[8,019.4-581.0] 0.029 or 2.9% 2.74% 434.9/[7,889.2-655.7] 0.06 or 6% 4.62%                         B. Liquidity ratios                     Current ratio     Current assets/Current liabilities 983.2/581.0 1.69 1.41% 693.0/655.7 1.06 1.06%   Acid test     Current assets-inventories/current liabilities 983.2-32.1/581.0 1.63 1.38% 693.0-272/655.7 1.02 1.02%                         C. Solvency ratios                     Debt ratio     Total liabilities/Total assets 7,175.4/8,019.4 0.89 0.62 6,799.1/7,889.4 0.86 0.74   Debt to Equity ratio     Total liabilities/Total equity 7,175.4/844.0 8.5 5 6,799.1/1,090.1 6.24 4.89   Equity ratio     Total Equity/Total Assets 844.0/8,0194.4 0.11 0.5 1,090.1/7,889.2 0.14 0.5   Asset turnover ratio     Sales/Average total assets 1,831.6/[8,019.4+7,715]/2 0.23 0.28 1,856.7/[8,019.4+7,889.2]/2 0.23 0.63                         D. Finanicing and Investment ratios                     Gearing     Debt/Equity 581.0/833.2 0.697 or 70% 65% 655.7/1,077.6 0.6085 or 61% 62%   Gearing(Total finance)     Debt/Debt+Equity 581.0/[581.0+833.2] 0.4108 or 41% 50% 655.7/[655.7+1,077.6] 0.3783 or 38% 47%   Interest cover     PBIT/Net interest charges 218.9/186.8 1.17 1 434.9/206.9 2.1 1.5   Read More