Trend Analysis and Cross-Sectional Analysis - Assignment Example

PART I Trend Analysis And Cross-Sectional Analysis Although the Chairman’s circular affirms that the company has performed exemplary well for the last four years due to its increased diversification and remarkable sale, this basis is not sufficient to reach to the conclusion that the management has run the business well. It will be extremely important to conduct a trend analysis for the last four years in order to establish significant indicators of financial strength, including liquidity, leverage, profitability, long-term financial position, and capital structure among other financial aspects. The fact that the management intends to raise the funds for this project entirely from Equity can be a good idea only if the firm’s capital structure is evaluated to make sure that increasing increasing equity will not cause an imbalance in the capital structure, and also to verify that the raising of equity will not face challenges depending on the company’s financial position. In order to convince the existing shareholders to make additional investments or new investors to invest in the company’s shares, it will be important to assure them that they will continue getting sufficient dividends and that their shares will continue growing in value among many other aspects that are considered by shareholder’s and potential investors (Atrill and McLaney, 1997). The financial position of Globetel Systems PLC can be evaluated by comparing the company’s performance from its historical figures and with its industry competitors as well as other successful entities from other industries. This includes not only examination of the company’s easily achievable numbers such as profits, total assets and sales, but also critically reading between the lines of its financial statement. This process is made easier by the use of well-tested ratios. These ratios help financial analysts identify and quantify the strengths and weaknesses of the business, and also make it possible to evaluate its financial positions hence understand the risks that may be experienced in the business (Bernstein and Wild, 2000). This part presents the six major types of financial ratios including working capital, profitability, income, Long-Term Analysis, Leverage and Bankrupcy. Financial ratios will be very important in the analysis of Globetel because it will help give recommendations to the management on they can implement plans that will help improve the company’s financial structure, liquidity, profitability, leverage, reordering as well as interest coverage. Through the trend analysis, the management can find what is good and what is bad with the business and make plans for improving the performance of the business so that equity investors can be encouraged to invest in the company. I. Income Ratios Turnover of total operating assets 2009 2010 2011 2012 Net sales 35 40 43 50 Total operating Assets 7.1 8.5 9.3 10.3 Turn over of total operating assets 4.9 4.7 4.6 4.8 This ratio shows the company’s effectiveness in using assets in generating sales. The ratio has declined slightly from 2009 through 2011, but the management has checked this and from 2012 the situation seems to be turning better. The management should strive to increase sales without necessarily investing in more assets, which in this case will be indicated by an increase in the ratio. The investors will want to be sure that the management will efficiently use the company’s assets to generate sales, because it is after deducting the relevant expenses from sales that the investors get their share (Atrill and McLaney, 1997). Gross Margin on Net Sales 2009 2010 2011 2012 Gross margin 25 27 29 34 Net Sales 35 40 43 50 Gross margin on Net Sales 0.71 0.68 0.67 0.68 The management should work hard to ensure that the gross margin on a net sales ratio is as high as possible since it shows what the shareholders will be allocated after all the relevant expenses have been settled. It is unfortunate that the gross margin fell slightly after 2009 – the management will want to investigate the cause of this fall and put measures to ensure that the cost of operations is reduced so the shareholders can enjoy better returns (Atrill and McLaney, 1997). II. Profitability ratios Net profits on Net Sales 2009 2010 2011 2012 Earnings after tax 25 27 29 34 Net Sales 7.7 9.1 11.2 14 Gross margin on Net Sales 3.25 2.97 2.59 2.43 The net profit on Net Sales has been declining since 2009, which shows that the management has not been very effective in investing the shareholder’s wealth to generate returns. The management should revisit the expenditure of the company and find out whether there it is excessive and if there are strategies that can be put in place to reduce it in order to improve this ratio. If the ratio continues to decline, the share price could also be affected and discourage equity investors. III. Liquidity Ratio’s Liquidity ratio’s can be used by the managers to estimate the position of short-term debts. It helps them estimate whether the firm is in a position to meet the obligations of the short-term creditors. If the firm is not in a position to meet its short-term obligations, then its bankruptcy risky can be very a high and equity investors will shy away from investing in such a company because of the fear of losing their money (Bernstein and Wild, 2000). Current ratio 2009 2010 2011 2012 Current assets 7.1 8.5 9.3 10.7 Current Liabilities 4.6 6 6.5 7.3 Current ratio 1.54 1.42 1.43 1.47 The current ratio reveals that the company is capable of meeting its current liabilities using its current assets. This ratio was most sound in 2009, after which it declined slightly but it is now picking. The management should put strategies to ensure this ratio does not go down again as this can put the firm at the risk of bankruptcy. Some of the strategies to improve the solvency of the company includes, among many others, encouraging the debtors to repay their dues in a short period. Receivable turnover ratio 2009 2010 2011 2012 Total Credit Sales 35 40 43 50 Average Receivables Owing 3 3.2 3.2 3.6 Receivables Turnover Ratio 11.7 12.5 13.4 13.9 Since 2009, receivables turnover ratio has been on the rise, which perhaps implies that the company’s collection of accounts receivable and extension of credit is becoming more efficient. Considering that the accounts receivable is an extension of credit to the customers, which is not earning the company any interest, the management should continue maintaining a high level of this ratio by continuing to pursue policies that will ensure timely collection of the credit (Atrill and McLaney, 1997). IV. Working Capital Ratios The management must pay attention to the fact that besides increasing the sales, sound policies must be put in place to ensure that other current assets are supported by adequate working capital. If the management finds that the company has maintained insufficient capital, the internal or external savings could be used to increase the current assets or the sales can be reduced in order to correct it. Working Capital turnover 2009 2010 2011 2012 Net Sales 7.7 9.1 11.2 14 Net Working Capital 2.5 2.5 2.8 3.4 Working capital turnover 3.08 3.64 4 4.12 The working capital ratio has generally increased since 2009, which is a positive indication because it implies that the company is efficiently using the working capital to generate more sales as time goes by. V. Bankruptcy Rations It is very important for the management to read the warning signs so the situation can be addressed before a business is declared bankrupt. Bankruptcy ratios can be used to predict bankruptcy before it occurs, hence offering the management a chance to take corrective measures before it is too late (Bernstein and Wild, 2000). Working capital to total assets 2009 2010 2011 2012 Working capital 2.5 2.5 2.8 3.4 Total assets 43.1 45.5 48.3 52.7 Working capital to total assets 0.06 0.05 0.06 0.06 The working capital has been maintained at approximately 0.06 except in 2010 when it fell to 0.05. Overall, firm’s working capital to total assets ratio is pretty low, which indicates that the company could be experiencing serious cash flow problems. This could lead to inability to pay creditors and suppliers even when the company generates profits and assets are available. If a corrective action is not taken urgently, this could lead to bankruptcy given that the reason for low ratio could be constant losses from operations due to slow sales that consume working capital reserves, causing it to reduce as compared with the total assets. To increase the ratio, the management should strategise how to generate sales from sales much faster than it makes payments for its operating expenses. Another option could be for the management to try to utilise its cash reserves more favourably. EBIT to Total Assets 2009 2010 2011 2012 EBIT 12 14 18 22 Total assets 43.1 45.5 48.3 52.7 EBIT to total assets 0.28 0.31 0.37 0.42 This ratio shows how effective the firm is in using its assets to realise profits before interest and tax is paid. This ratio has increased since 2009, which is a positive indication because it implies that the company is becoming more effective in using its assets. Equity to debt 2009 2010 2011 2012 Equity 16 16 16 16 Debt 19.6 21 25.1 29.18 Equity to debt 0.82 0.76 0.64 0.55 It is evident that Globetel maintains lower debt capital than equity capital. The key advantage of maintaining such a capital structure is reduction of bankruptcy risk. This is because debt capital requires repayment of the principal as well as payment of interest to the lenders. If the management maintains a high level of debt and fails to ensure sound cash management, then the company may fail to meet its obligations and hence get sued by the creditors. If such difficulties ensue, the company is forced to file for bankruptcy hence transferring the ownership of the assets to the debt holders. On the other hand, however, very low debt capital may deny the company relevant tax advantages as well as lose potential investment opportunities that could be aided by debt capital. The fact that the management intends to raise the entire capital for the proposed project is recommendable because this will possibly bring a balance in the company’s capital structure. Nevertheless, the management should make sure that equity and debt capital are well-balanced and maintained at their optimum levels (Atrill and McLaney, 1997). VI. Long-term analysis Stockholders Equity Ratio 2009 2010 2011 2012 Stockholders Equity 16 16 16 16 Total Assets 43.1 45.5 48.3 52.7 Stockholders Equity Ratio 0.37 0.35 0.33 0.30 The shareholders’ equity ratio shows how much shareholders would get in case the company undergoes liquidation. The shareholder’s Equity for Globetel has reduced over time indicating that the shareholder’s claim has declined since 2009. Unfortunately, this decline could mean that the company is increasing its difficulty in meeting its maturing debt obligations and fixed charges. VII. Leverage Ratios Leverage ratios estimate the extent to which creditors and owners contributes towards running of the business. Equity Ratio 2009 2010 2011 2012 Common Shareholders Equity 16 16 16 16 Total capital employed 38.5 39.5 41.8 45.4 Equity ratio 0.42 0.41 0.38 0.35 The equity ratio is an indication of the firm’s overall financial strength. A higher ratio is an indication of the firm’s better long-term financial strength while a low ratio is an indication of higher risk to the creditors. As such, the management should attempt to turn around the declining trend since it sends negative signals to the creditors (Atrill and McLaney, 1997). Debt to Equity Ratio 2009 2010 2011 2012 Debt Equity Debt to Equity Ratio The company’s debt-to-equity ratio has increased from 0.88 to 1.72, meaning that the company has been very aggressive in financing its growth using borrowed capital. As much as this could be a growth strategy, the management should be more cautious because this may lead to volatile earnings because interest expenses are likely to increase significantly. Nevertheless, the company is likely to generate more earnings, if it uses a lot of debt to finance its operations, in which case the management could argue that those earnings could be foregone if the debt is not used. Furthermore, if the earnings were to increase at a higher rate than the debt interest, then it can be prudent to use them because the shareholders are going to benefit. Therefore, the management should be careful not to use debt capital if its benefit does not outweigh its cost because this can lead to bankruptcy, whereby the shareholders lose their wealth. As discussed earlier, funding the proposed project with equity will favourably change this ratio. Competitor analysis Seemingly, the company’s shares performed exemplary well for the last four years and this is a major strength that could be looked upon to attract equity investors. However, considering that the shares of other major competitors have also performed very well for the last four years, this may not be a very good competitive edge. Nevertheless, the management should make sure that the company’s financial performance is healthy all round so it could be easy to convince the investors that the growth the share price will be sustained in the long-term. Ratio analysis Summary Following the company’s intention to start a new project, which will be financed by equity, it will be very important for the management to pay attention to the trends, which are generated through the ratio analysis. This is especially important because even the equity financiers will want to evaluate some of the financial ratio’s with the aim of evaluating the risk of investing in this company. Overall, the management should work hard to make sure the company’s profitability is increased so it can be attractive to the potential shareholders. More importantly, the company’s risk to bankrupcy is too high and this can keep off the potential investors because they will fear that their money could be lost in the event that the company is declared bankrupt. Therefore, the management should try to reduce the proportion of borrowed money that is used to finance the company (Atrill and McLaney, 1997). PART II Forecasting future cash flows and implementing capital budgeting methods to evaluate the proposed investment Net Present Value is the capital budgeting model that will be used in this part to evaluate the proposed investment. This technique estimates the amount of value that is generated by a project, which is above the opportunity costs estimated by the discounting rate. Generally, if the NPV of a particular project is positive, the project should be accepted; but if its NPV is negative, the project is considered not viable and hence dropped. Ideally, NPV can be used to make screening decisions; that is, identify whether the project will make money for the company. In this case, the management should approve the project for further consideration only if it meets a certain level of return. Nevertheless, the management should heed to the fact that this method cannot be used to rank projects because larger projects will practically have a higher NPV than than smaller projects. Therefore, if the management wishes to make preference decisions, it could be advisable to use a scoring method coupled with the project’s profitability index (Atrill and McLaney, 1997). The following section is the estimation of the proposed project’s NPV. Initial costs Market survey 50,000 Capital cost 50,000,000 Mortgage (Annual) 80,000 Working capital 1,500,000 Research for new technologies 1,000,000 The average price of all the services = [240+180+240+400] /4 = $265 Discounting for inflation and cost of capital = 3% + 18% = 21%   Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year7 Year 8 Year 9 Year 10 Landline*240 10,000 20,000 40,000 80,000 160,000 160,000 160,000 160,000 160,000 160,000 Internet subscribers*180 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 30,000 Cable TV subscribers*240 20,000 20,000 20,000 20,000 20,000 40,000 40,000 40,000 40,000 40,000 Bundle subscribers*400 10,000 20,000 30,000 40,000 50,000 60,000 70,000 70,000 70,000 70,000 Total 70,000 90,000 120,000 170,000 260,000 290,000 300,000 300,000 300,000 300,000 *$265 000 18,550 23,850 31,800 45,050 68,900 76,850 79,500 79,500 79,500 79,500 Less operating costs Staff costs(30%) 5,565 7,155 9,540 13,515 20,670 23,055 23,850 23,850 23,850 23,850 maintenance and inventory (10%) 1,855 2,385 3,180 4,505 6,890 7,685 7,685 7,685 7,685 7,685 miscellaneous costs 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 Total operating expenses 8420 10,540 13,720 19,020 28,560 31,740 32,535 32,535 32,535 32,535 Net Cash inflow before tax 10,130 13,310 18,080 26,030 40,340 45,110 47,315 46,965 46,965 46,965 Less depreciation(30%) 100 100 100 100 100 100 100 100 100 100 10,030 13,210 17,980 25,930 40,240 45,010 47,215 46,865 46,865 46,865 Corporate tax (30%) 3009 3963 5394 7779 12072 13503 14164.5 14059.5 14059.5 14059.5 7,021 9,247 12,586 18,151 28,168 31,507 33,051 32,806 32,806 32,806 Add back depreciation 100 100 100 100 100 100 100 100 100 100 NCF after tax 7,121 9,347 12,686 18,251 28,268 31,607 33,151 32,906 32,906 32,906 Less adverse impact on sales 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 2,000 5,121 7,347 10,686 16,251 26,268 29,607 31,151 30,906 30,906 30,906 Cash Outflow PVAF, 21%, 10 Years 000 Market survey 50,000 50 Capital cost 50,000,000 50,000 Mortgage (Annual) 80,000 324.19 Working capital 1,500,000 1,500 Research for new technologies 1,000,000 1,000 52,874 Year PVIF, 21%, n Initial cash outlay 0 52,874 1 -52,874 Cash Inflows 1 5,121 0.8264 4231.9944 2 7347 0.683 5018.001 3 10686 0.5645 6032.247 4 16251 0.4665 7581.0915 5 26268 0.3855 10126.314 6 29607 0.3186 9432.7902 7 31151 0.2633 8202.0583 8 30906 0.2176 6725.1456 9 30906 0.1799 5559.9894 10 30906 0.1486 4592.6316 Net Present Value (NPV) 14,628 NPV = 14,628,000 Conclusion and Recommendations Following evaluation of the proposed project using NPV, it has been found that a positive cash flow will be realised, which implies that the management should go ahead and implement the project because it is worth investing. The management should, however, verify the viability of the project using additional models to increase the credence of accepting the project. The fact that the project’s NPV is positive means that the company will generate positive cash flows and hence it will be justifiable to use the shareholder’s funds to invest in this project. References Atrill, P. and McLaney, E., 1997. Accounting and Finance for Non-Specialists. London: Prentice Hall. Bernstein, L. and Wild, P., 2000. Analysis of Financial Statements. London: McGraw-Hill, 2000. Read More