Fundamentals of Financial Management - Case Study Example

Evidence A: Short and Long-term Financing Sainsbury plc is a limited company publicly listed on the London Stock Exchange. Because of the type of company's business, it has access to a great number of financing opportunities as compared to other types of business like sole proprietorship and partnership etc. The different type of financing options available for the company is debt financing and equity financing. In debt financing, the company can acquire loan through bank, commercial paper, creditors and bond issuance. On the other hand, in equity financing, the company can obtain funds by issuing shares publicly both common and preferred. Sainsbury plc uses different types of financing such as borrowing, bank loans, term loans and equity funds to acquire needed cash. Long term finance is usually paid off after a long period of time such as 10-25 years. On the other hand, short term finance needs to be paid off within a year. Long term finance is acquired to fulfil a company's long-term funding needs whereas short term funds are used to finance company's working capital. Sainsbury relies on short term bank loans, bank overdrafts and short term notes for short term financing, and relies on equity shareholder's funds, medium term notes, finance leases and loan stock for long term financing. The company relies on too much loan capital, which is mostly high interest bearing in the long-term. High payments of interest reduce the company's profits. Also, high loan capital weakens a company's credit worthiness and increases risk in future. Equity financing carries high cost because it is more risky for investors. However, equity financing can be used to generate huge capital and payment of dividends is not compulsory. On the other hand, debt financing requires fixed payment of interest compulsorily. Businesses cannot rely on one source of finance rather they endeavour to maintain a mix of debt and equity capital. Companies with high debt capital are considered as more risky and therefore, the cost of capital will rise as creditors will demand more return i.e. high interest because of high risk involved. High risk, high return for investors and high cost for the company. Evidence B Working Capital Management- Sainsbury plc Working capital can simply be defined as the amount of funds in excess of current assets over current liabilities. It is basically the sum of money which is left after keeping aside the funds that are to be paid off to short term creditors. Working capital is used to finance a company's short term business needs and expenditures Working capital has two major elements viz. the current assets and the current liabilities. It can be mentioned as: Working capital = current assets-current liabilities In order to analyse a company's working capital management, it is useful to calculate ratios such as current ratio, quick ratio, receivable turnover ratio and stock turnover ratio (see appendix I). All these ratios help to determine a company's working capital position. Current ratio shows the ability of a company to meet its short term expenses and obligations out of its current assets less current liabilities. Sainsbury plc's current ratio is 0.79:1 at the end of the year 2006 whereas it was 0.57:1 in 2005 and 0.83:1 in the year 2004. It shows that the working capital position of the company has declined by about 5% over the last three years. The company is able to pay off only 79p for every 1 borrowed. Quick ratio is a variant of current ratio. It is calculated on the basis of only the current assets that can be readily converted into cash, excluding inventory and prepaid expenditures. Sainsbury plc's quick ratio is 0.67:1 at the end of year 2006, 0.46:1 in 2005 and 0.67 in 2004. This means that the company is only able to pay off 67p for every 1 of its short term obligations out of its quick current assets. For efficient working capital management, it is very essential that the company is able quickly convert its receivables and inventories into cash. The receivable turnover ratio shows the time that the company takes to convert all its receivables into cash. Sainsbury plc's receivable turnover ratio is 6.27 or 6 days in 2006, 7.66 or 8 days in 2005 and 7.56 or 8 days in 2004. This suggests that the company quickly and efficiently generates cash out of its receivables in about 6 days. Stock turnover ratio shows the number of times a company converts its stock into cash during the whole year. Sainsbury plc's stock turnover ratio is 26.03 times in 2006, 26.01 times in 2005 and 19.56 times in 2004. This suggests that the company has considerably improved its ability to generate sales out of its inventory in 2006 as compared to the year 2004. These ratios vary by industry and type of business. Sainsbury plc is in the grocery industry which is characterised by high inventory which is relatively quickly convertible into cash. The above analysis illuminate that working capital is moderately adequate in Sainsbury plc. The company can improve its working capital position by keeping more cash and generating more sales out of its inventory. EVIDENCE C Investment in Two Projects Investment appraisal techniques can be used to analyse the feasibility of two different projects. The two projects are in the form of two machines A and B with different investment, returns and costs. The major techniques that are utilised in this regard are ROCE, payback period and Net Present Values or NPV. Calculation of cash flows is essential in applying all the three techniques (see appendix II). ROCE ROCE simply shows the return that is expected to be generated on the investment in the form of net cash flows. The ROCE for machine A is 153% whereas for machine B it is 160% (see appendix III). The net ROCE is 53% and 60% respectively which suggests that machine B is expected to generate more return on invested funds as compared to machine A. The major advantages of ROCE are: It helps to estimate return on investment for projects ROCE also helps to compare two projects on the basis of returns expected to be generated. The major disadvantages of ROCE are: It does not consider time value of money for a medium or long term project It ignores the elements of risk involved in a project Payback Period The payback period shows the number of years it will take a project to recover the initial investment. The payback period for machine A is 2.56 years or 2 years 6 months and for machine B it is 2.54 years or 2 years and 5 months. Although this method does not suggest any big difference in the project cash flows, machine A will recover the initial investment in less time as compared to machine B. Major advantages of Payback period are: It shows an estimated period of time when the initial investment can be recovered It is quick and easy to calculate Major disadvantages of Payback period are: It can be unrealistic because it ignores time value of money It does not consider the variation in cash flows of two projects NPV NPV or Net Present Values is an effective method to appraise two projects. This method evaluates a project on the basis of time value of money. NPV for machine A is 9563, whereas for machine B it is (6,817). Hence on the basis of NPV, machine A should be accepted rather than machine B because machine A has positive NPV and machine B has negative NPV. In other words, machine A will generate cash flows that will be much higher in terms of time value of money than machine B. The major advantages of NPV are: It considers time value of money The calculation of NPV also considers discount rate: cost of capital It also considers variation in cash flows The major disadvantages of NPV are: It ignores the risk factors involved in a project Too much reliant on cash flows Sensitivity Analysis NPV is generally affected by cash flows but its sensitivity varies from project to project. The sensitivity of NPV to cash flows is determined in sensitivity analysis. In conducting sensitivity analysis for machine A and B, it is assumed that sales for each year dropped by 15%. This change in one variable has a great impact on the cash flows of the two projects (see appendix VI). The effect of this change in cash flows on NPV has been evaluated for both the machines, which suggests that a decrease in cash flows due to a fall in sales by 15% has caused NPV to decline by 48% for machine A, whereas machine B's NPV has fallen by 85% in response to a change in cash flows due to a drop in sales by 15%. Hence, Machine B's NPV is more sensitive to cash flows which also suggests that Machine B project is more risky than machine A. The greatest disadvantage of sensitivity analysis is that it is based on estimates and there are no specific criteria for evaluation of sensitivity in NPV due to cash flows. The cash flows are also based on estimation and assumption which might not be right every time. On the basis of all the above analysis, it is recommended that machine A project should be accepted because of the fact that it has positive NPV and the project is less risky than machine B. Appendix I: Ratios Sainsbury plc 2006 2005 2004 Current Ratio Current Assets___ = 3,820 2,901 4,055 Current Liabilities 4,810 5,036 4,906 = 0.79 0.57 0.83 Acid Test (Or Quick) Ratio Current Assets- Stock = 3,820-576 2,901-559 4,055-753 Current Liabilities 4,810 5,036 4,906 = 0.67 0.46 0.67 Receivables Turnover Receivables = 276 319 319 Turnover/365 16,061/365 15,202/365 15,409/365 = 6.27 7.66 7.56 Stock Turnover Cost of Goods Sold = 14,994 14,544 14,726 Stock 576 559 753 = 26.03 26.01 19.56 Appendix II: Calculation of Cash Flows Machine A Year 0 Year 1 Year 2 Year 3 Year 4 Investment (95000) Sales 55,000 70,000 80,000 60,000 Cost 20,000 30,000 35,000 40,000 Residual Value 5,000 Cash flows (95000) 35,000 40,000 45,000 25,000 Machine B Year 0 Year 1 Year 2 Year 3 Year 4 Investment (90,000) - - - - Sales - 45,000 72,000 85,000 65,000 Cost - 25,000 25,000 35,000 40,000 Residual Value - - - - 2,000 Cash flows (90,000) 20,000 47,000 50,000 27,000 Appendix III: ROCE: Machine A: Total Cash Flows Total Investment 145,000 = 153% 95,000 Machine B: 144,000= 160% 90,000 Appendix IV: Payback Period: Years before full recovery + Unrecovered amount at beginning of year Cash inflows of year Machine A: 2 + 25,000 = 2.56 years 45,000 Machine B: 2 + 27,000 = 2.54 years 50,000 Appendix V: Net Present Value NPV = Present value of inflows - Outflows Machine A = 35,000 + 40,000 + 45,000 + 25,000 - 95,000 (1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 = 104,563 - 95,000 = 9563: Positive NPV Machine B = 20,000 + 47,000 + 50,000 + 27,000 - 90,000 (1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 = 83,182 - 90,000 = (6,817): Negative NPV Appendix VI: Sensitivity Analysis For sensitivity analysis, it is assumed that sales for each year dropped by 15% in case of both the machines. Machine A Year 0 Year 1 Year 2 Year 3 Year 4 Investment (95000) Sales (-15%) 46,750 59,500 68,000 51,000 Cost 20,000 30,000 35,000 40,000 Residual Value 5,000 Cash flows (95000) 26,750 29,500 33,000 16,000 NPV = 26,750 29,500 33,000 + 16,000 - 95,000 (1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 = 76,413 - 95,000 = (18,586): Negative NPV NPV Sensitivity = 48% Machine B Year 0 Year 1 Year 2 Year 3 Year 4 Investment (90,000) - - - - Sales (-15%) - 31,500 50,400 59,500 45,500 Cost - 25,000 25,000 35,000 40,000 Residual Value - - - - 2,000 Cash flows (90,000) 6,500 25,400 24,500 7,500 Machine B = 6,500 + 25,400 + 24,500 + 7,500 - 90,000 (1 + 0.15)1 (1 + 0.15)2 (1 + 0.15)3 (1 + 0.15)4 = 45256 - 90,000 = (44,744): Negative NPV NPV Sensitivity = 85% EVIDENCE D Difference in Investment in Shares and Loan Investment in Osbourne plc's shares and making loan to the company with the same amount i.e. 10,000 is entirely different. Investing in the company's share capital will provide an investor the status of shareholder and thus a part of ownership in the company. On the other hand, by making loan to the company an investor will gain the status of a creditor and will create liability for the company. The major differences in both kinds of investment are the factors of risk and return. There is a little risk involved in giving loan to the company because in the event that the company goes bankrupt, the investor will have a priority in the claim on the company's assets. However, there's a great risk involved in investing into the company's shares because in the event of bankruptcy, shareholders have the least claim on the assets of the company. Furthermore the return or interest is always fixed in the case of loan, whereas in stock investment the return or dividend is not fixed. It is compulsory for the company to pay periodic interest on loan which is optional in the case of shares. Because of this fact, most investors prefer to invest in the form of making loan to the company. However, the return on stock investment is always higher than on loans because of high risk/high return phenomenon. Investment Evaluation- Ratio Analysis An evaluation of investment with the help of ratio analysis is provided below: Liquidity Ratios 2006 2005 Current ratio 1.21 1.10 Quick assets ratio 1.14 1.01 Debtor days 118.23 163.17 Creditor days 0.30 0.41 Osbourne plc' current ratio has increased by about 9% in the year 2006 as compared to 2005. The above table shows that the company's quick ratio has also increased by about 9% in the current year. It reveals that the Osbourne plc has 1.14 of liquid assets available to pay off 1 worth of liabilities after keeping aside stock from current assets. It further suggests that the company's liquidity position is gradually improving. Debtor days and creditors' days ratios indicate an important aspect of the company's payment and collection policies. Both the ratios have worsened in the last two years. Debtors days has risen whereas creditor days has fallen which signifies that Osbourne plc collects payment from customers in more days than it pays its creditors. This indicates collection and cash cycle problems in the company. Profitability Ratios 2006 2005 Gross Profit Ratio 22.39% 24.47% Net Profit Ratio 11.00% 12.00% Return On Capital Employed 0.36 0.32 Earnings per share 1.71 1.16 Interest Cover 20.70 12.76 Dividend cover 6.53 11.53 The gross profit ratio as well as the net profit ratio shows a decline by about 5% and 9% in the Osbourne plc's profitability. Net profit margin has declined at a higher rate than the gross profit margin which shows that the company's administration and distribution expenses have risen considerably by about 33% as evident from the company's profit and loss account. However, the ROCE ratio has increased by about 11%. Osbourne plc' EPS has also increased significantly by 32% which is highly attractive for the investors. The interest cover ratio shows that the company's profit before interest was about 20 times enough to pay the interest charges, which has increased by about 39%. Investors making loans to the company may find it very attractive. Dividend cover ratio shows that the company's profit were about 6 times enough to cover the dividend to be paid. Efficiency Ratios 2006 2005 Stock turnover 48.13 21.90 Asset turnover 3.13 2.54 Stock turnover ratio has increased by about 54% in the year 2006 which shows that the company has been converting its stock into sales more frequently and quickly as compared to the previous year. Asset turnover ratio reveals that the company is utilising its total assets more efficiently as compared to the previous year. Solvency Ratios 2006 2005 Gearing 0.16 0.19 Debt Ratio 0.56 0.64 The gearing ratio shows the extent to which Osbourne plc' assets have been financed with the help of debt finance. The company uses less long term debt to finance its assets as it has decreased by about 19%. Debt ratio reveals that the company uses a mixed capital structure to finance its major operations i.e. the level of debt and equity in the company are almost equal. The company has also reduced its reliance on debt capital over the last year. Comparison of Investment in Shares and Term deposits It is better for an investor to invest in the Osbourne plc's shares rather than term deposits and ISA because of the fact that Osbourne plc has the potential to offer higher returns to the investors in future. Investment in term deposits will offer lower return to investors as compared to the investment in Osbourne plc's shares. Appendix for ratio calculation References Brigham, E.F. and Houston, J.F. (2004). Fundamentals of Financial Management. 10th ed. Thomson South-Western: Ohio Read More