Accounting and Finance Analysis of Sainsbury Plc - Essay Example

Accounting and Finance Sainsbury Plc, what kind of finance the company might have raised You are required to attach just one copy of a balance Sheet as evidence. It is also suggested that you make use of important ratios based on capital structure of the company and make comments. Table 1 Sainsbury Plc. Capital Structure Items 2007 2008 % increase/ decrease Other payables 33 89 169 Long-term borrowings 2,090 2,084 -0.28 Called up share capital 495 499 0.80 Share premium account 857 896 4.55 Other reserves 143 494 245 Retained earnings 2,184 2,366 8.33 (Source: Balance sheet of Sainsbury Plc for 2007 and 2008) Gearing Ratio = (Long term borrowings and other payables) / (Total Equity) x 100 2007 = (33 + 2090) / (495 + 857 + 143 + 2184) x 100 = 57.7% 2008 = (89 + 2084) / ( 499 + 896 + 494 + 2366) x 100 = 51% The gearing ratio represents the extent to which the fixed income bearing securities are used by the firm along with equity in forming its total capitalization. The ratio signifies that in the first year the firm has used around 58 % long term borrowing. However, it was reduced in the next year because the equity portion increased to a higher level. It is evident from the Table 1 that all components of equity portion have increased substantially in the year 2008. 2. Explain briefly the meaning of factoring for business. How useful is it in the organization You may refer to your chosen organization above. Factoring is a method of short term financing whereby a firm sells its trade debts at a discount to a financial institution (Lajoux 2004). It is a continuous arrangement between a financial institution (namely the factor) and a company (namely the client) which sells goods and services to trade customers on credit. As per this arrangement, the factor purchases the client's trade debts including account receivables either with or without recourse to the client, and thus, exercise control over the credit extended to the customers and administers the sales ledger of hi client. The client is immediately paid a sizeable portion of the trade debts taken over and when the trade customers repay their dues, the factor will make the remaining payment. To put in simple language, a factor is an agent who collects the dues of hi client for a certain fee. Factoring offers a number of benefits to a client. In many cases factoring is found to be a more appropriate mode of financing than banks. Some of the benefits are briefed below: The first and foremost service offered by a factor to its client is that it offers an off balance sheet financing arrangement. By collecting receivables of the clients, factor provides them with a means of finance without bothering about the procedures and troubles of usual financing arrangement. Factoring allows firms to manage the cash flow more efficiently. It does not need to wait for the realization of debtors/receivable to find cash flows to pay off various obligations and cash needs. Therefore, cash position/working capital position can be made sound and stern. The efforts of collection of receivables can be canalized to some other areas and thereby organization's efficiency can be improved. In the absence of factoring arrangement, the risk of non-payment should have been borne by the client itself. Thus, factoring is also a kind of insurance whereby the risk of loss or non payment by debtors will be shared with factor(s) Apart from being a financier, a factor provides the client with the management and maintaining ledger of debtors A number of consultancy services such as assessing he credit worthiness of client's customers, ascertain their track record are also offered by factor. In addition to the direct benefits from a factor, the clients are benefited many other indirect trade benefits such as increased working capital position; liquidity; bargaining power and trustworthiness among customers and public at large. 3. Control of working capital has always been thought to be the most important factor in the short-term financial management of companies. In what sense your chosen company may have obtained finance. This must be discussed with some evidence from the figures you provide. (It is suggested that you make good use of your books and notes including use of library/web sites)- provide relevant diagrams. Working capital management is an important aspect of financial management of companies. The entire working capital management revolves around maintaining equilibrium between liquidity and profitability. In other words, working capital management or short term financial position relies on how well short term assets are managed to pay off short term obligations. If a firm has sufficient current assets to pay off current liabilities, the firm's liquidity position can be said to be sound. That does not mean that all current liabilities at a point of time are paid only out of current assets. Current liabilities are also paid out of long term loans and advances. However, at point of time, the firm must have sufficient assets to back up current liabilities. When the current assets are not enough to cove up short term loans, the working capital gets affected and liquidity will be endangered. Therefore, investment in current assets should be neither excess nor inadequate. It should find a trade-off between liquidity and profitability. The working capital position of the Sainsbury Plc is illustrated below: Table 2 Working Capital Position of Sainsbury Plc for 2007 Current assets Inventories 590 Trade and other receivables 197 Cash and cash equivalents 1,128 Total 1,915 Current Liabilities Trade and other payables 2,267 Short-term borrowings 373 Derivative financial instruments 2 Taxes payable 65 Provisions 14 Total 2,721 Current assets ratio = 1915 / 2721 = 0.7: 1 The company's working capital position does not seem to be sound as revealed by Table 2. It is clear from the table that the firm does not have sufficient investment in current assets to cover up short term obligations. The current assets ratio of 0.7:1 implies the company has 0.7 current assets to pay off 1 current liability. 4. Does capital market efficiency imply that all investors know all that there is to know about all securities traded in the market You should include in your discussion, the forms of efficiencies. The term 'efficient market' is used to describe a market in which relevant information is impounded into the price of financial assets. If capital markets are efficient, investors cannot expect to achieve superior profits by adopting a certain trading strategy. This is popularly called as the 'efficient market hypotheses. Informational efficiency of the market takes three forms depending upon the information reflected by securities prices. First, Efficient Market Hypothesis (EMH) in its weak form states that all information impounded in the past price of a stock is fully reflected in current price of the same. Therefore, information about recent or past trends in stock prices is of no use in predicting future price. The semi-strong form of the EMH states that current market prices reflect all publicly available information. So, analyzing annual reports or other published data with a view to make profit in access is not possible because market prices had already adjusted to any good or bad news contained in such reports as soon as they were revealed. The EMH in its strong form states that current market price reflects all-both public and private information and even insiders would find it impossible to earn abnormal returns in the stock market. In one of the pioneering works by Cowles and Jones (1937), it is shown that the US stock prices and other economic series also share these properties. Cowles (1933) found that there was no discernable evidence of any ability to outguess the market. In a subsequent work, Cowles (1944) provided corroborative results for a large number of forecasts over a much longer sample period. Until 1950s, these studies however remained largely overlooked by researchers. Thus, by 1940s, there were scattered evidence in favor of the weak-form market efficiency and strong-form efficiency. Since then, several studies were carried out on 'predicting prices from past prices', 'forecasting returns based on variables such as dividend yield and P/E ratios', and 'inadequacies of current asset pricing models'.2 Another set of studies examined the reaction of the stock market to the announcement of various events such as earnings, stock splits, capital expenditure, divestitures, and takeovers.3 In general, event studies confirmed that security prices seemed to adjust to new information within a day of the event announcement-consistent with the EMH. However, researchers repeatedly challenged the studies based on EMH. Roll (1984), for example, argues that most price movements for individual stocks cannot be traced to public announcements. Cutler et al. (1989) reach similar conclusions in their analysis and find that there is little or no correlation between the greatest aggregate market movement and public release of important information. In recent years, the accumulating evidence against EMH in the form of stock market anomalies such as 'January effect', 'weekend effect', 'small firm effect' and P/E ratio effect suggests that stock prices can be predicted with a fair degree of reliability. Two competing explanations have been put forward for predictability of stock prices. According to the proponents of EMH (Fama and French, 1995), predictability of stock prices results from time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk as predicted by Capital Asset Pricing Model (CAPM). Critics of EMH such as La Porta et al. (1997), however, maintain that the predictability of stock returns can be explained in terms of psychological factors, social factors, noise trading, and fashions or 'fads' of irrational investors. 5. Explain briefly the following terms used in finance a) Shareholders' wealth Shareholders' wealth is represented by the value of shares possessed by the shareholders. It has been accepted as the operational and most viable objective of financial management. The value of shares possessed by one holder is equal to the market value of shares multiplied by the number of shares held by him. For example, if a shareholder holds 100 shares of the market value of 10 per share, the wealth is computed as 100 x 10. All the efforts put by a financial manager should be in line with the ultimate objective of wealth maximization. b) Debentures Debentures are a mode of financing the long term investment decision of a firm. In fact, they are securities offered by a firm to those who are ready to lend money to the firm in return for periodical fixed interest and maturity repayment of principal amount. As a security, it is a written document acknowledging the money borrowed from some one on certain stipulated conditions. There are several forms of debentures such as convertible and non-convertible, secured and unsecured etc. c) Leasing Leasing is a financial arrangement by which one party makes use of another one's assets in return for a consideration called lease rental for a certain period of time. It is popular more as a financing arrangement rather than as asset rental. This legal agreement allows the user (tenant) and owner (landlord) to enjoy the benefits of investment without actually involving the troubles of actual investment. d) Gearing In financial literature, gearing implies the use of fixed income bearing securities such as bonds, debenture, loan stock and preference shares in the capital structure of a company. a company is said to be geared when its capital structure is composed of both fixed and variable income bearing securities. It is also common that companies may be highly geared or low geared depending upon the degree of usage of fixed interest bearing securities. e) Convertible loan stocks A loan stock is a kind of fixed interest bearing security issued by a company to lenders with or without collateral. Sometimes, the issuer also offers the lenders to convert the loan stock into a specified number of common stock after a certain period. Normally, the interest being paid on convertible loan stock is relatively low as it is more attracted by its feature of conversion. f) Portfolio theory/diversification A portfolio is a collection of securities selected by an investor to put his money. The portfolio theory revolves around the concept that putting the entire in single security is risky and investors are informed to diversify their investment and thereby reduce the risk. The main contention of the portfolio theory is that when investment is diversified, the loss from a security (s)can be nullified by profit fro other security (s). g) Overtrading Overtrading occurs when a company unnecessarily expands its business with out bothering about is working capital position. For example, when a start -up company undertake a project that needs huge resources, the initial investment in resources will harm the liquidity and short term financial position of the business. Eventually, this will turn out to be harmful for the creditworthiness and thereby production and earnings. h) Time value of money Time value of money is one of the fundamentals theories of financial management literature. This implies time has money value and thus, money payable and receivable at different points of time has different value and they should not be treated alike. For example, in the capital budgeting decisions of a firm, the present value of cash inflows receivable at different time points in future are not compared together as such. Instead, they are converted into a value at a certain time point and (present value such as value at zero time point) then compared. This is necessary to understand whether a proposal for investment is viable or not. i) Issuing houses An issuing house is one of the various elements of financial system of a country. Normally an issuing house is a merchant banker who takes care of the issue and related matters of a public issue by a corporation. Their services include making arrangements for issue and underwriting of shares and securities. In the UK, issuing houses represent of the three main classes of merchant bakers, the others being acceptance houses and discount houses. j) Capital asset pricing model (CAPM) Capital Asset Pricing Model (CAPM) is one of the earliest asset pricing models. It states that expected asset returns are given by a linear function of assets' etas, which are their regression coefficients against the market portfolio (Cochrane, 2000). The fundamental question is to arrive at the expected return for a particular security so as to price that security. The CAPM, which is an equilibrium model, arrives at this using market index utilizing the concept of mean-variance efficiency. Assumptions in CAPM model include the market is made of risk-averse investors who measure risk in terms of standard deviation of portfolio returns; all investors have a common time horizon; homogenous expectation i.e., all investors are expected to have same expectations about future security returns and risks; and markets are perfect. k) Average cost of capital It is the cost of all sources of capital of a firm. Average cost of capital is used to denote the combined cost of all sources of funds raised from different sources by a firm. By definition, average cost of capital represents the weighted average cost of all specific cost of various sources of long term funds. It is equal to the sum total of weighted average cost of all sources of funds. Weight is computed by assigning the weights to each specific cost on the basis of the proportion of each source in the total capitalization of the company. Thus, average cost of capital is referred; it implies firm's total cost of capital and not cost of any specific source of capital used by the firm. l) Spot rate The price at which a certain commodity, security or any other physical asset is traded at present/ or for immediate settlement is known as spot price. This is in contrast to the future price which is used to settle a transaction at a future time in forward or future contracts. m) Hedging Hedging is the act of reducing or eliminating the financial risks as a result of unforeseen future events. It involves the deployment of a range of tools and methods that can keep the traders from the dangers of price changes and exchange rate differentials as the case may be. The one who desirous of hedging has to come to an agreement (forwards, futures, options or swaps) with another to take a position (either seller or buyer) that can mitigate the likely loss arising from his basic business transactions. n) Preference shares Shares that are issued by a company with an offer to pay fixed dividend during the maturity period and principal on maturity are known as preference shares. They are coined as preferred shares because they enjoy preferential rights as to the payment of dividend and repayment principal when compared to ordinary shareholders. Unlike equity shareholders, preferential shareholders have no voting rights and hence they have no say in the management of the business. o) Premium share value The value over above the face of a share price is called its premium. A share is said to be priced at premium when the buyers are required to pay more than what the share has been issued for initially. Share premium is the extra price demanded by companies on their securities by virtue of their popularity and propensity among the investors. It implies companies that are highly profitable (blue chips) and high future potential are able to price their shares above the face (nominal) value. References Lajoux, Alexandra Reed and H. Peter Nesvold, 2004, The Art of M&A Structuring: Techniques for Mitigating Financial, Tax, and Legal Risk, McGraw-Hill Professional, 2004 Roll R 1984, "Orange Juice and Weather", American Economic Review, Vol. 74, pp. 861-880. Cutler D M, Poterba M and Summers L H 1989, "What Moves Stock Prices", Journal of Portfolio Management, Vol. 15, pp. 4-12. Fama E and French K 1995, "Size and Book-to-market Factors in Earnings and Returns", Journal of Finance, Vol. 50, pp. 131-155 La Porta R, Lakonishok J, Shliefer A and Vishny R 1997, "Good News for Value Stocks: Further Evidence on Market Efficiency", Journal of Finance, Vol. 52, pp. 859-874. Cochrane John H 2000, Asset Pricing, Princeton University Press, Princeton. Read More