A Financial Analysis of British Airways - Case Study Example

Running Head: A FINANCIAL ANALYSIS OF BRITISH AIRWAYS A Financial Analysis of British Airways in Harvard Style by University TABLE OF CONTENTS ABSTRACT 3 BACKGROUND TO THE STUDY 3 AIMS AND OBJECTIVES 4 RESEARCH QUESTION 5 REASONS FOR STUDY 5 INFORMATION GATHERING 5 TYPE OF DATA USED 6 INFORMATION GATHERING METHODOLOGY 6 ANALYSIS 7 ANALYSIS OF INFORMATION 7 PRESENTATION OF FINDINGS 13 CONCLUSION 20 APPENDICES 24 REFERENCES 27 1.0. ABSTRACT This report looks at the financial situation of British Airways Plc amidst the threats and challenges in its external environment. In doing so, this paper will utilize three different financial analysis techniques. First, the current performance of the company will be compared with its historical financial data in a trend analysis. In order to simplify the analyses, the six year period of 2001-2006 will be considered. Second, a financial ratio analysis will also be conducted in order to ascertain the profitability, working capital or efficiency, liquidity, and financial leverage of the company. Recognizing that the financial analysis will be maximized by more data, it uses 2005 as a comparative year for 2006. Lastly, this paper will also compare the financial data and ratios of British Airways Plc, its key competitors, and industry through a benchmarking analysis. The report concludes with the identification of the airline's financial strengths and weakness. 2.0. BACKGROUND TO THE STUDY The British airline is rapidly evolving due to external environmental forces. The industry has been faced with a dismal outlook with the onset of economic downturn in the world led by the business cycle in the United States (Sorensen 2006). Furthermore, the emergence of low cost carriers in the European airline industry is a living example of how the strategic directions of business organisations are strongly affected by the changes, trends, and developments and their external environment. It is apparent that the European airline industry has progressed from being dominated by large, business class air carriers to one which is increasingly controlled by the proliferation of low cost airlines (Sorensen 2006). The wide popularity and acceptance of budget air travel puts pressure on large carriers like British Airways (BA) Plc. to implement more aggressive market strategies in order to compete in the marketplace. With this backdrop, it has been expected that the performance of business class air carriers like BA have declined while budget airlines take center stage. This, in turn, is expected to be reflected in the financial performance of the business organization. Financial analysis has become one of the most popular techniques utilized in order to ascertain the health and well being of a business organization. Financial analysis enables decision makers to uncover trends in business performance and compare different business organizations (Keown, et. al 2005). In line with this, it becomes important to analyse the financial situation of the BA in order to understand how it copes with its weaknesses and faces various threats. 2.1. AIMS AND OBJECTIVES Based on its annual reports, its key competitors, and the whole airline industry, this report generally intends to examine the financial situation of British Airways Plc. This report aims to accomplish the following objectives: 1. Determine the trend of growth of BA's key income statement and balance sheet accounts; 2. Evaluate the performance of BA in terms of profitability, liquidity, solvency, and financial leverage through the use of financial ratio analysis; 3. Compare the performance of BA with its main competitor by benchmarking; and 4. Reveal the business organization's areas of financial strengths and weakness. 2.2. RESEARCH QUESTION Based on the aforementioned research aims and objectives, the research question in consideration can be adequately stated as follows: What is the general assessment on British Airways Plc's financial situation based on its revenue and asset growth, financial ratios, and relative performance compared to its key competitors 2.3. REASONS FOR STUDY Recognizing the intense competition and the public's increasing preference for low cost travel, it is interesting to uncover how BA performs. Industry experts have forecasted the rapid growth of low cost carriers and its adverse consequences for business class airlines like BA (Sorensen 2006). Taking the point of view of the current and potential investor of business organizations, it becomes important to evaluate and understand the financial situation of BA amidst these numerous challenges. This study is facilitated by the accessibility and availability of BA's annual reports. 3.0. INFORMATION GATHERING This report recognizes that the final output is only as good as the data used in the analysis and to arrive at a conclusion. Thus, it has ensured the accuracy of the data gathered and the efficiency of the data gathering technique employed. 3.1. TYPE OF DATA USED The nature and background of the study implies the sufficiency of secondary data in completing this report. Therefore, no primary sources are used. Instead, this research makes use of the following data 1. Annual Reports of BA from the six-year-period 2001-2006; 2. Annual Reports of BA's main competitors during 2006 including UAL Corporation, and Air-France KLM; and 3. Financial data and ratios of the airline industry. It should be noted that these financial statements have become the basis for the ratio, trend, and benchmarking analyses. For the theoretical frameworks which are used in the analyses, this paper draws important insight from textbooks, journals, business articles, and financial databases like FAME and Yahoo Finance. 3.2. INFORMATION GATHERING METHODOLOGY Technological advancements have facilitated the efficient gathering of the aforementioned secondary data. The annual reports of BA and the other business organizations in consideration are downloaded directly from their respective websites. Since the annual reports contain much more than the needed information, the author has focused only on the company's financial statements like the balance sheet, income statement, and statement of retained earnings. The required information is transcribed in Microsoft Excel spreadsheets to allow easier and more convenient processing. On the other hand, the other secondary sources like textbooks, journals, and business articles are obtained from libraries while some are retrieved electronically. This report also makes use of the FAME financial database. 4.0. ANALYSIS 4.1. ANALYSIS OF INFORMATION As previously stated, the analysis of the financial situation of British Airways will be accomplished through the employment of three methods: trend analysis, financial ratio analysis, and benchmarking. This section will briefly outline the methodology applied to the gathered data and the important theoretical frameworks where they are based. 4.1.1. Trend Analysis Trend analysis is defined as the "evaluation of financial data over several accounting periods" (Fraser and Ormiston 2004). Thus, trend analysis is the process of evaluating the changes in the company's financial accounts over time. This analysis does not just indicate the growth of company's sales, resources, and other accounts but also reveals important patterns. Looking at a business organization's performance over a period of time instead of focusing on only one financial period will give a better look of its financial performance. In this report, trend analysis will be administered to important financial accounts like current assets, fixed assets, revenue, net income, debt, and equity. Trends will be identified through a graphical presentation of yearly values drawn using Microsoft Excel. Another method which will be utilized is the computation of annual growth rates in these major financial accounts (Fraser and Ormiston 2004). For example, growth in total turnover in time t will be computed as: Turnover (t-1) - Turnover (t) x 100% Turnover(t-1) In order to ensure the accuracy of the graphical illustration and growth rate computations, the trend analysis is accomplished through the use of Microsoft Excel spreadsheet formulas. 4.1.2. Financial Analysis Financial ratio analysis is a very essential tool in assessing the financial health of a business entity. It enables a financial analyst to spot trends in a business and to compare it with the performance of similar business enterprises within the same industry. This tool is currently utilized by business managers, investors, creditors, suppliers, and other decision makers in order to determine the financial performance and well being of a business organisation (Horngren 2000). Financial ratios are grouped into five categories, each showing a different aspect of a company's financial operations. These are profitability ratios, financial leverage ratios, liquidity/solvency ratios, efficiency ratios, and investor ratios. Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred. The computed operating profit margin, which is the ratio of operating income to sales measures as a percentage of sales, the excess revenue from sales over cost of normal operation excluding financing. Net profit margin, on the other hand, is the ratio of net income to sales. Return on common equity (ROCE) is a variant of return on investment. The return on common equity assesses the rate of return on the investments of common stockholders in the company (Analyzing Company Reports 2005). Another ratio is the turnover ratio which shows to what the extent the company uses its assets to produce revenue. Logically, higher profitability ratios indicate a healthier financial condition. Table 1 shows the different formula used in the computation of the aforementioned profitability ratios. Table 1. Computation of Profitability Ratios Financial leverage ratios provide an indication of the long-term solvency of the firm. They indicate the extent of non-owner claims on the firm's profits as well as the firm's operating capability to meet its obligation. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm's long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Thomson 2002, p. C-6). Table 2 shows the different formula used in the computation of the aforementioned financial leverage ratios. Table 2. Computation of Financial Leverage Ratios Liquidity or solvency ratios are used as measures of the company's ability to finance its short-term obligations by its cash and near cash items. Included in these ratios are current, acid test or quick, and cash ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations. Cash ratio is an indicator of the extent to which a company can pay current liabilities without relying on the sale of inventory and without relying on the receipts of the accounts receivables (Horngren 2000, p.153). Higher ratios indicate more liquidity. Table 3 shows the different formula used in the computation of the aforementioned liquidity ratios. Table 3. Computation of Liquidity Ratios Activity ratios are operating efficiency measures, which determine the ability of a company to maximise its output given a certain level of resources. These ratios significantly gauge the asset, investment, and cost management performance of the business entity. Ratios under this category are average debtor's collection and average trade credits collection. Table 4 shows the different formula used in the computation of the aforementioned activity ratios. Table 4. Computation of Activity Ratios Investor ratios are financial ratios especially designed to covey to investors the asses the profitability of the company's stock as an investment. Earnings per share shows the return to common stock shareholder for each share owned. Shows the rate earned by shareholders from dividend relative to the stock price, while price to earnings ratio expresses the multiple that the market attributes to a common stock relative to its price (Fraser and Ormiston 2004). Table 5 shows the different formula used in the computation of the aforementioned investor ratios. Table 5. Computation of Investor Ratios 4.1.3. Benchmarking Benchmarking is a direct comparison of financial data and financial ratios of business organizations in the same industry (Fraser and Ormiston 2004). It has become a potent way of ascertaining the performance of a company in comparison to the other players who are also exposed to same challenges, opportunities, and threats. Since business organizations in the same industry serve the same market and faces almost the same problems, it becomes rational to compare their financial performance. Furthermore, it is also important to look at how individual companies perform relative to the whole industry. This report will conduct a benchmarking analysis based on the financial accounts and ratios of the other industry players in the global airline industry such as UAL Corporation, Air-France KLM, and industry averages. In order to aid in the process of computing the financial data and ratios, the competitor analysis of FAME and Yahoo Finance database is used. The benchmarking will be conducted through a direct comparison of the financial ratios under consideration. 4.2. PRESENTATION OF FINDINGS 4.2.1. Trend Analysis Figure 1 shows the graphical illustration of the major financial accounts of British Airways Plc from 2001-2005 while Table 6 shows the computed growth rates. It becomes apparent that 2002 has not been a good year for the company due to negative operating profit and net income. The company has managed to recover during the following financial years. Table 6. Growth Rates of Major Financial Accounts (in %, 2002-2005) British Airway's current assets have increased albeit at an inconsistent rate. The mount in current asset is highest at 6.49% yet this growth has slowed down during the following two years. Turnover, on the other hand has slid down during the four year period of 2001-2004. It managed to catch up in 2005 at a meager growth of 3.35% and peaked in 2006 by 33.21%. Operating profit has declined by more than 107% and 1450%, in 2002 and 2003, respectively. The next two years have recorded an impressive double digit increase of 80.56%. It more than tripled in 2005 and slowed down by 19.13% last year. The company has also been showing indications of changing its capital structure. The past five-year-period has seen the rapid decline in debt and ballooning of the less risky financing equity. Figure 1. Graphical Illustration of Major Financial Accounts (in million, 2001-2006) 4.2.2. Financial Analysis Table 1 shows the computed profitability ratios of British Airways in 2006. In order to fully asses the profitability of British Airways in 2006, the company's profitability ratios for 2005 are also included. Based on the computed net profit margin and operating profit margin, the company's profitability has improved. During 2006, the airline is able to turn 8.3% of its revenue in operating profit and 5.5% into net income from the 7.20% and 5.0% recorded in the previous year, respectively. It should be noted that operation in the airline industry requires incurring huge operating costs which could justify the relatively low percentages. In terms of asset turnover and return on equity, British Airways is in a downslide. This can be explained by the capital intensive nature of the business organization. Table 8. Computed Profitability Ratios (2005-2006) Table 9 shows the financial leverage ratios which reveal the capital structure of British Airways Plc. The gearing computed for 2005 and 2006 signify the airlines high dependence on creditors in terms of financing. It should be noted that even though the portion financed by liabilities slightly decreased from the 2006 level, creditors still account for over 82% of the company's resources. Thus, British Airways Plc has a capital structure of 82:18 capital structure in favor of creditors. Generally, this capital structure indicates the business class airline's preference for riskier financing. Liability is generally considered as a more costly source of financing since it ties up the firm with immediate and regular interest obligations. The interest coverage ratio computed shows the company's ability to service its interest obligations. In 2006, the company's interest obligations is 3.8 times British Airway's profit before interest and taxes indicating its huge operating profit relative to operating profit. The business organization seems to have no problem in meeting its interest obligations. Table 9. Computed Financial Leverage Ratios (2005-2006) The company's liquidity has improved from 2005 to 2006. During 2005, the company's liquid assets are not enough to pay off the company's current liabilities. In 2006, however, the current assets are more than enough to settle British Airway's immediate obligations. It should also be noted that the company's current assets are tied up into less liquid resources as cash only accounts for 2.6% of its current resources. Table 10. Computed Liquidity Ratios (2005-2006) Table 11 shows the working capital efficiency ratios of British Airways. Compared to 2005, the airline's ability to maximise the use of resources in order to generate revenue has improved. From the two ratios examined, it can be seen that the company was able to lessen the collection days for each significant transactions. The company's accounts receivables are collected within 29 days in 2006, a three day improvement from what has been recorded in the previous year. On the other hand, British Airway's short term creditors benefit from the huge improvement in its paying period. The company is able to service its trade credits within 25 days in 2006, 20 days shorter relative to the 2005 level. Table 11. Computed Working Capital/Efficiency Ratios Table 12 shows the computed investor ratios of British Airways Plc. The company has not been paying dividends for six year making the air carrier's generate a dividend yield of 0%. Earnings per share is in an uptrend, from 34.8p in 2005 to 39.8p in 2006. The ratio of price to earnings is very high which indicates overvaluation of the air line's common stock. In order to fully comprehend the implication of these ratios from the point of view of investors, it should be noted that stockholders gain from their investment in shares through dividends and capital gains. Dividends are declared by the discretion of the company. Declaration of dividends is often dependent of the amount of profit the business gains from the fiscal year and the size of the company's cash account. Market forces determine the capital gains to be gained from a stock investment. In the case of British Airways Plc, it can be seen that investors gain from huge capital gains alone and hardly from dividend. It is notable that the company's common stock price is in an uptrend. However, the company's inability to pay dividend may send a negative signal to investors. Though market price is rising, the company's financial performance does not seem to justify this uptrend. Table 12. Computed Investor Ratios 4.2.3. Benchmarking Analysis Table 13 shows the financial data and ratios of the British Airways Plc, its key competitors Air France KLM and UAL Corporation, and the whole airline industry during 2006. As stated above, these ratios are retrieved from the financial databases of FAME and Yahoo Finance. In terms of revenue, Air France KLM leads the airline industry with total of $29.29 billion in the fiscal year 2006. UAL Corporation follows with $19.34 billion. BA lags behind its two competitors however, it should be noted that compared with the whole industry, the company still posts higher turnover. Looking at the players' gross margin, British Airways Plc shows superior performance in managing its costs of operations. It should be noted that the business organization, aside from surpassing the industry average of 38.91%, also manages to outclass its competitors who perform below the industry's rate. UAL Corporation's gross profit accounts for 36.11% of its turnover while Air France records a very low gross margin of 15.24%. Table 13. Financial Data and Ratios of the BA, its Key Competitors, and Industry Consistent with total turnover, Air France KLM also comes up with the highest EBITDA (Earnings before Interest, Taxes, and Depreciation Allowance). BA once again shows efficiency in managing its costs as it is able to surpass UAL Corporation which can be recalled to have a far higher turnover. All of the three key players surpassed the industry EBITDA of $945.33 million. In terms of operating margin, British Airways Plc continues to show superlative performance. It records an operating profit margin of 8.59% which is almost twice the industry average of 4.40%. Air France KLM manages to report 4.90% operating margin which is a little above the industry rate. UAL Corporation's operational inefficiency is indicated by the company's 2.13% operating margin. UAL Corporation generates the highest net income of $22.88 billion during the fiscal year 2006. Ironically, Air France KLM which reports the highest revenue is left with the lowest net income ($911.10 million). BA manages to translate $1.01 billion of its revenue into net income. All of the players under consideration exceed the average industry net income of $304 million. Since it generates the highest net income, UAL Corporation logically reports the highest earnings per share (EPS) among the three players. The company's EPS in 2006 is $206.71, far and above the industry's ratio of $3.08. BA's EPS of $8.81 is better than Air France KLM's meager $3.2. After examining the players' and the industry's price/earnings ratio, it becomes apparent that the stocks of the air carriers are generally overvalued. The average price/earnings ratio is 14.44 which is higher than what is recorded by each individual player. Air France KLM's and BA's stocks are highly overvalued at 13.32 and 11.63, respectively. On the other hand, UAL Corporation's stocks are valued less than the earnings that they generate. 5.0. CONCLUSION The financial situation of an organization which is reflected in its various financial statements like the balance sheet, income statement, cash flow, and statement of retained earnings becomes an important indicator of the well being of a firm. Through the use of techniques like trend, financial ratio, and benchmarking analyses, the financial performance of a business organization can be adequately assessed. The trend analysis becomes essential in revealing how the company's current performance compared with the past years. It generally identifies whether the company's financial performance is an uptrend or in a decline. Financial ratio analysis, on the other hand, provides a closer look at a company's operation because it classifies ratios according to the factors measured which includes profitability, efficiency or activity, financial leverage and liquidity. Lastly, benchmarking enables the comparison of a company's performance with the other players in the sector together with the performance of the whole industry. This paper employs the aforementioned techniques in order to gain an insight of British Airway's current financial situation. It should be noted that there is an overall dismal outlook for the whole airline industry because of the various threats in the industry. However, amidst these challenges, the analyses presented in this paper reveal that the financial health of BA is generally stable. 5.1. British Airway's Financial Strengths Even though the company has been highly affected by the issue and controversy of terrorism in 2002 and 2003, BA manages to pull itself from the slump in revenue and losses. The company's current assets are slowly growing while there has also been announcement of plans to upgrade the fixed equipment of the air carrier. What is also apparent is BA's pursuit of aggressively changing its capital structure. This is signaled by the company's declining use of debt in financing its operations and debt. The company continues to boost its shareholder's fund. With this development in the capital structure, BA is continuously lowering its exposure to financial risk. British Airways Plc's cost management is apparently remarkable. The improvement in its operating profit margin and net profit margin indicates its efficiency in managing the costs that it incurs from its operation. When compared to other players in the industry like UAL Corporation and Air France KLM, this ability becomes even more distinct. The company also shows significant improvement in its management of working capital. Through its employment of technological breakthroughs like a computerized information system and online reservation, British Airways becomes more efficient in paying its short term creditors and collecting its receivables. Paying its creditors at a shorter time facilitates the creation of a better relationship between the company and its creditors. On the other hand, shorter collection period gives the business organization more available funds to finance its short term needs. British Airways Plc also experiences a rapid increase in its liquidity. This can be tied to the company's shorter collection period which generates cash more rapidly. Currently, the company can pay more than pay off all its immediate obligations with its huge current assets. The mounting earnings per share of the company amidst the growth in its shareholder's fund signals the maximization of shareholder value which is the primary goal of a business organization. When compared to its competitors in the air transportation industry, British Airways Plc can be considered to have excelled significantly in this aspect. The company's EPS is almost four times that of the industry average. 5.2. Financial Weaknesses The airline industry is a capital intensive business where huge investment is needed to invest in expensive airlines. Furthermore, the industry's operation also requires the acquisition of fuel and incurrence of large fixed costs for manpower. Because of this, British Airways Plc finds it difficult to recoup its investment. It should be noted that the company's return on capital employed is in a decline. Also, the company reports slower asset turnover in 2006 compared to 2005. Even though British Airways Plc seems to attain higher efficiency in managing its working capital, the company still suffers from the disparity of its collection and payment period. In 2006, the company reports that it pays it short term creditors within 29 days however, it is only able to collect from its customers within 25 days. This discrepancy in credit payment and receivables collection needs to be remedied as it can harm the company in the long run. British Airways Plc's investors primarily profits from their investment in the company's stocks through capital gains. It should be noted that the business organization's shares are highly overvalued as indicated by the company's high price/earnings ratio. Also, BA fails to declare any dividend within the last five years. This policy can discourage investors from financing the activities and resources of the company. If this happens, BA will be faced with the challenge of lowering its financial risk as it may resort to its creditors again. Based on the above analyses conducted, British Airways Plc is financially stable amidst the external challenges and threats that it faces. Like any other business organization, it has its fair share of financial weaknesses which can be remedied for further improvement. This paper has strongly emphasized the importance of financial analyses in order to ascertain the health and well-being of a company. However, this report also recognizes the inadequacy of this technique in evaluating a business organization's overall performance. Quantitative analysis often does not tell the whole the story, it should always be supplemented with qualitative analysis. 6.0. APPENDICES Appendix 1. Selected Financial Accounts of British Airways Plc (2001-2006, in million) Appendix 2. Financial Data Used in the Computation of Ratios (2005-2006, in million) Appendix 3. Competitor Analysis (in $, 2006) 7.0. REFERENCES Air France KLM 2007, Retrieved 02 March 2007, from http://www.airfrance.com Brealey and Myers 2005, Principles of corporate finance, McGraw-Hill, 8th Edition. British Airways, Retrieved 02 March 2007, from http://www.britishairways.com/travel/home/public/en_gb Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey Horngren , C. et. al..2000, Accounting.4th ed. New Jersey: Prentice Hall Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Sorensen, C. 2006, Low cost airline flying high, Financial Post, 06 December 2006 Thompson, A. & Strickland , J 2002,Strategic Management.3rd ed. New York McGraw- Hill UAL Corporation 2007, Retrieved 04 March 2007, from http://united.com Yahoo Finance 2007, Retrieved 02 March 2007, from http://finance.yahoo.com Read More