Short Term Debt Financing Used by Cable & Wireless - Essay Example

Financial analysis of Cables and Wireless Plc. FTSE 100 Company chosen for this study is Cables & Wireless Plc. a i) A. Short Term Debt FinancingUsed by Cable & Wireless The balance sheet of Cable & Wireless reflects following obligations under the head ‘Current Liabilities’ that appear to be of be of the nature of short term debt obligations of the company as on 31 march, 2007 31 March 2007 31 March 2006 Millions of Pounds Millions of Pounds Trade & Other Payables 1221 1381 Loans & Obligation under finance leases 77 143 Financial assets at Fair value 60 0 Provisions 72 89 Analysis: 1. Short term financing arising from the normal operations of the firm is called ‘Spontaneous financing’. Two major short term sources under this category are accounts payable and accruals. Cable & Wireless has clubbed these obligations under the categories ‘Trade & Other Payable’ and ‘Provisions’ It is interesting to note that ‘trade creditors & other payables’ have tremendously reduced from 1381m in 2005/06 to 1221m in 2006/07. Similarly provisions have also gone down to 72m as on March31, 2007 as against 89m as on March31, 2006. The basic reasons for such decline can be the following: a) Credit period is reduced by the suppliers. b) Most of creditors paid off to avail some benefit like cash discount c) Reduction in overall activity say in turnover of the firm The turnover of the firm has increased from 3230m in 2005/06 to 3348m in 2006/07. Despite increase in the turnover and overall business activities current liabilities under the category ‘Trade and other payables’ has reduced from 1381m as on March 31, 2006 to 1221m as in March 31, 2007. As per Cash flow statement (page 40 of the report), during the year 2006/07 trade payables has decreased by 186m. But if we look at the receivables in the same statement, those have also been reduced from 931m on March31, 2006 to 833m as on March 31, 2007. That means both ‘trade receivables’ and ‘trade payables’ have tremendously reduced during the year 2006/07. This gives an indication that overall credit policy in the industry has changed and thereby credit period has been reduced on both trade debtors and creditors. 2. Loan & Obligation under finance leases shown as current liabilities is current portion of long term liability under this category. The important feature to note is that this annual current portion of total long term liability have gone down drastically from 143m as on March31, 2006 to 77m as on March 31, 2007, and this needs an in depth analysis. The situation can be analyzed with reference to understated three categories of figures: 31 March 2007 31 March 2006 Millions of Pounds Millions of Pounds Property Plant & Equipments 1465 1489 Loans & Obligations under finance lease As Current liabilities 77 143 As Non- current liabilities 639 641 It may be noticed that non- current (or long term) liabilities of obligations under finance lease remained more or less same with slight decline of 2m as on March 31, 2007. Similarly the assets acquired has also reduced only by 24m when 2007 figure is compared to the figure of 2006, and this decline it appear is due to depreciation factor. But the current liabilities of obligations under finance lease are diminished by huge 66m when current year figures are compared to previous year figures. One can analyze that during the year 2006-07 certain fresh finance lease obligations were undertaken to acquire some new assets during the year; and also some earlier obligations might have matured. This has caused huge diminishing of current liability portion as diminished amount consisted of principal and interest portions of matured obligations, whereas fresh lease obligations has not contributed any principal amount (may be because of some moratorium period allowed under the scheme of undertaken obligations) into the diminished amount and only interest portion of fresh obligations was included as current liability constituting diminished amount. 3. Financial assets at fair value of 60m depicts huge reduction in market value as on March 31, 2007 of financial assets (may be investments held for trading) maturing in the coming period of twelve months. These investments are most likely be in shape of bonds or other such loan or debt assets. These are short term investments held for trading and being presented at their fair market value as per the requirements of International Accounting Standards now in operation in UK. The company has not earned any losses on this account but the disclosure of the assets is as per accounting standards. B. Long Term (or non- current) Debt Financing Used by Cable & Wireless Long term debt obligations in the balance sheet of Cable and Wireless as on March 31, 2007 with comparative figures of previous year are as under: 31 March 2007 31 March 2006 Millions of Pounds Millions of Pounds Trade and other payables 65 0 Financial Liabilities at fair value 75 106 Loans and Obligations under Finance leases 639 641 Analysis: 1, Trade and other Payables Trade creditors generally form part of current liabilities nut trade creditors as non- currant liabilities throngs the following conclusions: a) Cable and wireless would have entered into specific agreements or arrangements with Sundry Creditors that such trade liabilities extended beyond twelve months, or b) These might have been trade advances the services to be rendered by Cables and Wireless over a period of number of years. Following the concept of ‘matching with revenue’ long term trade payables need proper disclosure. In any case these obligations shall become due beyond the period of twelve months. 2. Financial Liabilities at fair value Financial liabilities may represent bonds or other debt obligations floated by the Cable and Wireless being shown at fair market values as on the date of balance sheet. There is a huge reduction in such liability as on March 31, 2007 when compared to March 31, 2007. These transactions are part of financial activities and cash outflow on account of repayments of borrowings to the tune of 212m have occurred during 2006-07. It can be analyzed some of liabilities representing borrowings would have matured and the rest have been evaluated at fair value as on the balance sheet date. Another matter to be considered is that is no recognition of profit or loss in consolidated income statement on fair valuation of such financial liabilities indicates the values of such liabilities would not have changed when compared to previous year figures. 3. Loan and obligations under finance leases Such long term or non- current obligations have only decreased by a mere 2m as on March 31st 2007 when compared to March 31st 2006. Though there is net cash outflow on account of borrowings is 212m in 2006-07 but outflow on account of purchases of Property Plant and Equipment is also 338m. That means there were fresh borrowings under finance leases during the year and the end result was that non- current liability on this account remained more or less as on the date of previous balance sheet. a) (ii) Gearing Policy and capital structure Capital structure plays an import role in resource mobilization for the benefit of the company; and here also gearing or leverage of capital structure is such a manipulating tools that some times high geared capital structure brings in more than expected profitability. This happens in highly inflationary and charged economic atmosphere. “Capital gearing is generally accepted to be the expression of net debt as percentage of shareholders’ funds.”1 Capital Gearing is also called ‘Leverage’ of capital structure. When debt capital form most part of the capital structure it is called high geared capital structure; and when debt are lower than the equity capital of shareholders, the company is said to be low geared. The amount of leverage in the company’s structure, i.e., mix of long term debt and equity maintained by the company, can significantly affect its value by affecting return and risks. Management has almost complete control over the risk introduced through usage of leverage. Gearing of the capital structure of any company can be tested through the calculations of Debt Ratio, Debt Equity Ratio, and Time- Interest-Earned ratio. For Cables and Wireless these ratios have been calculated in the annexure to this write- up. Due to non- availability of data for complete five years, the analysis is based on the ratios calculated only for two years, i.e., 2006/07 and 2006/07. These ratios provide indirect information on financial leverage or gearing of capital structure. The smaller the ratio, the less capable the company is to meet its obligations as they become due. Financial leverage is usually measured by the ratio of long term debt to long term capital. Since long term lease agreements also commit the firm to a series of fixed payments, it makes sense to include the value of lease obligations with long term debt. Debt ratio for both the years for Cables and Wireless has remained the same 0.29. With such low ratio the company has remained low geared as it was in the year 2005-06. The company has not at all the utilized the gearing tool to the benefit of capital structure manipulations. In fact the company has not felt any need to change the gearing of capital structure. The company has faithful followers in the shape of equity investments. Shareholders are pretty sure about company’s prospectus Similarly the Debt Equity ratio of the company has not moved much. In fact it was 0.41 as on March 31, 2007 and 0.40 as on March 31, 2006. The Debts are not even half of the total capital employed. No financial institution will hesitate in extending financial assistance to the company. Another measure of financial leverage is the extent to which interest is covered by earnings before interest and taxes (EBIT). The regular interest payment is a hurdle that companies must keep jumping if they are to avoid default. The times- interest- earned ratio measures how much clear air there is between hurdle and the hurdler. The company’s Time- Interest- Earned ratio is very strong as on March 31, 2007. It is 6.41 as compared 6.16 as on March 31, 2006. The profits are meeting quite comfortably the fixed interest obligations. During the year 2005-06 the company had operational losses to the tune 50m, but with the help of gains on terminations of operations and profits on sale of non- current assets, profit before interest, i.e., EBIT, rose to 94m and thus Time- Interest- Earned ratio remained maintained at 6.16. The company came back very strongly in 2006-07 with operational profit of 103 m and with resounding help of profits on sale on non- current assets and gains on termination of operations, the EBIT turned out to be 277m. With the resounding help of depreciation its Time-interest-earned ratio stood strongly at 6.41. In other words at present the company has nothing to worry about fixed interest coverage, as its assets are being refabricated every year and thus yielding a good amount of depreciation to maintain its EBIT at respectable level. No standard can be fixed with regard to gearing or leverages of capital structure. In fact the gearing differs from industry to industry and from company to company. b) Pecking Order The pecking order is a consequence of asymmetric information. Mangers know more about their firms than any of outsiders know about the firm. That is the reason Mangers are reluctant to issue stock when they believe the price is too low. They try to time the issues only when shares are fairly priced or overpriced. Investors understand this, and interpret the decision to issue shares as a bad news. That is why stock price usually falls when a stock issued is announced. As per S.C. Myers2 the ‘Pecking- order theory’ of corporate financing goes like this: 1. The firms prefer internal financing. 2. They adapt their target dividend payout ratios to their investment opportunities, while trying to avoid sudden changes in dividends. 3. Sticky dividend policies, plus incredible fluctuations in profitability and investment opportunities, mean that internally generated cash flows are some time more than capital expenditures and other tiles less than capital expenditures. If the cash flows are more, the firm pays off the debt or invests in marketable securities. If cash flows are less the firm firs draws down its cash balance or sells its marketable securities. 4. If external finances are required, firms issue the safest security first. That is to say that they start with debt securities, and then possibly mix securities such as convertible bonds, and then perhaps equity but only as a last resort. In this theory there is no well- defined target debt-equity mix, because there are two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom of the pecking order. Each firm’s debt ratio reflects its requirements of external sources. The pecking order is a consequence of asymmetric information. Debt is better than equity under such asymmetric in formations. Optimistic managers will prefer debt to undervalued equity, and pessimistic mangers will also be pressed to follow suit. The pecking- order theory says that equity will be issued only when debt capacity is running out and financial distress threatens. This theory explains why highly profitable companies borrow less. This is not because they have low debt ratios but because these companies do not need external funding. Less profitable companies issue debt because they do not have sufficient internal funding for their capital expenditure programs but because debt financing is first on the pecking order of external financing. The pecking order theory explains the inverse relationship between profitability and financial leverage. For example all firms in an industry invest to keep up growth in the industry. That means rates of investment will be similar with in an industry and there will be sticky dividend payouts. Under such circumstances the least profitable companies will have less internal funds and they will end up borrowing more as per this theory. So the less profitability mans more borrowings and vice versa. The pecking order theory is not a perfect theory. There are many instances when companies issued equity instead of borrowings. But this theory explains why most of external financing come from debts. It also explains why change in debt ratios tends to follow the requirements of external financing. Trade- off Theory Financial distrust occurs when promises to creditors are broken or honored with difficulties. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. Investors know that levered companies may fall into financial distrust, and the worry is reflected in the current market value of the levered firm’s securities. According to trade- off theory of capital structure, the company should choose the debt ratio that maximizes firm value. The trade off between the tax benefits and cost of distress determines optimal capital structure. At moderate debt levels the probability of financial distress is very small. The probability of financial distress increases rapidly with additional borrowings. If the company is not sure of profiting from tax shield, the tax advantage of additional debts is likely to dwindle and eventually disappear. The optimum capital structuring is reached when present value of tax savings due to further borrowings is just offset by increases in the present value of costs of distress. This is called the trade- off theory of capital structure. In the year 1995 a study between debts vs. equity choices by large firms was published by Rajan and Zingales. As per Rajan and Zingales3 the debt ratios of individual companies depend upon the following four main factors: 1. Size of the company: The larger the firms, the higher the debt ratios. 2. Tangible assets: Companies with high ratio of fixed assets to total assets have higher debt ratios. 3. Profitability: More profitable companies will have lower debt ratios. 4. Market to book: Companies with higher ratios of market- to- book value will have lower debt ratios. Trade- off theory stress that large companies with more of tangible assets are les exposed to costs of financial distress and therefore, would be expected to borrow more. It is further explained that growth companies could face high cost of financial distress and hence, would be expected to borrow less. It seems both the theories are correct theories. Pecking order theory works best foe large companies that have access to public bond markets. These companies rarely issue equities. They prefer internal financing, but turn to debt market, if needed to finance investments. The trade off theory balances the tax advantages of borrowing costs of financial distress. Companies try to select only that capital structure that maximizes company’s value. Companies with safe, tangible assets and plenty of taxable income to shield ought to high targets. Unlike profitable companies with risky, intangible assets ought to rely on equity finances. The trade off theory is particularly helpful in explaining differences in capital structure across the industries. Debt ratios are higher in relatively safe industries and those with tangible assets. Debt ratios are lower in riskier industries where value depends on intangible assets and growth opportunities. References 1Capital Gearing, viewed on November 28th, 2007, http://www.competition-commission.org.uk/rep_pub/reports/1989/fulltext/244a4.4.pdf 2 S.C.Myers, July 1984, The Capital Structure Puzzle, Journal of Finance 39, pp. 581- 582 3 R.G.Rajan and L. Zingales, December 1995, ‘, What do we know about capital structure? Some evidence from International data’ pp. 1421- 1460. Appendix (Ratio Calculations) Cable and Wireless Plc. Full year results Press release for 2006/07 http://www.cw.com/docs/about_us/investor_relations/Finals_Press_Release_200607.pdf Read More