British Airways' Perspectives to Get Investments - Research Proposal Example

Investment Analysis of British Airways Introduction The stock markets these days are behaving in a very depressing manner because of prevalent credit crunch and unpredictable downtrends in both national and international businesses. Many airlines have already closed their shops. Under such situation investment guidance to Tabatha Trotter to invest in stocks of British Airways has to be based on a analytical study of financial statements of BA as well as that of prevailing market trends and atmosphere. Accordingly an analytical study has been carried out in this report with regard to financial performance of BA over previous three years and financial and also of impacts of recent happenings on the present and potential market of stock of British Airways. The recommendations made in this report to Tabatha Trotter are based on results of analysis carried on in this write up. Contents Introduction Contents Performance Analysis Profitability Liquidity Efficiency Capital Structure Gearing Impact of recent happenings Recommendations Analysis Form References Performance Analysis The performance for previous three years of BA has been analyzed using ratio analysis method. The requisite ratios have been calculated in the analysis form. The financial statements of BA for 2008, 2007, and 2006 have been used to calculate the ratios. The analysis has been made under the categories of profitability, liquidity, efficiency, and capital structure. Profitability Profitability has been assessed using gross profit margin, net profit margin, and return on capital employed. ‘The Gross Profit Margin indicates the percentage of each sales dollar remaining after a business has paid for its goods. The higher the gross profit margin, the better. The normal rate is dependent upon the business you are in. The Gross profit margin is the actual mark up you has on goods sold.’(Lind Pinson, page 109)i BA has improved tremendously on its gross margins. Gross margin has increased from 8.5% in 2006 to7.1% in 2007, and then to 10% in 2008. Net Profit Margin is the profit remaining after meeting all finance and tax expenses from earning before interest and taxes (EBIT). “Net profit margin tells a company how much out of every sales dollar it gets to keep after every thing else has been paid off- people, vendors, lenders, the government and so on. Net profit is the proverbial bottom line, so net margin is a bottom line ratio. But it is highly variable from one industry to another.” (Karen Berman and others, page 154)ii BA’s net profit margins have been fluctuating over the last three years. In 2006 it was 5.7%, and that came down to 3.6% in 2007 despite the fact that total revenue increased from £8213m in 2006 to £8492m in 2007. It appears that certain non- recurring expenditure like ‘provision for settlement of competition investigations’ has caused the downfall of net margin in 2007. However, in the year 2008 its net margins gain rose to 7.9%. Return on capital employed is another ratio that has been used to analyze the profitability performance of BA. “This is a very common measure of profitability both for external assessment of company’s performance and for the internal assessment of the efficiency of management. It measures the return on the total capital of the business regardless of how it is financed.”(Michael Broadbent and John Cullen, page 57)iii ROCE of BA was 8.5% in 2006, 8.3% in 2007, and 12% in 2008. The performance of ROCE reflects that company has very well managed its capital resources into its business. Liquidity Liquidity is the indicator of short term solvency of the firm. It reveals whether the company is in a position to meet its short term obligations when those become due. Liquidity of a firm can be measured through its current ratio and quick ratio. “This ratio indicates the extent to which the claims of short term creditors are covered by assets that can be translated into cash in the short term.” (Carlos Correia and others, page 5- 13)iv Current ratio of 2:1 is considered optimum for any industry, but this standard again differs from industry to industry. BA has a current ratio of 1.1: 1 in 2006, 0.9:1 in 2007 and 1:1 in 2008. This current ratio is much lower than the required standard. BA is facing a liquidity crunch and if it continues like this BA might face difficulties in meeting its short term obligations. Current ratio changes in 2008 when compared to 2007 are not even noticeable. The contributing major factors to deteriorating liquid position of BA are current interest bearing deposits that have depleted from £ 1642m in 2007 to £ 1181m in 2008. Quick ratio is also called liquid ratio. “It is little more stringent than current ratio in that you calculate it without inventory. The acid test that this ratio reflects is embodied in the question. ‘Can the company pay its bills when times are tough?’ In other words, if the company can’t sell goods (inventories) can it still meet its short term liabilities.”(Paul Mladjenovic, page 313)v Quick ratio of 1:1 is considered optimum for any industry. BA has quick ratio 1.0, 0.9, and 0.9 in 2006, 2007, and 2008. This shows that liquidity position for BA is deteriorating over the years. The company is actually facing a liquidity challenge to meet its short term obligations. Liquidity is certainly a cause of concern for BA. Efficiency The test that BA is efficiently carrying out its activities is examined through three ratios, namely, stock turnover ratio, average collection period, and average payment period. Though stock turnover is not the main efficiency test for BA, as the company is in service industry, but stock turnover has an impact on overall efficiency of the company. Stock turnover ratio “indicates the number of times the stock is turned over, on an average, and must be replaced during a given accounting period. The higher the stock turnover ratio, the shorter is the average time between investment in stock and sales transaction. On the other hand a low stock turnover is an indicator of bad buying, accumulation of obsolete stock, or the carrying of excess stock. When stock turnover is quick, the company can afford to sell on a smaller gross profit margin.”(Bhabatosh Banjerjee, page 343)vi Stock turnover of BA is 12 times in 2006, 7 times in 2007, and 18 times in 2008. The company has improved upon rapidly in 2008. It appears that BA was not taking the importance of stock turnover seriously prior to 2007, when there was a huge improvement from 4 times in 2006 to 7 times in 2007. Average collection period indicates how quickly a company is able convert its receivables into cash. “It both suggests the quality of your accounts and notes receivable and tells you how well your credit department is handling the job of collecting these accounts.” (Ronal C Spurga, page 31)vii BA has average collection period of 30 days, 28 days, and 24 days in 2006, 2007, and 2008 respectively. The decreasing numbers of average collection days indicate the efficiency that is emerging into the working of BA. Average payment period tells how many days’ credit is available to company for payment to its accounts payables. The more number of days will involve less employment of working capital and certainly speaks of the efficiency with which working capital management is handled. BA has average payment period of 135 days, 125 days, and 118 days in 2006, 2007, and 2008 respectively. The decreasing average number of days over the period is reflecting inefficiency in handling accounts payable. This will involve more working capital as the credit period is reducing because of decreasing average days of payments to accounts payables. Capital Structure Gearing Capital structure of a company indicates how its assets have been financed. When debt capital is used in greater proportion than equity capital, the capital structure is said to be highly geared. On the other hand when more of equity capital is used to finance the assets as compared to debt capital, the capital structure of the company is said to be low geared. BA has a highly geared capital structure all along these three years. In 2006 the gross gearing ratio was 364.32, in 2007 it came down to 245.05, and that further reduced to 153.58 in 2008. It appears that BA is trying to reduce its debt capital over the years, and that will certainly effect the overall profitability of the company. However, from the point of view of investors in equities, even high geared capital structure provides an opportunity to trade in equity. During the period of rising profitability, equity holders stand benefited as residual beneficiaries, as after meeting the fixed interest liabilities the company will have rising profits for equity holders. Overall BA has performed very well on profitability front. The company has problems with its liquidity position. The company is efficiently utilizing its resources for increasing the shareholders wealth. That is why EPS (basic) per share has improved tremendously from 25.5p in 2007 to 59.0p in 2008, and this speaks volumes about the performance of BA up till 31 March 2008. Impact of recent happenings Reacting to current economic crisis being faced by airline industry, Mr. U K Richard Tams, the General Manager of British Airways termed this as ‘ a lot worse than 9/11. 9/11 was sharp shocked but the underlying economic environment was far better. Now we have rocketing fuel prices and weakening demand. It will be fatal for a lot more businesses.”(Travel weekly, 23 September, 2008)viii This clearly reflects that BA like other airlines is facing two major problems. The first problem relates to rising fuel prices, and the second is weakening demand of air traffic. Air traffic decline has direct impact on revenue. Like any other business, the management of revenue in an airline industry is the prime factor affecting its profitability. Under such conditions the airline has to juggle out with air fare settings and controlling seat inventory. Incidentally these factors of rate adjustments and controlling seat inventory are interdependent. The idea is that the airline cannot make heavy adjustments with air fare in order to increase revenue. Excess reduction of or discounting of air fare will ultimately result into decrease in revenue and the problem of low revenue from depleting air traffic remains unresolved. As per a report published in Travel-Mole(4 December 2008)ix, an online travel magazine, ‘the first and business- class traffic at British Airways has got on progressively worse for three months, with a 9.2 % decline in October and 8.6% decline in September. Economic class traffic declined 3.3 percent in October.’ British Airways has tried its best to reduce the capacity for superior first and business classes and increasing the capacity of economic class., but chances of increase in revenue in near future with these traditional airline management techniques seem difficult. As per airline management theory when more discount seats are made available the overall yield will get reduced. BA is facing serious liquidity crunch as stated in performance analysis for last three years. The decline in air traffic resulting in lowering of revenue will immediately affect the ability of BA to control worsening liquidity. With current ratios going further down, BA will find difficulty in meeting its short obligations when those fall due. BA is facing short term solvency problems Financial impacts suffered by BA due to the current economic crisis are enormous as has been reported by the company. The first half of 2008-09 results announced by the company shows a fall in profits of around 90% when compared with similar period of 2007-08. It is important to note that the company has not declared dividend since 2001. Investors are very keen on regularity of dividends. Non- declaration of dividend is a further indication of liquidity crunch that BA is facing for the last few years. As per Interim management reportx the company has shown the following financial highlights that clearly reflect the financial downfall of BA in first six months ending 30th September 2008: a. Operating profits have come down to £140m when the figure for first 6 months ending 30th September 2007 was £ 567m – reflecting a comparative decrease of 75.3% over 2007 performance of first six months. b. Profit before tax has been declared at £ 52m as compared to £616m in the same period in 2007 - that is a fall of 91.55% revealing fall out of the economic crisis on air line industry. c. Surprisingly BA has managed an increased revenue in this period to the tune of £ 4754m as compared to £4470m in 2007. This of course was the result of efficient management by effectively controlling and redesigning the seat inventory. Despite this efficiency the profits before taxes have shown an unprecedented dip of 91.55%. d. Fuel costs rose by 52% as compared to costs in the comparative period of 2007. The interim management report states that this happened despite the fact that the company covered the fuel costs by fuel hedging profits of £329m. An inflationary impact of 73% over the market price of comparative period of 2007 has created such a scenario. e. Another factor that contributed to such heavy slide in profitability is big hike in landing fee and en- route charges due to effects of exchange on non- UK costs, and airport charges in UK. As per interim management report these costs increased by 13.4% over previous comparative period. f. Interim management report also pointed out that other costs have inflated approximately by £ 200m and half of that was the result of currency effects of exchange. g. Again BA has not declared dividend, perhaps observing the slide in financial performance during six months since April 2008. h. The impact on financial performance can be assessed from the fact that earning per share (both basic and diluted) came down to minus (-) 4.3p from an imposing 42.5p (restated figure in interim results) for the year ending March 31, 2008. i. Current ratio has gone down to 0.81:1 as at 30 sep. 2008 from 1:1 on March 31, 2008 reflecting continuously deteriorating liquidity position of the company. Recommendations Ratio analysis has shown that performance wise BA has done better than many other airlines during periods from 2006 to 2008. But from the point of view of making investments into the stocks of BA, it is still like fishing in the troubled water. At present the behavior of stock market is completely unpredictable and any sort of recommendation may not result fruitful because of unprecedented slide in stock market since the end of January 2008. Still there are certain basic rules that will hold well even under unpredictable circumstances like the present one. Tabatha Trotter should follow those basic principles of investment in case they are thinking about investing in the scrip of British Airlines. Though the scrip is one of the best under present circumstances, but the suggestion to Tabatha Trotter is keep an eye on trend of prices of BA. If the trend remains bullish definitely invest the money in BA and if it turns bearish Tabatha Trotter should wait again till there is some sort of bullish tendency again come with longer period of stability Analysis Form References Read More