Financial Performance and Equity Value of EasyJet Plc - Case Study Example

 Financial Performance and Equity Value of EasyJet Plc. 1. Report on Financial Performance and Equity Value of Easy Jet Plc. Easy Jet Plc: Company Profile Easy Jet is one of the low fare airlines based in the European region. This low fare airline serves its customers in over 100 destinations and in around 30 countries. These destination hubs include popular vacation spots. The organisation operates mostly in Europe, with certain operations based in North America and in the Middle East regions. The company sells almost all its tickets through online booking facilities and does not offer free meals on board. This might be the reason behind being able to make their costs as low as possible. The dynamic fleet of Easy Jet comprises some 175 Boeing Jets and Airbuses (Hoovers, 2010). Have started back in 1995, Easy Jet has been able to mark its presence among the low fare airlines, in the European region. Past Financial Performance of the company The past financial performance of the company can offer some more insight into the operational and financial conditions of the organisation. To conduct this analysis two years data have been collected from the 2009 and 2008 annual reports of the company. Financial performances are mostly measured in terms of ratios. The rationale behind it is that financial ratios are independent of the size of the firm as they represent themselves as ratios, rather than an absolute value. The net profit of a firm can be reached by deducting interest and tax amount from the operating profit amount. The operating profit ratio is measured as the percentage amount of operating profit based on the revenue amount. In 2008, the operating profit has been higher than the net profit which is quite usual. The operating profit ratio in that year is quite high than that of 2009. The reason is quite clear. The market was down due to the financial downturn the world was facing. The organisation was also hit by the same. The net profit is not much less than the operating profit ratio, giving an idea that the interest expenses and taxation amount have not been much lower. In 2009, the operating profit has been lower than the net profit amount. This was due to the tax shield that the company was able to fetch that year. The current ratio is measured as the proportion of current assets as a percentage of current liabilities. This ratio actually discloses the strength of current assets to repay the current liabilites of the firm. Current assets here, are the assets that are liquid or can be liquidated whenever needed. The suppliers and the creditors are the ones who are most concerned about this ratio. It is of utmost importance to them that the firm maintains a required level of liquidity in its portfolio. This is also significant from the firm’s point of view. Easy Jet needs to have enough liquidity so that the intensity of financial distress can be minimised to a certain level and the company can lay its hands on the existing assets to meet its liquidity needs. Having enough liquidity may not help a firm to minimise its probability of financial downturn but still it can survice the distress by liquidating the current assets it has. The company has moderate current ratio. However the current ratio has been reduced in the year 2009. The decline has seen almost a straight line starting from the year 2008 till the year 2009. Since it is in the airlines industry, it is very much expected that the company would have less current asset ratio and would have high amount of fixed assets. Still the organistion must look at their current assets and must not allow it to fall down further, rather it should make efforts to enhance the same. However a higher value of current ratio would mean that the firm’s working capital is very much tied up in the current assets which would prove disadvantageous for the firm itself. Return on equity is of very much significant from the investors’ perspectives. Investors are very much interested to know about the return they would be getting on their investment in a particular company. No doubt, in this matter, Easy Jet has been able to offer higher return on investment. The investors must be quite happy with the company. The company has offered a return on equity of around 6.5%. Though in the year 2009, their performance has seen a downward ride, still it can be said that they have maintained a good return on equity ratio for their investors. In that year they offered around 5.5 % return on their equity investments. Asset turnover ratio is measured as the total assets as a proportion of total revenue. Being in the airline industry, it is very much obvious for this organisation to have higher asset turnover ratio. The asset turnover ratio has been quite high in the year 2009. The total asset amount had increased in 2009. The change in the total amount of the assets was higher than the overall adjustments in the total asset amount. The revenue had not seen much growth in the year 2009, enhancing the asset turnover ratio. The overall performance of this organistion, from every perspective, has declined during the period 2008- 09. No doubt, the reason has been the great recession that took place in that period. Easy Jet now must look at their finance and operations to enhance the profitability of the firm. At the same time, the firm should enhance its liquidity position so that it is ready to absorb the financial and operational difficulties which can come in the way of its business operations. It has been noticed that in 2009, the firm’s revenue has not seen much growth due to the economic turmoil. As the world has now recovered from the recession to a great extent, it is high time for the organisation to attract more customer to their airflights to enhance their revenues.The company still has quite been able to maintain its attraction for the investors as it offered a moderately positive return on equity, even in the time of recession, when all the other companies were offering negative return to their investors. This is surely a good sign. Another positive sign has been when most of the other airlines were making huge losses, the company was able to make a positive amount of profit in their business. Forecasted Balance sheets and Income statements The forecasted balance sheets and income statements have been shown for the next five years. For forecasting, the balance sheets and income statements of 2008 and 2009 have been considered as the base year. Forecasting is of much significance from a firm’s point of view. Forecasting can give a glimpse of the firms supposed performance in the next few years. The forecasting is based on the relation between the base years’ elements. For instance for forecasting the revenue, the annual growth rate has been considered. The other cost elements have been calculated as the percentage of the revenue amounts. The common size analysis of the income statement has been considered while doing the forecasting. The balance sheet elements have been calculated using the compound annual growth rate (CAGR). The forecasted profitability is not quite prospective for the organization. However there have been limitations since the 2008-2009 figures have been considered while forecasting the figures. One of the worst recessions had happened in that period, which can be treated as an extreme case. So forecasting, based on those figure, are not immune to questioning. However it can be a good warning to the farm about the consequences if it does not give proper attention to its operating and financial activities. In the year 2009, the firm has seen certain downturn in its values. If it does not enhance its conditions, the forecasted values may turn into reality. Determining the stock price “Residual income is net income less a charge (deduction) for common shareholders’ opportunity cost in generating net income” (East Tennessee State University, n.d.). In the recent years the residual incomes are used as valuation techniques under several names like economic profit, economic value added or abnormal earnings. Here this would be used to calculate the stock value. The traditional financial statements do not consider the deduction of dividend or any other charges which are charged on the equity capital. However abnormal earnings valuation model considers the dividend charges and other related charges on the net income available. It explicitly takes into account the cost of equity capital. There is a rationale behind using the residual income and abnormal earnings alternatively. For an instance let’s assume a firm to be operating for long time, after a certain time it should be able to recover its cost of capital. Any income in surplus to that is known as abnormal earnings. As per the abnormal earnings model, the intrinsic value of any firm is divided into two major parts. One being the current equity book value and another is the present value of the future residual income. The expression is as follows Price= Current Book Value + ∑ (RIt / (1+r)t ), Where RI= Residual Income T= Time r= Return on equity. Using this expression the value of the firm’s stock price at the end of 2009 has been calculated. The tabular form has been presented below. Here the net income is calculated on per share basis, so that it would be easy to carry out the calculation with per share items. The residual income is calculated as the net income after deducting the equity charge from the income value. The beginning of stock value has considered the stock price in the period 2008- 09. The supporting data have been taken from the 2009 annual report of easy Jet Plc (easy Jet, 2009). The estimated price at the end of the year 2009 has been higher than the stock price in 2008-09 periods. So it is recommended to buy the shares, so that when the stock price would increase in the next year, the investors can fetch the profit by selling the same. In this case if the return on equity increases, there would be decline in the stock price value. On the other hand an increase in the beginning stock value and net income would encourage the stock price to go up. Free cash flow valuation model is another approach to measure the stock price of the firm (RKM Investment Research, n.d.). In this process the operating profit is taken into account. In this method, it is assumed that the free cash flow is the cash available for the investors. The calculation has been shown below. The free cash flow amount has been divided among the number of outstanding shares. As the number of outstanding shares in not known at the end of the year 2009, it has been assumed that the outstanding numbers have been kept the same. As with the previous case, this one also has higher share price than that of the previous years, which means that it would be suggested to buy the stock only to sell it when the prices will be up. The share price is supposed to increase with an increase in the operating profit, amortization and interest amount. 2. Balance Sheet Based Accounting and Reporting Approach Vs Income Statement based Approach The primary objective of a firm is to enhance its earnings by increasing its revenues. In this process they will acquire more assets, transform and sell some of them in the process of realising more growth in the business ventures. In such a scenario, a balance sheet approach where it has been assumed that the firms are meant to acquire assets, store and grow them to enrich their operational activities, is not of much significance. The organisations today are working as ‘asset furnaces’ rather than ‘asset greenhouses’. The firms today maintain a continual stream of expenses with the expectation that it would help it to fetch more revenues and earnings through the incremental expenses. The balance sheet approach makes the firms look like eternal storage of the assets and that the pertaining asset values are going to be the same throughout the years. However, organisations with efficient operational and financial activities cannot survive in such an environment. Activities are only the temporary means to carry on the business. In a working paper, a case was mentioned to explain this situation. At the end of middle ages, the Italian business environment was quite fragmented. “Partners would get together to finance the purchase or rental of a ship, appoint the crew and advance other expenses” (Center for Excellence in Accounting & Security Analysis, 2007). At the project closure, partners used to divide the profits among themselves and disband the partnership. In this instance what mattered were the progression of expenses which took place in the business activities rather than the acquisition of those assets. The main concerns of any business are the revenues and profitability of the business, which can only be found in the income statement and not in the asset centred balance sheets. It is only the expenses which are supposed to deliver the profitability. For an instance there is a company which has acquired a number of assets and has stored them without advancing their expenditure through formation and selling of the pertaining assets. Without any further financial and operational expenditure, it will not be able to fetch any revenue and profit for the company. Until the firm pays for the research, production, marketing and other operations, it cannot expect the revenue and hence the profits to pour in. The assets may have a supporting role to enhance the revenues, but the primary roles are played by the advancement of the expenses. The main point is that if the firms are operating in a route of advancing the profits to make more money out of it and the existing assets are playing some supporting roles to enhance the process, then the proper accounting and financial reporting would need to reflect the picture that is significant in reality. Such critical analysis is logical to establish the supremacy of financial reporting, based on income statement of a firm. The Financial Accounting Standards board has consistently argued that the balance sheet approach of financial reporting has a strong logical appeal, which would naturally lead to the building of theoretical frame work of the financial accounting. Specifically the rationale behind this argument, as per the board is, the notion of assets is more important rather than the other parts of accounting as they are secondary to it. Almost all the parts of the financial accounting have their own extracts taken from the assets on the balance sheet. Liabilities are contrary to the assets; on the other hand equity is the remaining of the assets. So their argument is that revenues can also measured by the increase in the asset amount and decline in the liabilities amount, while the expenses come from the increase in liabilities and decrease in the asset value of a firm. FASB considers the revenues to be realised when there would be an increase in the contact assets and decline in the contract liabilities, which means the company is able to satisfy the performance obligations to the customers by shifting and reassigning the goods and the services (Cunnighum, 2009). FASB considers the earnings to be only a change of value and they argue how one can define value without taking into account the assets since they only allot the values. As a consequence one definitely cannot ignore the balance sheet approach. However they have put some contradictory examples to explain the same. They have mentioned that assets are the prospective future benefits which arise as a consequence of past events of transactions. For instance any property provides the rental benefits after it has absorbed some expenses within it, which can be seen as a stream of past transactions. So there is much dissimilarity in the thought processes of FASB. Hence, the superiority of the balance sheet approach is quite vague. It is better to look at the whole perspective from the investors’ point of views. Investors use the earnings as one of the most significant variable to decide on the company stocks. The concept that investors consider while thinking about earnings is the persistent earnings, not the change of the value of assets. So for the investors the earnings mean the recurring earnings of the firm with a good prospect of future earnings. In contrast, it would be a good idea to analyse the scenarios if the balance sheet approach is used while making the financial reporting for the investors. The asset values are quire relevant to the concept of the mark to market accounting. Even if this procedure is applied, the asset values would be valued at their fair values which are supposed to change each moment as per the condition of the market. As the market is very unpredictable, any accounting based on the market would mean it would be highly volatile with zero perseverance and probability. Investors would not find much interest in wasting time looking at some elements which are quite unpredictable in nature. Research has suggested that there can be huge changes in the reported earnings based on the balance sheet approach, while very little change has been noticed in the underlying expenditure and revenue amounts. The rationale has been quite clear. Balance sheet approach demands a number of disclosures on the assets which would include a number of write offs and ‘one time’ charges and certain other items in it, which are really complex to take into accounting with no such persistence in the same. It is not very intelligent to represent the accounting and report with such unpredictable items which do not have any consistency in its values. A number of problems have been discussed in the above writing. For instances it is quite difficult to apply some of the accounting rules like mark to market in absence of reliable approximation of the market values. That is why now a number of firms have moved towards mark to model approach. The main disadvantage of the model is that the model lies at the discretion of the managers’ abilities. The inputs can be different for different firms as the managers of the firm would not be thinking in the same direction and magnitude. As a matter of fact there can be a probability of error taking place in the systems. A big example of same was the incident of ‘Enron’. The ‘Enron’ experience has shown the notorious side of the mark to model approach. One can surely argue that ‘Enron’, being the extreme case, cannot be taken as the ultimate conclusion. However during this recent financial turmoil, a number of cases have been reported where extremely vague reporting have resulted in many companies to go bankrupt. The dangers of introducing unlimited subjectivity into the estimation of the financial results are quite enormous. The discussion can now be shifted to somewhat less recognised milieus of financial accounting. balance sheet based approach considers a much more extreme form of mark to market and fair value accounting models and creates a circulation loop between the financial markets and the real economy of the country which possibly contributes to the market bubbles. The fair value consideration puts more faith in the market values and thus attributes them a high level of correctness. Real value market is the place where the real values of the assets are being created and financial world is quite different from it. The financial world makes assumptions on the value of the assets in the real value market. The financial accounting and reporting approach must understand the difference between these two perspectives. For instance the market is going in positive direction as the firms are making money and on the other side the firms are making money as their assets are re-valued at the enhanced market prices. So balance sheet approach has created a circular framework to explain the rationale behind the performance of the firms and the markets. All the above analyses are able to successfully find out the loopholes in the balance sheet approach against the approaches based on the income statement. Hence the triumphant income statement based financial reporting and accounting approach has found out a way through the ailed autonomy of balance sheet approach of financial reporting and accounting. Reference Center for Excellence in Accounting & Security Analysis. On the Balance Sheet-Based Model of Financial Reporting. Columbia Business School, 2007. Cunnighum, C. October 27, 2009. FASB, IASB Plod Toward Convergence on Revenue. [Pdf]. Available at :http://www.resourcesglobal.com/content/us/docs/ifrs/FASB,%20IASB%20Plod%20Toward%20Convergence%20on%20Revenue.pdf [Accessed on April 22, 2010]. Hoovers. 2010. Company description.[Online]. Available at: http://www.hoovers.com/company/easyJet_plc/hxrhif-1.html [Accessed on April 22, 2010]. EasyJet. 2008. Annual Reports and accounts , 2008. [Pdf]. Available at: http://2008annualreport.easyjet.com/?id=23542 [Accessed on April 22, 2010]. EasyJet. 2009. Annual Reports and accounts , 2009. [Pdf]. Available at: http://2009annualreport.easyjet.com/ [Accessed on April 22, 2010]. East Tennessee State University. No Date. Residual Income Valuation. Available at: http://faculty.etsu.edu/trainor/FNCE%204617/AE5.ppt [Accessed on April 22, 2010]. RKM Investment Research. No Date. Example of Applying the Discounted Cash Flow Valuation Technique for an Actual Corporate Valuation. [Pdf]. Available at: www.rkminvestmentresearch.com/pdf/financial_analysis_techniques.pdf [Accessed on April 22, 2010]. Bibliography Barker, R. January, 2006. The operating-financing Distinction in Financial Reporting. [Pdf]. Available at: http://www.jabs.cam.ac.uk [Accessed on April 22, 2010]. Sloan School of Management. No Date. Using Accounting Earnings for Valuation. [Pdf]. Available at: http://ocw.mit.edu [Accessed on April 22, 2010]. Vardavaki, A. & Mylonakis, J. 2007. Empirical Evidence on Retail Firms’ Equity Valuation Models. [Pdf]. Available at: www.eurojournals.com/IRJFE%20ISSUE%207%20vadavaki.pdf [Accessed on April 22, 2010]. Appendix Read More