The Relationship Between Contribution and Profit Before Interest and Tax - Statistics Project Example

Capital or proper finance is a necessity that needs to be injected in a business to operate it effectively and efficiently; not only the management and operations in any particular business are of the essence, proper mode of financing also helps in determining the long term survival of any business entity. The two broad financing options available for any company are Equity and Debt Financing. Equity Finance is to raise finance by issuing shares, rights issue or by utilizing existing retained earnings of a company. Finance is gathered by all such modes and then it is used upon in profitable ventures for the long term stability of the company. Debt finance on the other hand is a way of raising finance through loan, debenture or other short or long term obligations. A company has to decide upon the benefits and the drawbacks of both these separate methods of financing before concluding upon any one. The issue of preference shares is deemed to be a form of debt financing as it carries with itself an element of loan. A predetermined rate of interest is to be paid to the preference shareholders out of the profit and only after that the residual profit is to be divided amongst the ordinary shareholders as dividend, even if a company winds-up, on its winding-up, preference is to be give to the preference shareholders over the ordinary shareholders. Debt financing is deemed to be less risky for the debt holder as it includes interest and it can be secured. The cost of debt to a company is therefore relatively less than equity financing. Besides this, debt is considered cheaper by the providers of finance and it attracts tax relief on interest payments. The greater the level of debt, the more will be the financial risk to the shareholder of the company. Hence the return required would be higher. Equity finance is considered a comparatively more risky approach of raising finance than debt financing, it is also considered more costly to raise equity finance than to raise debt finance as the cost involved in marketing and promoting the shares are higher as compared to minute costs relating to debt finance. Besides all such costs, there is always a risk that the shares issued by any company may remain unsold, hence to avoid such risks, many companies have to bear underwriting costs. Gearing is an essential element which also helps in deciding upon the balance between equity and debt financing. The more highly a company is geared, the more difficult it would be for the company to raise further debt finance as high level of gearing denotes that the company is highly involved in debt financing. The higher the level of gearing, the higher would be the return required from the loan provider as he would be exposed to greater risk and the susceptibility that his money might go unpaid if the company goes bankrupt. Gearing is usually divided into two types: Financial gearing; measures the relationship between shareholders capital plus reserves and either prior charge capital or borrowings or both. The most common ways of calculating financial gearing are based on the balance sheet values of the fixed interest and equity capital. It is calculated using the formula: Financial Gearing = Prior Charge capital × 100% Equity capital (Including Reserves) Operational gearing; measures the relationship between contribution and profit before interest and tax. It is commonly calculated as such: Operational Gearing = Contribution Profit before Interest and Tax “However, Operational and Financial gearing have the common feature that an increase in either (i.e. higher fixed cost or higher debt) reduces the earnings available to shareholders and thereby increases their risk. High operational gearing also exposes lenders to the risk that, if an entity makes losses or suffers a serious fall in profits, their loans may not be fully or even partially serviced” (Capital Structure and Cost of Capital, 2006) “Tesco operates 923 stores and employs 240,000 people, giving us access to a population of 260 million across our nine markets. Over the past five years, we have expanded from our traditional UK supermarket base into new countries, products and services, including a major non-food business, personal finance and internet shopping. The increasing scale and internationalization of our sales and purchasing operations makes a significant contribution to our efficiency and profitability, as we progress towards our long-term goal of becoming a truly international retailer” (Global Sources). Besides the formulas given above, there are many other ways in which the capital structure of a company can be ascertained. Debt to Equity ratio and Interest Cover are also used to calculate a company’s capital structure. Debt/Equity Ratio = Total debts : Total Equity Interest Cover = Profit before interest and tax Interest According to the financial statements of TESCO, the ratios calculated would be as follows: Gearing Ratios - TESCO Ratio Calculation 2009 Calculation 2008 FY 2009 FY 2008 Financial Gearing 14,255/ 12,995 × 100% 7,174/ 11,902 × 100% 109.6% 60.3% Interest Cover 3,432/ 478 3,053/ 250 7 times 12 times Debt/ Equity Ratio 14,255/ 12,955 7,174/ 11,902 109.6% 60.3% Prior Charge Capital; 2009 2008 Borrowings 12,391 5,972 Derivative financial instruments and other liabilities 302 322 Post-employment benefit obligations 1,494 838 Other non-current payables 68 42 Total 14,255 7,174 Profit before interest and tax; 2009 2008 Operating profit 3,206 2,791 Share of post-tax profits of joint ventures and associates 110 75 Finance income 116 187 Total 3,432 3,053 According to the Gearing ratios calculated above, TESCO’s capital structure shows a heavy reliance upon Debt finance in the Year 2009 whilst in 2008 it has been more involved with equity financing. According to the financial gearing ratio any company having a gearing ratio of less than 100% is deemed to be a low geared company, at 100% it is said to be neutrally geared and above 100% ratio indicates a highly geared company. With reference to this information, the TESCO seems to be a low geared company in 2008 with a sudden increase in its debt making it a highly geared company in 2009. On the contrary, according to the Debt/Equity ratio, 50% is regarded as a safe limit to debt but in TESCO’s case both the year 2008 and 2009 has an increased level of debt making the company too much dependent upon debt financing. This may refrain them from acquiring any major borrowing from any institution in the future as their ratio buzzers an alarming position, besides if TESCO obtains debt finance in the future, it would have to pay a heavy amount of return to its creditor because the one giving out the loan to the company would be exposed to greater risk in the future as compared to prior years. Interest cover is a measure of financial risk i.e. it shows a company ability to pay off its interest obligation on any borrowings that it has made with the profit that it makes in that period. TESCO’s interest cover is not that low compared to the fact that the company has a good profitability rate. Despite the increase in borrowings and interest paid by the company, it has an increase of approximately 2% in profits for 2009 as compared to 2008. The overall situation for the company with reference to the capital structure does not seem much alarming but if the company pays off some of its long term obligation in the near future, it may further improve their financial position and the capital structure as well. (Annual Report, TESCO, 2009) Factoring “Factoring allows you to raise finance based on the value of your outstanding invoices. Growing businesses, in particular, often find that factoring is a more flexible source of working capital than overdrafts or loans. Factoring also gives you the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems.” (Factoring and invoice discounting, 2008) Some companies use factoring and invoice discounting to help their short-term liquidity or to reduce administration costs. A factor is basically a third party which does transaction on behalf of its hiring company. It usually specializes in trade debts by managing the debts of a particular company on its client’s behalf. The factoring company in return for this service gets their share from the debt they have collected or they give the payment in advance to their client after deducting an appropriate amount as their margin from the original debt amount. This way the factor takes up the risk of the due amount from the debtor of its client, this facility given by the factoring company is known as the non-recourse service. There might be chances where the factor may not take up such risk of the debt and the risk of any bad debt may lie upon the client itself, such service is known as the recourse service. TESCO may hire factoring service in order to improve their working capital position, the factor hired may pay them in advance and in return TESCO can pay of its own debt, this way they would smoothen their working capital position and as a contrary, any loans taken up can be avoided as the cash flow position of the company would improve. TESCO – Short Term Finance Short term finance can be obtained from banks or other lending institutions. Any amount of finance borrowed for a period of less than or equal to a year would constitute as a short term finance. TESCO, according to its Annual Report, has obtained Short term finance from many different sources such as Banks and other lending institutions. As compared to 2008, there is an increase of £812 millions in Trade Payables in the year 2009. Besides this, TESCO has obtained several overdrafts from banks that mature within the next 12 months. Other mode of short term finance for TESCO is borrowing from Joint ventures and its associate companies for a period of less than a year. TESCO has used several modes of obtaining short term finance, besides, few of its long term debts too would be payable in the next year, hence they are categorized as short term or current liabilities in the Balance Sheet of the company. This short term finance is taken by a company to cover its working capital cycle, a working capital cycle is the period between which the supplier is paid and the cash is received from customer to whom sales are made on credit. This is the time when the company’s cash gets stuck up and it requires additional finance for a minimal time period to continue its daily operations, hence to fund in this short span of time, short term finance is obtained. (Johnson et al, 2004, Annual Report, TESCO, 2009) Capital market efficiency Capital markets and the Money markets are markets for long-term and short term capital respectively, a stock market acts as a primary market for raising finance and it acts as a secondary market when it comes to trading existing securities e.g. stocks, shares, etc. Capital markets help in attaining long term capital in contrast to Money market which lend on a shirt term basis. Capital markets deal in long term financing and instruments such as equity, debentures, etc. Stock markets are a good example of Capital markets. In an efficient market, the share prices reflect the type of information available to the investors. Hence an efficient capital market is one in which the prices of securities bought and sold reflect all the relevant information which is available to the buyers and sellers, in such markets share prices change quickly to reflect all new information about future prospects. No individual can dominate in such market. Share prices would vary in a balanced manner if a stock market is efficient, if a company makes a profitable investment, shareholders will know of it and would behave accordingly leading to an increase in the market price of the company’s shares in anticipation of future dividend increase and vice versa, hence an efficient market is one in which the market prices of all the securities traded on it reflect all available information. In such a market, there would be no possibility of forcing the share price to increase or to decrease to unrealistically high or low levels by speculative pressure. This in return would increase the confidence of investors, assuring them that the prices that they pay for shares and debentures give a proper reflection of their correct value. (Cabrera, 2009) Even with all this, firms may be exposed to certain risks such as Transaction risk, Economic risk or Translation risk. In order to avoid such risk, a hedging technique is used. Hedging is a strategy designed to minimize exposure to any unwanted business risk usually arising from fluctuations in exchange rates, commodity prices, interest rates, etc. a derivative instrument is purchased or sold in order to eliminate the risk completely or partially. A perfect hedge neither gives out a gain or any loss hence placing the hedged company in a risk free position in context of the hedged risk. TESCO has applied such hedging technique to avoid any market risk that it faces but has eventually landed up bearing a cost of £30 million as a result of the ineffectiveness of the hedge created. (Shafer et al, 1985) The portfolio theory is somewhat linked with the Capital Asset Pricing Model, an investor should spread his funds over several investments hence establishing a portfolio, as a result unexpected losses from one investment may be offset to some extent by the unexpected gains from the others thus the key motivation in establishing a diversified portfolio is the reduction of risk. The portfolio’s total risk comprises of systematic and unsystematic risk, systematic risk reflects the market wide factors such economic growth rate etc. The Capital Asset Pricing Model (CAPM) gives out the required return based on the perceived level of systematic risk of an investment. CAPM can further be elaborated in a formula as such: Expected Security Return = Riskless Return + Beta × (Expected Market Risk Premium). (Value Based Management.Net, 2010). Before any investment or any project is taken up by a company, that project is properly evaluated using many techniques such as Net Present Value using Discounted Cash Flow Technique, Internal Rate of Return, Payback Period, etc. Of all these techniques, the NPV technique is the most popular one, its uses proper cash flow as compared to other techniques using accounting profits to ascertain any project’s viability. NPV technique also uses the time value of money over the project’s or the investment’s life. Time Value of money is the concept that any denomination of a currency may not be holding the same value after a specified period of time as compared to the value that it holds today. While calculating the NPV, a Weighted Average Cost of Capital is also ascertained, it is later that WACC that determines the Discount factor at which the time value of the money is calculated. WACC is the average cost of the company’s finance, weighted according to the relative size of each element compared with total capital. Bibliography Artikis, George P. Capital Structure. [Bradford, England]: Emerald, 2007. . Annual Report and Financial Statements 2009 www.tescoplc.com/annualreport09 Cabrera, Juan F. Essays in Market Efficiency. Thesis (Ph. D.)--City University of New York, 2009, 2009. Capital Asset Pricing Model CAPM, Value Based Management.net, last updated 2010 http://www.valuebasedmanagement.net/methods_capm.html Capital Structure and Cost of Capital, MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY, 2006 http://www.download-it.org/free_files/filePages%20from%204%20Capital%20Structure%20and%20Cost%20of%20Capital.pdf Factoring and invoice discounting, Directors’ Briefing, IOD, 2008 http://www.iod.com/intershoproot/eCS/Store/en/pdfs/directors_briefing_factoring_invoice_discounting.pdf Fairplace Institute of Banking & Finance. Capital Asset Pricing Model. Financial flexible learning, workbook 17. London: FT Pitman, 1998. Global Sources, Buyer Profile, TESCO http://www.globalsources.com/PEC/PROFILES/TESCO.HTM Johnson, Millard. “Revving up the working capital cycle.” Corporate Report Wisconsin (July 1, 2004). www.allbusiness.com/accounting/959776-1.html Shafer, Carl E. Basic Hedging Mechanics: Target Prices, Net Prices and Basis Changes. College Station, Tex: Dept. of Agricultural Economics, Texas Agricultural Experiment Station, Texas A&M University System, 1985 Read More