The Financial State of British Airways - Case Study Example

Table of Contents Introduction 2 British Airways: An Overview 2 Literature Review 3 Gearing Decision 3 Dividend Policy 4 Working Capital Structure 6 Analysis of British Airways 8 Gearing Ratios 8 Dividend Decisions 12 Working Capital Management 14 Conclusion 14 Reference 15 Bibliography 18 Introduction Decision making in the field of financial management pertaining to capital structure, working capital management and payout strategies have been always been significant for a company. The current financial crisis has reinstated it in a much more intensified way. Undoubtedly, the recession has resulted in adverse consequences on the aviation sector because of the decline in demand and the increase in the operation cost. The report is an effort to present an insight into the financial state of large organisations, such as British Airways. The analysis is significant as it will attempt to excavate many interesting facts about the nature of the company’s financial management. A number of ratios have been inferred to present a comprehensive idea on the performance of the organisation. The report aims to provide an analysis of its working capital management, and check whether the gearing and dividend decisions are in alignment with the relevant financial theories. British Airways: An Overview British Airways is one of the leading airline companies serving 150 destinations in and around 75 countries from hubs based at London’s Heathrow and Gatwick airports. The airline has a fleet of more than 240 aircrafts; among which Airbus and Boeing jets are more prominent in numbers. The carrier extends its network to over 300 destinations in the form of code sharing relationships, majorly with AMR’s American Airlines and few members of Oneworld global marketing alliances like Qantas and Iberia (Hoovers, 2010). In the month of November 2009, the company had merged with Iberia, the leading airline company in Spain, to expand its business further. In the European section, British Airways has been the renowned airline company after Lufthansa and Air France- KLM flag carriers. Literature Review Gearing Decision A firm’s decision related to gearing is one of the most significant ones to be taken by the management because the decision influences every operations of the company starting from the risk profile to the profitability at the end of the financial year. A company’s capital structure can be said to be an accumulation of long and short term debt amount, and common and preferred equity stocks. The capital structure gives implied signals about the firm’s prospects. An optimal capital structure would require decision about “trading off” between costs and benefits. Back in the year 1958, Modigliani and Miller had introduced the modern capital structure theory. This was followed up in 1995 when Rajan and Zingales stated that “theory has clearly made some progress on the subject. We now understand the most important departures from the Modigliani and Miller assumptions that make capital structure relevant to a firm’s value. However, very little is known about the empirical relevance of the different theories” (Bauer, 2004). After that in 1991, a research carried out by Raviv and Harris claimed that they have identified a number of prospective determinants of capital structure. However, among those determinants finding out the significant ones would require more research on this field. Some other researches have also been carried out on the factors which may lead to the appropriate capital structure decisions. However, despite having considerable development in the researches regarding capital structure and gearing decisions, very little attention has been paid to analyse the impact of macro economic conditions on the credit risk and capital structure decisions (Hackbarth, Miao & Morrlec, 2006). In an empirical research done by Bauer, eight determinants that influence the capital structure decisions have been analysed; the factors are size, tangibility, profitability, growth opportunities, volatility, tax, non-debt tax shields and industry classification. A negative relationship has been observed between the leverage and non-debt tax shields. The capitals structure theories introduced by Modigliani and Miller have laid down the foundation for moderate corporate finance. There two theorems are more relevant to the propositions. If taxes do not exist in the market, there would be no value creation to raise the leverage. In the presence of tax, leverage can assist the organisation to reap the benefits of interest tax shield (Cohen, n.d.). The company has to decide on their optimal capital structure in such a way that the company can have enough strengths to pay off its obligations. The gearing decisions are significant for the companies as well as for the debt holders. The debt investors would prefer well controlled capital and financial gearing ratios for that company where they intend to invest their cash. Dividend Policy Dividend is the portion of a firm’s profit amount which is supposed to be distributed to the shareholders. There have been three different major dividend policies in theory and in practice. These are Miller and Modigliani’s dividend irrelevance theory, tax preference theory and Gordon and Lintner’s bird in the hand theory. Miller and Modigliani have opined that a firm’s dividend policy is independent of its cost of capital and market value of the organisation. According to dividend irrelevance theory, in a capital market, in the absence of taxes and transaction cost, the company’s success does not depend on the decision of profit sharing between dividend and retained earnings. The investors are supposed to have access to the same information and have the same expectation from any respective company. As per this theorem, investors are quite independent among dividends and capital gain. As per the ‘Tax Preference’ theorem, investors prefer to keep the capital gains over dividends. The reason is that capital gain is taxed at a lower rate than that of dividend payment. The taxes on the capital gains can also be deferred in future (Csub, n.d.). According to some researchers, the dividend theory ‘bird in hand’ has a better grounding than the ‘dividend irrelevance theory’. According to this theory, the investors of any firm prefer to have current dividends rather than relying on the future capital gains. Investors are supposed to be risk averse in this case and have a preference towards current low income over the potential higher income in future. These dividend policies influence the firm’s decision regarding paying off dividend to their shareholders. According to the ‘dividend irrelevance policy’, investors are independent of dividend and capital gains. Hence organistaions, relying on this policy, may not be bothered about their dividend policy and rather use an independent view towards the payout strategy. Generally investors prefer firm having a higher payout ratio over low paying firms. Hence larger firms prefer to pay a good amount to their shareholders by keeping the payout ratio high. Few investors are more concerned with their firms’ capital growth and would prefer to have higher capital gains in future. That is why many firms, mostly in the growth stage, prefer to retain the earnings for their prospective growth in the future. Broadly, the dividend policy is supposed to be of two types; residual and managed. In the latter one, the company mostly decides on their dividend policy and follows the same, whatever might be the situation. In the former one, the companies’ dividend payout depends upon the remained cash amount after the company is done with its preferable desirable investment. In this case, the dividend payout of the company can be highly variable, sometimes even leading to zero dividend payout. Working Capital Structure “Working capital management approach is frequently to be found as an area of tension between various corporate functions” (KPMG, 2005). Integrated working capital management is accumulation of all processes related to working capital and considers any interdependencies. In the time of need, a company would lay its hands on its liquid current assets as cash and the items which can easily be converted within one year. For an example, stocks, work in progress and debtors constitute a significant part of the working capital. Net working capital can be measured by deducting the short term obligation from these current assets. Short term current obligations are the amount owed by the firm payable within the next year. A major share of the current obligations is often the amount payable to the suppliers of the company. Undoubtedly, any firm is supposed to maintain its profitability as well as its liquidity while carrying out its day to day operations. The significance of cash as a strong indicator of continual financial health must not be so unanticipated in the light of its critical role within the business organisation. While managing the working capital, a mismatch between asset and liability is quite possible. This mismatch may, in turn, increase the profit margin of the organisation. However, this would happen at a cost of solvency risk, which is surely not desirable for a company. On the other hand, extensive liquidity can come at a cost of profitability. So it is a risk return tradeoff inherent in the working capital policies. The company has to decide on this trade off to maximize the firm value. A research study has shown that poor financial management leading to weak working capital management and insufficient long term financing contributing to the failure of a number of companies (Padachi, 2006). The fundamental internal and external factors, influencing the success and failure of a firm have been categorized into various sub factors. External factors like economic conditions, government regulations, competition, technology and environmental factors have significantly influenced the firm’s ability to succeed in the long run, while some of the internal factors like managing skills, accounting systems, workforce and financial management practices are also important for the day to day running of the operation. A number of research studies on working capital management have been undertaken for a few small and large firms in India, UK, US and Belgium to find out the influential factors which have lead the firms to opt for good working capital management practices. The study also looks into the association between working capital management and a firm’s profitability. The management of the working capital is responsible for managing the financial health of the enterprises of all sizes. In most of the cases, the amount put into working capital is larger than the total asset amount. Hence it is of utmost importance for a firm to manage the business working capital. “The twin objectives of profitability and liquidity must be synchronised and one should not impinge on the other for long. Investments in current assets are inevitable to ensure delivery of goods or services to the ultimate customers and a proper management of same should give the desired impact on either profitability or liquidity” (Padachi, 2006). Blocking the resources at the different stage of the supply chain would prolong the cash operating cycle. Although the profitability may enhance due to increased sales, a negative impact can be registered on the profitability, if the costs associated with the working capital is more than the benefits of holding more inventory or offering more trade credit to the customers. Analysis of British Airways Gearing Ratios Among some of the fairly known solvency ratios are the capital gearing ratios. These ratios are meant to analyse the firm’s capital structure, which is very significant from the organisation’s perspective. The following table accumulates the capital gearing ratios of British Airways. The ratios have been calculated for a period of five years’ period, starting from 2006 till 2010. These ratios have revealed the relationship between the long-term forms of financing against the shareholders’ capital. The values have been put into graphical format to facilitate comparative understanding of the ratios. British Airways prefers to have a moderately high level of debt on its accounting book. On an average the company’s operation is financed mostly with its debt. Among its total capital, only 20- 30 % is financed by long term debt. Undoubtedly, the company has enough current liabilities on its book. The red graphical line represents the evaluation of its long term debt against its shareholders’ fund. From 2006 to 2008, the company has reduced their long term debt. However, in 2009, the company has drastically changed its movement and stated accumulating more long term debt. The shareholders fund has been drastically decreased and reduced to half of the amount than what it was in 2008. This had happened in the wake of the global recession around the world, which had resulted in a huge loss for the company. The share prices had gone down with the investors losing their confidence on the organisational performance, leading to a decline in the shareholders’ fund. In 2009 and 2010, the company has increased its long term position; this had been done to avail the benefits of interest tax shields on the profit amount, leading to a reduced deductable amount. At the same time, as the cost of debt is lesser than cost of equity, the company has saved on the total cost of capital by taking more long term debt on its balance sheet. As of now the company has enough equity to pay off the obligations, if required. However, acquiring more debt can lead to a risk position for British Airways. A look at the financial gearing ratios would reveal an insightful analysis of its capital structure and gearing decisions. Financial gearing ratios assess the firm’s ability to pay the interest on its short and long term liabilities. This is an evaluation of a firm’s ability to service its debt obligations. In this case, the company’s condition is dismal with negative earnings in the year 2009 and 2010. However, starting from 2006 till 2008, the company’s interest obligations amounted only 1.5 % - 2 % of the total operating income. In these years, the company had enough capability to bear its interest expenses. The bad performance in the last two years can be attributed to the reduced demand in the airline industry due to the economic downturn across the globe. It is very much visible from the above graph that in the last two years the company failed to fetch profit against the interest spent to service the borrowing amount. The ratio has declined in 2009 due to the reduced purchasing power of the consumers. The company is in deep trouble as it does not even have enough profit to make the interest payments. This can raise the level of concern among the investors regarding the solvency of the organisation. The management must take some immediate action to recover its good financial health; else it will be too late to avoid the adverse consequences. Dividend Decisions The dividend decision is another significant decision to be made by the company management. The company has to understand the expectation of the investors and must react accordingly to gain shareholders’ confidence on the company. The company’s payout ratio reveals that the company assumes that the shareholders are independent between capital gains and dividend amount. However, they do not forget to share its high profit with its investors. It seems that the organisations’ dividend decision is based on residual profit amount. The company has achieved a high amount of profit in the year 2008. In the same year the company has given a high volume of dividend to their shareholders with a payout ratio of 8.15 %. Except that year, the company have not have paid any dividend to their equity holders. This is very much apparent from the above graph. The payout ratio is nil in four years. However, it has seen a stiff growth in 2008. The dividend decisions surely had an impact on the shareholders’ confidence, leading to the impact on the share prices of Bristish Airways. (Source: Yahoo Finance, 2010) The graph displays the share prices starting from 2006 till 2010. In the year 2008, the company had experienced a hike in its stock prices. This has been achieved in the wake of dividend announcement by British Airways. The vent has proved the practicality of ‘bird in hand’ theory. The investors prefer current dividend over future prospective capital gain. The company must review its dividend strategy to enhance its performance in the stock market by regaining the stockholders’ confidence. Working Capital Management The company is very much indulged in short term obligations. Apart from the year 2006, when the current assets exceeded the current liabilities, the rest of the years the company’s ability to pay off its current liabilities with its current assets has been very dismal. Earlier, it has been mentioned that the company’s share price has increased in the year 2008. In that year, apart from paying off the dividend the company has also increased its short term obligations to raise the stock price. The company has higher stock days, which means that considerable amount of money of the company is tied up in its stock. The average number of days before receiving the receivables is calculated by ‘debtor days’ (Chartered Management Institute, 2005). The debtor days have been high making it a risky proposition for the company. The working capital management is not appealing in British Airways. It must look into this factor to ensure enough liquidity on its accounting book. Conclusion The company is going through a very rough patch since the advent of recession. In the last two years, the company has made huge losses, which proved to be devastating in the absence of enough liquidity. Adding to it, the company has high debt on its financial book, which can pose as a major area of concern in this troubled times. The company should introduce a well planned payout strategy to regain the shareholders’ confidence, which is very important, specifically in a capital intensive industry. Undoubtedly, it is high time for the management to look into every section of the financial management including capital structure, working capital management and dividend decisions. Reference Bauer, P. 2004. Determinants of Capital Structure. Available at: http://journal.fsv.cuni.cz/storage/958_s_2-21.pdf [Accessed on August 03, 2010]. Chartered Management Institute. July, 2005. Managing Working Capital. Available at: http://www.barclays.com/latitudeclub/pdf/pdf_182_managing_working_capital.pdf [Accessed on August 03, 2010]. CSUB. No Date. Distributions to Shareholders:Dividends and Repurchases. 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