TR Limited: Financial Evaluation and Financing Decisions - Essay Example

? Contents Part a: Financial Performance and Position of the business 3 Profitability Ratios 5 Liquidity and efficiency Ratios 6 Gearing ratios 7 Part b: Raising fund through Venture Plc 8 Part c: Raising shares on Alternative Investment Market 9 Conclusion 10 Recommendation 10 References 10 Appendix 11 Part a: Financial Performance and Position of the business In order to appraise the financial condition of any organization, financial ratio analysis is regarding one of the most effective and efficient method. The financial appraisal of TR Limited can be undertaken by calculating the relevant financial ratios of the company and comparing it with the prior year in order to monitor growth or decline in the ratios. The financial ratio analysis provides the most effective result when it is compared with the benchmark ratios of the industry, but in the absence of the missing information, the ratios of the current year are compared with the ratios of the prior year. The financial ratio analysis also highlights the working capital condition of the company, whether the company is overtrading or not and how much finance would be required by the company in order to finance its working capital. Ratio analysis is considered to be a very accurate and reliable tool when it comes to analyzing and interpret the financial outlook and performance of an entity. The main reason for performing a ratio analysis is to quantify the results of the financial operations of an entity and analyze them in the light of financial performance of the prior year(s) in order to assess different aspects of the financial feasibility. [Peavler, R. (2001)] The financial ratios are usually divided into various sub categories such as profitability, gearing and liquidity, each put emphasis on a different area of the financial outlook of the organization. These analyses form an integral part of the financial statement analysis, especially from the investor’s point of view, which are always looking for avenues to invest in countries having strengthened and stabilized financial ratios and representing an upward trend. It is of great significance that the ratios must be benchmarked against a standard in order for them to possess a meaning. Keeping that into account, the comparison is usually conducted between companies portraying same business and financial risks, between industries and between different time periods of the same company. [Investopedia.com (2012] The financial ratio performance of TR Limited has been evaluated for the last two years in order to draw attention to various financial trends and significant changes over the period. The analysis is divided into three main categorize namely Profitability, Liquidity and Gearing. Profitability ratios identify how efficiently and effectively a company is utilizing its resources and how successful it has been in generating a desired rate of return for its shareholders and investors. Liquidity ratios measure the ability of the company to quickly convert its asset into liquid cash to settle its short term liabilities. Whereas, the Gearing ratios identifies the extent to which the company is financed through debt and to what degree the operations are being conducted from the finance raised through raising equity capital or otherwise. For the purpose of financial ratio analysis, the financial year from 2011-2012 have been evaluated in order to analyze the financial outlook of TR Limited. The information has been extracted from the annual report of the company. Profitability Ratios   2012 2011   Profitability Ratios Gross profit margin 73.19% 80.65% Net profit margin 21.38% 25.97% ROI 8.88% 23.67% ROCE 18.23% 33.75% Gross profit margin is an analyzing tool which assists in identifying how effectively and efficiently the company is utilizing its raw materials [1], variable cost related to labor and fixed costs such as rent and depreciation of property plant and equipment. The ratio is calculated by dividing the sales revenue by the gross profit. If we analyze the gross profit margin trend of TR Limited it appears that there is considerable decline in the percentage over the last financial year. This presents that fact that the company has not been able to maintain its cost of sales and did not make sure that it remains in constant proportion with the revenue. In addition, the company has not been able to manage the impact of inflation in the cost of material and labor. Net profit margin, on the other hand analyzes the profitability of the company before deducting the taxation and finance charges from the earnings [2]. The ratio is calculated by dividing the profit after interest and tax with the sales revenue of the current financial period. The ratio highlights how well the company is managing its selling and administrative expenses it also highlights the other income generated by the company during the course of its operations. The net profit decreased significantly in the financial year 2012 as compared to the financial year 2011. The primary reason behind such decrease in the net profit margin is that the operating expenses of TR Limited increased by a considerable 43.66% during the current financial year which has caused the net profit margin to decrease during the current year. Return on capital employed (ROCE) is, according to the analyst, is considered to be the most significant ratio in order to evaluate a company’s performance from an investor’s point of view. ROCE measures a company’s ability to earn a return on all of the capital that is being employed by the company [3]. The ratio is calculated as net income upon total capital employed, which is the sum of debt and equity financings. The return on capital employed has decreased significantly from the previous financial year as presented in the tabular representation. If we evaluate the tabular information, the ROCE increased sharply from the financial year 2010 to financial year 2011. The primary reason behind such decline is the massive decrease in the net profit for the company due to the increased finance charge during the year. An analysis of the balance sheet of the company would also reveal the fact that the long term borrowing of the company has also increased during the current financial year which has a direct accelerated impact on the finance charge for the year. The reason behind such hiked up administrative expenses is the cost expanded on the refurbishment and setting up of the new stores and outlets, which the company plans to open in the coming time. In addition, the finance charge of the company also increased during the current year due to the fact that the company acquired additional financing facilities from several banks and financial institutions in order to finance its working capital requirements. Liquidity and efficiency Ratios 2012 2010 Liquidity Current ratio 1.65 2.55 Acid test ratio 1.01 1.47 Receivable collection days 31.06 23.55 Working Capital 142 132 The liquidity ratio measures the company’s ability to pay its short term liabilities. The ratio illustrates that how quickly a company can convert its assets into cash and cash equivalent in order to pay off its short term liabilities [Investopedia.com (2012)]. The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The strengthened the current ratio the more ability the company has to pay its debts and short term obligations over the next 12 months. As apparent from the above financial ratio analysis, the current ratio of the company has always remained above 1 which shows that the company has the ability to discharge its current liabilities. The current ratio of the company has decreased from the financial year 2011 to financial year 2012, which was primarily due to the decrease in the cash balance of the company. A reason behind such decrease would be due to the fact that the company had to pay off the interest charges on the additional loan acquired during the year. The accounts receivable of the company increased considerably in line with the revenue. Although from one point of view, it appears to be a positive sign for the financial outlook of the company that its accounts receivable are increasing and correspondingly increasing its current asset ratio. But on the other hand, this shows that the company has been slower in recovering in cash from its customer thus resulting in a higher accounts receivable to revenue percentage. The acid test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance. Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. The acid test ratio has followed the same trend as the current ratio and only marginal change has been experienced in the acid test ratio. Receivable collection days represent how quickly the cash is received from the debtors. The ratio is calculated by dividing the accounts receivable as per the balance sheet with the revenue for the period and multiplying the result with the days in the financial year. The formula calculates the number of days it takes to collect cash from the debtors on average. The higher the value the less efficient the management is in collecting debts. The debtor collection days has increased during the current financial year which shows that the company has become in efficient in collection the debts. The management of the company should put serious focus on its recovery department and should ensure that the collection period is reduced to the prior year figure or at least it is down to the industry average. In the absence of lower collection period, the company would have to finance its working capital through short term financing acquired from a bank or financial institution on which it will have to pay interest charges. The working capital of the company has also increased which is calculated by subtracting the current assets with the current liabilities of the company. The primary reason behind the increase in the working capital is due to the increase in the trade debts of the company. The additional working capital of the company is needed to be financed through the short term or long term borrowing acquired from any bank or financial institution. Company’s having positive and strengthened financial outlook finances their working capital requirement from internally generated funds and thus avoids incurring interest expenses on loans and advances acquired. Companies, such as TR Limited, whose profitability ratio indicates that the company is facing financial difficulties, usually acquire the working capital requirements by obtaining funds from outside. Gearing ratios 2012 2011 Gearing Ratios Equity ratio 0.49 0.70 Debt ratio 0.51 0.30 Debt : equity ratio 0.49:0.51 0.70:0.30 The gearing ratios and indicate the level of risk taken by a company as a result of its capital structure [Peavler, R. (2012)]. These ratios are a great source of determining the level of financial risk to which the company is exposed and thus helps in reducing it to the optimum. The equity ratio indicates how much of the entity’s assets are financed through the finances generated through the revenue generated from the operations of the entity and raising financing through equity issue rather than acquiring debts or other financial institution. It is apparent from the above mentioned tabular information that the debt equity ratio of the company has worsened as the equity percentage in the capital structure of the company has decreased from 70% to 49%. An analysis of the balance sheet of the company would reveal the fact that the reason behind such decline in the equity ratio is due to the fact that the company’s long term borrowing has increased 3 times during the current financial year. The company must have acquired additional long term borrowing in order to finance its future expansion and to carter to recently received large order from the customers. Considering other financial information, the market value of the company’s non-current asset is ? 29,000 higher than it’s written down value. If the company decides to keep its assets on revaluation model, its equity is likely in increase by the revaluation surplus mentioned before, which in turn will improve its debt equity ratio. The dividend payout percentage has increased which is likely to increase the shareholders confidence on the company. Part b: Raising fund through Venture Plc In a venture capital contract, a company enters into a business relationship with another company, the fund provider, in exchange of holding shares in the company. As mentioned in the case under consideration, TR limited as agreed to award 65% shares to Venture Plc if it agrees to provide funds which would be utilized by the company in order to finance its current and future expansion. There are several advantages of entering into a venture capital relationship with a company. The venture in addition to providing funds is also likely to provide value added services such as mentoring, alliances and facilitate exit. In most of the cases, the venture capitalists are companies which have experience in building companies and providing expert opinions to the company under financial distress. Keeping this particular advantage of venture capitalism into consideration, Venture Plc is also likely to provide TR limited with advice in order to reduce its financial difficulties and strengthened its financial outlook. By entering into a venture capital relationship the company would be able to keep its debt in the capital structure to the minimum and which would be highly beneficial for the financial outlook of the company. There are also certain disadvantages of raising funds through venture capital method. The first and foremost disadvantages of raising funds through this method are that the finalization of the contract can take a long time and it can become a very tedious process. The venture would want to strike the best deal in return for its money and thus the negotiation process can be prolonged as compared to other method of raising finances such as through issuance of equity or debt. In addition, as mentioned in the case, the company is offering 65% shares in the company to Venture plc as a result of which, Venture Plc would hold controlling shares and thus would be able to manage the business as per its own discretion. Part c: Raising shares on Alternative Investment Market As per the general equation of accountancy, the assets of a company are financed either through equity or debt. In the statement of financial position or balance sheet of a company, the total of assets is always equal to the total of liabilities and debt. The decision of how to finance the asset of a company is of prime importance for the management of the company. In most situations, the management strives to strike a balance between the level of debt and equity in its capital structure. Raising finance through Alternative Investment Market requires floating shares in the market. Equity is usually generated by issuing shares in the stock market where the company is listed. Initially at the time of the inception of the company, the shares are floated for the first time in the stock market which is termed as the Initial Public Offering (IPO). Primarily the equity shares are issued at ‘Par value’ but subsequent issues are made at premium. The cost of raising equity comprises of printing of shares, cost of listing the equity shares on the stock market and the legal and professional charges paid to the consultants for the due diligence of floating the new shares in the market. When it comes to raising finance through debt, very little or minimal cost is involved for the sanctioning of the loan whether it is long term or short term. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank or financial institution by filing an application for the sanctioning of the loan. The bank or any other financial institution, after evaluating the necessary details such as credit history, financial outlook for assessing the ability of the entity to repay the loans in future, and the purpose of the project for which the loan application was filed, sanctions the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a predefined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. There is another drawback of raising finances through issuance of equity. There is always an uncertainty that the shares will not be completely subscribed by the public, whenever they are floated in the market, and thus the company would not be able to raise the required funds. In contrast, in equity financing, the company has to wait for a considerable longer period of time for the funds to become available for their utilization. Conclusion The financial analysis shows that TR Limited is managing its resources prudently and effectively. The company is making every possible effort to reduce the amount of debt in its capital structure as much as it is possible so that it does not have to bear excess cost of interest charge in its income statement. In addition, the company has enough liquid assets through which it can easily discharge it liabilities in the near future. Although the company is facing some liquidity crunch currently, as presented from the deteriorating current asset and acid test ratio, but effective management of the resources can turn this situation around. The profitability ratio of the company can also be uplifted through curtailing cost of sales and other operational costs so that the gross and net profit margin of the company can be improve. Recommendation Keeping in view of the above pros and cons of raising funds through venture capital relationship or raising funds through Alternative investment market, it is suggested that the funds should be generated by issuing fresh equity shares in the AIM. The primary reason, as mentioned earlier, venture capital relationship will compromise the director’s control over the company and 65% of the shares would be awards to the counterparty to the agreement. Raising funds through AIM would not only improve the capital structure of the company by improving its debt equity ratio but will also increase the volume of shares being traded in the stock market, which is always a positive sign for any company References [1] Peavler, R. (2001) Profitability Ratio Analysis. [online] Available at: http://bizfinance.about.com/od/financialratios/a/Profitability_Ratios.htm [Accessed: June 24 2013]. [2] Peavler, R. (2013) Debt and Equity Financing. [online] Available at: http://bizfinance.about.com/od/generalinformatio1/a/debtequityfin.htm [Accessed: June 24 2013]. [3] Qfinance.com (2010) Gearing Ratios - Definition of Gearing Ratios - QFINANCE. [online] Available at: http://www.qfinance.com/dictionary/gearing-ratios [Accessed: June 24 2013]. [4] R.A. Brealey, S.C. Myers and F. Allen. (2011) 'Principles of Corporate Finance. 11th ed. McGraw-Hill/Irwin [5] Neale, R. P. (2003). Corporate Finance and Investment Decisions and Strategies . 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Appendix 2012 2011 in thousand ?   Sales 940.00 620.00 Cost of Sales 252.00 120.00 Gross Profit 688.00 500.00 Operating Expenses 487.00 339.00 Operating Profit 201.00 161.00 Other income - - Profit before interest 201.00 161.00 Finance expense/ (income) 122.00 28.00 Taxation 15.00 26.00 Profit for shareholders 64.00 107.00 Dividends - - Retained profit / (loss) - - Non-Current Assets 359.00 235.00 Current Assets Stock 140.00 92.00 Trade and other receivable 210.00 100.00 Other - - Cash 12.00 25.00 362.00 217.00 Total assets 721.00 452 Current Liabilities Trade and other payab. 80.00 40.00 Overdrafts 140.00 45.00 Other - - 220.00 85.00 Non-Current 150.00 50.00 Liabilities Total Liabilities 370.00 135.00 Net Assets 351.00 317.00 Equity Share Capital (?1 nominal) 50.00 50.00     Retained Profits 301.00 267.00 351.00 317.00 Debt and equity 721.00 452.00 Ratio Formulae Gross profit margin Gross profit/Sales Net profit margin Net profit/Sales ROI Net Profit/Total assets ROE Net Profit/Shareholder's Equity Current ratio Current Assets/Current Liabilities Acid test ratio Current asset(except inventory)/Current Liabilities Equity ratio Shareholders Equity/Total Assets Debt ratio Total liabilities/Total Assets Read More