Financial Analysis of two companies- Iggle and Piggle - Essay Example

 Case Study: Financial Analysis of two companies- Iggle and Piggle Financial analysis involves systematic knowledge of financial management which entails future planning of individual or business enterprise to guarantee positive cash inflows. The methods of administrating and maintaining of financial assets and liabilities of a company falls under its financial management. The process of financial risk management is also a part of the financial management.. In the organizational structures, the financial management process involves the planning and control of finance. The planning of finance involves the utilization of resources that are available and plan the timing of expenditures whereas; the financial control is done by monitoring the cash flows. The cash inflows are the amount of money that is coming in to the business and cash outflows means the amount of money that is spent for the initiation of the business. This fund management is an essential part in the business and should be followed well. In the corporate world, the main aim on which the management focuses in terms of managing its finances is by achieving various goals that are set for a particular period. There are particular financial processes which should be followed by a firm to fulfill its profit making objectives. Here we will analyse and evaluate the business performance of the two companies- Iggle plc and Piggle plc, with the help of different techniques and tools of financial management. (Economy watch, n.d). Overview of the two companies Iggle plc The company Iggle plc had a return on capital employed of 35% with the return on equity of 20% which is determined by the ratio of net income to the total equity of the company. The net profit margin of the company that is, the profit after interest but before payment of tax is said to be 15%. For the company, the average settlement period of debtors and the average settlement period of creditors are 78 days and 85 days respectively. The stock holding period of the company is 88 days with a gross profit margin of 44%. The company had 15 times of fixed asset turnover and a capital gearing ratio of 65%. The current ratio of the company, which is the ratio between current assets and current liabilities, is 8:1 and the acid test ratio or the quick ratio is 6:1. The company had a price earning (PE) ratio which is determined by market price of shares per earnings per share of 6 and it shows the valuation of the company. Piggle plc The company Piggle plc had a return on capital employed of 20% with the return on equity of 10% which is determined by the ratio of net income to the total equity of the company. The net profit margin of the company that is, the profit after interest but before payment of tax is said to be 9%. For the company, the average settlement period of debtors and the average settlement period of creditors are 25 days and 45 days respectively. The stock holding period of the company is 21 days with a gross profit margin of 27%. The company had 3 times of fixed asset turnover and a capital gearing ratio of 15%. The current ratio of the company is 9:1 and the acid test ratio is 1:1. This company had a price earning (PE) ratio of 10. Evaluation of business performance of the two companies with Ratio Analysis For the evaluation of business performance of two firms, the most helpful and significant method is the ratio analysis. The different ratios used in ratio analysis helps in determining the relative performance of two companies and their valuations. The ratio analysis provides the overall profile along with the economic characteristics and the competitive strategies of the company. The major advantage that ratio analysis provides is the comparison of firms of different sizes. In ratio analysis, process of standardization is very important and is needed in the construction of different ratios, for this some specific differences among the firms are ignored. Ratio analysis is one way which helps in putting the financial statements to work. Ratios are nothing but a number divided with another to show the relationship between them. In finance, two items of financial statement are divided with each other which provide practical and sufficient information for the user for analyzing the business performances of firms. Not all the ratios that can be obtained from financial statements are of equal importance; some of them are not so helpful and can be ignored. The ratios are classified into four areas, liquidity, turnover, profitability and debt. (Atrill and McLaney, 2006) For a business owner or manager ratio analysis is the main tool to spot the business trends and to compare it with other similar type of business in the industry, to evaluate the business performance. These comparisons are done by comparing the different ratios of a company with the similar ratios of other companies to study the trend of the business. It is also helpful in future forecasting by studying and comparing the different ratios of previous successive years. Ratio analysis indicates early warnings in business and gives time for solving the coming hazards before the business gets destroyed by them. Thus, ratio analysis is very important from a business point of view and should be regularly evaluated for smooth running of the business. (Advani, 2006). Now we perform the ratio analysis to evaluate the business performance of the two companies, Iggle plc and Piggle plc. As we can see that the primary measure of profitability, return on capital employed which shows the relationship between net profit of the company and the long-term capital employed for Iggle plc is 35% is higher than 20% of Piggle plc, Iggle plc is better off in this case. The return on equity, which shows the relationship between net income and total equity and provides information about the amount of profit available to equity holders, is 20% for Iggle plc and 10% for Piggle plc. So, as ROE is higher for Iggle plc hence it is better among the two. The gross profit margin, which shows the difference between sales and cost of sales and therefore profitability in buying or selling goods, is 44% for Iggle plc and 27% for Piggle plc. Therefore the analysis of gross profit margin also goes in favor of Iggle plc. The net profit margin, which shows the relationship between one output “sales” to another output “profit”, is 15% for Iggle plc and 9% for Piggle plc. Hence the higher net profit margin for Iggle plc makes it better in comparison to Piggle plc. The average settlement period for debtors shows how quickly an average debtor takes to pay his debt and is better if the number of days is small. The average settlement period for debtors is 78 days for Iggle plc and 25 days for Piggle plc showing that money is coming quicker to Piggle plc than Iggle plc hence, Piggle is better in this case. The average settlement period for creditors shows how long on average it takes for a business to pay its trade creditors, if the days are minimum then that is good for the reputation of the business. The average settlement period of creditors is 85 days for Iggle plc and 45 days for Piggle plc. It can be clearly seen that Piggle plc is better off in this case which implicates that Piggle plc is better in terms of fund circulation in business among the two. The fixed asset turnover shows the effectiveness of investment in fixed assets on sales of the company. It is 15 times in case of Iggle plc and 3 times in case of Piggle plc showing the effectiveness is better in Iggle plc. The current ratio shows that there are sufficient current assets available in the company to cover the current liabilities as they fall due. The current ratios of Iggle plc and Piggle plc are 8:1 and 9:1 respectively which is showing that Piggle plc is more able in terms of paying up the current liabilities. The acid test ratio or the quick ratio shows the coverage of current liabilities by liquid assets that is, assets without inventory. The ratios for Iggle plc and Piggle plc are 6:1 and 1:1 respectively showing Iggle plc to be better in this case. The capital gearing ratio shows the contribution of long-term lenders to the long-term capital structure and it has a benchmark of 30%. The gearing ratios for Iggle plc and Piggle plc are 65% and 15% respectively showing Iggle plc is way above the limit and should apply restrictions whereas, Piggle plc is ok with it. The price earning ratio or P/E ratio compares the market value of the shares with its earnings. A high figure shows the market’s confidence in the future earnings potential of the company. The higher the confidence, the more investors will be prepared to pay for shares in relation to the current earning level. The ratios for Iggle plc and Piggle plc are 6 and 10 respectively showing the confidence of Piggle plc is higher among the two. Project Appraisal of Piggle plc Piggle is currently making investment appraisals of two potential long-term projects, A and B with same initial investment of ₤ 2 millions. The accounting profitability of the project, from the projected financial statements, may not be useful to understand financial feasibility of a project. The financial statements present only expected overall profit of the project, but money value, investment do not reflect in the profitability statements. The worth that will be added by the project is assessed in terms of evaluation of the project. An appraisal criterion of a project consists of estimation of investment requirements and cash flows, and use of several evaluation techniques. The basic assumptions made while applying the evaluation techniques are: 1. Risk associated with all proposed projects under consideration do not differ from the risk of existing investment projects of the firm. 2. The acceptance of any investment proposals does not change the relative business risk of the firm. 3. The firm has certain benchmarks; the investment decisions will be either to accept or to reject the proposal. We assume, both the projects have uniform cash inflows throughout their life cycle and let the life of the projects be 10years. To evaluate the projects, A and B we use the evaluation techniques which are classified as discounted methods and non-discounted methods. The discounted methods take into account the time value of money and all the cash flows occurring during the entire life of the project. It means cash flows are discounted by using cost of capital as minimum discounting rate and all the benefits and costs occurring during the entire life of the project are considered. NPV: The NPV of a project is equal to the sum of the present value of all the cash flows associated with it. It means, NPV is equal to the difference between the present value of future cash inflows and the present cash outflow. If the NPV of the proposed project is positive it is accepted, else it is rejected. In case of mutually exclusive projects, the proposal with the highest NPV gets the first rank while the last rank is given to the proposal with the lowest NPV. The NPV of project A and project B are ₤120 millions and ₤145 millions respectively. Internal Rate of Return (IRR): the IRR of a project is the discount rate at which the present value of cash inflows is equal to the present value of cash outflows. At this rate, project’s NPV is zero. If the IRR exceeds the required rate of return or cost of capital, the project is accepted otherwise rejected. In case of mutually exclusive projects, the project with highest IRR is ranked first and so on. The IRR of project A and project B are 16% and 13% respectively. The non-discounted methods ignore time value of money and all the cash flows occurring during entire life of the project may not be considered. Pay back period: Pay back period signifies the length of time needed to recover the initial outlay incurred on the project. In order to accept or reject a project, a cut-off period is required. Projects with pay back periods less than or equal to the cut-off period will be accepted while others will be rejected. In case of mutually exclusive projects, the first rank is assigned to the project having shorter payback period. The payback period of project A and project B are 4 years and 5 years respectively. Accounting Rate of Return (ARR): Accounting rate of return is the average rate of return on average investments and it is based on the accounting profits. Compare the ARR to a predetermined minimum rate of return or else reject it. In case of mutually exclusive projects, assign first rank to the project having highest ARR and last rank to the project having the lowest ARR. The ARR of project A and project B are 15% and 20% respectively. We analyse and evaluate the two projects, A and B, with discounted methods. Now from the given NPV’s point of view we can see that project B is better among the two but from IRR project A seems to have better future prospects. But as the NPV of project B is much higher than project A, it out runs the effect of higher IRR and hence, project B is preferred over project A in terms of discounted methods. Now we analyse, project A and project B in terms of non-discounting methods, with respect to the given pay back periods for both. The payback period of project A and project B are 4 years and 5 years respectively and accordingly it can be said that project A is better in this term. In terms of accounting rate of return, where the ARR of project A and project B are 15% and 20% respectively we see that project B is better in this respect from project A. From an analyst’s point of view seeing the whole scenario it can be said that overall prospect of project B is better than project A and hence, investment should be made in project B. (Dyson, 2007) Means of Finance Once the project cost has been estimated, the next step is to find out how to finance it. The means of finance and the capital structure (debt, equity mix) bound to have a far-reaching effect on the profitability and also the risk associated with the project. Hence, greater care has to be taken while selecting the financing mix. Available sources of financing include: Equity: It is permanent capital and has no obligation to pay dividend regularly. Those who subscribed equity capital are owners of the company. Normally, a part of the equity capital, sometimes major stake, is brought in by the promoters while the rest is issued to the public. Equity may also be raised from foreign countries by using Global Depository Receipts (GDRs). Preference Capital: It is a hybrid between the equity capital and debt capital. The preference share capital carries preferential rights over equity share at the time of payment of dividends, and repayment of principal amount. The companies issue different kinds of preference shares, such as redeemable or irredeemable, cumulative or non-cumulative, etc. Debentures: This is debt capital, raised by issuing debentures. Generally, debenture capital carries coupon rate (or rate of interest) and with a fixed maturity period. Companies have legal obligation to pay interest on debentures and it is tax deductible. There is no restriction on the period of maturity varies between five and ten years. Debentures may be protected by a charge on the assets of the company or may be unsecured. Term loans: Financial institutions and commercial banks extend term loans with a repayment period ranging generally between eight and fifteen years. The loans are secured by first charge on the assets financed and a second charge on all other assets of the firm. Unsecured loans: The promoters have a choice to get funds in the way of unsecured loans from friends and relatives. The loans are long-term in nature and cannot be withdrawn without the permission of the lending institutions. (Helfert, 2001). From Piggle plc’s point of view, as the chosen project is project A, it can finance the project by the mix of above means. Generally, for this kind of projects, the financing is done by the mix of equity capital and debt capital with different proportions as per the preferences of the company. If the company prefers it can take up maximum equity capital from the market by issuing shares but it has some limitations and so, the rest of the amount should be borrowed in terms of loan from financial institutions and commercial banks. They can also arrange some funds in terms of unsecured loans, that is, arranging funds from friends and relatives. Budgeting Techniques The smooth running and good performance of a project is based on its budgeting techniques. The Piggle plc should follow proper budgeting technique to make its chosen project work well. The budgeting techniques might be helpful for the smooth performance of project A. It should have a systematic approach in daily operational work of the project. There are three major budgeting techniques in case of successful run of a project which are discussed below. Zero based budgeting: Zero based budgeting, unlike a traditional budget, does not use the previous year’s budget or expenses as the basis for a new budget; each expenses starts at a zero (base), it is not allocated, it is not allocated, if the expenses is not justified or the activity on which it is to be spent is not required anymore. Under zero based budgeting, each project or activity is evaluated; ranks are assigned on the basis of relative importance, and funding is first made to the projects considered most important, moving in the descending order of importance. Planning-Programming-Budgeting system: Under this system, a systematic procedure is followed to allocate the resources. It starts with planning, that is, identifying the goals and objectives in each major area of activity for the organization or department; in the next step, projects and programs are developed by indicating their contribution to the organization. After developing the programs, the total cost for each of the project or program is estimated. Finally, a portfolio of project or program will be selected on the basis of their total cost and total benefit to the firm. Life cycle costing: In life cycle costing system, the choices made are evaluated against the total life cycle costs of the system. Life cycle costs are the total cost of acquiring and maintaining (ownership) of the system for the organization. The total cost includes, the cost of research and development, production costs, operating and maintenance costs, construction costs and phase out costs. Costs under each of these heads, for alternative projects, are calculated and the aggregates are compared to choose the best. Thus, life cycle system is a method of evaluating alternative courses of action early in the life of a project, so that the resources can be committed to the best. (Collier, 2006) Conclusion The financial analysis of the given case study involved lots of logical reasoning for the evaluation of the business performance of the two companies, Iggle plc and Piggle plc, and eventually it can be concluded that both the companies have shown promising results in the ratio analysis. The performance of Iggle plc is a bit better in comparison to Piggle plc in terms of its profitability ratios but in terms of efficiency ratios point of view, Piggle plc is preferred. In case of liquidity ratios and gearing ratios, we find Piggle plc to be better in comparison to Iggle plc. It is also seen that in case of the investment ratios, Piggle plc is better than Iggle plc. Hence, overall we can say that the future of Piggle plc seems to be sounder in terms of efficiency and investments. After the appraisal of the two projects it seems that project A is more preferable in terms of future prospects. The two projects have high NPV but very low required rate of return in comparison with their IRR but the appraisal through discounted methods is done by calculating the uniform cash inflows for both the projects and project A is thus preferred. In the non-discounted methods the appraisal is done mainly on the basis of pay back period for the given two projects and here also project A is preferred over project B. The means of finance and the budgeting techniques are discussed for the successful implementation of the project. References 1. Atrill P. and McLaney E. (2006), Analysing and interpreting financial statements, Accounting and Finance for Non-Specialists, fifth edition, Prentice Hall. (accessed on December 21, 2009) 2. Advani (2006), Ratio Analysis, The Wall Street MBA, Tata McGraw Hill. 3. Dyson J. R. (2007), Cash flow statements, Accounting for non-accounting students, seventh edition, Prentice Hall. (accessed on December 21, 2009) 4. Collier P. M. (2006), Budgeting, Accounting for managers – interpreting accounting information for decision-making, second edition, Wiley. (accessed on December 21, 2009) 5. Economy watch (n.d), Financial Management, Economy, Investment & Finance, Stanley St lab. Available at: http://www.economywatch.com/finance/financial-management.html (accessed on December 21, 2009) 6. Helfert, E.A, (2001), Financial Analysis: tools and techniques: a guide for managers, McGraw Hill Professional Read More