Principles of Corporate Finance - Term Paper Example

Running Header: Financial Performance Comparison OF Astrazeneca Plc and GlaxoSmithKline Plc Financial Performance Comparison of Astrazeneca Plc andGlaxoSmithKline Plc in Harvard Style by Student’s Name Course Name University 1.0 Introduction This report will take the point of view of a financial analyst looking at the financial performances of Astrazeneca Plc (Astrazeneca) or GlaxoSmithKline Plc (GSK) during the fiscal year 2005. In order to fully identify which of the two companies fared better, this paper will utilize ratio analysis where ratios are categorized according to four classifications—profitability, liquidity, leverage, and activity. Due to data constraints, this report will not go beyond these two organizations. Industry ratio comparisons will not be presented. Also, as this paper is only concerned about the financial performance of the entities considered, qualitative issues will not be included. The rationale of choosing these two business organizations is simple. It should be noted that both of them are regarded as important players in the global pharmaceutical industry. Astrazeneca is involved in the “discovery, development, manufacture, and marketing of prescription pharmaceuticals primarily for the cardiovascular, gastrointestinal, neuroscience, oncology, respiratory and inflammation, and infection areas in the healthcare sector worldwide” (Astrazeneca Plc Profile 2006). GSK is the major competitor of Astrazeneca as the former engages in the “creation, discovery, development, manufacture, and marketing of pharmaceutical and consumer health related products worldwide” (GlaxoSmithKline Plc Profile 2006). Being in the same line of business and the same industry, it is right to assume that GSK and Astrazeneca both faces the same challenges and opportunities in the industry. This assumption justifies the comparability of their financial performance during the fiscal year. 2.0 Financial Ratio Analysis Financial ratio analysis is a very essential tool in assessing the financial health of a business entity. It enables a financial analyst to spot trends in a business and to compare it with the performance of similar business enterprises within the same industry. This tool is currently utilized by business managers, investors, creditors, suppliers, and other decision makers in order to determine the financial performance and well being of a business organisation. Financial ratios are grouped into four broad categories, each showing a different aspect of a company’s financial performance. These are profitability ratios, financial leverage ratios, liquidity/solvency ratios, and efficiency ratios. 2.1 Profitability Ratio Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred (Fraser & Ormiston 2004). The ratios computed for this category are return on capital employed, sales profit margin, asset turnover, and net profit margin. Return on capital employed is a variant of return on investment which measures how well the company is utilizing its capital. The computed sales profit margin, which is the ratio of operating income to sales measures as a percentage of sales, show the excess revenue from sales over cost of normal operation excluding financing. On the other hand, asset turnover measures the amount of sales generated by every pound in the company’s assets. Net profit margin is the ratio of net income to sales showing the company’s ability to efficiently manage cost and turn its revenue into profits (Fraser and Ormiston 2006). Logically, higher performance ratios indicate a healthier financial condition. Appendix 1 shows the computed the profitability ratios of Astrazeneca and GSK during the fiscal year 2005. It becomes apparent that GSK is more profitable than its competitor as this business organization reports higher return on three of the profitability ratios under consideration: capital employed, gross profit margin, and net profit margin. The computed return on capital employed of GSK is 38.06% while Astrazeneca manages to have a lower 37.04%. On the other hand, GSK is seen to generate more margin from its revenue as it is able to turn 78.01% while the competitor is not far behind with 77.64%. Lastly, GSK’s more efficient cost management is emphasized with its ability to turn more than 22% of its total revenue into net income as opposed to the 19.72% recorded by its competitor. Astrazeneca only manages to overtake GSK in asset turnover ratio during 2005, implying that the former is more efficient in utilizing its resources to generate revenue. Every pound in Astrazeneca’s asset is able to generate 1.33 in sales while GSK’s only manages to return 1.22. 2.2. Liquidity Ratio Liquidity or solvency ratios are used as measures of the company’s ability to finance its short-term obligations by its cash and near cash items. Included in these ratios are current and acid test or quick ratios. Current ratio expresses the “working capital’ relationship of current assets available to meet the company’s current obligations” (Horngren 2000, p.153). The acid test is more indicative as it shows the company’s ability to pay its current obligations without relying on the sale of its inventory. Higher ratios indicate more liquidity. However, analysts should also be cautioned that excess liquidity might indicate some money just sitting in the cash vault of the company which could have been invested in profitable undertakings. Appendix 2 shows the liquidity ratios of Astrazeneca and GSK during 2005. As opposed to what is observed in profitability ratios, Astrazeneca is superior in terms of liquidity. Even though both of the companies enjoy excellent liquidity, it should be noted that both current and acid test ratios of Astrazeneca are far and above its competitor. The current assets account of the company is more than twice its current obligations while GSK, though having a lower ratio can also cover its current liabilities with its liquid resources. Excluding its inventory, Astrazeneca is still able to immediately pay off its current liabilities. However, it should also be noted that most of the company’s liquid assets are tied up in inventory based on the wide gap between its current and acid-test ratios. 2.3 Activity Ratio Activity ratios are operating efficiency measures, which determine the ability of a company to maximise its output given a certain level of resources (Fraser and Ormiston 2004). These ratios significantly gauge the asset, investment, and cost management performance of the business entity. Ratios under this category are inventory, creditors’ and debtors’ ratio. The inventory ratio measures the number of days the inventories stay in the company’s distribution center or warehouses. The debtors’ ratio reveals the efficiency of a business organisation in collecting its account receivables while creditors’ ratio shows the number of days the company is able to pay its suppliers. Lower numbers are typically preferred in this ratio classification as they signify speed and efficiency of the business organisation in dealing with its different transactions with stakeholders (Fraser and Ormiston 2004). Appendix 3 shows the computed activity ratios for Astrazeneca and GSK. It should be noted that the three ratios are expressed in days. During 2005, it can be seen that Astrazeneca reports lower figures which signifies its relatively higher efficiency in servicing its debts, collecting its receivables, and selling its products to customers. Astrazeneca is able to sell its goods 150 days on the average, far from the 232 days recorded by GSK. In terms of collection from debtor, GSK lags behind by four days. Astrazeneca’s suppliers are being paid in 372 days compared to the 394 days for GSK’s supplier. 2.4 Financial Leverage Ratio Financial leverage ratios provide an indication of the long-term solvency of the firm. They indicate the extent of non-owner claims on the firm’s profits as well as the firm’s operating capability to meet its obligation. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm’s long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Thomson 2002, p. C-6). It should be noted that both of the ratios in this category are related to each other. If the company relies more on its creditor than its stockholders, it is more likely to incur interest obligations. Appendix 4 shows the performance of the two pharmaceutical firms under consideration in terms of leverage for the fiscal year 2005. It should be noted that as stated above, the two ratios under this category are closely related to each other. Based on its gearing, Astrazeneca Plc is more dependent on equity than on debt. It can be noted that even though the company is increasing its preference of financing its resources through liabilities, Astrazeneca still funds a greater percentage of its total assets by offering stocks to potential investors. The company has a 55:45 capital structure in favor of debt during 2005. This seems to be a good indicator for Astrazeneca as equity is always less risky source of financing than financing as it does not require financial obligatios for the company involved (Keown et al 2004). However, even though it is highly dependent on equity, Astrazeneca has a high interest coverage ratio which secures its creditors of regular and timely interest payments. In contrast to its competitor, GSK is heavily leveraged with debt. Since 2003, GSK is highly dependent on its creditors in financing its resources. This dependence is furthered during the following years leading to a capital structure of 38:62 in favor of debt in 2005. Being highly reliant on its creditors, GSK allocates a large portion of its operating income to service its interest obligations. It should be noted that the company consistently maintained a significantly high level of interest coverage ratio, even higher than what is allocated by its top competitor. 3.0. Recommendation and Conclusion In summary, GSK and AstraZeneca, even though facing the same challenges and opportunities in the pharmaceutical industry is apparently pursuing different financial strategies. As previously discussed and highlighted by the financial ratio analysis, GSK is more profitable than AstraZeneca both in ratio analysis and revenue generation. GSK also seems to be reaping economies of scale in research and development and production evidenced by its higher gross profit margin. The company also appears to be more efficient in managing its costs and expenses as indicated by its higher net profit margin. However, amidst these successes in profitability, the discrepancy between AstraZeneca and GSK seems to be waning because the computed ratios are almost the same. Thus, it is a challenge for GSK to maintain its competitive advantage and enhance its cost management efficiency as there is a possible threat that its competitor can overtake it in the long run. In the case of AstraZeneca, it should strive to be at par and even better than GSK by eliminating wastage in its value chain. The company should focus on improving its processes to reduce any unnecessary costs. In terms of liquidity, AstraZeneca is more liquid than GSK though much of its current assets are tied up in inventory. AstraZeneca seems to be having excess liquidity but at the same time foregoing the chance to invest its money in more profitable endeavors. It is highly recommended that the company finds a way in disposing its less liquid inventories and finding profitable investments where it can put its excess cash. AstraZeneca, in terms of activity ratio, shows more efficiency than its competitor. It is thus recommended that GSK looks in speeding its transaction with its stakeholders. In this continuously evolving highly competitive industry, business organizations need to look at increasing their efficiency. For example, collection of receivables should be prioritized in order to facilitate the collection of funds for other important purposes. Appendix 1. Profitability Ratios of Astrazeneca and GSK (2005) Appendix 2. Liquidity Ratios of Astrazeneca and GSK (2005) Appendix 3. Activity Ratios of Astrazeneca and GSK (2005, in days) Appendix 4. Leverage Ratios of AstraZeneca and GSK (2005) Appendix 5. Major Accounts of AstraZeneca and GlaxoSmithKline (in £m, 2005) References Astrazeneca Plc Profile 2006, Retrieved 20 January 2007, from http://finance.yahoo.com/q/pr?s=azn Brealey and Myers 2005, Principles of corporate finance, McGraw-Hill, 8th Edition. Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey GlaxoSmithKline Plc Profile 2006, Retrieved 21 January 2007, from http://finance.yahoo.com/q/pr?s=GSK Horngren , C. et. al.. 2000,  Accounting. 4th ed.  New Jersey: Prentice Hall Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Thompson, A. & Strickland , J 2002, Strategic Management. 3rd ed. New York McGraw- Hill Read More