Financial Statement Analysis of Next PLC - Assignment Example

FINANCIAL MENT ANALYSIS OF NEXT PLC Answer1 From Financial ment, following heads have been picked for analysis: Earnings per share from Income Statement Corporate Bonds from Balance Sheet Repurchase of own Shares from Statement of Cash flows EARNINGS PER SHARE FROM INCOME STATEMENT Earnings per share for the year 2012 have been 282.0p. This has shown as increase of 15.1% as compared to year 2011 (Next Plc, 2012). Increase in earnings per share reflects an increase in the income earned by NEXT. Increased EPS even in times when UK economy is striving hard to push the growth momentum is reflective of sound efforts by NEXT plc to provide its shareholders capital and revenue benefit. Moreover, an increase in EPS is also increasing dividend paid to NEXT plc shareholders, thus satisfying more the shareholders. This increase in EPS is also tested for quality based on the information from cash flows. Increase in EPS is strengthening positive operating cash flows; as increase in EPS is sometimes shown only on income statement and cash flow statement provides real picture with negative cash flows for operations (Next Plc, 2012).. This increase in EPS in line directors stated objective to provide sustainable long term growth in EPS. For this purpose, NEXT has adopted two strategies; one to increase the sales of the company by increasing the product quality and new stores along with increased cost control. The second strategy is buying back of outstanding shares. Buy backed shares reduces the number of shares outstanding in the market and hence, allows greater proportion of net income to individual share, thus it will lead to same earnings with less outstanding shares, therefore lower EPS. EPS increase also puts positive impact in share price (though not always) and has also benefitted NEXT plc. CORPORATE BONDS FROM BALANCE SHEET For year 2012 NEXT plc has increased corporate bonds liability amounting to 652.1 million as compare to 471.2 million in year 2011. In the current year firm has issued 10 year 325m bond. Increase in corporate bonds has increased interest expense to 28m (Next Plc, 2012). Increase corporate bonds indicate that firm is extending its debt source of financing as against equity financing to take tax benefit. Equity financing is the most expensive source of financing; therefore, firms are more inclined to debt financing that is relatively cheaper as per Pecking theory (Zhao, Katchova, and Barry, 2004). Moreover, increase in debt facilitates firms firm with cash flows without giving any rights of decision making. Since in difficult economic situation firms have to make tough decisions therefore, management is interested to maintain decision making more in their own hands. In addition to this, increase in debt gives the opportunity to firms to take advantage of the leverage concept which in return increases its Return on Equity (ROE) (Booth, Aivazian, Demirgue-Kunt and Maksimovic, 2001). This makes the firm more attractive for investors against competitors and it gives a positive signal to the investors according to Signal Theory. Benefit of this strategy has started to be reflecting as NEXT plc share has been ranked as the second best performing firms on FTSE-100 companies and has led its earnings per share increased by compound rate of 18 percent. NEXT Plc has been increasing its debt source of financing to facilitate two objectives; first, to tender cash flows for operations and capital investment. And second to gain the sustainable long term growth in EPS. To continue growth strategy in terms of location, product and sales firm and also EPS, NEXT plc has planned to increase the debt further and has also increased its bank facility by 300 million for 5 years. Moreover, NEXT plc has planned to increase debt max by 700m in order to support the share buyback strategy. REPURCHASE OF OWN SHARES FROM STATEMENT OF CASH FLOWS NEXT plc has been following to continue share buy back from on market and off market. In year 2012 firm conducted in investment activity of buying back its own shares amounting to 291.1m as compare to 221.6m in the year 2010 (Next Plc, 2012). Share buy-back reflects the firm is maintaining investment momentum but since could not find any investment avenue better than their own share therefore this option is undertaken. It is also aimed to increase the demand for its share by reducing supply and thus with demand remaining constant and supply increasing, it will increase the price of the stock. Moreover, buyback shares will also increase the EPS as well as dividend per share. Buying back shares has been adopted as the main strategy by NEXT plc. Stated aim for the purpose is to increase the long term sustained growth to its existing shareholders and also increasing dividend provision from by 15.4% in comparison with dividend paid last year. NEXT plc has bought 12.5 m and 0.6 m shares in current year with cost of 290m and 16 m respectively. Directors have been confident of the benefit of this strategy and aims to continue with the same strategy in the coming years to gain the maximum benefit from debt inclined structure that contributes considerably in increasing its EPS (Next Plc, 2012). Answer2 COMPARATIVE ADVANTAGES AND DISADVANTAGES OF RAISING £5,000,000 OF FINANCE FROM DIFFERENT SOURCES Pecking Order Theory has defined which sources of finance an organization should go for while raising funds along with how they should prioritize these sources (Vanacker and Manigart, 2010). Raising finance for the firm is guided by Pecking Order Theory (or pecking order model) that states firm in order to raise finance follows certain route to raise the funds (Vasiliou, Eriotis, and Daskalakis, 2009). It is first and foremost source of financing is the retained earnings that benefits firms largely as funds are available without incurring extra cost. In case when this resort is not able to facilitate the capital requirement then second option shall be to raise capital through debt and after reaching point where raising funds through debt does not remain feasible anymore then firm shall raise funds by floating shares. Equity is considered the last resort as it incurs the highest cost in fund raising process and return required by investors is the highest as compare to other options (Harris and Raviv, 1991) Evaluating only external sources of financing and making decision related to debt and equity is critical (Harris and Raviv, 1991). The decision is based on taking the optimum benefit from tax shield offered to debt; as suggested by MM theory (MacKie-Mason, 1990). However, critics of MM suggest the impact of bankruptcy and related cost increase with increasing the level of debt (Bevan, and Danbolt, 2002). Hence, maximum level of debt shall be at point where benefits from debt stops paying off. Moreover, going beyond this maximum point would lead to increase in bankruptcy cost faster and at a rate higher than tax shield benefit. It is same point where WACC also starts to increase after reaching the minimum rate. Hence, the firm shall remain on point where the marginal subsidy from debt financing is equal to marginal cost (Gitman, 2003). Instances when firms are expected to increase their debt more when expectations of profits are high. Moreover, increase in debt increases tax shield benefit much more as compare to minimal increase in the bankruptcy and related cost (Jensen, 2001). Strategy is also supported by signaling concept. Firm when signals an intention to raise funds through debt they are valued more by investors. This is often practiced by managers and sometimes only to fool around investor by sending diverse signals and to increase their share price they raise fund through debt and buy back share from market (Zhao, Katchova, and Barry, 2004). Since each source of financing has merits and demerits. For instance, debt increases risk, less costly, fixed repayment, no sharing in decision making, less legal formalities and reduces the tax payable etc. For equity the most feature play reverse role and hence merits of debt are demerits of equity (Eland, 1994). With above discussion it can be noted that NEXT plc has been increasing its firm value by buying back shares and increasing its debt level. Every increase in debt level is taken as value signal by investor leads to increase in share prices and so does EPS. Aligned with the signaling theory, factual evidence from NEXT plc is also supporting it has become second best performing firms on FTSE-100 companies and its earnings per share has been increased by compound rate of 18%. Moreover, annual report states that NEXT plc will continue this strategy of share buyback and facilitate its capital requirement by debt. With declaration it appears that firm is confident of increase in profits and intends to take benefit of both MM theories as well signaling theory. However, as mentioned earlier, firm can only take benefit of this constantly increasing debt to the point where marginal cost of debt equates the marginal benefit it can be confidently assumed that share issued in beginning of 2012 were also aimed for the same purpose as NEXT plc bought portion of it back within same year (Tucker and Lean, 2003). With the practice of NEXT plc as discussed above, raising capital with either source needs to be discussed. In case, NEXT plc raises £5,000,000 for increasing debt it will have to bear more cost than cost of previous debt. Moreover, after reaching point where increased debt is viewed as increase in risk than positive signal, benefit of signaling theory dampens. Moreover, firm can fall vulnerable to criticism by analyst for playing fool around the investors. Implications can be highly negative. Raising debt for buying back equity also increases cost on dual front; cost of raising and maintaining debt as well cost of buying back shares. It can increase in audit concern within firm. Finally, for every increase unit of debt firm has to under more complicated legal formalities as its risk has been increased. On the other hand, raising equity firm has to bear incremental cost for being last resort and its associated implications; mainly negative impact on EPS. If the equity is raised only to rebalance capital structure and then again undergoing share buy-back and debt raising then firm has face multiple costs: including of raising fund, buying back shares and all cost associated with reason debt as it would have to raise debt again to finance capital needs. Hence, though debt inclined structure is beneficial but constantly undergoing in cycle to increase EPS and firm’s value only can have detrimental implications. References Bevan, A.A. and Danbolt, J. (2002). ‘Capital structure and its determinants in the United Kingdom – A de-compositional analysis.’ Applied Financial Economics, vol. 12, no. 3, pp. 159-170. Booth, L., Aivazian, V., Demirgue-Kunt, A. and Maksimovic, V. (2001). Capital structure in developing countries’. The Journal of Finance, vol. 56, no. 1, pp. 87-130. Eland, H. E. (1994). ‘Corporate Debt Value, Bond Covenants, and Optimal Capital Structure’. The Journal of Finance, vol. 49, no. 4, pp. 1213–1252. Gitman, L. (2003). Principles of Managerial Finance. Addison-Wesley Publishing: Boston. Harris, M. and Raviv, A. (1991). ‘The theory of capital structure’. Journal of Financial Economics, vol. 41, pp. 297-355. MacKie-Mason, J. (1990). ‘Do taxes affect corporate financing decisions?’. The Journal of Finance, vol. 45, pp. 1471-1493. McLaney, E. (2009). Business Finance: Theory and Practice, Pearson Education: New Jersey. Mello, A. S. and Parsons, J. E. (1992). ‘Measuring the Agency Cost of Debt’. The Journal of Finance, vol. 47, no. 5, pp. 1887–1904. Next Plc. (2012). Annual Report. Available from http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/latest-news/2012/ar2012.pdf [Accessed 17 November 2012] Tucker, J. and Lean, J. (2003). ‘Small firm finance and public policy’. Journal of Small Business and Enterprise Development, vol. 10, no. 1, pp. 50-61. Vanacker, T. R. and Manigart, S. (2010). ‘Pecking order and debt capacity considerations for high-growth companies seeking financing’. Small Business Economics, vol. 35, pp. 53-69. Vasiliou, D., Eriotis, N. and Daskalakis, N. (2009). ‘Testing the pecking order theory: the importance of methodology’. Qualitative Research in Financial, vol. 1, no. 2, pp. 85-96. Zhao, J., Katchova, A., and Barry, P. (2004). ‘Testing the Pecking Order Theory and the Signaling Theory for Farm Businesses’. American Agricultural Economics Association Annual Meeting, available from [Accessed 17 November 2012] Jensen, M. C. (2001). ‘Value Maximization, Stakeholder Theory, And The Corporate Objective Function’. Journal of Applied Corporate Finance, vol. 14, pp. 8–21. Read More