The Ratios Determined For BAE Systems - Essay Example

1. The Ratios Determined For BAE Systems BAE Systems - Ratio Analysis (2006 – 2011) Following are the ratios determined for BAE Systems as per the financial information presented in the financial statements for the company for the past 6 years. Ratio 2011 2010 2009 2008 2007 2006 Liquidity Ratios Current Ratio 0.62 0.65 0.73 0.75 0.74 0.79 Acid Test Ratio 0.55 0.59 0.66 0.66 0.67 0.74 Profitability Ratios Operating Profit Margin Ratio 7.07 % 5.12 % - 0.22 % 10.61 % 6.44 % 13.29 % Return on Capital Employed 9.79 % 8.74 % - 0.34 % 11.88 % 8.61 % 16.06 % Efficiency Ratios Average Settlement Period for Trade Receivables 69.20 days 61.57 days 67.43 days 83.87 days 74.82 days 66.68 days Assets Turnover Ratio 0.77 0.88 0.80 0.65 0.70 0.68 Financial Gearing Ratios Gearing Ratio 1.98 1.29 1.84 1.04 0.78 1.47 2. Ration Analysis Interpretations and Recommendations Following is a comprehensive analysis of BAE Systems’ working capital and the resulting recommendations on the basis of this analysis. 2.1. Evaluation of BAE Systems’ Finance Performance Based on the ratios determined above, the management of BAE Systems’ working capital resources can be analyzed. Considering the liquidity position of the company, it can be stated that there has been a consistent decline in the current ratio and acid test ratio of the company during the past six years. As noted in the table above, the ratio has declined consistently over the past six years due to regular imbalance noted in the current assets and current liabilities. Keeping in view the financial statements of the BAE Systems for the last 6 years, it can be noted that the current liabilities of the company have fluctuated over the years and the relative changes in the current assets of the company have not been such to maintain a constant liquidity position of the company. This in turn has affected the working capital position of the company over the years, as current liabilities have remained higher than the current assets of the company rendering a negative working capital value for the company during the past six years (Helfert, 2001; Peterson & Fabozzi, 2012). As far as the profitability of the company is concerned, there has been improvement shown in this regard during the last two years. After incurring losses during the financial year 2009, possibly due to the impact of recent financial crisis and therefore decline in demand, the company has been able to report profits in the year 2010 and 2011 with an increasing trend in the operating profit margin ratio. Similar to the operating profit margin ratio, the return on capital employed has also shown similar patterns (Peterson & Fabozzi, 2012; Siddiqui, 2006; Helfert, 2001). As far as the efficiency in the operations of the company is concerned with respect to average settlement period for trade receivables, there has been an increasing trend noted in this regard from 2006 to 2008, thus indicating inefficient nature of operations continued in these three years. However, from 2009 to 2010, the company managed to bring down the average settlement period for trade receivables, which increased again in the last year, i.e. 2011. Although, being efficient in this regard does not has a significant influence on the total current assets of the company, but it does influence the current liabilities portion of the company, as the company is able to use cash obtained from trade debtors to pay off some of its current liabilities and thus improve working capital position. Moreover, total assets turnover is also influenced by the working capital of the company as it includes the current assets and current liabilities of the company. The assets turnover has increased till 2010, but has declined in 2011 due to a comparative larger increase in the total assets of the company in comparison with the total revenue earned (Helfert, 2001; Warren et al., 2011; Arnold & Kumar, 2008). As can be inferred from the values of gearing ratio presented above, it can be noted that there is no particular pattern noted in the company’s gearing ratio in the past six years. However, there is an overall increasing trend noted in this regard over the years, which follows that the company has been inclined at raising its capital requirements from borrowing rather than increasing its equity. This further implies that the working capital held by the company during these years has included significant amounts of liquid cash which the company has used in its operating activities. Furthermore, upon reviewing the details of total non-current liabilities and total current liabilities, it can be noted that there has been significant reliance on long term borrowing rather than short term borrowing by the company, which in turn explains the increasing gearing ratio of the company (Warren et al., 2011; Jiambalvo, 2010; Needles & Powers, 2010). 2.2. Three Measures for Improvement in BAE Systems’ Working Capital Situation Based on the analysis and evaluation presented in the preceding section, following are the recommendations for BAE Systems to improve its working capital situation in the years to come. Measure 1 Keeping in view the current assets and current liabilities of the company, and the liquidity ratios determined for the company, it has been noted that the liquidity position of the company deteriorated during the past few years. This in turn follows that the working capital position of the company has also deteriorated and remained unfavorable for the company. In order to improve this situation, it is pertinent that the management of BAE Systems focuses on the improvement of current assets and current liabilities. This can be attained by way of managing current liabilities, as they have been observed to be significantly higher than that of current assets (Warren et al., 2011; Jiambalvo, 2010; Arnold & Kumar, 2008). Measure 2 There is an indirect but interesting relationship between return on capital employed and working capital situation of the company. As for instance, there has been a healthy return on capital employed maintained by the company, apart from the situation in 2009 in which losses were incurred by the company. If the company improves its liquidity position, thereby resulting an increase in current assets and a decrease in the current liabilities, it would influence the return on capital employed negatively (Arnold & Kumar, 2008; Warren et al., 2011; Moyer et al., 2001). Therefore, BAE Systems shall consider managing its working capital in a way that its return on capital employed is not affected in an unfavorable manner. Measure 3 In addition to the above two measures, the company shall also consider lowering down its long term borrowings for financing its operations. As noted in the analysis presented earlier, there has been a continuous rise in the long term borrowing by the company as against the short term borrowing. This makes the company to remain indebted for longer periods of time and thus affecting its solvency position. Therefore, the company shall focus on borrowing at short term and if not possible, then preference shall be on the issuance of new equity (Lasher, 2010; Brigham & Houston, 1998; Arnold & Kumar, 2008). 3. Limitations of Use of Investment Related Ratios as Decision Making Technique Decision making in relation to investment in a company by investors or analysts or strategy formation on the basis of certain ratios’ analysis is a common practice (Helfert, 2001). Trends and patterns noted in the ratios determined for multiple financial periods serve as a tool for decision making (Siddiqui, 2006). However, apart from numerous advantages associated with the use of such financial ratios, there are certain limitations too which financial analysts and decision makers may encounter. The most concerned area in this regard is ratios related to investment decisions, such as dividend payout ratio, dividend yield, earnings per share ratio and price earnings ratio (Needles & Powers, 2010; Peterson & Fabozzi, 2012). The limitations associated with these ratios are presented in the sections below. 3.1. Limitations Associated with Dividend Payout Ratio The dividend payout ratio tells about a company’s ability to pay out its dividends to its shareholders from its earnings. A higher dividend payout ratio reflects a favorable situation for the company as it can meet its dividends payment requirements to its shareholders. The dividend payout ratio is determined by dividing the annual amount of dividend paid by the company for each share with the earnings per share, or by dividing the total dividend payments with the total net income of the company during a year. Apart from the fact that this ratio tells the ability of the company to pay dividends to its shareholders on the basis of its earnings, but at the same time, this ratio may become misleading for investors and financial analysts. As for instance, a primary determinant of dividend payout ratio is the earnings per share of the company; if the value of earnings per share is not determined correctly due to unadjusted earnings per share, which takes into consideration the impact of exceptional items, the resulting dividend payout ratio may come out to be incorrect (Moyer et al., 2001; Lasher, 2010; Warren et al., 2011). 3.2. Limitations Associated with Dividend Yield Dividend yield is a financial performance analysis ratio which signifies the proportion of dividends paid by the company to its shareholders in relation to its share’s market value. The ratio is determined by dividing the amount of annual dividend paid by a company for each share to its shareholders with the market price for each share (Warren et al., 2011). Apart from its usefulness for investors and analysts, the ratio is largely reflective of past performance and therefore cannot be deemed as such to indicate any particular future situation associated with the payment of dividends by the company (Bamber et al., 2008; Peterson & Fabozzi, 2012; Brigham & Houston, 1998). 3.3. Limitations Associated with Earnings per Share (EPS) Ratio The earnings per share of a company reflect the profit earned by the company for each of its ordinary share issued. For the purpose of determining the value of earnings per share, net profits are considered after accounting for interest and taxation expenses of the company incurred during a year and then dividing the resulting value by the number of outstanding shares issued by the company to its shareholders (Warren et al., 2011; Moyer et al., 2001). Although, earnings per share is regarded and therefore determined by the companies as an effective measure of comparing a company’s performance with that of pervious year(s), there are certain limitations associated with its use to, while making business decisions on the basis of trends indicated by the earnings per share values (Warren et al., 2011). As for instance, the computation of earnings per share require the consideration of total number of ordinary shares issued by the company in a particular period of time for which the earnings per share is required to be determined. This requirement follows that a precise determination of ordinary shares issued by the company is required to be undertaken. However, the fact that it is difficult to determine the exact number of shares issued by the company, therefore inappropriate or incorrect earnings per share may be determined which in turn may lead to unrealistic assumptions and decisions by the management of a company (Balakrishnan et al., 2009; Warren et al., 2011). In addition to this, another limitation associated with decision making on the basis of earnings per share value of the company is that this ratio depicts the performance of a company which relates to its operations in the past. Therefore, the use of earnings per share can result in inappropriate or unrealistic decisions being taken by the management for future performance on the basis of historical information considered while determining earnings per share (Bamber et al., 2008; Warren et al., 2011). 3.4. Limitations Associated with Price Earnings Ratio The price earnings ratio is a ratio used to evaluate the equity of a business enterprise. For the purpose of determining this ratio, two values are required to be obtained, which are market price per share of the company under consideration and earnings per share of that company computed for a financial year ended. The market value of company’s stocks is divided by the earnings per share of that company so as to reach at a price earnings ratio for the company (Needles & Powers, 2010; Helfert, 2001). Similar to the use of other ratios discussed above, price earnings ratio also serves as a key performance indicator for analysts, managers and investors. However, due to certain limitations associated with this ratio, the decisions or conclusions reached by its users in relation to a company’ performance or future trends may be misleading. As noted earlier, the computation of price earnings ratio requires consideration of earnings per share too. The value of earnings per share can be inappropriate at times due to factors noted in the previous section and also due to changes in accounting policies and other assumptions applied by management while determining such ratios. As a result, the value of price earnings ratio can also come out to be inappropriate which may in turn lead to false conclusions about investment possibilities in the stocks of the company under consideration. Moreover, if the earnings per share of a company are not adjusted before considering it for the computation of price earnings ratio, the resulting ratio may also come out to be misleading too due to the presence of exceptional items (Brigham & Houston, 1998; Helfert, 2001; Bamber et al., 2008; Warren et al., 2011). Above all, if earnings per share come out to be negative, the ratio cannot be used in investment related decisions as the company under consideration is making losses (Warren et al., 2011; Bamber et al., 2008). 4. Advantages and Disadvantages of Securitization Pike et al (2012) define “securitization” as “the technique of packaging non-tradable claims into a traded security backed by an asset such as a flow of low risk income payments.” According to the critics, the complex nature of securitization places limitations on the ability of investors to foresee risk (Kothari, 2006; Joseph, 2011; Karoly, 2006). Apart from this, there are certain advantages and disadvantages associated with the process of securitization. These advantages and disadvantages are presented as under: Advantages of Securitization Following are the advantages of securitization: Securitization allows a company to improve its liquidity position by converting its non-current assets into liquid assets and therefore the options for selling the liquid assets increase (Kothari, 2006; Joseph, 2011). From originators’ point of view, securitization is highly advantageous in a way that it has lower costs and risks involved as compared to other options available for the originators. Moreover, the concept of securitization allows the investors to benefit from the process also (Kothari, 2006; Karoly, 2006). With the introduction of securitization, the risk related to loss on trading of assets is reduced. This implies that if the assets are not of good quality as per investors thoughts and the cash flows associated with the investment in such assets are insufficient, the owner will not have to bear such losses (Kothari, 2006; Joseph, 2011). One other benefit associated with securitization of assets is that it allows business entities to manage their respective balance sheets in a more effective and efficient manner, by way of managing the outlay of balance sheet items in a suitable manner (Kothari, 2006; Joseph, 2011; Karoly, 2006). The securitization process allows separation of cash flows relating to securitized assets from the other cash flows. As a result of this separation, it becomes relatively easy to rate the quality and strength of securitized assets (Karoly, 2006; Joseph, 2011). In addition, securitization enables an originator to obtain more funding without having regard to the existing sources of funding in use by an entity. Keeping this advantage in view, business entities can make use of securitization while maintaining their existing sources of funding and thus expanding their sources of finance for capital expenditures and other requirements (Karoly, 2006; Joseph, 2011). Apart from the advantages mentioned above, securitization also helps in lowering the WACC (weighted average cost of capital). This happens because funds obtained through securitization are regarded as debt financing which thereby reduce the proportion of equity and increase the proportion of debt in the total capital employed by a business entity. Thus, equity, which carries higher cost of capital, gets lower proportion in the total capital employed by a business entity and resultantly reduction in the weighted average cost of capital is noted. In addition to this, interest payable on debts obtained through securitization is lower than that of the interest payable on traditional financing available (Karoly, 2006; Joseph, 2011). Securitization also brings down the risks like portfolio and systematic risks, which are faced by the financial institutions. Since the credit risk and interest rates risk is moved to the capital markets, the risk carried by the financial institutions is reduced significantly (Karoly, 2006; Joseph, 2011; Karoly, 2006). Securitization also results in offering higher returns to the investors taking part in the securitization process. The profits obtained through investment in a special purpose vehicle are generally greater than that of the profits offered on governmental securities with similar portfolio attributes. In addition to this, the profits under securitization are also less volatile and therefore less risky because the securitized assets perform in a stable manner (Karoly, 2006; Joseph, 2011). Disadvantages of Securitization Having discussed the benefits associated with the securitization of assets, there are some disadvantages in relation to securitization. These disadvantages are presented as follows: Securitization process takes time and is a complicated process which requires expertise to take place. As for instance, securitization requires financial and legal expertise together with significant amount of documentation and therefore significant amount of costs are incurred for the conduct of this process (Kothari, 2006; Joseph, 2011). The comparison of returns generated through the securitized assets and the returns paid to investors is a difficult procedure (Kothari, 2006; Joseph, 2011). Transferring mortgages under securitization may be a difficult process due to significant regulations relating to legal and taxation matters involved in the process (Kothari, 2006; Joseph, 2011; Karoly, 2006). Since the transactions under securitization arrangements are complex because they take into consideration every possible risk factor, therefore complex documentation of the same is required (Kothari, 2006; Joseph, 2011). For lenders, the securitization may be disadvantageous as lenders have to give away those profit making loans which are low in terms of risk, so as to balance their high risk loans which are included in the securitized pools (Kothari, 2006; Joseph, 2011; Karoly, 2006). Since the securitization is an expensive process, therefore it is not suitable in instances where financing required is low (Karoly, 2006; Joseph, 2011). In order to carry out a securitization process, a significant amount of historical information is required relating to the performance of the assets in the past, so as to determine the risks involved in doing so (Karoly, 2006; Joseph, 2011). There is a lack of privacy for originators in a securitization process because information relating to the assets which have been securitized and their relative cash flows is shared with the special purpose vehicles. This information is accessible by the investors at any time, as they possess the right of doing so. However, in the meanwhile, there is always a risk that a competitor of the originator may also get access to such information (Karoly, 2006; Joseph, 2011). List of References Arnold, G. & Kumar, M., 2008. Corporate Financial Management. New Delhi: Pearson Education India. Balakrishnan, R., Sivaramakrishnan, K. & Sprinkle, G., 2009. Managerial Accounting. Hoboken: John Wiley & Sons, Inc. Bamber, L.S., Braun, K.W. & Harrison, W.T., 2008. Managerial Accounting. New Delhi: Prentice Hall. Brigham, E.F. & Houston, J.F., 1998. Fundamentals of Financial Management. 8th ed. Orlando: Dryden Press. Helfert, E.A., 2001. Financial Analysis Tools and Techniques: A Guide for Managers. New York: McGraw-Hill. Jiambalvo, J., 2010. Managerial Accounting. Hoboken: John Wiley & Sons, Inc. Joseph, C.H., 2011. Asset Securitization: Theory and Practice. Singapore: Wiley Finance. Karoly, V., 2006. A Case Study of South African Commercial Mortgage Backed Securitization. Thesis. University of South Africa. Kothari, V., 2006. Securitization: The Financial Instrument of the Future. Singapore: Wiley Finance. Lasher, W., 2010. Practical Financial Management. Mason: CENGAGE Learning. Moyer, R.C., McGuigan, J.R. & Kretlow, W.J., 2001. Contemporary Financial Management. Cincinnati: South-Western College Publishing. Needles, B.E. & Powers, M., 2010. Financial Accounting. Mason: Cengage Learning. Peterson, P.P. & Fabozzi, F.J., 2012. Analysis of Financial Statements. John Wiley & Sons, Inc.: New York. Siddiqui, S.A., 2006. Managerial Economics And Financial Analysis. New Delhi: New Age International Publishers. Warren, C.S., Reeve, J.M. & Duchac, J., 2011. Financial and Managerial Accounting. Mason: South-Western Cengage Learning. Read More