The Company Financial Ratios - Essay Example

Order No. 341635 – Topic: Annual Report Analysis of FKI 1. Introduction: This paper seeks to examine in detail the 2006 Annual Report of FKI (available online www.fki.co.uk) in order to provide an “in depth analysis” of the business and its financial performance. 2. Analysis and Discussion 2. 1. Company Background Company’s website said “FKI plc is a major international diversified engineering group quoted on the London Stock Exchange.” It claims to be “driven by value-based metrics, principally return on invested capital, and actively manages the strategy and performance of its businesses.” The company or Group’s aims “to maximise the value of the portfolio as a whole and to deliver growth in shareholder value through increased focus on businesses that have superior and sustainable market positions in sizeable, attractive markets, leading brands and world-class technology.”1 2.2 Profitability RATIO ANALYSIS 2006 2005 A. PROFITABILITY RATIOS Return On Equity 0.36 (0.22) Return On Assets 0.06 (0.03) Cost of Goods Sold To Sales (0.77) (.76) Gross Profit Margin 0.23 0.24 Net Margin 0.07 (0.18) Earning per Share 16.1 (40.6) ASSETS UTILIZATION RATIOS/Activity Ratios Asset Turnover 0.86 0.79 Fixed Assets Turnover 1.67 1.55 The company exhibited a significant improvement in profitability2 from 2006 with return on equity improving negative 22% in 2005. Return of on assets also had turn around from negative 3% in 2005 for 5% in 2006. The turn around appears to show an inconsistency considering that gross margin in 2006 deteriorated from 24% in 2005 to 23% in 2006. As to what caused a loss in 2005 could despite the higher gross margin in 2006 against 2006 could be traced to the £ 84.2 million loss from discontinued operation in 2005 after it was deducted from the net income before discontinued operation in the amount of £ 43.6 million for the said year. As a result the net margin for 2005 was posted at negative 18% but it significantly had a turnaround in 2006 to 7% because of the absence how of loss from discontinued operation. The above finding on profitability is consistent with the statement of Chairman Gordon Page’s statement about the company, who said, “"The general economic environment remained robust in the year with strong demand from extractive industries, energy generation, US housing starts and expenditure on housing underpinning improved performance for the Group."3 The chairman’s confirmation of the company’s improve performance The increase in profitability was attributed by the Chairman to the strong growth in operating performance, where he refers to the increase in revenues. The increase in profitability also resulted to the “material improvement in the Group's net debt position.”4 This effect will be found to consistent also to the improve in the company’s financial leverage5 as will be reflected in the debt to equity ratio of the company. See Appendix A. The chairman’s reading of the favourable general economic environment remaining robust in the 2006 was coupled with the “strong demand from extractive industries, energy generation, and the fact that the US housing had started with increased expenditure to have caused the improved performance for the Group. The chairman appeared to have attributed improvement in performance due to the translation effect of foreign currency but according to him it had only a minor impact on reported results, which was noticeably less than in previous years. The chairman’s qualified the favourable operating performance on the significant effect on company’s margins and returns of “increased commodity prices, especially copper, zinc and energy costs.” To put it in quantitative terms, the Chairman said, “Overall turnover from continuing businesses grew by 13.8% to £1,273.4 million (2005: £1,118.8 million) with underlying profits up by 14.2% to £108.0 million (2005: £94.6 million). Underlying profit before tax also increased by 14.2% to £79.0 million (2005: £69.2 million) and adjusted earnings per share by 9% to 9.7p (2005: 8.9p).”6 The turnaround in profitability from 2005 to 2006 with the negative profitability in 2005 due to the loss on discontinued operation is also supported by the Chairman’s statement of previous year’s disposals of some of the company’s business. The Chairman said: “The sale of Bristol Babcock represents the largest disposal to date as part of the active portfolio management being followed by the Group to concentrate on fewer, larger and more competitive businesses. Since the start of the process in 2003, five businesses have been closed, 12 businesses sold and five businesses acquired. This is a continuous process as evidenced by the acquisition of Harrington Generators in April 2006. As we enter the new year the six major operating units within the Group: Bridon, Crosby, Truth, Hickory, FKI Generators and FKI Logistex utilise over 90% of Group assets and generate a similar percentage of the Group's continuing operating profit. Further changes in the business portfolio are expected in the coming year.”7 The improvement in profitability or turn around from 2005 to 2006 was also supported by the introduction of the company’s Chief Executive Paul Heiden. The Chief Executive’s said,” This was a year of many positives for FKI. Robust market demand in many sectors in which the Group operates, together with improvements in market positioning and operational efficiencies, resulted in strong sales and profit growth. This was despite significant increases in raw material and energy costs.”8 It may be observed that the Chief executive’s introduction of the annual report is taken from a different perspective. While the Chairman may have explained in terms of looking at the economy9 and the industry10, the chief executive was talking form the perspective of the operation level of the company. He was talking in terms of more specific terms like the demand of the company’s products as differentiated from broad statements of whether statement about the general economic conditions. The chief executive was also talking with further attribution with what the management has done in relation to the environment by talking of ‘market positioning and operational efficiencies’ that has caused the in stronger sales and profit growth. Specifically he named the identities of inputs by acknowledging the increase in prices of raw materials and energy costs. The report therefore delivers the message that management may have done more than expected for having overcome not only ordinary situations that may be caused external factors but also internal factors that management may be demanded to deliver. In support of the above analysis the Chief Executive said, “The Group's strong trading performance for the year reflects good top-line growth of over £150 million or nearly 14% combined with an underlying operating profit improvement of 14.2%. This was achieved despite a backdrop of materially increased and volatile input prices11.” In line with the improvement of operating performance of in 2006 as compared with 2005, the Chief Executive detailed the improvement of the whole company by explaining the performance of the subsidiaries. Paul Heiden thus said, “FKI Logistex continued its recovery with increases in sales and margin performance whilst Lifting Products and Services businesses returned excellent results on the back of buoyant demand in extractive industries. As predicted, the Hardware group produced a stable performance following the completion of the majority of the outsourcing strategy for non-window hardware which had impacted results over the previous two years. Underlying performance in Energy Technology showed strong top-line growth and good profit growth despite being the group hardest hit by commodity price increases and incurring some restructuring costs. Bristol Babcock, which was disposed of in March 2006, was the major contributor to this improved performance.”12 Being inevitably in charged also with the attainment of the company’s financial objectives, he also discussed from a functional management point of view, which is consistent also with the prior statement of the Chairman. Paul Heiden thus said, “Active portfolio management to concentrate activities was reflected in six disposals and four acquisitions, one completed just after the year-end. Following these actions, FKI's six major businesses utilise 90% of Group assets and are expected to generate a similar percentage of Group profit. This improved focus has been achieved whilst strengthening the balance sheet, having a neutral impact on earnings and increasing Return on Invested Capital (ROIC) from 7.1% to 8.4%.13” In trying to be articulate with the definite role of management has done to respond to the environment in turning around the performance of the company he particularly discussed how the company formulated and implemented strategies14. Thus he said, "The implementation of the strategies of the six major businesses continued to gain momentum during the period." To explain what he actually meant about these strategies, he said, “The Group's strategy involves the reshaping of the business portfolio to focus on its major businesses with strong market positions. To that end, six disposal transactions were completed in the period, including Laurence, Scott & Electromotors, the European operations of Certex, the wind turbine business and, towards the end of the year, Bristol Babcock. In addition, the acquisitions of three small companies were completed with a fourth finalised just after the year-end.”15 The Chief Executive particularly emphasized, “Each of these companies' operations complements the activities of one of the six major businesses. These major businesses now utilise 90% of the assets of the Group and generate a similar percentage of Group profits, a situation that has been achieved over the past three years through strong performance improvements in continuing businesses, a £201 million reduction in net debt, and a significant improvement in ROIC.16” The context of these statements would therefore characterize what the present management could do, so that if viewed from Pareto principle of management, the company have superbly delivered. Dwelling therefore on the “implementation of the strategies of the six major businesses1718” which the Chief Executive claimed to have continued to gain momentum in 2006, Paul Heiden made a status report of the strategies applied by the six major business. He therefore represented FKI Logistex to be “investing in operating efficiencies, improving capabilities and products and building market position both in traditional markets and the Far East”; Crosby to be “increasing product range and geographical coverage outside US markets”; Bridon to be “consolidating wire rope activities and moving into synthetics with acquisition of Marlow Ropes19”; Truth Hardware to have “improved customer care and new product introduction - increasing market share”; Hickory Hardware to have “improved sector focus and operating efficiency in outsourced hardware”; and FKI Generators to be “leveraging its capabilities and market position with new product offerings and acquisition of Harrington Generators.20” Banking on improved financial performance in 2006 from 2005, the Chief Executive the summarizes in effect the result of the financial performance by saying, “Overall, despite an environment of volatile commodity prices and fluctuations in exchange and interest rates, the Group is well positioned to strengthen the market position of its major businesses and improve its underlying operating performance again in 2006/07.21” He was in effect predicting a favourable future based on past performance. It could then be inferred that Chief executive used the past as score cards to boost about their confidence about the future. In so predicting future, Paul Heiden has introduced some of the company’s future plans. Thus he said that “active portfolio management will continue with further acquisitions and disposals anticipated in the coming year.” Moreover, since property disposals appeared to have performed well in 2006 by generating sales proceeds of £12.4 million in 2006, Heiden said planned to have a number of surplus properties still to remain to be disposed of and that group property assets will also be continued “to be reviewed with the intention of aligning ownership with future business requirements and releasing further assets for disposal.22” In addition, it is also part of the company’ plan to have some existing surplus properties be possibly “transferred to the UK pension scheme as part of the Company's ongoing strategy to reduce the pension’s deficit.” Director’s Financial Review further explained improvement in performance. The profitability of the FKI as computed and as confirmed by the Chairman of the Board as supported by the Chief Executive’s explanation is further brought to details by Finance director Neil Bamford. Director Bamford, in making the Finance Review said, “Group turnover from continuing activities during the period was £1,273.4 million (2005: £1,118.8 million). This increase in turnover comprised a sales increase from trading of £125.8 million assisted by a favourable currency translation effect of £28.8 million.” It could be noticed that the perspective from the Finance Director is looking is now in terms of attainment of Finance Objectives. His attribution of the increase in revenues due to favourable was mainly attributed to the favourable currency translations without mention of the economic factors and the industry. It is more understandable that the finance director will now dwell more than the Chief Executive Officer and the Chairman of the board. And so consistent with his attribution of the increase in revenues to favourable foreign exchange, he also used the same reason in explaining the increase in operating profit to have grown by 5.9%. Being under the Chief Executive, his review focused more on details. If the Chief Executive Officer reported on how well the business units or subsidiaries operated, the Finance Director further explained the same by putting more mathematical figures. Thus he said, “Special items amounting to a loss of £0.4 million (2005: a loss of £8.5 million) included a £4.1 million profit, before taxation and finance costs, on the sale of a number of surplus properties, offset by a £4.3 million loss on the sale of White Systems, a small unintegrated part of North American FKI Logistex activities. Profit from continuing operations before taxation increased by 19.9% to £99.6 million (2005: £83.1 million).23” He added, “Net finance costs were £29.4 million (2005: £25.1 million). The increase over the corresponding period last year is principally a result of a rise in short-term US interest rates. The effect of these increases was partially offset by a reduction of £0.6 million in net finance costs on pension schemes and fair value gains on financial instruments of £0.9 million.24” He also further explained the fact that the resulting negative profitability in 2005 as compared to 2006 was due to the effect of discontinued operation. Thus he explained, “The profit for the year from discontinued operations of £41.3 million (2005 loss: £84.2 million) comprised a £36.9 million net profit on the sale of businesses plus profits after taxation of £4.4 million generated up to the dates each disposal occurred. The principal contributory transaction was the sale of Bristol Babcock with figures of £39.9 million and £5.6 million respectively.25” Impacts exchanges rate are the meat of director’s explanation. Since the Director’s Report mainly attribute the changes to the impact of the exchange there is basis to include in this paper the relevance of his financial review with the earlier financial review conducted. Finance director Neil Bamford explained that “74% of FKI's continuing turnover came from outside the UK26” and that the company’s financial results must have reason to behave understandingly to changes in exchange rates. With the turnover made in foreign currencies, particularly the US dollars the needed to have trading results and cash flow of overseas operations be converted into sterling (UK’ local currency) for financial reporting since the company is based in UK at average rates of exchange. It also converted balance sheets figures in dollars to sterling at year end rates. The company made exports to at least foreign currencies, hence in explaining the most significant rates for the Group US dollars, Canadian dollars , Euro, and Danish krone it pointed out the strengthening of the foreign currencies as against the UK Sterling. To illustrate, exchange rate of 1US $ at the 31 March 2005 to £1 and the 2006 average rates of exchange to £1, were 1.73 and 1.78 respectively as compared with same for information at March 31,2005 and 2005 average rate of exchange of 1.89 and 1.85, respectively. This strengthening of the foreign currencies or weakening of the sterling when viewed on the reverse makes it favourable to have more revenues, hence the greater turnover for 2006 of £1,273m as compared to 2005 of £1,118.8m. The finance director confirmed this analysis when it said, “The average exchange rate of the US dollar to sterling strengthened by 3.8% compared with last year which primarily affected the Hardware division, whose operations are in the US, and Lifting Products and Services who’s US operations are particularly successful and have a significant exposure to energy markets.” To back up his assertions, the finance director was able to show the currency effect on results of turnover increase in £m under the following business units: FKI Logistex, Lifting Products and Services, Hardware, Energy Technology, Discontinued Operation and Head Office operation. The changes in interest expense as accounted for The finance director was also able to explain the company or Group's net finance cost increase by more than £4 million as a result of higher interest rates on the floating rate portion of the Group's debt and currency translation effects. He thus said, “These net finance costs primarily consist of £29.1 million (2005: £23.3 million) of net interest costs arising on the Group's net debt. The remaining cost of £0.3 million (2005: £1.8 million) consists of net pension scheme interest of £1.2 million (2006: £1.8 million) offset by other financing net gains of £0.9 million (2005: £nil) being mainly net gains and losses on foreign exchange and fair values of financial instruments.27” Directly related to the increase in the interest expense was the increase in the debt of the FKI as a result of the adoption of the International Reporting Standards or (IFRS). which the finance director to have increased the year's average net debt from £443 million to £481 million. Financial risk management is part of the company’s strategy. Due to nature of the company’s business which exports a lot and its finances are influences are sensitively affected by the fluctuations in foreign currency, the company’s practices hedging to for its financial risk management which the finance director claimed to be “based upon sound economic objectives and good corporate practice.” The finance director admitted that derivative and other financial instruments are used to manage trading exposures, liabilities and assets under parameters promulgated by the Board of Directors. The following risks are part of being mitigated by the company: “ (i) Currency transaction risks for trading exposures denominated in other currencies; (ii) Fair value and cash flow interest rate risks associated with the Eurobond; and (iii) Currency translation risks of net assets in overseas subsidiaries28.” The finance director also claimed that company of the “Group has not used derivative financial instruments for purposes other than for hedging its exposures.2930” He claimed also that with the adoption of accounting standard IAS 39 on 1 April 2005 its hedging resulted in the recognition at fair value of all derivative financial instruments previously held off balance sheet under UK GAAP. In being objective about it and to refrain from income statement volatility, and where such benefits outweigh the costs of compliance, the FKI decided to its economic hedges as hedging instruments under the IAS 39, some of however is not permitted under IFRS to be part of income. As part of its hedging, the finance director also claimed that the company “maintain a range of maturity dates for its borrowings, and to refinance them at the appropriate time so as to reduce refinancing risk.” Liquidity C. LIQUIDITY RATIOS (Short-term Solvency) Quick Ratio(Acid Test Ratio) 1.14 1.07 Current Ratio(Working Capital Ratio) 1.53 1.51 Cash & Cash Equivalents to Current Assets 0.50 0.34 Receivables to Current Assets 0.41 0.48 Accounts Receivable Days 83.82 101.10 Inventories Days Held 67.20 81.44 Receivable Turnover 4.29 3.56 Inventory Turnover 5.36 4.42 The company’s liquidity in terms of current improved further from 1.51 in 2005 to 1.53 in 2006. The increase in liquidity is supported also by increase in quick assets ratio which increaser also from 1.07 to 1.14. The increase in liquidity is of course caused by the improvement in profitability in 2006 which actually exhibited a turn around. See Appendix A. Solvency or Financial Leverage B. LEVERAGE RATIOS(Coverage Ratios/Gearing) Total Debt to Total Equity Ratio 4.68 6.60 Long Term Debt to Total Equity Ratio 2.85 4.19 Long Term Debt to Total Assets Ratio 0.50 0.55 Total Debt to Total Assets 0.82 0.87 Total Equity to Total Assets 0.18 0.13 The company’s profitability further affected an increase in its solvency with the significant improvement in debt to equity ration from 6.60 in 2005 to 4.68 in 2006. The improvement in debt to equity ration is further made more specific by the remarkable improvement of the long-term debt to equity ration from 4.19 2005 to 2.85 in 2006. This is also confirmed and validate by the lesser amount of liabilities in relation to the total assets of the corporation which improved form .50 to 55. See Appendix A. This means that the company has become less risky to invest with. Less risk would indicate the company will have an improved credit rating for the company since it could now borrow further so sustain growth. The improvement in company’s financial leverage is supported by the Chairman’s statement that the “Group businesses continued to produce strong cash flows despite the pressure on working capital of rising turnover and increased input costs. Reported net debt at the end of the period was £304.7 million, a reduction in the year of £46.0 million. This represented a gross reduction of £110.6 million offset by increases of £40.3 million resulting from the adoption of IAS 32 and IAS 39 and £24.3 million from the effect of adverse exchange rates.” Improvements in financial leverage as proven by the ratios are also confirmed by the Chairman’s statement is further underpinned by the separate assessment of the Chief Executive’s introduction of the company’s 2006 Annual Report. The Chief Executive thus said, “In addition, the overall risks to Group activities were decreased materially. Active business portfolio management has concentrated business activities into fewer, larger operations, whilst operating cash flows and proceeds from business disposals have significantly reduced net debt. The lessening of the UK Pension Scheme's deficit, with discussions underway to reduce it further by the transfer of surplus property, also lowers uncertainty regarding its future funding requirements.31” In quantitative terms the Chief Executive said, “The balance sheet continued to be strengthened with a significant reduction in net debt to £305 million from the adjusted* net debt of £391 million in 2006, in spite of adverse currency translation of £24.3 million.32” Conclusion: The company financial ratios indicate profitability improvement which impacted on increase on company’s liquidity and in financial leverage because of the reduction of debt. The annual report of the FKI would indicate that the financial performance of the corporation as far as doing its business is concerned as the most important part of the said Annual Report. The Annual Report is the document used by the stockholders to demand accountability from their elected managers, the board of directors through the leadership of the chairman. Changes in profitability passes through a process before it could be finally arrived at; hence the accounting report contained many possible causes of the changes which may either be internal or external to the company. Appendix A – Financial Ratio’s and Changes in Accounts, see excel file Work Cited: 1. FKI Plc, 2006 Annual Report, 2007 {www document} URL, http://www.fki.co.uk/investorrelations/ 2. Brigham and Houston , Fundamentals of Financial Management, Thomson South-Western, London, UK, 2002 3. Papers For You , What is Pest Analysis?, 2007 {www document} URL http://www.coursework4you.co.uk/pest.htm, Accessed February 19,2007 4. Porter, Competitive Strategy, The Free Press, USA, 1980 5. Samuelson and Nordhaus (1992), Economics, McGraw-Hill, Inc, London, UK , 1992 6. Van Horne Financial Management and Policy, Prentice Hall International, London, UK, 1992 \ Read More