Financial Analysis of Next PLC and Debenhams PLC - Example

Financial Analysis of Next PLC and Debenhams PLC xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Table of Contents Table of Contents 2 d. operating profit margin; 4 Reasons For Year-on-Year Performance. 7 Next PLC Company 7 Debenhams PLC Company 8 Comment on the information disclosed by ratio analysis 9 Limitations of ratio analysis 9 Description of the content of two major notes to financial statements 11 Contingent liabilities 11 Stock/share option 13 References 15 Introduction; This paper will discuss financial performance of two companies. These two companies operate in the same industrial sector. The performance of the two companies will be undertaken by ratio analyses. The ratios of the two companies will be compared to determine competitive advantage of these companies. The ratios to be employed are; gross/operating profit percentage, percentage change in revenue, major expense(s) to revenue, return on capital employed, acid test/quick ratio, inventory ratio, gearing ratio(three of them), earnings per share, dividend yield and dividend cover. The companies to be analyzed are next Plc and Debenhams Company. The financial statement results to be used range from 2009 to 2011. a. Gross/operating profit percentage ; is a ratio of the gross profit made to sales. It is determined as follows: gross profit percentage= sales-cost of goods sold/sales Next plc gross profit percentage for the year 2009 to 2011 will be; 2009----------(3,271.5m-2,363m/3.271.5m)*100=27.77% 2010----------(3,406.5m-2,409.6m/3.406.5m)*100=29.26% 2011-----------(3453.7-2445/3453.7)*100=29.21% Debenhams gross profit percentage for the year 2009 to 2011 will be; 2009-----------(1915.6-1650.7/1915.6)*100=13.83% 2010----------(2119.9-1838.9/2119.9)*100=13.26% 2011----------(2209.8-1913.1/2209.8)*100=13.42% b. Quick ratio; is determined as follows: current assets-inventory/current liabilities. Next plc quick ratios for the year 2009 to 2011 are; 2009------------------(1073.4-318.7/713.5)= 1.05 2010------------------(1041.2-309.0/758)= 0.97 2011-----------------(1067.3-368/832.9)=0.83 Debenhams quick ratios will be; 2009-------------------(537.1-270.9/611.5)=0.43 2010--------------------(447.1-295.3/1083.6)=0.14 2011----------------------(423.6-321.3/715.6)=0.14 c. Gearing ratios; is a measure of how much the company has borrowed compared to shareholders fund (Black, 2003). The ratio is calculated as follows; 1.(Long term borrowing+short-term loan+overdrafts /shareholders funds). Next plc gearing ratio from 2009 to 2011 is; 2009---------------(567.8/2351.2)=0.27 2010---------------(520.9+4.7/1693)= 0.31 2011---------------(471+10.2+115/1792.3= 0.33 2(total debts to assets ratio= (total debt/total assets) 2009-----------------------(678.7/3029.9)=0.22 2010-----------------------(1560/1693.5)=0.92 2011------------------------(1559.9/1792)= 0.87 3(long-term debt/total assets=long-term debt to assets ratio 2009---------------------------(570.2/3029.9)=0.19 2010-------------------------(520.9+4.4/2667.3)= 0.20 Debenhams gearing ratios will be; 2009---------------------------(1099+611.5/425.3)=4.02 2010---------------------------(500.3+1083.6/503.4)=3.15 2(total debts/total assets=total debt to total assets) 2009---------------------------(1710.5/2135.8)=0.8 2010---------------------------(1583.6/2177.3)=0.73 3(long-term debts /total assets=long-term debt to assets ratio) 2009---------------------------(1099.0/2135.8)=0.51 2010---------------------------(500.3/2177.3)=0.23 d. operating profit margin; Is defined as follows, (operating profit/ revenue)*100 Next plc operating profit margin for the year 2009 to 2011 is; 2009-----------------------(478.3/3,271.5)*100=14.61% 2010------------------------(529.8/3,406.5)*100=15.55% 2011------------------------(574.8/3453.7)*100=16.64% Debenhams operating margin ratio for year 2009 to 2011 will be; 2009------------------------(182.2/1915.6)*100=9.51% 2010-------------------------(189.7/2119.9)*100=8.95% 2011--------------------------(183.7/2209.8)*100=8.31% e. inventory ratio; is defined by , cost of goods/inventory = inventory turnover ratio Next plc inventory turnover ratio for the year 2009 to 2011 will be; 2009-------------------(2,363/319.1)=7.4 2010-------------------(2,409.6/318.7)=7.5 2011-------------------(2445/368.3)=6.64 Debenhams inventory turnover ratio s for the year 2009 to 2011 will be; 2009-----------------------------------(1650.7/270.9)=6.1 2010---------------------------------------(1838.9/295.3)= 6.22 2011----------------------------------------(1913.1/321)=6.0 f. Return on capital employed; is defined as follows, net profit before interest, tax and dividends/ total assets. Next plc return on capital employed for the year 2009 to 2011 will be; 2009-----------------------------(428.8/3029.9)=0.14 2010------------------------------(505.3/1693.5)=0.29 2011------------------------------ (551.4/1792.3)=0.31 Debenhams return on capital employed for the year 2009 to 2011 will be; 2009---------------------------(120.8/2135.8)= 0.05 2010---------------------------(139.9/2087.3)=0.07 2011---------------------------(160.3/2018.2)=0.07 g. Major expense(s) to revenue = Major expense(s)/revenue Next plc 2011 = £214.7 million/£3,453.7 million = 0.0622 2010 = £236.6 million/£3,406.5 million = 0.0695 This shows that Next plc was more effective in expenses in year 2011 than in year 2010 Debenhams plc 2011 = £42.8 million/£2,209.8 million = 0.0194 2010 = £43.0 million/£2,119.9 million = 0.0203 This shows that Debenhams plc was more effective in expenses in year 2011 than in year 2010 This analysis shows that Debenhams plc is more effective in minimizing expenses than Next plc. h. Dividend yield = (dividend per share/market price per share) * 100 Next plc 2011 = 2.57% 2010 = 3.93% This shows that the value of Next plc was higher in year 2010 than in year 2011 Debenhams plc 2011 = 5% 2010 = 5% This shows that Debenhams plc was equally valuable in year 2011 as it was in year 2010 The ratio shows that Debenhams plc is more valuable than Next plc i. Earnings per share = earnings available to ordinary shareholders/number of ordinary shares Next plc 2011 = £2.22 2010 = £1.89 This shows a share of stock of Next plc earned more in year 2011 than in year 2010 Debenhams plc 2011 = £0.91 2010 = £0.75 This shows that Next plc uses the equity share capital more effectively than Debenhams plc j. Dividend cover = earnings per share/dividend per share Next plc 2011 = 2.22/0.78 = 2.846 2010 = 1.89/0.66= 2.864 This shows that Next plc was more able to pay dividends in year 2010 than in year 2011 Debenhams plc 2011 = 0.91/0.03= 30.33 This shows that the ability of Debenhams plc to pay dividends will be higher in year 2011 than the ability of Next plc in year 2011. Question b); Reasons For Year-on-Year Performance. Discussion on the reasons given in the annual report for the year-on-year performance of the Next PLC and Debenhams PLC companies Next PLC Company Adopting some changes to accounting standards in the current year. Accounting standards is a constitution that leads to consistent standards and that prescribes the nature, functions and limits of financial accounting and reporting. According to Brown and Matysiak (2007), the fundamentals are the underlined concepts of accounting that guides the selection of events to be accounted for the measurement of those events and the means of summarizing and communicating them to interested parties. This means a departure from an accounting standards can results to changes in assets, liabilities and income or expenditure reported in the year the change is adopted. If a material change in accounting standards has occurred, the reported increase in any improvement in the underlying business activity may not be true. Segmental analysis shows that results for the 2011 financial year was for 52 weeks while in year 2010 the results are for 53 weeks (page 45 in company statement). Information is material if it can have an effect on a decision made by users. If the financial statement for the current accounting period shows larger earning than for the preceding period, the user assumes that operations have been more profitable. If the business transactions conducted in that one week difference is material, then the two years are not comparable. Debenhams PLC Company Acquisition of “Magasin” –the group agreed to acquire “Magasin” in 2009 and the final purchase was in 2010 (page 12 in the company’s statement). The recognition and measurement concept explains which, when and how financial elements should be recognized, measured and reported in the accounting system. This means that the expenses which were incurred under this transaction since 2009 were recognized in year 2010. Reduction in the corporate tax rate – the main rate of corporate tax reduced from 27% in year 2010 to 26% in year 2011. The effect of this is a reduction in the net deferred tax assets. The decrease has been recognized as a profit increase in part in the income statement and as a loss in the comprehensive income statement. This has been done according to the treatment of liabilities and assets, which has given rise to net deferred tax assets. Corporate taxes are determined from net income after interest has been deducted. This means if the rate of corporate tax is low, the earnings after tax will be higher during year 2011 than in year 2010. Therefore, for good comparisons in these two years, the ratio analysis should make use of the net profit before taxation. Question c) Comment on the information disclosed by ratio analysis The information disclosed by ratio analysis shows that both companies have ability to generate profits or returns from investment. The gearing ratios indicate that both companies are using financial leverage to maximize shareholders’ returns under favourable economic condition. The ratio analysis of the two companies discloses that Next plc is more effective in using its assets in order to generate the sales revenue than Debenhams plc. Question d) Limitations of ratio analysis Ratio analysis as stated by Greite (2007) is a technique of financial analysis, which helps in evaluating the financial condition and performance of a company. However, it suffers from the limitations outlined below. It relies on accounting data – this means if the accounting data are not correct then the ratios obtained from these data will also be incorrect Ratio analysis ignores the qualitative factors – the importance of qualitative factors is insubordinate since ratio analysis is quantitative analysis. The comparative operating profit margin of the two companies in 2011 shows that Next plc was more profitable than Debenhams plc. However, it does not tell on the quality of the products produced by the two companies. Ratio analysis gives historical information – this information tells us on the past records, which may not be a true representation of the current affairs of the company. The latest information that can be obtained by ratio analysis about the two companies is upto year 2011. It is impossible to compare the performance of these two companies for year 2012 before their calendar year is over to report the information used for ratio analysis in the financial statements of the companies. Ratio analysis does not have any meaning when used on its own. It has significance only if studied in appropriate context and when compared over a period. For instance, inventory ratio for Next plc in the year 2010 conveys no sense if it is not compared with the previous year 2009 or compared with inventory ratio of Debenhams plc in the same year 2010. Ratio analysis is not definite since they never make concrete assertion hence it is possible to make wrong investment decision. It is not conclusive that since ROCE of Next plc is higher than ROCE for Debenhams, then an investor should invest in Next plc. Ratios can easily be manipulated through creative accounting or using accounting policies that are inappropriate. The investment decision made out of this analysis will be misinforming. Ratios do not have standardization with respect to presentation formats and their interpretation. This makes the interpretation of ratios hard and in some case arbitrary. Subjectivity – since ratios have no general standards, two investors are likely to make differing interpretations from the same ratio. The use of different accounting practice makes the ratios incomparable. Therefore, in order to compare Next plc and Debenhams through ratio analysis, they must adopt similar accounting practice. Question e) Description of the content of two major notes to financial statements The objectives of financial reporting and financial statements are derived from the needs of the external users of accounting information. Stating objective of financial; statements would be simple if all the external users had the same needs and interests, but this is not the case. The disclosure principle requires that financial statements be complete in the sense of improving all information necessary to users of the statements (Picker, 2009). If the omission of certain information would cause the financial statements to be misleading, disclosure of such information is essential. Examples of information often disclosed in notes to financial statements include a summary of significant accounting policy, related party transactions, description of stock option and pension plan, and amount and nature of contingencies and commitments and terms and status of proposed business combination. Contingent liabilities A contingency is something which might happen in the future and it will create a liability or an asset. According to the international accounting standards, a contingent is a condition which exists at the financial statement date where the outcome will be confirmed by the occurrence or non-occurrence of one or more uncertain events. For instance, legal actions where the outcome is yet to be decided, guarantees undertaken on behalf of other people or firms (page 105 of Debenhams plc statement), and options available to acquire assets. A contingency may result in either a gain or a loss in the future (Brownell, 1995). The accounting treatment is as follows: In case of a contingent loss, a provision should be provided where the loss is probable and can also be estimated with reasonable accuracy at the time when the accounts are approved by the board of directors. When a contingent gain is probable then it should be disclosed in the notes to the accounts. If there is only a reasonable possibility that the contingent loss will arise, then only a disclosure in the notes in the notes to the accounts is required. If a contingent loss is considered to be remote, then there is no disclosure required at all. The contingent liabilities, which are disclosed in the notes to the accounts, are required to be accompanied by the following: -A brief description of the nature of the contingent liability -An indication of the uncertainties which exists -An estimate of the financial effect of the contingent liability -A possibility of any future benefits or costs that will arise from the liability. Disclosing contingent liabilities as notes to financial statements provides information about the economic resources of an enterprise, the claim to those resources and the effect of transactions, events and circumstances that change resources and claims to those resources (Deegan, 2010). These notes are also useful to present and potential investors and creditors and other users in assessing the amount, timing and uncertainty of prospective cash receipts. Since investors and creditors cash inflows are related to the enterprise cash flows, disclosure of contingent liabilities to the notes in financial statements provides information to help assess the amount, timing and uncertainty of prospective cash inflows. Stock/share option Though profit is important, the key issue is how to use them in setting the goals of the firm. The ultimate measure of performance is not what the firm earn, but how the earnings is valued by investors. When analyzing the firm, investors will consider the risk inherent in the firm’s operation, the time pattern over which the earning increases or decreases, the quality and reliability of reported earning among other factors. If a decision maintains or decreases the overall value of the firm, it is acceptable from a financial view point. Shareholders invest in a company with the aim of getting a reward in the form of dividend. If a company pays out as dividend most of what it earns, then for business expansion and other requirements it will depend upon outside resources such as debt, which are usually costly than the company’s internal sources such as retained earnings. As a result, the company’s decision to pay dividends must be reached in such a manner in order to equitably apportion the distributed profit and retained earnings because dividend policy of a company affect both the long term financing and the wealth of the shareholders. The stock options, which are disclosed in the notes to the accounts, are required to be accompanied by the following: The purpose for which the stock option is given. For instance, making management and employee’s compensation to be share option (Next plc, page 35), which depend on the company’s earning or on some other performance measures. The price at which the stock option is given. For instance, stock given as a compensation for dividend may not have the same price at which the stock is issued to the public. The number of common stock at which preferred stock is convertible. Disclosure of stock option to the notes in financial statements is useful to the readers of the accounts as it helps them in making rational investment, credit and similar decision. Dividend payout points at profitability of the company since it is only declared by the board of directors in the year the company has made a profit. Therefore, existing investors will remain in the company if the company rewards them in the form of dividend and the potential investors will decide to invest in the company if its dividend policy is acceptable o them. Therefore, in order to create confidence in the investors a company will declare dividend in form of stock option if the company did not make enough profit in the current year and wants to award the same or more dividend than it were in the previous years. References Black, G., 2003. Students' Guide To Accounting and Financial Reporting Standards. London: Financial Times Prentice Hall. Brown, G.R. and Matysiak, G.A., 2007. Real Estate Investment: A Capital Market Approach. London: Financial Times. Greite, S., 2007. The Development of the Australian Accounting Standards after the End of the G4+1. Sydney: GRIN Verlag. Picker, R., 2009. Australian accounting standards. Australia: John Wiley & Sons. Brownell, P. 1995. Research methods in management accounting. Melbourne: Coopers & Lybrand and AAANZ. Deegan, C., 2010. Australian Financial Accounting, 66th ed. North Ryde, NSW: McGraw- Hill. Read More