Recommendations for DeHavilland Aircraft Services Share Holdings - Assignment Example

Analysis and Recommendations for DeHavilland Aircraft Services Share Holdings Contents Executive Summary ii 1. Introduction 1 2. Analysis Method & Rationale 1 3. Detailed Analysis 2 4. Recommendations 4 5. Conclusion 5 References 6 Appendix 7 Executive Summary The report analyses the financial indicators of DeHavilland Aircraft Services plc (DAS) in the context of a request for a recommendation from a client who now holds a 10% stake in the company, and is considering whether to increase that share to 25%, sell the present stake, or to retain it as is. An analysis is conducted using six financial ratios – current ratio, acid test ratio, return on capital employed, price to earnings ratio, cash ratio, and total debt to assets ratio – and the company’s profit and cash flow performance are analysed as well. The analysis of the current, acid test, and return on capital employed ratios indicate that DAS plc suffers from some financial inefficiency and does not perform as well as the sector average. There has also been a decline in profits and profit margins, and a positive cash flow for 2011 was mostly the result of a one-off financing issue. However, the company is in a very sound position with regards to its liabilities and at this point presents a very low risk. In addition, the price to earnings ratio of its stocks is excellent. Since the increase in the clients’ stake to 25% carries with it some influence over company policy and management direction, our recommendation is that the client should exercise that option. 1. Introduction This report presents an analysis and recommendations of options available to our client with respect to their share holdings in DeHavilland Aircraft Services plc (DAS), specifically, whether they should retain their current 10% share in the company, divest themselves of that share, or increase the holding to 25%. A brief background summary of DAS is presented below, followed by an explanation of the financial ratio analysis methodology used. The detailed findings of the analysis are then presented, along with recommendations as to how our client should proceed. Background of DAS and Current Situation DeHavilland Aircraft Services plc (DAS) is a leading provider of aircraft service and maintenance, with about a 20% market share in the sector. The financial performance of the company from 2010 to 2011 has been mixed; this is analysed in greater detail below, but in general the company is in sound financial health despite slightly lower profits and cash flows year-on-year. Significant challenges DAS will face in the near term are the renewal of its contract with English Airways, which currently provides DAS with the largest part of its turnover and operating profit, and the unknown implications of the recent loss by theft of £ 800,000 of parts from DAS’ warehouse. 2. Analysis Method & Rationale In order to properly form conclusions about the financial health and future prospects of DAS, an analysis of a number of financial ratios is conducted. Financial ratios are divided into four categories. Activity ratios provide insight into the company’s management in the context of turning resources into income. Liquidity ratios assess the company’s ability to meet its financial obligations. Profitability ratios are another way to measure management effectiveness, by providing an insight into control of expenses. Finally, leverage ratios indicate the company’s ability to acquire additional debt, and pay its long-term debt obligations. (Colbert, 1994) In order to compare DAS with its industry sector, the following ratios are calculated: Current Ratio: The Current Ratio compares current assets and liabilities, and is a liquidity ratio that indicates the company’s ability to meet its short-term (one year or less) obligations. (Kumar & Ravi, 2007) The ideal ratio would be 1:1, but in practise this is almost never the case; the key analysis is how much the current ratio of DAS differs from the sector average either positively or negatively. Acid Test Ratio: The Acid Test Ratio is another liquidity ratio, and measures the company’s ability to quickly access funds; it differs from the current ratio in that it excludes inventory and expenses that have been pre-paid, and so is always lower than the current ratio. (Colbert, 1994: 6) Return on Capital Employed: Return on Capital Employed (ROCE) is a profitability ratio that measures how well the company is using its capital to generate profits. It is a similar to the Return on Assets (ROA) ratio, but differs in that it is calculated using before-tax profits, whereas ROA is usually calculated from the net profit. (Altman, et al., 1977: 34) Price to Earnings Ratio: The price to earnings (P/E) ratio is a good way to determine the relative value of companies with different amounts of stock and different stock prices, and measures the amount of income per share of stock. The typical P/E ratio for the industry sector is 14, meaning that, on average, the price of a share of stock is 14 times the earnings of that share. In addition to these comparative analyses, we take a look at a couple of other tests to assess the financial health of DAS: Cash Ratio: This is a somewhat more conservative test of a firm’s ability to meet its debt obligations than the Current Ratio or Acid Test Ratios, used when a problem with liquidity is suspected with receivables or inventory. (Kumar & Ravi, 2007) It is an appropriate test for DAS in view of the recent loss of parts inventory due to theft. Total Debts to Assets: The Total Debts to Assets (TDA) ratio measures the company’s ability to sustain losses to assets without interfering with its ability to meet debt obligations. (Altman & Hotchkiss, 2006) The higher the ratio, the more at risk the company may be of defaulting on some of its debts. The calculations of these factors are detailed in the Appendix, while their analyses and the significance of these are discussed in the following section. 3. Detailed Analysis Current Ratio: The current ratio is calculated by dividing the current assets of the company by its current liabilities, and for DAS declined from 1.3:1 in 2007 to 0.7:1 in 2009. In 2010, DAS’ current ratio was 0.94:1, and in 2011, the current ratio had increased to 1.53:1. Sector averages for the years 2010 and 2011 were 1.3:1 and 1.4:1, respectively. The position of DAS in comparison to the sector improved significantly from 2010 to 2011, in the respect that the difference in DAS’ current ratio from the industry average was not as great. However, while the current ratio was much lower than the average in 2010, in 2011 the situation had completely reversed to make the current ratio slightly higher than the average. The steady decreasing trend of the years 2007 through 2009 indicated that DAS had increasing liquidity pressures, but the current ratio of 2011 indicates that the company might have over-corrected for that problem to some extent, and now has a slight overabundance of assets. (Altman & Hotchkiss, 2006) Acid Test Ratio: The acid-test ratio is the ratio of the company’s cash, marketable securities, and accounts receivable to its current liabilities. In the case of DAS, the share premium account is counted as the total of marketable securities, since this account represents an amount that could be issued as new shares. The same pattern shown by the current ratio is reflected in DAS’ acid test ratio; in 2010, the acid test ratio was 0.32:1, but by 2011 it had jumped to 1.14:1. The 2010 figure was far below the sector average, but the 2011 figure is significantly higher. Taken together with the current ratio, the acid test ratio indicates that DAS does not have a liquidity problem, that is, is not at serious risk of failing to meet its current obligations. What the two ratios do suggest, however, is that the company is not using its assets as efficiently as it could, particularly in comparison to the industry sector overall. Return on Capital Employed Analysis: In 2010, DAS’ Return on Capital Employed dipped from the upward trend of the years 2007 through 2009, but its ROCE of 29% was still ahead of the average of 27% for the sector. In 2011, however, ROCE declined significantly to 17.4%, well below the sector average of 28%. This may be a negative signal; DAS has seen a decline in ROCE of 3% and nearly 12% in two consecutive years. This tends to support the conclusion suggested by the outcomes of the current ratio and acid test ratio analyses that DAS’ assets are not being used to optimal effectiveness. Price to Earnings Ratio: The Price to Earnings (P/E) ratio can be calculated by dividing the company’s market capitalisation by the net profit (Kumar & Ravi, 2007), where market capitalisation is equal to the total number of shares (three million) times the current share price (792 p, or £0.792). The typical P/E ratio for the industry sector is said to be 14, which is a figure we must view with some scepticism in view of the result for DAS, which is an extremely positive 0.56. Cash Ratio Analysis: To calculate this ratio, the cash equivalents plus the marketable securities are divided by the company’s current liabilities. The cash equivalents are assumed to be the sum of the balances of cash flows from financing and investing activities. For 2010, DAS has a Cash Ratio of -0.196, but this had improved to 0.160 for 2011, indicating an improved liquidity situation despite the problem with the lost inventory. Total Debts to Assets: Finally, we examine the total debts to assets (TDA) ratio of DAS, which is a leverage ratio that gives an indication of the company’s risk of reducing the earnings of shareholders, or in a more extreme case, defaulting on its debts. (Altman & Hotchkiss, 2006) The TDA ratio is calculated by dividing the total liabilities by the total assets; if the figure is positive, the liabilities of the company are greater than its assets, which could be a bad sign. This is not the case for DAS, fortunately; in 2010, the company’s TDA ratio was 0.67, which improved slightly to 0.62 in 2011. Cash Flow and Profit Assessment One area of concern for DAS is the reduction of its profits in the past two years. From an operating profit margin of 14% in 2009, operating profits declined to 11% in 2010 and 8% in 2011. In both 2009 and 2010, DAS had an ending negative cash and cash equivalents balance, -£6,400,000 at the end of 2009, and -£3,400,000 at the end of 2010. In 2011, however, the balance had become positive, ending at £2,480,000. Compared to 2010, DAS had a smaller total profit, a smaller profit margin, a smaller amount of cash generated from operations, paid less in interest and income tax charges, and paid more towards investment activities in purchases under the plants and equipment category. This illustrates why positive cash flow is not necessarily a good indicator of the company’s financial health. The difference between the higher profit/negative cash flow circumstances of 2010 and the lower profit/higher cash flow circumstances in 2011 is almost entirely accounted for by a financing issue amounting to £4,000,000, as well as significant increases in inventories and receivables. 4. Recommendations As noted in the introduction, DAS’ financial indicators provide somewhat mixed reviews of the company’s soundness. The current ratio, acid test ratio, and ROCE analyses indicate that there is some trouble with using assets effectively, and this conclusion is only reinforced by the analysis of the company’s cash flow in view of declining profits over the past two years. While the positive cash balance at the end of 2011 is generally a good thing, if these resources are not used efficiently that benefit will be negated. It is important to note that the largest factor in the positive cash flow was through financing. This did help to correct a negative cash ratio from 2010, but the issue of debentures is a one-off occurrence, and the positive impact from it will not be reflected in the company’s accounts for 2012. Also, part of the positive cash flow was accounted for by an increase of £450,000 in inventory, but the 2012 balance sheet will inevitably have to reflect the £800,000 loss due to theft. On the other hand, DAS does have some very good indicators. The company’s stock has an outstanding P/E ratio, and this factor alone makes increasing our clients’ holdings in DAS a very attractive proposition. The company also has a very good total debt to assets ratio, which even improved from 2010 to 2011. This means that despite other indicators which might not be quite as encouraging, DAS has very little debt exposure and in that manner provides a great deal of security for its shareholders. There are limitations to analysis using financial ratios, and this caveat should be made clear. Some intangibles cannot be accounted for at all by financial ratios, particular the impact of future events. (Altman, et al., 1977) A very obvious example in the case of DAS plc is the unknown outcome of contract renewal negotiations with English Airways. In addition, much more detailed financial information would be required to use more sophisticated analysis techniques such as a Z-Score analysis, which would require knowing the market value of equity and the book value of the company’s debt, among other things. (Altman & Hotchkiss, 2006) The analysis presented here, however, is accurate to the degree permitted by the information provided, and does not indicate that a completely different picture would be presented using more detailed techniques, but only one that has a greater level of detail. Therefore, the recommendation to our client is to increase their holdings in DAS plc from the current 10% to 25%. DAS stock is an outstanding value, particularly in view of the opportunity that the increased share will provide our client to influence the management of DAS and some of the inefficiencies in resource usage indicated by the analysis. 5. Conclusion The task undertaken by this report has been to analyse the options presented to our client whether to retain, increase, or sell their holdings in DeHavilland Aircraft Service plc. In order to make a sound recommendation, a number of financial ratios were analysed, both for purposes of comparing DAS to its industry sector, and assessing its financial position on its own merits. There are some questions about DAS’ deployment of its financial resources, as several of the financial ratios indicate. Cash flows and profits – both in real and marginal terms – have also seen drops in performance over the past two years. Despite this, the company is in a strong position with regards to its debts, and has an excellent P/E ratio. Given that an increase in holdings will allow our client to exercise some management input and hopefully influence corrections, the recommendation is for our client to increase their holdings in DAS plc from 10% to 25%. References Altman, E.I., Haldeman, R.G., and Narayanan, P. (1977) “ZETA Analysis”. Journal of Banking and Finance, 1: 29-54. Altman, E.I., and Hotchkiss, E. (2006) Corporate Financial Distress and Bankruptcy, 3rd Ed. New Jersey: John Wiley & Sons. Colbert, J.L. (1994) “Analytical Procedures for Management Accountants and Auditors”. Managerial Auditing Journal, (9)5: 3-7. Kumar, P.R., and Ravi, V. (2007) “Bankruptcy prediction in banks and firms via statistical and intelligent techniques – A review”. European Journal of Operational Research, 180: 1-28. Appendix: Financial Ratio Calculations 1. Current Ratio – The Current Ratio is calculated by the formula Current Assets/Current Liabilities 2010: £9,550,000 / £10,200,000 = 0.936 2011: £12,930,000 / £8,440,000 = 1.531 2. Acid Test Ratio – The Acid Test Ratio is represented by the formula Cash+Marketable Securities+Accounts Receivable/Current Liabilities 2010: -£3,400,000 + £1,000,000 + £5,700,000 / £10,200,000 = 0.32 2011: £2,480,000 + £1,000,000 + £6,150,000 / £8,440,000 = 1.14 3. Return on Capital Employed – The ROCE is calculated by the formula EBIT/Total Assets – Current Liabilities Where EBIT = Earnings Before Income Tax. 2010: £5,800,000 / £30,200,000 - £10,200,000 = 0.29 or 29.0% 2011: £4,280,000 / £33,080,000 - £8,440,000 = 0.1737 or 17.4% 4. Price to Earnings Ratio – The P/E ratio is calculated according to the formula Market Capitalisation/EBIT Where the market capitalisation is equal to the total number of shares times the current share price. (£0.792 x 3,000,000) / £4,280,000 = 0.56 5. Cash Ratio – The calculation of the Cash Ratio is according to the formula Cash Equivalents + Marketable Securities/Current Liabilities 2010: -£3,000,000 + £1,000,000 / £10,200,000 = -0.196 2011: £350,000 + £1,000,000 / £8,440,000 = 0.160 6. Total Debt to Assets – TDA is calculated by the formula Total Liabilities/Total Assets 2010: £20,200,000 / £30,200,000 = 0.67 2011: £20,440,000 / £33,080,000 = 0.62 Read More