Investment Decision - Managerial Accounting and Business Analysis - Case Study Example

INTRODUCTION This report provides an insight into the financial position and performance of two companies Whittard of Chelsea plc and Greggs plc, both from the same industry, in order to evaluate these companies’ future potential for investment. For this purpose, various tool and techniques of financial statement analysis will be utilised to compare and contrast these two companies’ investment potential including horizontal and trend analysis plus vertical and ratio analysis. The report has been designed to peep into every single aspect of the companies’ financial position and performance. Both the companies are from food and manufacturing industry and their business operations cover the entire boundaries of United Kingdom. Greggs plc is engaged in bakery related retailing business (Greggs plc annual report, p7) while the major area of Whittard of Chelsea plc’s operations is coffee and tea retailing (WOC annual report) HORIZONTAL AND TREND ANALYSIS According to Flamholtz (1986), the horizontal and trend analysis techniques are used to assess and evaluate the percentage changes occurred in various items of a company’s financial statements year on year. Therefore, the horizontal analysis can be helpful in analysing major “trends” in the financial performance and position of a company, in order to evaluate the company’s investment potential and identify any approaching risks to the company. The following is the horizontal analysis of financial statements for the two companies in consideration i.e., Whittard of Chelsea Plc and Greggs Plc based on the excerpts from the companies’ financial statements: Greggs Plc -- Horizontal and Trend Analysis The trend analysis of Greggs Plc’s income statement shows that the increase in company’s sales has been stable over the years with a hike in sales by about 19% in 2004. The cost of sales has also rising with the increase in sales and they have finally risen by about 18% during the last financial year. However, the percentage change in sales is apparently greater than the percentage change in cost of sales, which has magnified the company’s gross profit by 20% in 2004. The SG&A have expanded by almost at the same rate as the increase in sales i.e., by 19%. However, due to a substantial increase in gross profit, the company managed to display a rise in the operating income by about 20%. The company’s net interest income increased by about 49% during 2004, causing a considerable widening of the company’s profit before tax by 27% in the same year. The profit after tax has shown a sustainable expansion by 20% last year, causing both the dividends to shareholders and retained profit to rise by 34% and 24% respectively. Balance Sheet Analysis Financials (£'000) Horizontal Trend 2004 2003 2002 2004 2003 2002 Fixed assets 163,110 160,704 151,745 7% 6% 100% Stocks 7,283 7,126 6,330 15% 13% 100% Debtors 13,949 13,037 11,740 19% 11% 100% Cash at bank and in hand 62,601 36,358 28,635 119% 27% 100% Total Current Assets 83,833 56,521 46,705 79% 21% 100% Total Assets 246,943 217,225 198,450 24% 9% 100% Short Term Liabilities 74,811 68,558 64,943 15% 6% 100% Long Term Liabilities 105 112 119 (3%) (5%) 100% Total Liabilities 89,785 83,075 78,485 14% 6% 100% Equity Shareholders Funds 157,158 134,150 119,965 31% 12% 100% Cash Flow Analysis Financials (£'000) Horizontal Trend 2004 2003 2002 2004 2003 2002 Cash inflow from operations 69,261 57,722 55,555 25% 4% 100% Cash outflow from investment (23,742) (31,574) (41,132) (42)% (23%) 100% Cash from Financing 2,945 (15) 295 898% (94%) 100% Net increase in cash 26,243 7,723 (1,392) 1985% 654% 100% The balance sheet analysis for last three years reveals that the company has increased its investment in fixed assets slightly by 7%. However, out of this 7% increase in 2004, about 6% took place in the year 2003. This fact is evident in cash outflow statement, which shows that although cash outflow from investment activities had been declining for both the years, but the rate of decrease is more in 2004 than the year 2003. This substantial hike by 79% in the current assets is mostly due to the boost in company’s cash balance, which has augmented by about 119% in 2004 (27% in 2003). According to the company’s cash flow statement, the reason for such a considerable increment in the cash balance (about 20 times in 2004) is mostly due to the augmentation in operational inflow, reduction in investment outflow, and a substantial inflow of cash through disposal of fixed assets and investments. Before the year 2004, the company’s current assets were not enough to meet its short-term liabilities as shown by the balance sheet. However, the company has successfully turned its shortage of cash into sufficiency during the last years, especially in the year 2004 showing healthy liquidity position of the company. Whittard of Chelsea Plc -- Horizontal and Trend Analysis Income Statement Analysis Financials (£'000) Trend 2005 2004 2003 2005 2004 2003 Turnover 46,079 42,136 37,409 23% 13% 100% Cost of Sales 39,489 35,000 31,545 25% 11% 100% Gross Profit 6,590 7,136 5,864 12% 22% 100% SG&A 4,201 3,901 3,609 16% 8% 100% Operating Profit 2,389 3,235 2,255 6% 43% 100% Net Interest Payable 45 -- -- 45% -- 100% Profit Before Tax 2,354 3,317 2,305 2% 44% 100% Tax on Profit 245 1,004 697 (65%) 44% 100% Profit After Tax 2,109 2,313 1,608 31% 44% 100% Dividends 863 762 439 97% 74% 100% Retained Profit 1,246 1,551 1,169 7% 33% 100% The horizontal and trend analysis of Whittard Chelsea Plc reveals that the company’s sales have increased by 23% in 2005 (13% in 2004). However the company’s cost of sales have also been increasing, which rose by 25% in 2005 from 11% in 2005. Due to this fact, despite the increase in sales generation, the company’s gross margin fell by 8% in 2005 as compared to the year 2004. Similarly, the rate of increase in the company’s operating income has also declined 43% in 2004 to just 6% in 2005 due to an upsurge in selling, general and administrative expenses by 16% in 2005. This exposes a mismanagement of various production, distribution and operating expenses on the part of the company. Although the rate of increase in profit after tax for the company has declined from 44% in 2004 to 31% in the year 2005, but the company has transferred increased returns to shareholders in the form of dividend showing an increase by about 97%. It is therefore evident that the company has paid enhanced dividends to the shareholders out of its retained earnings balance, which has declined by about 20% in 2005 as compared to the year 2004. Balance Sheet Analysis Financials (£'000) Trend 2005 2004 2003 2005 2004 2003 Fixed assets 7,554 6,026 4,477 69% 39% 100% Stocks 5,234 4,039 2,993 75% 35% 100% Debtors 3,717 2,331 2,126 75% 9% 100% Cash at bank and in hand -- 3,084 2,979 -- 4% 100% Total Current Assets 8,951 9,454 8,098 11% 17% 100% Total Assets 16,505 15,480 12,545 32% 23% 100% Short Term Liabilities 6,894 6,250 4,989 38% 25% 100% Long Term Liabilities 8 -- 3 166% -- 100% Total Liabilities 6,902 6,250 4,992 38% 25% 100% Equity Shareholders Funds 9,603 8,481 7,583 27% 12% 100% The above horizontal analysis of balance sheet and cash flow statement displays that the company has increased its investment in fixed assets by about 69% and this enhancement in fixed assets has been stable over the last three years. The cash flow statement confirms this point by showing 30% decline in cash through investment activities. This is interesting to note that the company has lost its current assets by 5% during the year 2005 as compared to 2004, which has resulted mostly due to a sharp decline in the company’s cash balance leaving it to nil. It is evident that company has lost its cash balance by about 202% in the year 2005 and the possible causes for it have been a substantial reduction in cash inflow from operations and a sharp outflow of cash from investment activities. It clearly exposes that the company has been facing a severe shortage of cash for the last three years and at the end of the year 2005, it was left with virtually no cash. Although the total current assets balance shows that it still is enough to meet the company’s short-term obligations, but most of the cash is tied into stock and debtors that have increased both by about 75% during the last year and thus might be one of the causes of company’s nil cash balance. According to Flamholtz (1986), most of the companies in California at a time filed for bankruptcy and the reason of which was that the companies gradually ran out of necessary cash. VERTICAL ANALYSIS According to Flamholtz (1986), the vertical analysis reflects the relationship between different items in a particular financial statement. This relationship is evaluated by apportioning a specific item in financial statement to 100%. In the balance sheet, the 100% item may be total assets or liabilities plus shareholders’ equity while in the income statement; the total item may be the net sales. The following vertical analysis compares the financial performance of both the companies: Vertical Income Statement Analysis Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Turnover 100% 100% 100% 100% 100% 100% Cost of Sales 85.6% 83.1% 84.3% 38.3% 38.3% 38.6% Gross Profit 14.3% 16.9% 15.7% 61.7% 61.6% 61.3% SG&A 9.1% 9.3% 9.6% 52.9% 53.0% 52.9% Operating Profit 5.2% 7.6% 6.0% 8.9% 9% 8.4% Net Interest Receivable/ (Payable) (0.07%) 0.19% 0.13% 0.32% 0.29% 0.3% Profit Before Tax 5.1% 7.9% 6.1% 9.3% 8.9% 8.7% Tax on Profit 0.53% 2.4% 1.9% 2.9% 2.8% 2.8% Profit After Tax 4.6% 5.5% 4.3% 6.3% 5.9% 5.8% Dividends 1.9% 1.8% 1.2% 2.3% 2.1% 2.0% Retained Profit 2.7% 3.7% 3.1% 3.9% 3.9% 3.8% According to the above vertical analysis, Greggs plc has had an interesting stable financial performance over the last three years whereas Whittard of Chelsea plc has had a quite fluctuating performance record for the last few years. The cost of sales of WOC plc has been very high i.e., about 85% of the total sales revenue, which shows that the most of the company’s sales revenue has been lost in the production and distribution expenses. Greggs plc, on the other hand lost only 38% of sales as expenses. The after tax profit for WOC plc has been mostly affected by cost of sales, while Greggs plc’s after tax profit was affected by SG&A expenses, accounting for about 52% of the total sales. Overall, Greggs plc has had a more stable financial performance for the last three years. Vertical Balance Sheet Analysis Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Total Assets 100% 100% 100% 100% 100% 100% Fixed assets 45.8% 34.1% 35.7% 66.1% 73.9% 74.7% Stocks 31.7% 26.1% 23.9% 2.9% 3.3% 3.2% Debtors 22.5% 15.1% 16.9% 5.6% 6.0% 5.9% Cash at bank and in hand 0.00% 19.9% 23.7% 25.4% 16.7% 14.4% Total Current Assets 54.2% 61.1% 39.8% 33.9% 26.0% 23.5% Short Term Liabilities 41.8% 40.4% 75.6% 30.3% 31.6% 32.7% Long Term Liabilities 0.05% 0.00% 0.02% 0.04% 0.05% 0.06% Total Liabilities 41.8% 40.4% 39.8% 36.4% 38.2% 39.5% Equity Shareholders Funds 58.2% 54.8% 60.4% 63.6% 61.8% 60.4% The above vertical balance sheet analysis reveals that WOC plc has invested more on current assets i.e., about 54% than fixed assets. On the contrary, Greggs plc seems to be relying more on fixed assets (about 66%) than the current assets. Most of the WOC plc’s current assets remain occupied with debtors and stocks with zero cash balance (decreasing considerably each year), while Greggs plc has a sufficient balance of cash which has been increasing significantly over the years. Therefore, the working capital position of WOC plc is more doubtful than Greggs plc. RATIO ANALYSIS Ratio analysis is the best tool to evaluate a company’s performance and identify problems (Meigs & Meigs, 1993). The ratio analysis for last three years has been done for both the companies in order to gain good insight into their investment potential. Profitability Ratios Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Gross Profit Ratio 14.3% 16.9% 15.7% 61.7% 61.6% 61.3% Net Profit Ratio 4.6% 5.5% 4.3% 6.26% 5.96% 5.84% Gross profit ratio reveals the profit obtained by a company after accounting for cost of sales. The gross profit ratio for WOC plc has also been fluctuating over the years and during the last financial it came to be about 14% of total sales, whereas for Greggs plc it has been very stable about 61% of the total sales. Net profit ratio shows the profit retained by a company after accounting for various operating costs. Profitability analysis shows that the Greggs plc is a more profitable and stable business than WOC plc. Liquidity Ratios Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Current Ratio 1.2:1 1.5:1 1.6:1 1.12:1 0.82:1 0.72:1 Quick Ratio 0.5:1 0.9:1 1.02:1 1.02:1 0.72:1 0.62:1 The current ratio measure’s a company’s abilities to pay off its short-term liabilities out of its current assets (Meigs & Meigs, 1993). For the last financial year ended, both the companies had almost same liquidity position however, Greggs plc showed healthy signs of improvement and enhancement whereas WOC plc has faced a deteriorating trend in its liquidity. The quick ratio tests the short-term solvency of a company after keeping aside its stock from the current assets (Mcmenamin Jim, 1999). It tells that WOC plc has more assets tied up in inventory than Greggs plc. Therefore, liquidity analysis also goes in the favour of Greggs plc. Investment Ratios Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Earnings Per Share 9.5p 10.6p 7.4p 264.7p 230.5p 209.2p Dividend Per Share 2.50p 2.50p 2.00p 66.0p 54.5p 49.0p “Common shareholders and potential investors in common stock first look at a company’s earning record” (Meigs & Meigs, p934, 1993). The above analysis show that the Greggs plc is transferring more returns to the company’s shareholders in the form of earnings per share as well as dividend per share. WOC plc’s earning per share is not stable, plus its dividend per share is also lower than Greggs plc. Therefore investment analysis confirms the feasibility of investing money into Greggs plc’s shares. Debt Analysis The companies with high leverage have less potential for investment as these companies may consequently fail to obtain further debt from the lenders to finance their operations (Meyers, 1997). The debt analysis for the companies over the last three financial years has been given below: Debt Analysis Whittard of Chelsea Plc Greggs Plc 2005 2004 2003 2004 2003 2002 Debt Ratio 42% 40% 40% 36% 38% 40% Debt to Equity 72% 74% 66% 57% 62% 65% The debt ratio analyses the extent of a company’s total assets that is financed with the long-term debts (Meigs & Meigs, 1993). The debt ratio for WOC plc reveals that about 42% of its assets have been financed by external funds and borrowings, whereas in Greggs plc about 36% percent of the assets have been funded with debts. Here also, WOC plc has had an increasing tendency of acquiring more debt to finance its assets while Greggs plc has reduced its debts over the last three financial years. The debt-to-equity ratio exposes the capital structure of a company i.e., to what extent the company relies on borrowed funds as compared to the equity funds for the purpose of financing its business operations (Meigs & Meigs, 1993). The debt to equity ratio shows that WOC plc has a more debt based capital structure than Greggs plc. However, it has not yet reached a risky bar, as there is still enough business operations being financed by equity capital in the company. CONCLUSION The above report evaluates the investment potential of both the companies using different tools and techniques ranging from horizontal and trend analysis to vertical and ratio analysis of the companies financial position. As both the companies are from the food manufacturing industry, they have a potential to be compared with each other with respect to financial position and performance. The above analysis reflects that of both the companies, Greggs plc has high investment potential than Whittard of Chelsea plc, because the former has had a more stable and sustainable growth in terms of profitability, liquidity, solvency and investment. The company has sufficient cash and working capital to meet its short-term debts, it is less geared so has a less risk for bankruptcy, and has had a record of paying enhanced returns to its shareholders every year (Greggs plc annual report, p7). All these evaluations as discussed above indicate that Greggs plc has a strong potential to be a profitable and return-oriented investment for its shareholder and investors in future. References Greggs plc Annual Report (2004), accessed from World Wide Web http://www.ir.greggs.plc.uk/greggsplc/upload/AnnualReport_2004.pdf Greggs plc Annual Report (2004), accessed from World Wide Web http://www.ir.greggs.plc.uk/greggsplc/upload/4AnnualReport_2003.pdf Flamholtz, Diane T. (1986), “Financial Accounting”, Boston, MA: PWS-KENT Publishing Co. Meyers S. (1977), “The Determinants of Corporate Borrowing”, Journal of Financial Economics, (5) Meigs & Meigs (1993), “Accounting: The Basis For Business Decision Making”, Mc Graw Hill: New York, p934 Mcmenamin Jim (1999), “Financial Management: An Introduction”, Routledge, London Whittard of Chelsea plc Annual Report (2005), accessed from World Wide Web: http://www.londonstockexchange.com/LSECWS/IFSPages/MarketNewsPopup.aspx?id=1065306&source=RNS Whittard of Chelsea plc Annual Report (2005), accessed from World Wide Web: http://webfund5.finexprestel.com/webfund5/equityannouncement.wsp?unitcode=WOC&articleid=200409070700056643C Read More