Financial Activities that Establish Business Sustainability - Term Paper Example

Business Valuation Table of Contents 1.0 Company Background. 2 2.0 Analysis of the current business and financial situation Error: Reference source not found 3.0 Analysis of Company future expected economic benefit 11 4.0 Appraisal of WACC 13 5.0 Discounting Cash Flow Valuation 14 6.0 Relative Valuation 16 7.0 Discussion of key Assumptions and Sensitivity Analysis 18 8.0 Critique of methodologies applied and relation to specific issues for River Island Error: Reference source not found 9.0 Conclusion and recommendation 20 References 21 1.0 Company Background The River Island Clothing Company is a United Kingdom (UK) based designs Company. The Company designs most of the clothing and accessories which it sells to its target customers who are mostly youths. The Company sells over 350 clothing designs, accessories, jewelers and the footwear. According to recent studies from Abrams (2010), River Island Clothing Company is rated as one of the best companies in the UK for selling Knitwear, Jeans, Trousers, jackets among other accessories for men and women. Additionally, the company has chain of superstores and online shops where customers may make orders. The Company is owned by Lewis trust investment firm and sells its products mostly in the UK, Turkey, Poland, Ireland, Middle East Market and Singapore. The company is private, limited by shares capital only, and it was incorporated in the year 1959. The current company CEO is Ben Lewis, and he was appointed in April 2010. 2.0 Analysis of the current business and financial situation In this section, the paper will discuss major economic trends and set financial policies. Financial analysis can be described as the process of evaluating the business, projects, and budgets among other financial activities to establish business sustainability and performance (Damodaran, 2016). Additionally, this section discusses various financial ratios and will carry out a trend analysis of the company to establish its solvent, liquid, and profitability (Bilolikar & Jain, 2014; Jennergren, 2010). Liquidity Ratios This report establishes River Island Clothing Company liquidity ratio to understand the extent to which it can meet its financial obligations. Since its operations and current performance needs to be assessed, liquidity ration computes its ability to pay owed short-term debts. Beginning with current ratio; 2015 = 478.8/ 159.7 = 2.998 2014 = 453.8/259.1 = 1.751 The current ratio is a financial ratio that measures whether or not River Island Clothing Company has enough assets to pay its obligation throughout the following business cycle (in this case, River Island Clothing Company period over 12 months), by comparing the firm's current assets to its current liabilities (Edmister, 2012). Since both current ratios are more than 1, it shows that Island Clothing Company can pay its current liabilities three times in 2015 and 1.8 times in 2014. It was lower in 2014 and increased in 2015. This trend, therefore, gives a higher level of stability and leverages. Overall, the company is doing well regarding current ratio (Bilolikar & Jain, 2014; Iacob et al., 2012) 2015 = (478.8 - 159.7) / 894 = 0.357 2014 = (453.8 - 259.1)/890.4 = 0.219 The calculation as obtained above has been made typically on trailing 12 month period. Additionally, the calculation uses the average working capital in the period stated in the calculation above (2014 and 2015). In as much as the figures above show that the Clothing Company has the ability to finance its additional sales without getting into additional debt, the working capital turnover is a measurement comparing the finished of working capital to the production of sales over a given period. This provides some useful information as to how effectively a company is using its working capital to generate sales. With a ratio of 0.357 in 2015, it shows that the enterprise is fully utilising its assets and can generate its capital 0.357 times while in 2014 it is 0.219 times. Other liquidity ratio analyses for the last five years are shown in the table below: ST Liquidity / LT Solvency Years 2010 2011 2012 2013 2014 2015 Current Ratio 1.0 1.3 1.6 1.5 1.8 3.0 Quick Ratio 0.2 0.3 0.3 0.3 0.5 0.6 Average Days Payable Out. 0 14.1 26.0 24.7 28.3 28.3 Avg. Cash Conversion Cycle 32.8 15.9 22.2 22.7 21.8 Avg. Days Inventory Out. 40.7 40.2 37.1 40.4 42.2 41.1 Avg. Days Sales Out. 7.0 6.7 4.8 6.5 8.9 9.0 Total Debt/Equity - 1.7% 0.4% 0.8% - 0.3% Total Debt/Capital - 1.7% 0.4% 0.8% - 0.3% LT Debt/Equity - 0.5% 0.4% 0.4% - - LT Debt/Capital - 0.5% 0.4% 0.4% - - Total Liabilities / Total Assets 71.1% 60.7% 51.7% 55.5% 49.1% 31.1% These ratios help in determining the company’s ability to meets its short-term obligations. The trend analysis, current ratio, quick ratio, average cash conversion cycle all show improvement from the year 2010 to 2015 indicating that the company is in the upward trends hence good performance. Profitability Ratios 2015 = 183.4/894 = 20.5% 2014= 191.3/890.4 = 21.48% In 2015 the gross profit margin was 20.5% while in 2014 it was 21.48%. This is an about 1% drop from the previous year. The performance is good since the drop was mostly caused by an increase in overheads, which should be reduced by the management. 2015 = 144/ 894.0 = 16.10% 2014 =144.5/ 890.4 = 16.22% The operating profit is fairly constant for the two-year period, and it shows good performance of the Company for the two years. The trend analysis which gives a synopsis of the business profitability performance is presented in the table below. Margin Analysis 2010 2011 2012 2013 2014 2015 Gross Profit Margin % 21.7% 18.2% 18.8% 15.5% 21.5% 20.5% SG & A Margin % 22.5% 6.4% 5.9% 4.8% 5.3% 4.4% EBITDA Margin % 20.0% - - - - - EBIT Margin % 15.8% 11.8% 12.9% 10.7% 16.2% 16.1% Net Income Margin % 13.1% 10.3% 10.7% 9.1% 13.2% 13.3% Earnings from Cont. Ops Margin % 13.1% 10.3% 10.7% 9.1% 13.2% 13.3% Both margins from gross profit margin, earnings before interest and tax and net income margin show an upward trend from 2012-2015. Declining trend was only reported in 2011 and this might be as a result of hard economic times River Island Clothing Company was experiencing. From the table, gross profit margin in the 2010 is 21.7% while in the year 2011 it is 18.2 showing a decline by 3.5%. In the year 2012, it further increases to 18.8 indicating and increase in profit. This is the same to net profit margin and other ratios. In 2013, declining trends is recorded but the company performance further improved in 2014 and 2015 thus showing marginal trend as far as decline is concerned. This trend can be further explained in the graph below. Efficiency ratio The efficiency ratios are shown in the table and graph below Asset Turnover Total Asset Turnover 1.9 1.6 1.4 1.5 1.6 1.6 Fixed Assets Turnover 5.9 6.0 6.9 8.1 9.1 9.5 Inventory Turnover 9.0 9.1 9.8 9.0 8.7 8.9 Accounts Receivable Turnover 51.9 54.3 75.5 56.2 41.2 40.6 The efficiency ratio remains fairly constant for the four periods with a bit high performance in the year 2013. A sensible business and mission require effective orchestrating and financial organization. Proportion examination is a useful organization mechanical assembly that will upgrade an understanding of money related results and examples after trading period, and give key pointers of progressive execution. Directors will use proportion examination to pinpoint qualities and weaknesses from which strategies and exercises can be formed. Funders may use proportion examination to gage results against various affiliations or make judgments concerning organization reasonability and mission influence. Leverage ratio Leverage ratio aimed at evaluating the debt level of the company. For the River Island company one of the ratio. Debt ratio = Total Liabilities/Total Assets 2015 = 177.8/571.7 = 31.10% 2014 = 270.1/549.7 = 49.10% In 2015, the debt ratio was 31.1% indicating a drop from 2014 which it was 49.10%. This is a good indication that shows how the company is utilizing its funds. Lower ratio is more favorable than higher ratio hence in 2015, it has improved better than 2014. Debt to equity ratio This ratio shows relationship between the company total liabilities against its total equity. Debt to equity ratio = Total Liability/Total equity = 2015 = 177.8/394.0 = 45.13% 2014 = 270.1/279.6 = 96.6% In 2014 ratio was 0.966 indicating unstable since debtors are shareholders were almost having equal shares while this changed in the year 2015 when ratio reduced to 0.451 indicating higher stability of the company financial management. Growth ratio Growth ratio shows the trend on how the company is growing for the past years. There are various ratios indicating the company growth. This can be summarized in the table below:- Year 2010 2011 2012 2013 2014 2015 Total Revenues -2.10% 0.10% 2.60% 9.40% 10.00% 0.40% Gross Profit -7.50% -16.00% 6.30% -10.10% 52.70% -4.10% EBIT -12.60% -25.60% 12.90% -9.50% 67.10% -0.30% Earnings from Cont. Ops. -21.00% -21.20% 5.80% -6.10% 58.50% 1.70% Net Income -21.00% -21.20% 5.80% -6.10% 58.50% 1.70% Accounts Receivable 45.10% -38.60% -5.90% 103.20% 23.80% -15.90% Inventory 32.60% -18.60% 9.40% 37.60% -16.10% 17.20% Net PP&E 3.70% -7.90% -14.10% 1.50% -4.30% -3.00% From the above table, the company growth has not been stable over time. The company posted high growth in 2012 and 2014 while the rest of the years it posted low growth. This can be further represented in the table below:- 3.0 Analysis of Company future expected economic benefit Generally, cash flow statements help in showing cash that flows in and out of business over a given period. Financial analysts are interested in cash flow, because only cash can be used to pay bills, purchases of assets among others. Free cash flow can be described as the flow which is available to the company's suppliers of capital after deduction of operating expenses and tax. Furthermore, necessary investments in working capital like inventory and other fixed capital have been paid (Edmister, 2012; Schulze et al., 2012). Free cash flow help in measuring company financial performance. It shows the amount of cash the company can generate after spending the money required to maintain or expand its asset base. The company cash flow can be estimated in several ways. First, by calculating earnings before depreciated and amortization. This can be calculated as; EBITDA = Net profit +Interest + Taxes + depreciation + amortization 2015 = 119.3 +29.8+ 27.7 + 1.8 = 178.6 2014 = 117.3 + 30.3+ 35.9 + 0.1 = 183.6 In this case, the calculations add back the primary non-cash expense that had been previously deducted to arrive at the income. This one does not give a clear picture of the cash flow which should be available to the company supplier of the capital hence need to add interest. Hence the formula will be EBITDA = Net profit +Interest + Taxes + depreciation + amortization 2015 = 119.3 +29.8+ 27.7 + 1.8 = 178.6 2014 = 117.3 + 30.3+ 35.9 + 0.1 = 183.6 The company cash flow from operating activities is very useful when it comes to analyzing the company financial health. This is because, without the ability to generate cash flow from its operation, the company might have difficulties in the future. In the analysis and valuation, the importance of the free cash flow is normally expressed as cash flow from operations less any capita; expenditure necessary to maintain its current growth. It is calculated as follows:- Free cash flow = Cash flow from operation – capital expenditure required to maintain current growth. However, since it is not easy to establish the capital expenditure necessary to maintain current growth, the new formula will be:- Free cash flow = Cash flow from operation- capital expenditure. 2015 = 144 - 6.73 = 137.27 2014 = 144.5 - 3.45 = 141.05 Too much free cash flow is not good for the company as per agency theory while a smaller amount of free cash flow is good for the company. From the agency theory, the company is heading in the right direction has the free cash flow has been reduced in 2015 compared to 2014. 4.0 Appraisal of WACC The weighted average cost of capital is simply the average discount rate applied by the debt-holder and equity holders in the company future cash flow (Kashyap, 2014). The WACC is calculated as:- WACC = (D / D + E) rd (1 – Tc) + (E / D + E) re Where:- a) D = is the market value of the debt b) E = this is the market value of equity c) Rd = is the company cost of debt capital d) Re = is the company cost of equity capital e) Tc = is the corporate tax rate From the case study of the River Island Clothing Company have the following: Ear - UK Gilt yield as at January 2017 – 1.47% UK Equity risk premium – 5.00% Small size premium – 2.00% Corporate tax rate 20% WACC = (1 + 0.0147)0.05*(1-0.02) + (0.0147/0.013+0.0147)0.015 =0.067 =6.7% From the calculation, WACC is more than risk premium rate of 5%. Hence, the company weighted average cost of capital indicates healthy performance for the Company. This implies that the firm can get back all the invested capital within the required period. The calculation on WACC is based on the assumption that it is market driven and it is a function of the investment and not the investor, and lastly, it is based on the expected returns. 5.0 Discounting Cash Flow Valuation Discounting cash flow on the other hand help in evaluating the company future cash flow based on the present value which is based on the perceived risk of investing capital in the Company and this case the River Island clothing company (Ehrenmann & Smeers, 2013). Evaluating company using DCF method is based on three major components which include projected cash flow, the discount rate and lastly the terminal value. The company cost of equity is calculated as:- Cost of equity = Risk - free rate + (Equity risk premium x Beta) + Size risk premium Risk free rate = 1.45% Risk Premium = 5.00% Beta = 3 Size risk premium 2% Cost of equity = 0.0145 + (0.05 x 3) + 0.02 = 0.1845 The volatility which is beta of the industry is given from yahoo finance and it is 3 from the historical beta. Using the net profit as the cash flow of the company then the company net present value will be given as:- Year 2010 2011 2012 2013 2014 2015 Net Profit 94.5 74.5 78.8 74 117.3 119.3 PV 97.902 79.96055 87.62045 82.28316 135.1254 142.3768 NPV 625.2684 In billions With positive NPV, it means that the company is in the right direction and the cash flow can maintain the business operation in the long run. Therefore, the investment is viable according to NPV decision rule. For the internal rate of return, (IRR); for each dollar invested in any investment, investors expect a return, and this return is what is called internal rate of return. It is calculated over a given period. It typically helps the investor by giving him or her means through which she/he may compare different types of investment available based on their return (Ehrenmann & Smeers, 2013). Generally speaking, the rate of return should be higher than the cost of capital for an investor to invest in it, and in case it is less, then the investment or the project is not viable. For this project, the IRR is 6%> 3.6%. Hence, indicate the project is viable. It is therefore very potential to invest in this business since the DCF indicate positive NPV from the cash flow. 6.0 Relative Valuation This is a way of comparing a firm performance with those other enterprises in the same industry. From this case, the comparison is shown in the table below Company Market Cap (£m) Sales Turnover (£m) Average no. Employees Prospective P/E (12 months) Beta Next PLC 5,494.3 4,261.00 30,591 8.6 0.29 River Island Cl. 4,521.3 3,782.9 40,098 20.8 0.5 Burberry PLC 7,153.6 2,568.70 10,613 28.00 0.57 Marks and Spencer Group 5,575.0 10,597.6 80,041 22.30 0.65 ASOS PLC 4,409.9 1,444.9 2,645 127.3 0.69 Brown (N) Group PLC 1,233.48 834.90 3,429 16.36 0.67 Ted Baker PLC 1,251.5 488.9 3,276 26.7 0.22 Super Group 1,426.3 495.00 3,000 32.1 0.65 Mulberry Group PLC 654.7 162.6 1,400 298.40 0.07 Mothercare PLC 194.7 680.1 5,521 107.1 -0.19 Moss Bros Group PLC 98.2 123.6 935 18.3 0.46 French Connection Group PLC 32.00 157.6 1,999 54.87 1.92 Average for sample 2,502.15 1,121.73 13,040.91 67.28 0.53 Median for sample 1,251.5 587.55 3,276.00 28.00 0.52 Comparing the company performance with average market sample, it is clear that the market cap is less than that of the company, sales turnover of the company is more than market average. While the beta is less than the market average indicating that the company is less risky compared with overall market risk (Kashyap, 2014). This gives potential investors hope to invest in this Company due to low risk and higher earnings per share compared with overall average market share. From the result, it is also clear that the company intrinsic value is more than that of the average market and its overall market competitors like French Connection Group PLC among others. 7.0 Discussion of Key Assumptions and Sensitivity Analysis Sensitivity analysis gives in-depth variable cost analysis using the concept of linear programming. From the analysis of the investment scenario for this project, the results are shown in the table below:- Company growth Base value (2%) 1.0% 1.90% 2.00% 2.10% 2.20% NPV 625.2684 FALSE FALSE FALSE FALSE FALSE NPV Percentage change   -100.00% -100.00% -100.00% -100.00% -100.00% IRR 6.013% FALSE FALSE FALSE FALSE FALSE IRR Percentage change   -100.00% -100.00% -100.00% -100.00% -100.00%               Exit yield Base value (4%) 3.60% 3.80% 4.00% 4.20% 4.40% NPV $300,817,347 FALSE FALSE £9,795,216 FALSE FALSE Percentage change   -100.00% -100.00% 4046.21% -100.00% -100.00% IRR 6.013% FALSE FALSE 9.92% FALSE FALSE IRR Percentage change   -100.00% -100.00% 0.00% -100.00% -100.00% The results using the linear programming indicate, that the project is viable and chances of success are very high as per the table of sensitivity analysis. Some of the key assumptions include the base value of the exit yield which is given in the table above, estimated company growth for six years. Among other significant assumptions in calculating the WACC and NPV, where net profit is assumed to be the company expected cash flow for fives year. 8.0 Critique of methodologies applied and relation to specific issues for River Island For the River Island Clothing Company, one of the valuation methods is the use of company ratios. Ratios have significant weakness since they can only compare companies within the same industry and trend analysis of the same company. Ratios fail to give an investor the broader view of the overall economy performance. For large businesses that operate in different sectors of the economy, this method won't be ideal for evaluation the company performance. The ratio analysis fails to factor in the inflation effect in their books of accounts especially the balance sheet. This effect trend analysis since they should be interpreted differently. Lastly, ratio analysis is being affected by seasonal factors which are hard to factor in the process. Another method of valuation is the free cash flow analysis and the DCF. Though this method is important since it gives the company intrinsic value, it has several gaps in the process of valuation. First, there are several assumptions when it comes to the company perpetual growth rate and the discount rate (Bilolikar & Jain, 2014). A small mistake will distort the overall business valuation process hence require maximum keenness in the process. Continuous changes in the process need constant vigilant and modification to meet the demand of the target audience. Lastly, it is only good for short term valuation of the company and not long term. 9.0 Conclusion and recommendation From the evaluation of the River Island Clothing Company, it has a higher potential of growth and development. The company capital structure and investment strategies are capable of giving the company good returns with a greater level of liquidity and return on capital invested. The company financial health is in good condition, and any potential investors can take advantage of the potential growth in the firm and add additional capita. From the director's point of view, the shareholding and ownership of the company are not yet diluted due to strict capital structure applied by the firm, and this may result in higher earnings per share. References Abrams, J. B. (2010). Quantitative business valuation: a mathematical approach for today's professionals. John Wiley & Sons. Bilolikar, V.S. & Jain, M.K. (2014). An adaptive crossover genetic algorithm for multi-mode resource constrained project scheduling with discounted cash flows. 1-9. Proceeding. Damodaran, A. (2016). Damodaran on valuation: security analysis for investment and corporate finance (Vol. 324). John Wiley & Sons. Edmister, R. O. (2012). An empirical test of financial ratio analysis for small business failure prediction. Journal of Financial and Quantitative analysis, 7(02), 1477-1493. Ehrenmann, A. & Smeers, Y. (2013). Risk adjusted discounted cash flows in capacity expansion models. Mathematical Programming, 140(2), pp.267-293. Iacob, M. E., Quartel, D., & Jonkers, H. (2012). Capturing business strategy and value in enterprise architecture to support portfolio valuation. In Enterprise Distributed Object Computing Conference (EDOC), 2012 IEEE 16th International (pp. 11-20). IEEE. Jennergren, L. P. (2010). On the forecasting of net property, plant and equipment and depreciation in firm valuation by the discounted cash flow model. Journal of Business Valuation and Economic Loss Analysis, 5(1). Kashyap, A. (2014). Capital Allocating Decisions: Time Value of Money. Asian Journal of Management, 5(1), pp.106-110. Schulze, C., Skiera, B., & Wiesel, T. (2012). Linking customer and financial metrics to shareholder value: The leverage effect in customer-based valuation. Journal of Marketing, 76(2), 17-32. Read More