Importance of Financial Ratio Analysis - Assignment Example

• Introduction

Financial values play a significant role in making an investment decision (Carr and Hasan, 2008). The first section of the report reviews financial values and makes improvement and investment recommendations. The two businesses under consideration belong to travel and leisure industry in the UK and include Manchester United PLC (MANU) and Arsenal Holdings PLC (AFC). The second section of the report includes discussion related to the capital investment decision.

• Financial and non-financial performance study of these two clubs

Manchester United PLC operates in three sectors and has 813 employees (Financial Times, 2016a). Arsenal Holdings PLC is has a diversified presence in three different sectors and has 605 employees (Financial Times, 2016b).

• • Importance of financial ratio analysis

The ratios are useful tool for interpreting business performance (Kumbirai and Webb, 2010). People with limited financial knowledge can also easily understand ratios.

• • Profitability Analysis: reviews the performance of business in generating value or returns (Lee and Park, 2009)
    • Operating Margin: analyzes the net of expenses saving from in revenue the firm (Feng, and Wang, 2000).

OM for the Manchester declined from 19% (2011) to 8.01% (2015). In 2015, group’s failure to qualify the league caaused reduced revenue that pushed OM down (McMahon, 2015b). The operating profits for the Arsenal are negative because of the cost of property sales rose to £ 33,078,00 (2013) from £ 5,463,000 (2012). Impact also resulted from the wage cost that increased £150 million (AFC, 2013). As this value declined again in recent years, the performance turned positive again (AFC, 2014). Manchester has a better position because despite overall decline, its operating margins are much higher than Arsenal.

• • • Net Profit Margin

The ratio helps in understanding net bottom line results of the business operations (Feng, and Wang, 2000).

Recent net profit margin from Manchester reflects its failure in qualifying in the league (McMahon, 2015b). Additionally, finance income also fell from £1,275,000 (2013) to£ 256,000 (2014) and £204,000 (2015). The tax credit of £155,212,000 that arose from the recognition of the assets which were realized as deferred in USA causednet income to rise in 2013(MANU, 2013 and MANU, 2015).

Arsenal gained net income positive as a result of gains from ordinary activities and benefits that group reaped on the disposal of registration of employees (AFC, 2013). Hence, it is revealed that success of Arsenal is the resulting contribution from property section(McMahon, 2015a).

• • Liquidity analysis provides review about the firm’s solvency in meeting its liabilities (Feng, and Wang, 2000).
    • Current Ratioexplains the capability of the business to pay off its liabilities using its current asset (Feng, and Wang, 2000).).

The current ratio of Manchester improved in 2015 as result of improvement in the working capital of amount of £ 93.3 million that increased current asset (MANU, 2015). Arsenal’s liquidity declined because its cost accruals and deferred income increased from £132,559,000 to £173,266,000 and payment to other creditors increased from £30,977,000 (2014) to £57,795,000 (2015) (AFC, 2015). Though the overall performance of Arsenal declined; however, it is better than Manchester as it has a ratio above threshold of one.

• • • Quick Ratio: analyzes the business liquidity without inventory (Eriotis, Vasiliou, and Ventoura-Neokosmidi, 2007).

The quick ratio for Manchester is same as current ratio because company has not discussed inventory in its balance sheet (MANU, 2015) Taking off inventory reduced Arsenal’s liquidity strength significantly but it is still above one and higher than Manchester, except in 2015. Arsenal’s liquidity problem in 2015 resulted because of rise in the current liabilities was so high that excluding total inventory of £14,271,000 could not let business meet its current obligations without inventory (AFC, 2015).

• • Efficiency analysis

Efficiency ratio reflects the efficiency in using assets for generating business results (Singh, and Davidson III, 2003).

• • • Asset Turnover

The comparative performance of the both ratios shows that both groups are equally capitalizing on an asset, but Arsenal is in a better position. Arsenal improved performance because it increased its revenue by 14% whereas increase in total assets was 10% from 2014 to 2015. The main contributor in revenue came from soccer operations that rose by 10 percent in 2015 (McMahon, 2015a). While, Manchester showed a decline in performance due to rise because of decline in revenue due to failure to qualify for the Champions League that reduced revenue by around £38 million and reduce revenue by 8.76% (MANU, 2015 and McMahon, 2015b).

• • • Receivables Turnover

It is selected to review the efficiency of business in collecting its revenue and dues from debtors (Yurdakul, and Ic, Y.T., 2004).

Here again, the performance of Manchester declined over time whereas Arsenal’s performance showed fluctuation. Performance of Manchester declined in 2012 as the company incurred loss of £104 million when team failed to perform Champions League was knock out early (Cabural, 2012). Manchester’s ratio then fell again in 2015 due to its failure in making place in the league that reduced revenue (McMahon, 2015b). Though for Arsenal the revenue fell in 2012, the decline for receivable was much higher; hence, increased the ratio. In 2013, receivable increased and ratio fell again. The extensive increase in revenue for Arsenal in 2015 from 344,522,000 from 301,872,000 (2014) while limited rises in trade receivables increased the ratio steeply. Despite these fluctuations, still Arsenal is better than Manchester because it is receiving its revenue in greater frequency than Manchester.

• • Financial gearing analysis
    • Long Term Debt/Equity is selected for understanding the level of bankruptcy due to debt levels (Margaritis, and Psillaki, 2010).

Both groups are having almost equal debt ranging between 70-85%, except the initial years when Manchester had massive debt. During the said and highlighted time, Manchester reduced its borrowing by repaying the debt of around £259,254,000 while increased its equity portion by issuing shares and getting £70,258 in proceeds from the issue (MANU, 2015 and MANU, 2013). Arsenal is better off as Manchester is again increasing its debt portion.

• • Investment Analysis
    • Earnings Per Share

It is analyzed so that the net income available to stock owners can be analyzed.

For Manchester, adverse earnings per share in 2015 are due to hit on revenue from the reason of not qualifying for the league and its resulting overall impact (McMahon, 2015b) . Otherwise, net income based on EPS is consistent expect 2013 where EPS rose due to tax credits (MANU, 2013). Arsenal Holdings EPS in 2012 increased due to gains realized on ordinary activities and the disposal activity of registration of employees. The fluctuation in the EPS of Arsenal is due to the variation in the cost of players registration and profits on assets disposal related gains (AFC, 2013 and AFC, 2015). Here again, the EPS of Arsenal is much higher than Manchester.

• • Valuation
    • Free Cash Flow/Share

The ratio is analyzed for understanding the level of money from operating activities and other capital expenditure (Bryan, Hwang, and Lilien, 2000)

Manchester has negative free cash flows over the period except 2015 where it has managed to generate positive cash flows. In 2011, the Manchester had negative free cash flows due to loss of £40.8 million from operations while company also incurred investment of £7.1million in property and plant that further reduced its free cash flows. Overtime it improved as company increased its operating cash flow to £30.9 million (2012), £57.2 million (2013) £72.8 million in (2014) and £ 143.9 million in (2015) (MANU, 2013 and MANU, 2015). Arsenal, on the other hand, had only run into trouble in 2013, and it was due to property sale wage cost (AFC, 2013). Overall Arsenal is in a better position as it has cash flows available for expansion and other needs.

• • • Operating Cash Flow/Share

Operating cash flow is important determinant of firm’s performance than net income (DeFond, and Hung, 2003).

Operating cash flows of Manchester was negative in 2011 due to the operating losses of £40.8 million. It then improved over a period of time to£40.8 million in 2015 (MANU, 2013 and MANU, 2015). For Arsenal, operating cash flows declined due to the impact of cost of property and the wage (AFC, 2013). It is increasing in other years due to overall improvement in operations. Still, Arsenal is in a better position as it does not have to rely on extensive external financing for expansion like situation for Manchester.

• • Non-financial analysis
    • Numbers of Facebook Fans

The ratio is selected as the online audience is a valuable asset to the business.

Here, the Manchester is in a much better position than Arsenal. Facebook engagement for Arsenal is also increasing; however, the pace of Manchester is much steep and it is due to global social media network strategy that the company unveiled in 2011 for attracting 660 million target audiences (Shearman, 2011).Arsenal’s social audience is growing now at a higher pace as the company’s social media team has come up with a unique idea of using comedy in message (Moody, 2016).

Revenue/Employee

It is selected for understanding the comparative performance and productivity of employees.

The decline in the ratio in 2012 for both groups is due to fall revenue. In 2015 the income of the Manchester group fell again due to its inability in qualifying for the league. On the other hand, Arsenal is showing improved performance since 2013 to 2015 as the company is increasing its revenue from £ 280,374,000 in 2013 to £ 344,524,000 in 2015 (AFC, 2013, and AFC, 2015). Hence, Arsenal has improved its revenue per employee over years. .

• • Ranking and suggestion for investment

A comparative analysis of both firm’s financial and non financial ratios is produced below, and levels are given depending upon the performance of the business. Each ratio is given certain weight and based on the five year’s average; then ranks of 1 and 2 are assigned on leading and lagging performance respectively. The leading company is given the score of 10 while lagging one is given 5 score. The performance of the business is reviewed by an average of five years. Conclusively, the given below result is arrived at:

Manchester group has better performance in term of profitability, debt, and social media measures. However, the weighted score of the Arsenal is 8.25 whereas the Manchester ranks lower and stands at 6.75. Based on the above collective results, it is concluded that Arsenal is a better option for making the investment. It is important to mention here, that though the performance of Arsenal groups is better as compared to the Manchester; however, there are areas where Arsenal group must improve its performance. For example, operating margins of the Arsenal group needs to be improved.

• • Recommendations for Manchester United

There are different views where Manchester can enhance its overall performance. For instance, the firm’s liquidity is significantly weak, and it must improve its ability to pay off its liability using current assets. When reviewing the liquidity performance of the business excluding the role of inventory; the liquidity strength of Manchester deteriorates significantly. Hence, it is an important area of improvement.

Manchester must improve its assets utilization and increase revenue per unit invested in the asset. The increase in the content distributiona and growing number of matches, is the key improvement areas for Manchester. Its active social media should be converted into revenue by deploying effective strategy. Importantly, the Manchester has a higher number of employees as compared to Arsenal which means that Manchester can either reduce its number of employees or increase revenue per employee and bring it in line with Arsenal.

Most important aspect is the free cash flows where Manchester is running into negative. Cash flows are the lifeline of the business and cash flows from operations reflect the effectiveness of the firm management (DeFond, and Hung, 2003). Improving performance in all these areas will have a significantly positive impact on the business.

• • Limitations of relying on financial ratios

As a matter of fact, the ratio analysis is one of the widely used techniques for the review of the business performance. However, despite this fact, ratio analysis has some limitations that influence its usefulness. Some of the restrictions are listed as follows:

• Ratios when compared with competitors or other industry peers often does not produce consistent results due to different factors like diversification etc (Grunert, Norden, and Weber, 2005)
• Ratios rely on past performance and need some other technique for anticipating future performance (Lewellen, 2004)
• Ratios often become meaningless if numerator or denominator involved is a negative value (Halkos, and Salamouris, 2004).

Despite these limitations, ratios are widely used as the ratios are easily understandable by the people with limited understanding of the financial concepts.

• Capital Investment Appraisal

Capital investment decisions are made considering capital budgeting techniques and time value of money factor (Graham, and Harvey, 2002). This section of the report is related to the assessment of the Alpha business proposal of investing in the chain of car exhaust and tyre fitting centers. For the purpose, the capital budgeting techniques are deployed.

• • Payback period

The payback period refers to the time within which the business will get its initial investment back (Graham, and Harvey, 2002)..

The payback period of this project will be 2 + (15/138) = 2.11 years. Based on the analysis, the project appears to be viable for investment.

• • Net present value

NPV is the net discounted saving that a business generates after meeting its expenses and applying discount factor that accommodate the impact of the time value of money (Ryan, and Ryan, 2002) .

Using three different rate, the results revealed that the business is viable at 10% and 15% rate with the profit of £ 115.9237 (in thousands) and £33.1048 (in thousands) respectively. However as the cost of capital increases to 20%, the NPV of the project turns negative to -£31.51 (in thousands). Hence, with the required rate of return of 15%, the business is profitable. However, in case the cost of capital increases to 20%, it must not invest in the firm.

• • Internal rate of return (IRR)

IRR or internal rate of return is the rate at which the discounted revenues from the business become equal to the initial investment and costs incurred by the firm. (Hartman, and Schafrick, 2004)

Change in NPV for every 1 percent change in the discount rate is:

23.9625/2=11.9813

The reduction in the 10% discount rate required to achieve a zero NPV would, therefore, be:

(-7.556/11.9813)*1%=0.63%

Hence, IRR is 18%-0.63%=17.37%.

The IRR of the business implies that in case the cost of the businesses increases to 17%, then the business will not remain viable for investment anymore. As the required rate of return for business is 15% and IRR is 17%, it means that the threshold cost is higher than the required rate of return; hence, referring to the viability of business.

• • Limitations of using investment appraisal

Capital budgeting techniques are subject to certain limitations that are discussed below:

• There is no fixed method of finding accurate discount rate and it varies depending upon the understanding and preference of decision maker.( Graham, and Harvey, 2002)
• NPV often losses its usefulness for high growth and non-dividend paying firms as their projects often generate much late cash flows and NPV rejects investment in them (Graham, and Harvey, 2002).
• Payback period ignores time value of money and the cash flows beyond the payback period (Graham, and Harvey, 2002).
• Managers often misleadingly reject the viable project (with positive NPV) in sought for higher IRR (Graham, and Harvey, 2002).

As a matter of fact, each technique has some limitation; however, the insights provided by capital budgeting are significantly useful enough in providing a guideline for an investment decision. Therefore, methods are used for analyzing the investment projects.

• Conclusion

The above report results reveal that a group (Arsenal) with some diversified business is in a better position than MANU in different aspects. In the second section, the report concludes that in case the project successfully generates 15% required return. Further, the capital budgeting technique also provides the threshold limit over and above which the business will not be able to sustain its viability for investment.