Finance for E-Business - Case Study Example

Table of Contents Introduction 1. Financial Performance 1.1 Profitability ratios 1.1.1 Return on capital employed 1.1.2 Profit margin 1.1.3 Asset turnover 1.1.4 Earnings before interest, tax, depreciation and amortisation (EBITDA) 2 Limitations to information and ratios presented 2.1 Problems with historical cost information 2.2 Manipulation of accounts 3 Future Solvency of BT PLC 3.1 How is BT PLC financed? 3.2 BT PLC capital structure 3.3 BT PLC times interest earned References Introduction Buying shares of companies listed on the London Stock Exchange is a good way to invest. One such company is BT PLC. An analysis of the company’s financial statements would be able to guide you in making your decision. “BT is the world's oldest communications company, with a direct line of descent from the first national telecommunications undertaking in the world” (btplc.com). The company operates in approximately 170 countries and is one of the leading providers of communications solutions and services in the world. “British Telecommunications plc (BT) is a wholly-owned subsidiary of BT Group plc and encompasses virtually all businesses and assets of the BT Group. BT Group plc is listed on stock exchanges in London and New York.” (btplc.com). The group has four (4) principal lines of business: BT Global Services; Openreach, BT Retail and BT Wholesale. The principal activities of the group include: “networked IT services, local, national and international telecommunications services, and higher value broadband and internet products and services” (btplc.com).) The ratios below and an explanation as to their use will indicate to you why this particular company’s share may or may not be recommended. However, as you will find out, there are limitations to these ratios. 1 Financial Performance The Income Statement shows the financial performance of a business for a given period; usually a year. It indicates whether the business has made a profit or a loss. 1. 1 Profitability Ratios Profitability ratios are usually calculated in order to perform vertical analysis or to compare one year with another. These ratios include net profit margin and gross profit margin. Figures are also taken from the balance sheet and used for the calculation of specific ratios to determine how well the fixed assets were utilised. These ratios are known as asset management ratios. These include asset turnover ratios and return on capital employed. Shareholder or investment ratios such as return on equity, earnings per share and price earnings ratio are some of the other ratios that are useful here. A number of these ratios will be used to assess the financial performance of BT group over the past three (3) years. 1.1.1 Return on Capital Employed “It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed” (BPP 2009) Calculation of return on capital employed (ROCE): 2010 2009 2008 Profit before interest and tax (PBIT) x 100% = 2,123 301 2,356 Total assets – current liabilities 18,260 20,206 19,857 = 11.63% 1.5% 11.86% The figures above show the return on capital employed for the past three (3) years.. ROCE fell sharply from 11.86% in 2008 to 1.5% in 2009. However it increased in 2010 to 11.63%. These percentages when compared to market borrowing rates indicate that they were quite favourable. In 2008 the market interest rate was on average 5.5% and in 2009 it averaged lower. (houseweb.co.uk) In 2009 BT Group acquired four companies. The total costs of these acquisitions were £186mn. However, in order to properly assess ROCE it is important to look at its two (2) secondary or underlying ratios: profit margin and asset turnover. “There is a trade off between profit margin and asset turnover, and you cannot look at one without allowing for the other” (BPP 2009). Calculations of these ratios are shown below. 1.1.2 Profit margin The profit margin indicates the percentage net profit on sales. Calculation of profit margin: 2010 2009 2008 PBIT x 100% = 2,123 301 2,356 Sales 20,859 21,390 20,704 = 10.17% 1.4% 11.38% BT Group’s net profit declined in 2009, but rebounded in 2010. This may be as a result of the anticipated synergies from the acquisitions during 2009 not impacting on the financial statements in that year. 1.1.3 Asset turnover The asset turnover indicates how well the assets employed have been utilized in generating sales. Calculation of the asset turnover ratio: 2010 2009 2008 Sales = 20,859 21,390 20,704 Capital Employed 18,260 20,206 19,857 = 1.14 times 1.06 times 1.04 t The ratios indicate that there has been some improvement, though very minor in the asset turnover ratio. This indicates that the net profit had a major impact on the return on capital employed as both the ROCE and the net profit margin shows a similar trend. 1.1.4 Earnings before interest, tax, depreciation and amortisation (EBITDA) Depreciation and amortisation are non-cash expenditure that does not include the outflow of funds. It is therefore a good measure of whether the company can afford to pay its debts. Depreciation is charged in the accounts as a form of economic rent. The aim is to spread the cost of the asset over its useful life. Except for historical cost problems and the limitations it imposes, charging depreciation is a way of ensuring that all cost incurred in earning revenues are matched with these revenues. If we substitute this figure in the calculations involving profitability and interest cover, it would give a different picture. 2 Limitations to information and ratios presented “Financial statements are affected by the obvious shortcomings of historic cost information and are also subject to manipulation” (BPP 2009). Financial statements are required to give a true and fair view of the companies operations for a period. They should provide relevant and reliable information such that users can make informed decisions. The International Accounting Standards Board has established a framework for the presentation and preparation of financial statements which is to be used along with International Accounting Standards (IASs) or International Financial Reporting Standards (IFRSs). These provide guidelines for the presentation and preparation of the statements. The external auditors are expected to determine whether the accounts show a true and fair view based on these guidelines. The accounts that were obtained for BT Group were unaudited and so they are not necessarily reliable. The figures for 2008 and 2009 were restated to reflect changes in policies and other adjustments. It is also true that over the past years a number of auditors have been found wanting and the financial statements that were stated as showing a true and fair view were deemed to be otherwise. 2.1 Problems with historical cost information The ratios calculated in Section 1 above are based on historical cost data. The figures for fixed assets are shown at historical cost and these costs may be significantly different from the current costs of these assets. Additionally, the depreciation charge for these assets would be lower than normal and would therefore lead to the overstatement of profits. It therefore means that BT Groups return on capital employed is not necessarily a true reflection of what it would have been if more appropriate figures were used in its calculation. To further emphasise this point, BPP 2009 indicates: This is particularly misleading when attempting to predict future performance. It could be that a major asset will need to be replaced in two years time, at vastly more than the original cost of the asset currently shown in the statement of financial position. This will then entail much higher depreciation and interest payments (if a loan or finance lease is used). In addition, overstatement of profit due to the low depreciation charge could have led to too much profit having been distributed, increasing the likelihood of new asset purchases having to be financed by loans. This information could not have been obtained just from looking at the financial statements. During periods of high inflation, if adjustments are not made to reflect the holding gains on assets then distributions may be made to shareholders without taking these factors into consideration. There are other factors that will affect the profits shown in the financial statements as BPP 2009 points out: In a period of inflation, financial statements based on historic cost are subject to an additional distortion. Sales revenue will be keeping pace with inflation and so will the cost of purchases. However, using FIFO (and to some degree the weighted average method) inventory being used will be valued as the earliest (and therefore cheapest) purchases. This leads to understatement of cost of sales and overstatement of profits. This is the result of inventory carried at historic cost. These are only some of the factors to consider as it relates to the problems with historical cost information and one has to understand appreciate this fact. 2.2 Manipulation of accounts Financial statements are frequently manipulated by what is described as creative accounting. Management may become creative for a number of reasons. The expectations of shareholders and prospective investors as well as their own personal gains may lead them to manipulate the figures keeping some items off the books or treating items in such a way that they do not affect profits. There are various standards in place to prevent this from happening but they often find a way out through various loopholes. To prevent this ISAB revise IFRS’s and IAS’s where this becomes necessary. The standards also require that there should be plausible reasons for changes in accounting policies and that the financial statements for previous years should be restated to show how the current changes in policies would affect them. Other ways of manipulating the account may be to keep loans off the books in order to keep gearing as low as possible. In order to emphasise how management tries to manipulate the accounts, BPP 2009 indicates that: Listed companies produce their financial statements with one eye on the stock market and, where possible, they like to produce financial statements which show analysts what they are expecting to see. For instance, a steady rise in profits, with no peaks or troughs, is reassuring to potential investors. Companies could sometimes achieve this by using provisions to smooth out the peaks and troughs. This has been largely outlawed by IAS 37, but companies can still achieve similar effects by delaying or advancing invoicing or manipulating cut-offs or accruals. Directors who are paid performance bonuses will favour the steady rise (enough to secure the bonus each year, rather than up one year, down the next) while those who hold share options may be aiming for one spectacular set of results just before they sell. An important aspect of improving the appearance of the statement of financial position is keeping gearing as low as possible. Investors know that interest payments reduce the amount available for distribution and potential lenders will be less willing to lend to a company which is already highly geared. We cannot vouch for BT Group. We can only make the point that there are possibilities that these problems may exist and therefore place limits our reliance on these ratios. 3 Future Solvency of BT Group A business is solvent if it is able to pay its debts as they fall due. Brigham et al 1999 states that: “Firms with relatively high debt ratios have higher expected returns when the economy is normal, but they can also suffer losses when the economy goes into recession. Thus, firms with low debt ratios are less risky, but they also forgo the opportunity to leverage up their return on equity.” Banks and other lenders will be interested in the level of solvency of BT Group. This information may be gleaned from various ratios such as: debt ratio; leverage ratio and interest cover. The debt ratio is used to determine how BT Group is financed, the leverage ratio - the capital structure and the interest cover – the extent to which BT Group will be able to meet its interest payments. 3.1 How is BT Group Financed? The debt ratio is the ratio of total debts to total assets. Total debts include all current and non-current liabilities while total assets include all current and non-current assets. It measures the percentage of funds that have been provided by creditors. Banks and other lenders will be interested in BT Group’s gearing level. “Debt ratios are concerned with how much the company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light” (BPP 2009) Calculation of debt ratio: 2010 2009 2008 Debt ratio = Total debt x 100% = 31,306 29,105 23,920 Total assets 28,680 29,274 29,352 = 109% 99.42% 81.49 The level of debt has shown increases over the three year period. The Group’s debt burden has increased from 81.49% in 2008 to 99.42% in 2009 (an 18% increase) and 109% in 2010 (a further 10% increase). This can be explained by the fact that the Group took on additional liabilities in its acquisition of four (4) companies in 2009. Its non-current liabilities increased by approximately £7bn in that same year while its current liabilities declined by approximately £0.63bn. BT Group’s debt burden is very high and lenders will be hesitant to lend any more funds for this reason. The group’s profits vary from modest to low and with this level of debt there is really not much to pay shareholders, although the group continues to make annual dividend payments. In future there may be little left to pay shareholders after interest has been paid. If interest goes up or foreign exchange losses occur, there may be nothing left to pay dividends. If interest charges are higher than profits before interest and tax (PBIT) the group may be forced into liquidation. There might be no reason for alarm. However, BPP 2009 states that: There is no absolute guide to the maximum safe debt ratio, but as a very general guide, you may regard 50% as a safe limit to debt. In practice, many companies operate successfully with a higher debt ratio than this, but 50% is nonetheless a helpful benchmark. In addition, if the debt ratio is over 50% and getting worse, the company’s debt position is worth looking at more carefully. For this and other reasons we calculate other ratios such as capital structure and times interest earned. 3.2 BT Group’s Long-Term Capital Structure “The capital gearing (or leverage) ratio is a measure of the proportion of a company’s capital that is debt” (BPP 2009). Calculation of gearing: 2010 2009 2008 Gearing = Interest bearing debt x 100% Shareholders’ equity + interest bearing debt = 12,791 13,907 11,342 22,965 24,275 22,352 55.70% 57.29% 51% The gearing ratio for BP Group for the three (3) year period, varied between 51 and 57%. The ratio rose by approximately 6% in 2009 from 51% to 57.29 %. It later fell by 1.5% from 57.29% in 2009 to 55.7% in 2010. There is no absolute limit but 50% is the benchmark as with the debt ratio. BP Group’s ratio is greater than 50% and so the company is considered to be highly geared. It may seek to increase its share capital by a rights issue or by retaining profits. The problem here is that the company is highly indebted and these debts carry a fixed rate of interest and so it has to make these payments first before it can pay shareholder. BPP 2009 states: “If these borrowings are secured in any way, then the holders of the debt are perfectly entitled to force the company to realise assets pay their interest if funds are not available from other sources.” It is very clear that the more highly geared a company is the more likely it is that it will be placed into liquidation if it is unable to pay its debts when its profits decline. BPP profits declined in 2009 but it continues to pay dividends as in 2008, out of retained earnings. 3.3 BT Group’s times interest earned “The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in PBIT would then have a significant impact on profits available for ordinary shareholders” (BPP 2000). Calculation of BT Group’s Interest Cover is as follows. 2010 2009 2008 Interest Cover = PBIT = 2,123 301 2,356 Interest Charges 1,158 620 378 1.8 times 0.48 times 6.23 t The company’s current and previous interest rate cover is way below par. It has declined from a strong 6.23 times to way below 1 in 2009 and increased in 2010 to 1.8 times. The benchmark suggests that it should exceed three (3). For the three (3) years only 2008 showed strong interest cover. All other years indicated unacceptable levels of interest coverage. References Brigham, E. F., Gapenski, L. C & Ehrhardt, M. C (1999). Financial Management: Theory and Practice. 9th USA: Dryden Press BPP (2009). Financial Accounting: Study Text. 3rd ed. London: BPP Learning Media Ltd. BPP (2009). Financial Reporting: Study Text. London: 3rd ed. BPP Learning Media Ltd. BT PLC (2010). BT Annual Report and Financial Statements. Available: http://www.btplc.com/Sharesandperformance/Annualreportandreview/pdf/2010_financial-statements.pdf. Last accessed 29th Dec 2010 BT PLC (2010). Company Profile. Available: http://www.btplc.com/Thegroup/Ourcompany/Companyprofile/index.htm. Last accessed 26th Dec 2010 BT PLC (2010). History. Available: http://www.btplc.com/thegroup/btshistory/index.htm. Last accessed 26th Dec 2010 BT PLC (2010). Our Company. Available: http://www.btplc.com/Thegroup/Ourcompany/index.htm. Last accessed 31th Dec 2010 Houseweb. (nd.) Interest rates. Available: http://www.houseweb.co.uk/house/market/ir.html. Last accessed 29th Dec 2010 Gitman, L. J (1997) Principles of Managerial Finance. 8th ed. USA: AddisonWesley Pearce, J. A. & Robinson, R, B (1997) Strategic Management: Formulation, Implementation, and Control. 6th ed. USA: Irwin McGraw Hill Telegraph (2010). Quote for BT Group PLC. Available: http://shares.telegraph.co.uk/quote/index.php?epic=BT.A. Last accessed 28th Dec 201031 Read More