Financial Analysis for Ted Baker Plc - Essay Example

Running Head: FINANCIAL ANALYSIS FOR TED BAKER PLC Financial Analysis for Ted Baker Plc in Harvard Style by University Part A. Discuss what other objectives may be important to Ted Baker PLC and whether such objectives are consistent with the primary objective of shareholder wealth maximisation. Financially, the primary objective of a business organisation is the maximisation of shareholder value. According to Keown, this means the "maximization of the shareholder price" (2005) which, is irrefutably linked with the internal operation of the firm and the external perception of the different players in the company's environment. It should be noted that shareholders gain from their investments through accumulated earnings per share and dividend distributed by the business organisation. Externally, investor value is maximised through the increase in capital gains or the stock price. In order to attain this goal, companies strive to manage their operations which are quantitatively reflected in their annual reports. Thus, at the heart of every decision made by a company is the primary concern about its possible effects on the owners. The determination of Ted Baker Plc (Ted) creates and maximises value for shareholders can be aided by utilising financial analysis techniques which looks at the overall performance of the company. Through a financial ratio analysis, this portion will look at the specific areas where Ted's financial position can be further enhanced. Lastly, this paper will critically examine whether the financial objectives are in line with the goal the primary goal of shareholder value maximisation. Financial ratio analysis is a very essential tool in assessing the financial health of a business entity. Financial ratios are grouped into five categories, each showing a different aspect of a company's financial operations. These are profitability ratios, financial leverage ratios, liquidity/solvency ratios, efficiency ratios, and investor ratios. Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred (Fraser and Orniston 2004). Table 1 shows the computed profitability ratios of Ted Baker Plc during the fiscal years 2006 and 2005 which includes gross profit margin, net profit margin, and return on capital employed. When measured in terms of gross profit margin and ROCE, Ted shows a decline in profitability. This also shows the company's higher costs of goods sold relative to sales. On the other hand, the company's lower ROCE slower growth of income relative to capital employed. However, amidst all these, Ted shows efficiency in allocating costs evidenced on its net profit margin. Table 1. Liquidity or solvency ratios are used as measures of the company's ability to finance its short-term obligations by its cash and near cash items (Fraser and Orniston 2004). Table 2 shows the computed liquidity ratios of Ted during the fiscal years 2006 and 2005 which includes current and quick ratios. Generally, the company's liquidity is improving. It should be noted that in both years, all the current assets of the company can more than pay off its current liabilities. However, the large discrepancies between the current and quick ratios indicate that almost half of the current assets are tied up in inventory. This huge stock dilutes the liquidity of Ted Baker Plc. Table 2. Working capital ratios are also called efficiency ratios because they reveal the company's ability to manage their working capital efficiently (Fraser and Orniston 2004).. Table 3 shows the computed the working capital efficiency ratios of Ted during the fiscal years 2006 and 2005 which includes stock, debtors, and creditors turnover. The company's stock turnover has improved although sales of merchandises is still slow. Both of the debtors and creditors turnover has declined indicating longer collection of receivables and supplier payment periods. Table 3. Financial leverage ratios provide an indication of the long-term solvency of the firm (Fraser and Orniston 2004). They indicate the extent of non-owner claims on the firm's profits as well as the firm's operating capability to meet its obligation. Table 4 shows the computed financial leverage ratios of Ted during the fiscal years 2006 and 2005 which includes gearing and interest coverage. Ted's capital structure entails minimal risk as shown by the low gearing ratios. Stockholders finance almost 99% of the company's assets. This implies low level of interest rate and very high interest coverage ratio. Table 4. Investor ratios are financial ratios especially designed to convey to investors the profitability of the company's stock as an investment (Fraser and Orniston 2004). Table 5 shows the computed investment ratios for Ted Baker Plc during the fiscal years 2006 and 2005 which includes earnings per share, dividend yield, and price earnings ratio. In general, Ted Baker Plc generates a high return for its stockholders. The company's earnings per share leapt from 26.800pence to 30.600pence during the fiscal years 2005 and 2006, respectively. Dividend yield declined but this is due to the sharp increase in the weighted average share price. Price earnings ratio also increased indicating the attractiveness of stock in the market. Table 5. Based on the above discussion, there are three financial objectives that Ted Baker Plc can pursue. First, the company should improve its liquidity by reducing the level of stocks by in its current assets. The company should also enhance its efficiency by lowering its inventory turnover, speed up collection of accounts receivable and payments of trades payable. The improvement in the company's liquidity can help in maximising shareholder value of Ted. It should be noted that a business organisation holding huge inventory also incurs inventory holding cost. The longer the time it stays in Ted's warehouse, the higher the cost associated with it including the salary of warehousemen and maintenance. Furthermore, Ted is in the fashion industry whose products are highly exposed to the risk of product obsolescence. It should be noted that Ted markets itself as the leader in fashion in the UK industry. Thus, when the merchandise are not sold shortly after the introduction of the new designs, there is only a nil possibility that they can still be marketed. Clothes and accessories can go out of fashion in only a short period of time. This unsold inventory can be a burden to dispose for Ted because it will not be able to recover the costs associated with production. Writing off inventories also represents additional expense for the company. The objective of maintaining a low level of inventory in the warehouse is one way of maximising shareholder value. As the discussion above points out, the optimal number of stocks can minimise stockholding costs, helps Ted Baker Plc sustain its reputation of being a fashion leader, and eliminate the costs associated in writing off unsold inventories. Ted Baker might also opt to shorten the period of collecting its accounts receivables. Right now, the company suffers from very slow collection which indicates the company's hardships in generating cash to finance its working capital expenditures. It should be noted that as long as sales are not yet converted into cash, it cannot be used by the business organisation. Ted Baker Plc can speed up cash collection by giving discounts for early payments. Speeding up the collection of accounts receivable through discounts will not be directly instrumental in maximising shareholder value as it erodes the amount of sales generated by the company consequently lowering the net profits derived. This can lead to lower levels of earnings per share which are attributed to stockholders. However, shorter collection period will lead to improvements in the financial statements which cannot be fully attributable to stockholders such as higher liquidity and lower level of uncollectible accounts. Another area which Ted Baker Plc can focus on is its supplier payment period. Currently, the company has a very slow payment period which can erode its strategic partnerships with its suppliers. In the view of stockholders, shorter payment period cannot affect their investments in the company. It should be noted that delay in payments are not fully reflected in the income statement because the cost of goods sold remain unchanged with the payment days. Thus, in the short run, Ted Baker might not opt to speed up payment of suppliers and still maximise shareholder value. In the long run, however, the success and even mere survival of a business organisation can be directly linked to its rapport with its different suppliers. Part B. Critically discuss whether you consider that companies, by integrating a sensible level of gearing into their capital structure, can minimise their WACC. It is irrefutable that the company's financial policy, that is, "the policies regarding the sources of finances it plans to use and the particular mix (proportion) in which they will be used" (Keown, et. al 2005) gives us the company's preferred capital structure. The capital structure of the business organisation shows the proportion of debt and equity used to finance the assets of the company. This, in turn, has very significant implications in the company's computation of weighted average cost of capital. Weighted average cost of capital (WACC) is one of the most important financial tools used to ascertain the value of a company. WACC is defined as the "weighted average of the after tax costs of each of the sources of capital used by the firm to finance a project, where the weights reflect the proportion of total financing raised from each source" (Keown, et. al 2005). Thus, WACC reflects the required return on the firm's assets as a whole and the proportion of debt and equity or the capital structure is directly linked to the level of the cost of capital. To illustrate further, the WACC is computed as follows: where : D + E =K; c = cost of capital; y = cost of equity; b = cost of debt; tc = corporate tax rate; D = total debt and leases; E = total equity and equity equivalent; and K = total capital invested in the going concern. The formula clearly illustrates that as the WACC takes the proportion of debt and equity financing in total capital investments, the company's capital structure can be optimised in order to come up with the least WACC. It is apparent that any business organisation's goal is the minimisation of WACC by finding the optimal level of debt and equity to finance their resources. The WACC varies with the level of capital structure. It is usually argued that by integrating a sensible level of leverage in the company's capital structure, WACC can be minimised where leverage refers to debt financing. This statement appears to be true if the cost of debt is less than the cost of equity. In this situation, the company can maximise its value by financing its assets through debt because WACC can be minimised by funding most of its resources through the instrument which incurs less cost. Furthermore, it can be seen that the tax shield from interest expense can significantly lower the cost of borrowing. Take for example, Ted Baker Plc which has a 750million in total debt which represents 1% of the capital structure, corporate tax rate of 30%, and interest rate of 10%. Without the interest tax shield, the cost of debt will be 10%. However, the tax rate of 30% lowers this to only 7%. Because of these reasons, most firms consider that the use of leverage lowers WACC and consequently improves profitability. However, the decision to utilise leverage as a primary source of financing should be thoroughly evaluated. It should be noted that the cost of capital should not be based on the interest and tax rates alone. Risks should also be considered especially financial risk which refers to the inherent risks in using debt. Since debt is a multiplier, its returns are multiplied when returns on investments are greater than its costs. However, losses are also multiplied when cost exceeds the returns (Hamm 2006). In comparison to equity, debt is considered as a more risky source of financing. This is due to the interest payments which are generally associated with debt financing. In the case of Ted Baker, if profits are down, the company can easily defer dividend payments to its stockholders. However, interest payments are obligations and must be paid whether or not the company earns profit. Inability to pay interest will lead to low credit rating which in the long run can hurt the company's ability to generate additional financing (Hamm 2006). Lastly, the static theory of capital emphasises that the gains from shield are offset by the greater potential of financial distress costs or the costs incurred in order to avoid bankruptcy (Hamm 2006). Every business organisation should strive to come up with its most efficient capital structure where there is an optimal amount of debt, maximum value of the firm, optimal debt to equity ratio, and minimal cost of WACC. This does not necessarily mean utilising a high amount of leverage but only the most sensible and optimal so as to minimise the risks inherent with it. In principle, firms with greater risk of financial distress and have more volatile earnings before interest and taxes should borrow less. Also, companies with low liquidity which implies higher possible of default in interest obligations should avoid integrating a high amount of debt in their capital structure. References Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey Hamm, D 2006, The Cost of Capital, Retrieved 22 March 2007, from http://web.ovc.edu/advance/hamm/fin15.ppt Horngren , C. et. al..2000, Accounting.4th ed. New Jersey: Prentice Hall Keown, A.J., Martin, J.D., Petty, J.W., and Scott Jr., D.F, 2005, Financial Management principles and applications, Pearson/Prentice Hall International Edition, 10th Edition. Ted Baker Plc 2007, Retrieved 22 March 2007 from http://ww.tedbakerplc.com Read More