Financial Statement Analysis of British Airways - Essay Example

Running Header: FINANCIAL MENT ANALYSIS OF BRITISH AIRWAYS Financial ment Analysis of British Airways in Harvard Styleby Student's Name Course Name University Part I. Ratio Analysis Executive Summary This section assesses the financial performance of British Airways in 2006 by looking at the firm's profitability, leverage, efficiency, liquidity, and investor ratios. In terms of profitability, British Airways reports increasing profit margins yet still lags behind its competitors like Ryanair and Thomsonfly. The company's primary goal of maximizing shareholder wealth is unattained evidenced by its decreasing return on common equity ratio. British Airway's resources are largely financed by riskier financing debt. The company enjoys higher liquidity enhancing the ability of the air carrier to pay off its immediate obligation by its current assets. The company also improves its efficiency by lessening the day its pays off its suppliers and collects from its customers. An investor is most likely be attracted by the escalating share price of British Airways but be put off by the 0 dividend yield. Profitability Ratios Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred. The computed operating profit margin, which is the ratio of operating income to sales measures as a percentage of sales, the excess revenue from sales over cost of normal operation excluding financing. Net profit margin, on the other hand, is the ratio of net income to sales. Return on common equity (ROCE) is a variant of return on investment. The return on common equity assesses the rate of return on the investments of common stockholders in the company (Analyzing Company Reports 2005). Another ratio is the turnover ratio which shows to what the extent the company uses its assets to produce revenue. Logically, higher profitability ratios indicate a healthier financial condition. Table 1 Table 1 shows the computed profitability ratios of British Airways in 2006. In order to fully asses the profitability of British Airways in 2006, the company's profitability ratios for 2005 are also included. Based on the computed net profit margin and operating profit margin, the company's profitability has improved. During 2006, the airline is able to turn 8.3% of its revenue in operating profit and 5.5% into net income from the 7.20% and 5.0% recorded in the previous year, respectively. It should be noted that operation in the airline industry requires incurring huge operating costs which could justify the relatively low percentages. However, compared to its competitors like Ryaniar Ltd and Thomsonfly Ltd, British Airways lags far behind. In term of asset turnover and return on equity, British Airways is in a downslide. It can be recalled that the main goal of a business organisation is the maximization of stockholder value which is reflected on its return on equity. British Airways declining ROCE indicates its deviation from this goal. From the point of view of investors, British Airways appears to be mediocre investment relative to its competitors. This is also true for creditors who look at the profitability of a business organisation to assess its paying capacity. For managers, this can signal the company to check its management of cost and other disbursements. Financial Leverage Ratios Financial leverage ratios provide an indication of the long-term solvency of the firm. 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. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm's long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Thomson 2002, p. C-6). Table 2 Table 2 shows the financial leverage ratios which reveal the capital structure of British Airways. The debt-to-assets and debt-to-equity ratios computed for 2005 and 2006 signify the airlines high dependence on creditors in terms of financing. Though the portion financed by liabilities slightly decreased from the 2006 level, creditors still account for over 82% of the company's resources. Generally, this capital structure indicates the company's preference for riskier financing. It should be noted that liability is considered more costly financing as the firm is tied up with interest payments. In the viewpoint of creditors the higher percentage of liability implies that they hold a higher level of leverage. However, this may put off investors who also expect return on their investments. Liquidity Ratios 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. Included in these ratios are current, acid test or quick, and cash ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations. Cash ratio is an indicator of the extent to which a company can pay current liabilities without relying on the sale of inventory and without relying on the receipts of the accounts receivables (Horngren 2000, p.153). Higher ratios indicate more liquidity. Table 3 The company's liquidity has improved from 2005 to 2006. During 2005, the company's liquid assets are not enough to pay off the company's current liabilities. In 2006, however, the current assets are more than enough to settle British Airway's immediate obligations. It should also be noted that the company's current assets are tied up into less liquid resources as cash only accounts for 2.6% of its current resources. The higher liquidity encourages creditors to lend to British Airways. With the higher cash that the company holds, the company can easily pay off interest expenses. Though investors do not specifically refer to these ratios, it should be noted that liquidity improvements signals that British Airways can possibly pay dividends. In the point of view of managers higher liquidity might signify investment opportunities to be taken advantage of in order to maximize the use of cash. Working Capital Efficiency Ratios Activity ratios are operating efficiency measures, which determine the ability of a company to maximise its output given a certain level of resources. These ratios significantly gauge the asset, investment, and cost management performance of the business entity. Ratios under this category are average debtor's collection and average trade credits collection. Table 4 Table 4 shows the working capital efficiency ratios of British Airways. Compared to 2005, the airline's ability to maximise the use of resources in order to generate revenue has improved. From the two ratios examined, it can be seen that the company was able to lessen the collection days for each significant transactions. In the point of view of creditors, investors, and managers, higher efficiency is a good sign of financial health. This also signals the company's efficient utilization of resources. Investor Ratios Investor ratios are financial ratios especially designed to covey to investors the asses the profitability of the company's stock as an investment. Earnings per share shows the return to common stock shareholder for each share owned. Shows the rate earned by shareholders from dividend relative to the stock price, while price to earnings ratio expresses the multiple that the market attributes to a common stock relative to its price (Fraser and Ormiston 2004). Table 5 It can be seen that British Airway's common stock's earning per share is in a decline from the 2005 level. The company has not been paying dividends for six year making the air carrier yield a dividend yield of 0%. The ratio of price to earnings is very high which indicates overvaluation of the air line's common stock. Stockholders gain from their investment in shares through dividends and capital gains. Dividends are declared by the discretion of the company. Declaration of dividends is often dependent of the amount of profit the business gains from the fiscal year and the size of the company's cash account. Market forces determine the capital gains to be gained from a stock investment. In the case of British Airways, it can be seen that investors gain from huge capital gains alone and hardly from dividend. It is notable that the company's common stock price is in an uptrend. Inability to pay dividend may send a negative signal to investors. Though market price is rising, the company's financial performance does not seem to justify this uptrend. Part 2. SWOT Analysis SWOT (Strengths, Weaknesses, Opportunities, Threats) analysis is one of the most widely utilised business models in assessing the current position of a business entity. This analysis is an integration of the results of other tools like the PESTEL analysis, industry analysis, and internal analysis. The company's strengths and weaknesses are derived from internal analysis while the PESTEL and industry analyses provide the required information to ascertain the opportunities and threats specific to the company (Thomson 2004). Putting all the information together will yield the needed data for the SWOT Analysis. Strengths British Airways has always been regarded because of its size and strong brand equity, strong network presence, cost cutting efficiency, and customer loyalty (Datamonitor 2005). It should be noted that the company is ranked as the world's second largest airline in terms of assets (British Airways 2006). Compared to other players in the airline industry, British Airways occupies the fifth notch in servicing passenger demand. The size and popularity of the company is one of its competitive advantages. Operating in a highly capital intensive industry implies that being large brings in economies of scale. On the other hand, brand awareness will further boost revenue generation. The airline also benefits from strong net work presence which enables it to "generate traffic feed for both domestic and international flights" (Datamonitor 2005, pp.6). With its effort to enhance its competitiveness in the market, British Airways has efficiently and miraculously reduced cost amidst the incapability of its competitors to accomplish the same. It should also be noted that the airline's efforts to retain customers are very effective (Datamonitor 2005). Customer loyalty has helped British Airways to maintain a mutually beneficial partnership with its clients allowing the airline to save funds which should have been invested in attracting new customers. Weaknesses British Airways currently struggles with its various internal weaknesses like its high dependence on business and transatlantic passengers, high level of debt, and internal issues like labor unions (Datamonitor 2005). The main operation of the air carrier is focused on servicing customers in the business segment and transatlantic passengers. However, pressures from the external environment cause pressure for British Airways to revamp its market positioning as heavy reliance on these revenue streams can prove to be unprofitable in the long run. British Airways, as stated in the previous section, is highly dependent on credit financing. In fact, 82% of the airline's resources is financed by liabilities. This poses a significant risk for British Airways as credit is typically more costly than equity. Financing from creditors requires enough cash flow to service its interest obligation. Opportunities There are four identified opportunities in the external environment that British Airways can take advantage of. First, the opening of the Terminal 5 at London Heathrow Airport posts more opportunities to boost the revenue of British Airways since it can now fly into more destinations (Datamonitor 2005). This, together with the expected increase in demand in air travel, can help the air carrier leverage its position in the industry (Datamonitor 2005). The international market for air travel has been rapidly evolving as customers' preferences and needs also change. For the past years, while British Airways has taken efforts to capture the high-end market, customers have been increasingly becoming more price sensitive (Datamonitor 2005). Thus, the proliferation of low-cost carriers has been warmly welcomed by the market to the detriment of British Airways. However, this trend can post huge opportunities for British Airways to enhance efficiency and price more competitively in order to recapture its lost markets share. British Air ways can also take advantage of the expected boom in the air travel industry and by forging new strategic alliances with other players in related sectors. After the grim of the 9-11 tragedy has been forgotten, it is forecasted that demand for air travel will rise. In effect, British Airways can forge partnerships with other business organisations like hotels and land transportation to be able to extend maximum customer satisfaction. Threats Kotler states that the global arena is becoming a hypercompetitive which is characterised by more intense rivalry among players (Marketing Management 2004). This is true in the air travel industry. Other low-cost carriers are putting much pressure on British Airways to revamp its strategies. As with other international air carriers, one of the major challenges faced by British Airways is currency fluctuations. An operation on other countries where the local currency depreciates becomes a threat because it also lowers the amount of income generated by the business organisation. The unstable price and supply of oil also poses formidable threat especially that fuel is very crucial in British Airway's operation. Part 3. Financial Reporting and Analysis: Uses and Limitations Investors, creditors, government, and other institutions often assess the health of a business organisation by conducting financial analyses. Defined simply, financial analysis is the process of evaluating a firm's financial information as disclosed in their financial statements (Fraser and Ormiston 2004). This analysis is considered very significant as it shows a potential investor or the creditor the expected gains from investing in the organisation. For decision and policy makers, financial analysis becomes a diagnosis which reveals the problems and issues within the company. It should be noted however, that the input in financial analysis comes from the business organisation under examination. Companies are mandated to produce and provide financial reports for the benefit of the public. Thus, financial analysis is only as good as the accuracy of the information and data they present. Financial statements can be regarded as a window which enables an outsider to see what's going on inside the business organisation: "Financial statements and their accompanying notes contain a wealth of useful information regarding the financial position of a company, the success of its operations, the policies and strategies of management, and insight into its future performance" (Fraser and Ormiston 2004, pp. 3). Like a map which guides investors, stakeholders and other decision makers, financial statements form the basis for understanding the financial position of a business firm and for assessing its historical and prospective financial performance " (Fraser and Ormiston 2004). Financial statements becomes the foundation of financial analysis, which implies that the choices being made by business organisation on reporting their financial condition can largely affect the amounts they present in the financial reports. Discretions often raise the question of ethics in the reporting party. The global business arena has documented how companies abuse their discretionary powers in financial reporting. Accounting fiascos has been very prevalent in the past decade and it has tainted the credibility of firms in reporting their true financial positions. What became apparent is their desires to create portray good financial conditions amidst their predicaments (Keown et. al. 2004). Business organisations have been choosing to act unethically than to admit their losses. These fraudulent activities put pressure on policy makers to mandate the shift from using GAAP to IFRS which is less discretionary than the former. Looking at the case of British Airways there are huge differences among the amounts of profit and net assets reported following the UK GAAP, IFRS, and US GAAP. These disparities represent the effect of the different accounting rules and guidelines as prescribed by the different accounting standards. Consistent with what was pointed out by the company's Chief Financial Officer, this paper supports that "the adoption of IFRS represents an accounting change only, and does not affect the underlying operation of the business or its cash flows for 2004/5." For British Airways, the shift from GAAP to IFRS is only a matter of changing how they report their activities and business performance in terms of money. The difference in the numbers reported under GAAP and IFRS only recognizes the new rules on how different transactions should be recorded. This does not change anything in the "real" activities and performance of business organisations. The utilisation of the new accounting standard only represents a new way of manipulating and computing the numbers to be input in the financial statements. However, this does not change the way the health of the business organisation. What it changes is the way the company is perceived by outside stakeholders. Table 6 It is stated above that financial analysis is only as good as the accuracy of the numbers reported in the financial statements. The company's financial reports become the primary basis of how business organisations project themselves to investors, creditors, and other stakeholders. Thus, even though British Airways only consider the shift from GAAP to IFRS as only an accounting change, other stakeholders will view it otherwise. As shown in Table 5, using the IFRS will yield the highest net profit for the year 2005. In the computation of the net profit margin which simply divides the net income with total revenue will yield different results. UK GAAP will declare a net profit margin of 3.23%, IRFS will report 4.9%, while US GAAP will yield 4.4%. This will significantly change the perceived performance of British Airways as well as its position relative to other competitors in the market. The differences in the adopted accounting standards have significant effects in the comparability of firms operating in different countries. For instance, an investor who's contemplating in putting his money between British Airways and Singapore Airlines is faced with the challenge of accurately comparing the performance of the two air carriers. It should be noted that Singapore Airlines adheres to the US GAAP in reporting its financial situation. For the year ended March 2006, Singapore airlines reports US$13,341.1 under the US GAAP while British Airways reports US$16,102.70 under the IFRS. At first, it can be seen that British Airways seem to be generating more dollars for its service. However, it should be noted that IFRS and GAAP applies different guidelines in revenue recognition. As shown above, compared to GAAP, the IFRS seems to "overstate" revenue. Thus, it becomes apparent that different accounting standards complicate benchmarking as it makes business organisations less comparable. This gives a very significant caution for investors to become aware of the differences in accounting principles in comparing financial statements. As the results of financial analysis is highly dependent on the contents on the financial statements, investors and other information users should be knowledgeable on how business organisations come up with the amount they are reporting. They should at least see to it that the companies they are comparing employ the same accounting standards. Different stakeholders must also be to understand the certain limitations of financial analysis. The performance of firms cannot be fully accounted by quantitative analyses. Financial analysis is only one of the various tools where business performance can be assessed. Oftentimes, using this tool alone is insufficient. It should always be supplemented by a thorough analysis of the business environment, industry factors, and other qualitative issues within and outside a business organisation. References Analyzing Company Reports, Ameritrade.com. Retrieved 16 November 2006 from, http://www.ameritrade.com/educationv2/fhtml/learning/profratios.fhtml Brealey and Myers 2005, Principles of corporate finance, McGraw-Hill, 8th Ed ition. British Airways, Retrieved 16 November 2006, from http://www.britishairways.com/travel/home/public/en_gb Fraser, L. & Ormiston A 2004, Understanding Financial Statements, Pearson-Prentice Hall: Upper Saddle New Jersey 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. Some Key Differences between IFRSs and US GAAP as of August 2005, Retrieved 16 November 2006, from http://www.iasplus.com/usa/ifrsus.htm Thompson, A. & Strickland , J 2002,Strategic Management.3rd ed. New York McGraw- Hill Read More