The Financial Performance of Defense Systems BAE Systems - Case Study Example

Running Head: FINANCIAL RATIO ANALYSIS FOR BAE SYSTEMS PLC Financial Ratio Analysis for BAE Systems Plc In APA Style By Name University Table of Contents 1.0. Introduction The performance of a business organization is often linked in its ability to show good quantitative results at the end of the fiscal year. In addition, its likely performance is also judged according to its historical figures. This paper will look at the financial performance of one of the world's renowned manufacturer of defense systems BAE Systems Plc by making use of financial ratio analysis. In order to get a better view of its financial health, its results will be compared to its close competitor, Cobham Plc. In the end, future outlook will also be presented according to the historic and other available information. 1.1. The Market for Defense System The threats of terrorism have significantly boost defense systems spending especially for countries like United States. After the September 11 tragedy which shocked the global business environment becomes a grim reminder for nations to improve their defense systems. 1.2. BAE Systems Plc: Company Profile BAE Systems Plc (BAE) traces its origin to the 7.7 billion merger of Marconi Electronic Systems which is the defense electronics and naval shipbuilding subsidiary of the General Electric Company Plc and British Aerospace which specializes in the manufacture of aircraft, ammunition, and naval systems. Out of these prestigious business organizations, its establishment in 1999 equipped with a unique competitive advantage which enables it to position itself as the third largest global defence company and sixth largest US defense company employing 97, 500 highly skilled people. 2.0. Financial Ratio Analysis Financial ratio analysis is a very essential tool in assessing the financial health of a business entity. It enables a financial analyst to spot trends in a business and to compare it with the performance of similar business enterprises within the same industry. This tool is currently utilized by business managers, investors, creditors, suppliers, and other decision makers in order to determine the financial performance and well being of a business organisation. Financial ratios are grouped into four broad categories, each showing a different aspect of a company's financial performance. These are profitability ratios, financial leverage ratios, liquidity/solvency ratios, and efficiency ratios. In order to get a deeper insight of BAE's financial performance, its computed financial ratios will be benchmarked with its competitor's Cobham Plc. The rationale of choosing these two business organizations is simple. It should be noted that both of them are regarded as important players in the global pharmaceutical industry. Being in the same line of business and the same industry, it is right to assume that BAE and Cobham Plc both face the same challenges and opportunities in the sector under consideration. This assumption justifies the comparability of their financial performance during the fiscal years. 2.1. Profitability Ratios Profitability ratios measure the ability of the company to generate income from its investments less the costs incurred (Fraser & Ormiston 2004). The ratios computed for this category are return on capital employed, sales profit margin, and return on equity. Return on capital employed is a variant of return on investment which measures how well the company is utilizing its capital. The computed sales profit margin, which is the ratio of operating income to sales measures as a percentage of sales, show the excess revenue from sales over cost of normal operation excluding financing. On the other hand, return on equity measures how much wealth is created for the company's stockholders for every shares that they have on hand (Fraser and Ormiston 2006). Logically, higher performance ratios indicate a healthier financial condition. Table 1. Profitability Ratios Comparison Table 1 shows the comparative profitability ratios of BAE Systems Plc and its major competitor Cobham Plc. Both business organization shows decline in ROCE and sales profit margin from the fiscal years 2004 to 2005. This decline can be attributed to the generally slower growth of the defense industry as well as higher expenditures. In both areas Cobham shows a better performance evidenced by the higher ratios. Compared to BAE which reports ROCE of 14.20% in 2004, Cobham records 18.55%. It also surpasses BAE in sales profit margin recording 14.12%. However, BAE shows higher return on equity. It is also very impressive how ROE in BAE jumped from 0.10% to 19.80% during the two years considered. BAE's increase in ROE is simultaneous with Cobhams's decline from 18.80% to 16.70%. BAE attributes the increase in ROE with its capacity to generate a higher level of profits due to technological advances. 2.2. 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 and acid test or quick ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations" (Horngren 2000, p.153). The acid test is more indicative as it shows the company's ability to pay its current obligations without relying on the sale of its inventory. Higher ratios indicate more liquidity. However, analysts should also be cautioned that excess liquidity might indicate some money just sitting in the cash vault of the company which could have been invested in profitable undertakings. Table 2. Liquidity Ratios Comparison Table 2 shows the comparative liquidity ratios of BAE and Cobham. Based on the computations, Cobham is much more liquid having current assets which can more than pay-off all its current liabilities. On the other hand, BAE's liquid assets can pay off only around 60% of all its immediate obligations. Cobham also manages inventories to the minimum but BAE keeps it lower when compared to the whole stock of current assets. In its annual report, BAE admits its weakness of showing profitability yet income is not converted into cash (Annual Report 2005). 2.3. Activity Ratios Activity ratios are operating efficiency measures, which determine the ability of a company to maximise its output given a certain level of resources (Fraser and Ormiston 2004). These ratios significantly gauge the asset, investment, and cost management performance of the business entity. Ratios under this category are inventory, creditors' and debtors' ratio. The inventory ratio measures the number of days the inventories stay in the company's distribution center or warehouses. The debtors' ratio reveals the efficiency of a business organisation in collecting its account receivables while creditors' ratio shows the number of days the company is able to pay its suppliers. Lower numbers are typically preferred in this ratio classification as they signify speed and efficiency of the business organisation in dealing with its different transactions with stakeholders (Fraser and Ormiston 2004). On the other hand, asset turnover measures the amount of sales generated by every pound in the company's assets. Table 3. Efficiency Ratios Comparison In managing its working capital, BAE is superior indicated by the results shown in Table 3. Stock turnover, stock days, and debtor days are more favorable is able to sell its finished good at a much shorter time and also collect accounts receivable more efficiently. It should be noted that the production system at BAE makes this working capital management possible (Annual Report 2005). However, Cobham shows better and still improving asset utilization compared to BAE which shows lower and stagnant ratio. This can be attributed to the continuous acquisition of technologically advanced products for BAEs operation which boost the level of assets (Annual Report 2005). As the company is expected to benefit from this in the near future, the gains are not yet evident quantitatively. 2.4. 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). It should be noted that both of the ratios in this category are related to each other. If the company relies more on its creditor than its stockholders, it is more likely to incur interest obligations. Table 4. Leverage Ratios Comparison Table 4 shows the comparative leverage ratios of BAE and Cobham. Based on the computations, BAE is more highly leverage than Cobham as its resources are heavily financed by long term borrowings. Meanwhile, Cobham is relying more on its shareholders as evidenced by the decreasing capital gearing ratio. In order to cover the higher allocation for interest expense, BAE also improves its interest cover ratio from 3.93 to 4.22 during the fiscal years considered (Annual Report 2005). Being more reliant on its stockholders, Cobham's interest cover significantly declined from 12.25 to 5.80. 2.5. Investor Ratios Investor ratios are financial ratios especially designed to convey to investors 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. Investor Ratios Comparison Table 5 shows the comparative investor ratios of the business organizations under consideration. Consistent with the ROE computation, BAE shows superior performance in creating value for its stockholders evidenced in its earnings per share. This can be attributed to the company's effort in creating sustainable shareholder wealth (Annual Report 2005). BAE also shows this by its higher dividend yield and dividend cover than its competitor. 3.0. Future Outlook The likely financial performance of BAE Systems Plc is directly linked to the overall business climate in the defense and aerospace industry. Experts expect that growth in these sectors will be strengthened by the higher demand arising from the dsire of nations to safeguard their nations. According to the 2005 Annual Report of BAE, "New threats and conflict arenas are placing unprecedented demands on military forces and presenting BAE Systems with new challenges and opportunities to assist those forces in meeting changing defense and security needs." The United States will remain to be the major market for its product because of the September 11 tragedy while Europe, after becoming mostly stagnant in defense spending is expected to follow suit. Middle East is also a major market which will demand more developed and more technologically advanced products. China, India, and other emerging economies will also be boosting demand in commercial aircraft. In order to take advantage of these opportunities in the global market, BAE will be harnessing the power of the new technology to deliver better products for its customers (Annual Report 2005). It is forecasted that spending for research and development will continue to soar but benefits will also be reaped in the long run. 4.0. Appendixes 5.0. References & Bibliography BAE Systems Plc Annual Reports, 2005, Retrieved 20 May 2008, from http://www.investis.com/reports/bae_ar_2005_en/report.phptype=1&zoom=1&page=757f166062c09c42d8fdea5909f54b79 Cobham Plc Annual Reports, 2005, Retrieved 20 May 2008, from http://miranda.hemscott.com/servlet/HsPubliccontext=ir.access.jsp&ir_client_id=290&ir_option=RNS_HEADLINES&transform=investor_home&sidenav=nav&font=1 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. Thompson, A. & Strickland , J 2002,Strategic Management.3rd ed. New York McGraw- Hill Read More