Financial Analysis of Jessops - Essay Example

Financial analysis - Jessops Capital structure is perhaps the single most important factor for long term sustainability of any firm. In the simplest form, capital can be classified into two types - (i) equity and (ii) debt. In general it is neither possible nor prudent to finance a business activity entirely depending upon any one of these two possible types of financing. It is usually rational to finance any business activity with a combination of these two. The vital question that arises is the proportion in which or the level of combination in which these two types of capital should be used in order to fulfill the objectives of the firm from time to time. Since a business organization is susceptible to changing economic condition, changing consumers' choice, availability of alternative products in the market, its operational and marketing aspects of performance is dynamic in nature. This non static feature of the functional activities makes capital structure planning one of the most challenging tasks. (Brealey and Myers, 2002) Debt and equity financing vary due to several factors. Since equity entitles one to ownership it demands greater degree of accountability and a much higher degree of risk appetite. On the other hand debt does not give any ownership right and demands relatively lower degree of risk. Debt financing gets some advantage from the standpoint of taxation. In real business situation due to varying degree of complexity associated with payment patterns and more importantly the paying capability, different debt instruments are constructed. A very high degree of dependence on equity financing does not allow the firm to take the advantage of tax benefit; on the other hand too much dependence on debt makes the firm vulnerable to buyout. The buyout threat can come from many ways. For instance, due to very low payment of dividend the share holders may no longer be interested in the continuation of the situation and instigate hostile takeover by other firms. The other type of threat can come in case the company faces default risk. (Brealey, and Myers, 2002) When the firm is unable to maintain a good credit history i.e. a record of timely repayment of interest and principle to the lenders - its possibility of managing a good lender becomes more and more difficult. Higher degree of uncertainty associated with the firms repayment virtually forces it to take loan with several bitter clauses like higher rate of interest, higher sensitivity of term with rate i.e. the firm has to 'buy' duration of the loan payable at a higher cost of interest. So dependence on debt also triggers the exposure to risk. This is the reason for which a leveraged firm (a highly debt dependent firm) usually have high-risk indicating parameter, commonly known as beta. Beta determines the company's risk exposure with respect to overall market. People will take additional risk if and only if they are proportionately paid i.e. paid something more than that they could have got without taking any additional risk. So more the risk involved, in repayment more will be the cost of debt. So it is very important to determine what fraction of capital will be through equity financing and what fraction will be through debt financing. Optimum capital structure can said to be that combination of debt and equity financing that will maximize their combined positive effect and minimize the negative ones. So the importance of capital structure cannot be overstated for the sustainability of the organization. The financial health of Jessops, the photography retailer of UK is going through a critical stage due to several reasons. Entry of low cost substitute products and overall economic slowdown are the two main apparent reasons behind it. (Jessops: Reports and Accounts", 2008) It is prevalent from the financial structure of the company that it is a debt ridden company. The debt to equity ratio is found out to be around -3.67. Debt-equity ratio is measured by the following formula: total liabilities/ total assets. Here total liabilities is ' 65794000 and total asset is ' 15306000 so the ratio (65794000/15306000) is 4.3 approximately) Its inability to launch timely low cost products synchronizing consumers' choice is definitely a strategic blunder. Steps taken by the authority to slender the operating expense is a timely decision. The attempt made by the authorities to chalk out alternative market coverage technique is also rational. It is very important to note that the company must try its best at least to reduce its operating loss. Gradual increase in bank charges is a matter of concern. The company is almost at the mercy of the banker and hence there is almost no sign of a reduced bank charge. If the company is in trouble it has to request the bank to restructure the loan and consequently there will be an increase in bank charges. The company needs to be more careful in time of managing tax. It is being a highly levered firm it has to utilize its structural advantage towards tax planning. High volatility in stock prices has the most phenomenal impact on the financial health of an organization .It is true that the market itself is volatile and a fraction of the company specific volatility is the result of this market risk-but a continuous above the market volatility will be treated as a company specific weakness. Nonstop decline in revenue is the result of primarily huge drop in sales and compulsive reduction in sales price (due to price war fueled by the low cost alternatives). Revenue being the sum of the product of number of items sold and their selling price-it is clear that falls in both, the number of items sold and selling price will more intensely affect the revenue. Without a very successful cost management system it is virtually impossible to generate profit in this situation. The company being highly depending on debt and not performing well for a number of years its credit history is losing its good impression. The company is not even in the position to trade off between some alternatives but debt restructuring. Debt restructuring is bound to increase bank charges, the riders imposed by the bank is bound to be more challenging to the company. Continuous nonpayment of dividend has already made the firm unattractive to the equity investors. No dividend has been declared in 2008. (Jessops: Reports and Accounts", 2008) The decision of the management of the company to amend some debt riders (loosely speaking, terms and conditions) even at a cost of losing some other flexibilities, can said to be strategically right if and only if the newly extended repayment period can be utilized so effectively that the company is at least partially able to come out of the debt trap. If the company is not able to utilize even this extended time period in the aforesaid way, the debt restructuring may have more deteriorating impact on the organization. If the company is unable to repay even after the extended repayment period the lending bank will most probably will not be in a position to lock its capital in an almost perpetually non performing company. The present nightmare of the management of the company to lose the operating control will be loomed larger in that case. Fluctuating performance is a well known and even expected business phenomenon. If this fluctuation is the result of the adverse market condition as a whole and thought to be correctable in an acceptable limit of time -it is not a matter of concern. If a company can perform in such a manner that falls light on its fundamental strengths, it will not come under the cloud of buyout. The company concerned here has to perform in this direction in order to regain, the lost interest and more importantly lost confidence, among all. The absolute value of gross gearing ratio, which is basically identical with debt equity ratio of the firm, is about 3.67. The formula of gross gearing ratio is as follows: (total liabilities/total assets)*100. Total liabilities sum up to ' 65794000 and total assets sum up to ' 15306000. So, the gross gearing ratio = 65794000/15306000 = 3.67 or 367 percent. (Jessops: Reports and Accounts", 2008 Gearing ratio above (taking the absolute value ) shows the dominance of debt over equity and a higher value like 3.67 shows a very poor utilization of debt to generate income and hence shows the firm's vulnerability to debt exposure. Debt ratio [long term debt/ (long term debt + equity)], here long term debt is ' 56174000 and equity is ' 22299000 of the firm is calculated to be 0.71. this also shows poor debt situation. (Jessops: Reports and Accounts", 2008) Although some steps like shutting down 81 show rooms can improve the situation to some extent yet the overall picture is bleak. The decision taken by the management not to pay dividend it is a timely one but not strong enough to improve the case. Nonpayment of dividend increases the retention of income and helps in growth for a limited period of time. There is a decline in sales (about 6.5%), fall in share price (about 87%) and 6.2% increase in operating expenses. (Jessops: Reports and Accounts", 2008) So the overall picture that can be obtained from this is the high value of the probable bankruptcy as the possibility of bankruptcy is directly proportional to the declining values of the aforesaid factors. Only ray of hope lies in its relatively better operational loss management. The continued faith of the loudening bank to the company shouldn't be taken without the factors the bank has ascertained in its favor including the discontinuation of swap driven interest rate management facilities. Moreover the bank has given another condition of handling over 5 % of equity share of the firm subject to non fulfillment of contract details. One side the company has to pay initially 5 million pound in place of 7 million pound at the initial deadline ("Jessops: Reports and Accounts", 2008 )The company also has been successful to negotiate on interest rate; instead of paying 5.25% the company will pay 2.25% to the bank (Jessops: Reports and Accounts", 2008). This reduction in interest will reduce the cost of debt to the company. The condition to take over 5% of share capital under the non fulfillment of terms and conditions is formally known as debt-equity swap. Informally speaking it can said to be a case of taking risk of losing operating control over the firm in order to get some soft loan clauses. It is important to see how the management of the firm utilizes the extended time period of repayment allowed by the lending bank. The management of the company has talked about a plan to ensure a 4 million pound of EBITA (Braithwaite, 2008) EBITA being the earnings before interest, tax and amortization its impact is sensitive to tax rate and rate of interest. Increase in EBIT has positive impact on debt service coverage ratio of the firm. Debt service coverage ratio, shortly known as DSCR falls light on the firms' debt management potential at the prevalent rate of interest payable for loan and tax rate. On the other hand if it fails to perform it will lose its operating control to the lending bank. This situation may lead to the extinct of the company as its possible takeover by some firm cannot be ruled out. Ratio analysis being an accounting technique usually depends on past performance; if there is any considerable change in performance in future the prediction made by ratio analysis may not capture the true picture. Ratio analysis definitely gives in general a reliable idea about the possible performance of the firm. It not only gives the idea about the performance of the firm but also indicate the strength, weakness, opportunities and threat of it. Throwing light on these factors, ratio analysis helps both the in house managers and lenders, investors about the possible fulfillment of their respective interests with the firm. In general it can be said that the company is going through a tough phase of financial situation. It has to rely on innovative operational, marketing and last but not the least financial strategies in order to ensure its strong future. References 1. Braithwaite, T. 2008, Jessops takes broad view and refinances debt, Financial Times, available at: http://www.ft.com/cms/s/0/0d32d3b6-8e87-11dd-9b46-0000779fd18c.html'nclick_check=1 (accessed on March 18, 2009) 2. Brealey, R.A. and Myers,S.C. 2002, Principles of Corporate Finance, McGraw Hill Higher Education 3. "Jessops: Reports and Accounts", 2008, available at: http://production.investis.com/jessops/reports/annual08/annual08.pdf (accessed on March 18, 2009) Read More