Investment decisions companies make today will have a direct impact on their ability to reach financial objectives. Most companies are faced with questions such as: which projects should your company invest in, which returns are needed and what risks the company is willing to take to achieve company goals?
This paper will explain what is, and how to calculate a weighted average cost of capital of Tesco Plc based on company's balance sheet1 and cash flow statement.2 The second part will focus on a report on the Tesco's cash flow over the two year period starting in 2005. In the last part essay will explain what discount rate Tesco Plc. should use when deciding on major investment projects.]
This report will give an overview of NEXT plc business performance and its comparative financial analysis. The data consists of annual reports, collected from the respective official websites and are taking the period of five years starting from 27th January 2006 to 27th January 2010.
Next plc is a UK based retailer, founded in 1864 by Joseph Hepworth, sells high qualified clothing, foot wear, accessories and home products. Since 1982 it has been bearing its current name - Next, which now is the logo of " the third most successful high street chain in the UK after Marks and Spencer and BHS/Arcadia Group". (wikipedia)
Our report is based on ratio analysis of Next plc and Marks&Spencer's financial performance which will help the investors to decide in which market to invest.
Profitability:
Profitability ratios are used both to evaluate company's profitability and measure its performance. If we look at the changes in ROCE and ROSF of the Next plc, we will see that they both are characterized by slight fluctuation during last 5 years, and if it is not so strongly marked in ROSF data, the variation of ROCE is much prominent, as we can see on the graph.(App1)
These differences couldn't be caused only by taxes, so we can conclude that interest changes were the main reason this ratio went down. Such an increase in interest cost usually means an increase in borrowing, due to which NEXT has kept a relatively low and fixed amount of ordinary share in comparison with its lenders and in fact increased the ROSF.
During the last two years, the NPM has successively decreased and increased. However, this positive change did not pull the ROCE ratio. Therefore, the decrease in ROCE comes from the way the business is financed. PBIT did not decrease, which means that the capital invested has been arisen with a proportionally bigger amount than the return on investment. We assume that ROCE growth comes from in a proportionally bigger increase in capital invested.
The fluctuations, which could be observed during 4 years in the gross profit margin, were around 28%.
However, last year recorded a growth of 29,26%. Knowing that inventories remained almost at the same level, this means that the business incurred lower inventories purchasing cost to the sale revenue. Moreover, we can see that that the growth in GP is bigger than the increase in NPM, therefore operating cost has absorbed a part of the increase in profit.
Efficiency ratios data give us an idea of how well a company uses its assets and liabilities. As for the Next plc, we can see that in five years' period, company's AI turnover maintained at a relatively stable state but the trend was downward. During 2006, Next had 8.5% decline in AI turnover, which indicated its higher sales volume and low stock holding costs than before. In 2009, the number became still higher.
Comparing last two years with M&S, obviously M&S is making its profit on the stock quicker than NEXT and flow faster. High stock level might tie up Next's capital. The more the stock level is, the more the rental, insurance and related risk of the business are. For NEXT to speed up sales and stop ordering the slow-moving stock will be the better remedy.
Average Settlement Period for Receivable
For NEXT, the longer the credit period the greater will be the risk of bad debts and loss of purchasing power during inflation. However, in the current year Next managed to decrease its average settlement period for receivables by 5.3%, that is very welcome, as it means that customers paid quickly and there is less cash tied up.
The credit control of M&S was much more efficient since last two years; it took only 11.13 days on average to collect money. Nevertheless, it should be taken into account that M&S are running both apparel and food stores. For the latest, most goods should be paid for when going through the till. As a result, it is normal for such retail companies as Next to have much higher debt collection periods.
Average Settlement Period for Payables
The "payables" of NEXT was increasing at first two years and reached the peak at 2008. For trade "payables", 100.05 days is a long period, though such a rapid increase could be caused by UK cut of interest rate and reaction on the economic recession. Although it was beneficial for NEXT, it made their small suppliers worrying, as most of them preferred short terms. We believe NEXT changed their policy for the following year. Therefore, in the year 2009 there was a dramatic decreasing.
M&S paid its creditors a little bit quicker than the NEXT in recent years. Probably, because M&S has a chain of supermarkets that made the company to pay their suppliers soon. Both NEXT and M&S had slight increasing at the financial 2010 in "payables" and we think it could be the result of economic crisis.
Sales Revenue to Capital Employed Ratio
There were wild fluctuations in Asset Turnover ratio of NEXT and the trend was downward. The AT ratio of 2008 was extremely high than the previous years and it was 43% higher than 2007's. Although, it was suddenly rising up, the Sales revenue kept at the same level. This issue may illustrate that the company was overtrading on its assets. It probably scrapped a lot of fixed assets rather than improve their efficiency.
As compared with M&S, AT ratio of M&S was at low state for a long-term. It indicates that the business has lot of excess of idle assets and over-investment in assets. NEXT has better operating performance and better business management due to which their assets are effectively used and generate desired revenue.
Sales per employee ratio
The sales per employee ratio can be a good measure of personnel productivity. For NEXT, there was a gradual increase in this number which showed that the company was using their staff efficiently. However, in the year 2010, the ratio increased by 11.6%. The only reason we can assume is because NEXT discharged 6.7% employees. Compared to M&S, NEXT significant lagged behind it. The reason of why M&S's ratio is higher than the NEXT's is that their food's sales revenue takes nearly half of the total revenue.
The business recorded almost equal decrease of its liquid ratios in the course of years 2009-2010, even though it didn't come from the way of managing inventories. Liquid assets do not cover the current liabilities and the business will need to finance its working capital by increasing its long-term liabilities. However, over the year 2010 Next cancelled its current liabilities position and tried to reduce bank overdrafts and unsecured bank loans to the maximum. At the same time their financial forms of liabilities have increased, which is safer position. Thus, even with a low CR, the company excludes a possible anxiety of the short-term lender.
As we can see from the graph, the gearing ratio altered significantly. This could be caused by increase in long-term lenders to the financing of the business, or be the result of economic recession.
The hazardous changes in the interest cover ratio cannot be left without attention. It has declined from 12.4 times in 2008 to 9.42 times in 2009, which is much lower even than in 2007 (15.33 times), which also could occur because of the increase in borrowings in 2008. Nevertheless, the situation seems to improve in this year, inasmuch interest cover ratio rose almost by 55% since 2009 thanks to the increase in profit and decrease in interest cost.
Q2
As for the financial position of Next, it seems to improve since last years. Its fluctuations are shown on the graph above. The positive net cash at 27 January 2010 summed to £104.3m, compared to the decrease in cash of previous year (of £22.6m). Thus, there has been a net increase of 73% for the year which is a very positive change for the company.
Another sign of financial improvement of Next is its repurchase of own shares, which rose almost by 45% this year. On the one hand, as a part of company's strategy, it keeps long term growth in earnings per share, on the other hand - it signals to the market that the company is financially healthy, and shows to the investors the place to put up their money.
Moreover, total interest expenses were lower this year - £32.1m (2009: £50.1m, 2008: £40.6m), though we assume that it could be the step to minimize debt payment.
Repayment of unsecured bank loans was much lower this year than in 2009 (by £55m.), though it's probably because the company tried to keep more cash in hand to rise its earnings per share. For this matter, as we assume, the repurchase of corporate bonds for £46.6m in debt was made.
The dividend payout increased this year by £2 m. (from £106.5 in 2009 to £108.5 in 2010). In spite of it is not so much, after few years of unsteadiness, the stockholders will become much confident in the company that pays dividends.
Overall, the closing cash in year 2010 was £102.3m, which testifies that company's profitability improved since last year (2009: £1.5m.), though cash used for capital expansion and dividend payments.
To conclude we can say that financial "health" of Next plc is stabilizing after uncertainty of recent years. Though it has been affected by the UK cut of interest rate and suffered losses in sales during last 5 years, now company's cash outflows should be treated as the positive steps towards expansion and keeping the value high.
We have chosen to analyse the earnings per share ratio (EPS) and the price-earnings ratio (P/E). While the first is commonly regarded as a measure of the share performance, the second allows us to analyse the confidence of the market in the share performance. Over this analysis we make the assumption that the overall long-term purpose and better off of a manager is to keep the share price stable.
For the period from 2006 to 2007 EPS ratio of NEXT has increased (14,68%) thanks to their strategy of share buy-back, decrease of the total number of share in issue (-7,90%) and the increase in net profit after tax (5,70%). Even if the earnings per share ratio increased proportionally more than the dividends per share (14,68% against 11,36%), the company has been wised not to level out this two ratios. As a matter of fact, whereas the net profit after tax did not increase as much as the dividend per share (5,70% against 11,36%), we can even assume that the increase in dividends per share was too high (presuming that the best amount of dividends paid is to level out the net profit after tax). Therefore, that could be one of the reasons why the confidence of the market in the Next's share remains proportionally the same despite the increasing in earnings per share ratio. The market could have seen that company tries to boost its dividends per share.
We can see that from 2007 to 2008 the price earnings ratio recorded an important loss (-8,76%). Despite the share buy-back policy of the company (-7,50% of ordinary share in issue) associated to an increase in net profit after tax (6,81%) and more dividends per share paid the share price has completely fallen (-29,34%). Thus, we can suppose that the financial crisis has an in important weight in this trend. Another explanation (giving the increase in net profit after tax) could be that the company has made bad investment and the market does not rely on Next's return profit anymore. In such a case, the company has decided to increase the dividend paid to pull the share price (+12,24%). This is a reasonable choice giving the increase in earnings per share. Actually, the company could allow a proportionally more important growth in dividend per share relative to the increase in earnings per share (11,36% against 14,68%). However, here again, we are in the same situation as in previous year, the increase in dividends per share (12,24%) is already two times as large as the growth in net profit after tax (6,81%).
The period, covered 2008 and 2009 and incurred the same trend, keeps apart the fact that for the present there is a decrease in earnings per share (7,52%), that is the consequence of the important decrease in net profit after tax (14,60%). Even the decrease in the number of share in issue of 7,67%, did not compensate the loss. This important loss in earning per share has pushed the downward pressure on the share price (-21,21%). Giving the decrease in net profit after tax it could have been more sensible for managers to decease the dividends paid. However, this could lower the share price. Moreover, we can also notice that the share price has fallen more than the net profit after tax (-20,21% against -14,60%), it means that there is another reason behind this decrease in share price (assuming that each reaction of the market is logical), the market does not rely on the business anymore.
During the last year, Next has recorded a big growth in net profit after tax (20,40%). Such a level (364,1m £) has not been reached over these 5 years. This increase has strongly pulled the earnings per share (20,83%) without any necessity to decrease the number of share in issue (variation -0,30%). So the company has logically increased its dividends per share (20%) in order to make its share price position stronger (variation +79,21%). This year the increase in dividend paid, earnings per share and net profit after tax are almost equal (20,40%). The growth in dividend paid match with the increase in net profit after tax, which is a good position. Moreover, we can see that the answer of the market has been proportionally bigger than expected, the price earnings ratio has recorded an high increase (48,36%), and thus thanks to the astonishing variation in share price (79,21%). This situation is alarming for Next, because this increase could be an overvaluation of the market. Managers should use a part of the profit to buy back and thus lock down the bid on the share.
We can now summarize the information of two ratios analysed. They both depend on a share buy-back policy consisting in reducing the number of share in issue, which permits to avoid an accumulation of excessive cash and retained earnings. When using these reserves, the company increases its share price, making a takeover more expensive. Actually, Next could be quite attractive for a takeover, in view of the fact that the company has funds to finance the acquisition's debt. Actually the level of cash and short term deposits has more than doubled last year (from 47,8£m to 107£M) and its retained earnings have increased by 95£m.
This Policy also prevents the company from an undervaluation. For example, during the year 2007 to 2008 the price of the share has decreased whereas the net profit after tax increased, other things being equals, the share buy-back increased the bid on the share price. This could have slow down the decrease in share price without any need to change the dividend paid.
The increasing earnings per share ratio policy's of the company could be dangerous. If after the profitable year of 2010 the company gets into a lean period, it will have to decrease the dividend and that would incur an adverse reaction from investors.
Refferences:
Apendix 1
Apendix 2
Apendix 3
Bibliorgaphy
