FdA Business Management
The financial analysis report for Perfect Brew provides a detailed analysis of the performance of our company over the past two years. It also provides an analysis and evaluation of the financial performance of Perfect Brew over the last two years using selected results and relevant supporting accounting information. Recommendations are also provided on weaknesses experienced. Part two provides an evaluation and recommendation of the most appropriate method of financing Perfect Brew.
(ii) Analysis and evaluation of performance
An analysis and evaluation of financial performance of Perfect Brew
The major use of financial ratio analysis is to determine the past, current, and future financial aspects of an organization. In this context, financial ratios of 2012 and 2013with its Brewers and Pub Retailers Federation to determine the financial health of Perfect Brew over the last two years.
These are adopted to measure the ability of Perfect Brew to generate profits compared to its costs and expenses in 2012 and 2013. It provides a projection of a firm’s projection in terms of debts and assets. Profit metrics assists in assessing a company’s health and performance. The major profit metrics are gross profit, operating and net profits (Periasamy 2009).
Return on Capital Employed (ROCE)
Based on the financial calculation in table 1 and 2, the ROCE for perfect brew was 18% and 17.6% in 2012 and 2013 respectively, while that of BPRF was 15%. In this context, the ROCE for Perfect Brew is higher than the average of BPRF for the two consecutive years. The implication made is that there is greater capital efficiency and use of working capital (Kuppapally 2010). This means that Perfect Brew is not affected by its capital structure and it is more profitable compared to BPRF.
The Perfect Brew Plc percentage gross profit for 2012 and 2013 was both 48%, while that of BPRF was 45%. This implies that Perfect Brew’s financial performance is better than that of BPRF. Perfect Brew has maintained its profits, which is good sign for the company in operation management via cutting down production cost and purchasing cost (Mittel 2010).
Operating (Net profit)
This is the ratio of net profit to total sales. The higher the ratio, the more profitable a business is. In reference to Perfect Brew, the operating profits for 2012 and 2013 were 13.7% and 14.8% respectively, while that of BPRF was 12%. Additionally, there was an increase in net profit in 2013 by 1.1%, and the performance was better than the average of BPRF. The implication is that the company is not only efficient in its operations but also profitable (Kuppapally 2010).
There are the ratios used to evaluate the solvency of a business. In other words, they measure a company’s position to effectively repay short term loans (Mittel 2010). The major focus is on short term liabilities and assets. In this context, the major liquidity ratios adopted to evaluate the performance of Perfect Brew Plc are current ratio, acid test ratio, gearing ratio, and interest cover.
The Perfect Brew current ratios for 2012 and 2013 were 2.8 and 3.0 respectively, while that of BPRF was 0.8. The implication made was that Perfect Brew is far better off compared to BPRF in terms of the solvency of a business. The financial thumb rule stipulates that the current ratio should be more than 1 for a company to be able to pay its short-term debts as well as other current liabilities. In this context, the current ratios for Perfect Brew imply that the company has the ability to settle short term debts, while BPRF may experience a liquidity crisis resulting from problems associated with inability to settle its short-term debts. Thus, Perfect Brew is liquid and can effectively repay short term loans (Mittel 2010).
The acid ratio for Perfect Brew for 2012 and 2013 was 2.8 and 3 respectively, which implies that there was an increase of 0.2 in 2013 from 2012. The implication made is that for every £1 of current liabilities, Perfect Brew Plc possesses £ 2.8 and £ 3.0 respectively of its available cash in the short term. Since the ratios are above 1 while that of BPRF are less than one, it implies that the former is liquid, while the later may experience liquidity crisis in the future (Kuppapally 2010).
The gearing ratio for Perfect Brew was 30.75 and 27.1% in 2012 and 2013 respectively, while that of BPRF was 20%. In 2012, the ratio was high an indication of high proportion of debt to equity, but decreased by 3. 65% in 2013, this indicates that the company had reduced the amount of debt used to pay for its operations. The gearing ratio for Perfect Brew is higher compared to BPRF, which indicates that it may enter into liquidity crisis in the future as it uses much of its debts to finance its operations. It also means that despite the profitability, the company may not meet its debt repayment schedules, and can risk bankruptcy (Periasamy 2009).
Interest cover for perfect Brew is 13.9 times and 15 times for 2012 and 2013 respectively, while that of BPRF is 6 times. The figures for Perfect Brew are much higher compared to BPRF. This means that Perfect Brew has higher capability to pay interest out of profits. Moreover, there was an increase of 1.1 times in 2013, which is an indication of better performance (Periasamy 2009).
The efficiency of a company is measured through the use of trade receivables, trade payables, rate of inventory turnover days and fixed asset turnover. Based on the fixed asset turnover ratio, it implies that Perfect Brew compared to BPRF has utilised its assets less efficiently in 2012 (0.5:1) and 2013 (0.4:1). In respect to trade receivables, BPRF takes 30 days while Perfect Brew took 33 and 32 days in 2012 and 2013 respectively, which implies that Perfect Brew takes to pay its debts compared to BPRF. On the other hand, rate of inventory turnover days for Perfect Brew is 16 days for both 2012 and 2013 compared to 15 days for BPRF. This means that BPRF is more efficient as it has much efficiency to turn its inventory into sales.
This is measured in terms of earning per share, dividend yield, price/earnings ratio, and dividend cover. Price/earnings ratio shows the number years at current earning the company will take to ensure that its investors recover the cost of share. Moreover, the company has lower EPS, dividend yield than that of BPRF, which means that despite the profits, Perfect Brew does not have strong financial position and, for that reason, not a reliable company to invest funds into. However, the company has higher price/earnings ratio (17 times 2012 and 18 times 2013) compared to BPRF which is to times (Periasamy 2009)
It is conclusive that the profitability of Perfect Brew is very high compared to BPRF and do is its liquidity. In other words, the company is in a better position to effectively repay short term loans. However, its efficiency is not effective. For example, in both 2012 and 2013, Perfect Brew utilised its assets less effectively and efficiently to generate sales. Moreover, it takes longer to ensure debt repayment and to turn its inventory into sales. For these reasons, there is need to improve its efficiency in its performance. Moreover, the company lacks strong financial position, which makes it less reliable to invest funds into.
Because of the higher gearing ratio, the following methods are suggested that can be used to reduce its gearing ratio.
-The company can share part of its shares to pay down debt.
-The company can covert loans by swapping existing debt for its shares.
-It can reduce working capital, by increasing the speed of accounts receivable collection, lengthen days necessary to settle down accounts payable, minimize inventories to increase cash for debt repayment.
-It can adopt other methods to increases its profits, which in turn, generates more cash required for debt repayment.
In respect to efficiency, it is advisable for Perfect Brew to utilize its assets to generate more sales. Additionally, the company is advised to reduce rate of inventory turnover days to be lower than BPRF for it to be more efficient. It also needs to reduce the number of days required for debts repayment to less than 30 days although there was decrease in 2013.
The available methods that Perfect Brew can use to finance the estimated £4.5 million needed for its expansion plans are:
-Bank Loan (10 year repayment term) with a variable interest rate commencing at 6%;
-Rights issue of ordinary shares on a basis of 1 for every 20 held at a price of £2 per share;
- 9% Debenture stock due for repayment in 2024
The three methods of financing are appropriate for long term financing and below are some of their advantages and disadvantages, potential costs and possible implications of each method for Perfect Brew.
This is the common method adapted by most companies to secure expansion financing. According to DeMerceau (2014), banks loans are reliable and secure methods of financing, despite the fact that they have to be repaid back with an interest rate, which in our case is at 6%. Since the interest rate provided is variable, it means that it shall increase based on the market performance. For this reason, such a loan may affect the functionality and performance of the company in terms of paying interests even when the market is affected by microeconomic changes. Borrowing £4.5 million can result to decreased cash flow and payments, thus affecting the profitability of the company.
Based on the liquidity ratios, the use of bank loans shall affect its gearing ratio. For this reason, it is not advisable to secure the loan as the company may enter into liquidity crisis in the future for using much of its debts to finance its operations. Since loan is a debt, it means that the company shall be required to support its operation for the next ten years through the use of debts.
Rights issue of ordinary shares
Ordinary shares are also referred to as equity shares and are common in the U.K. According to MacDonald and Cheng (1997), “Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value, typically of $1 or 50 cents. The market value of a quoted company's shares bears no relationship to their nominal value, except that when ordinary shares are issued for cash, the issue price must be equal to or be more than the nominal value of the shares” (p. 93). In reference to rights issues of ordinary shares, the existing shareholders are invited to acquire for new shares in proportion to their existing holding. In reference to the case, the rights issues of ordinary shares on a basis of 1 for every 20 held at a price of £2 per share, which means that each shareholder shall acquire 1 share for each 20 shares held for £2 per share (MacDonald & Cheng 1997). It is important to note that the price set should be low to ensure that acceptance of the shareholders, requested to provide extra funding. However, it should not be too low to avoid excessive dilution in terms of earning per share.
The major advantages associated with the method are:
-It is relatively less expensive source of financing
-It has simple issue procedures
-It harbours greater competition
-It is more cheaper than other methods
-Ownership and control is not diluted
-Have low expenses compared to bank loans which have interests’ rates.
The major drawback is that the use of rights issue may dilute the earnings per share (EPS). ‘The major impacts of rights of ordinary shares to the company’s performance are such as effect on share earning price, and increase the expected profitability of new capital injected in the company (Woods 2009).
A debenture is a legal term for secured loan stock. It is imperative to note that debenture stocks are treated as equity rather than debt, which means that investors are protected in case the company goes through a liquidation process (McLaughlin 2014). Since the debenture are offered at 9 percent from the current 8%, it implies that the non-long term liabilities for the next 24 years shall be increased, which results to increased liabilities. This means that the current ration of Perfect Brew shall be decreased from the current 3.0: 1. For this reason, the liquidity and solvency of the company shall be affected negatively. That is, Perfect Brew may enter into liquid crisis in the future (Manson 2012).
The major advantage of debenture stock is protection to the investor in case a company collapses. Moreover, the stocks have a fixed payments placed at regular intervals, which assists in making sure that the investor can expect steady return on investment. Like any stock, debenture stock is risky (Manson 2012).
The most appropriate means to secure £4.5 million financing required for expansion is through the use of rights of issues of ordinary shares. Compared to the other two methods (bank loan and debentures stock), rights of issues of ordinary shares is more convenient, less costly, affects the company positively, and does not have liquidity, efficiency and investment challenges (Pandey 2009).
Cheng, D C B & MacDonald, N J 1997 Basic finance for marketers, Rome, Food and Agriculture Organization of the United Nations.
DeMerceau, J 2014, Advantages & Disadvantages of Bank Loans, viewed 17 June 2014, < http://smallbusiness.chron.com/advantages-amp-disadvantages-bank-loans-47377.html>
Kuppapally, J J 2010, Accounting for managers, India, PHI Learning.
Manson, E 2012, The Debentures and Debenture Stock of Trading and Other Companies; With Forms Including Forms of Proceedings to Enforce Securities, General Books, Oxford.
McLaughlin , S 2014, Unlocking Company Law, Routledge, USA.
Mittal RK 2010, Management Accounting and Financial Management, New Delhi.
Pandey, I M 1979 Financial management, Delhi, Vikas Publishing House.
Periasamy, P 2009, Financial management, New Delhi, Tata McGraw-Hill.
Woods, I R 2004, An analysis of the possible effects of a rights issue on the issueing company’s share price, viewed 17 June 2014, < http://www.iassa.co.za/wp-content/uploads/2009/06/009_mar1977_04.pdf>