Understanding Financial Management - Essay Example

Brief company background (company analysis) Table of Contents Answer 3 Answer 2 4 Answer 3 8 Answer 4 11 References 15 Answer The ratios calculated here can be grouped together into four different categories depending upon the characteristics of each of the ratio groups. They are: a) Profitability ratios b) Efficiency Ratios, c) Liquidity Ratios, and d) Gearing ratios. It has been calculated and discussed in details below: BAE Systems Financial Analysis 2006-2011 Profitability Ratios Formula 2011 2010 2009 2008 2007 2006                 Return on Equity Profit after Tax/Shareholders Equity 29.22% 20.01% -0.95% 24.26% 15.36% 39.65% Operating Profit Margin Operating Profit/Sales 8.89% 7.13% 4.82% 10.31% 8.23% 8.55%                                 Efficiency Ratios Formula 2011 2010 2009 2008 2007 2006                 Asset Turnover Sales/Total Assets 2.78 2.77 2.32 2.07 2.02 1.96 Receivables Turnover Ratio Sales/Receivables 5 6 5 4 5 5                                 Liquidity Ratios Formula 2011 2010 2009 2008 2007 2006                 Current Ratio Current Assets/Current Liabilities 0.62 0.65 0.73 0.75 0.74 0.79 Acid Test (Current Assets-Inventory)/Current Liabilities 0.55 0.60 0.66 0.66 0.67 0.74                                 Financial Gearing Ratios Formula Used 2011 2010 2009 2008 2007 2006                 Gearing Ratio Non-Current Liabilities / (equity + non-current liabilities) 0.66 0.56 0.65 0.51 0.44 0.59 Answer 2 The performance and efficiency of an organization can be evaluated through proper analysis of its financial statements (Chandra, 2005, p. 24.17). Ratio analysis is a method of analyzing the financial information of a company as presented in its financial statements. It includes calculations of various ratios which help in the measurement of the financial performance of a company (Siddiqui, 2006, p.623). One of the most significant reasons as to why people analyse the balance sheet, is to find the working capital or liquid resources of the company. This reveals more regarding the financial status of the company than any other financial calculation. It depicts what the company would be having with it if it raises all its current or short-term resources to meet its short-term liabilities. It shows the efficiency of the company to meet its day to day liabilities or financial burdens. In such cases the liquidity ratios are helpful in determining the liquidity position of the company by revealing the status of the current assets and the amount of current liabilities of the company. Working capital assists the investors in assessing the operational efficiency of the company. The money that is locked with the inventory or which the customer owes is not usable, so such issues can be highlighted through the calculation of liquidity ratios. Liquidity ratios are calculated to measure the liquidity position of a company. It shows its current ability to meet its current existing obligations (Graham, and Smart, 2011, p. 41). These ratios are vital for a company because its inability to pay such kind of short-term obligations can ultimately result in its bankruptcy (Gallagher, and Andrew, 2007, p. 94). Two types of ratios falling under the category of liquidity ratios have been calculated here. They are: a) Current ratio, b) Acid test, as can be analysed from Figure 1. Figure 1 i. Current ratio Current Ratio measures that how much a company or a firm is able to pay back its storm-term liabilities like debts, payables, etc. utilizing its short-term assets like cash, inventory, and receivables (Stickney, Weil, Schipper, and Francis, 2009, p. 266). As evident from the Figure – 1, the current ratio of BAE Systems has declined from 0.79 in 2006 to 0.62 in 2011. This implies that the company’s liquidity position has declined in the year 2011. The current asset figures of the company BAE Systems is lower than the current liabilities. This reveals that the company may face trouble in paying off to the creditors for short-term loans. A declining level of current ratio also depicts that the working capital is declining and red flag should be issues, so that the worst case, that is bankruptcy can be avoided. ii. Acid test ratio Acid Test Ratio or Quick Ratio indicates the short-term liquidity of a company. It shows a company’s ability to meet its short-term obligations (Gibson, 2012, p. 244). It does not take into account the inventories which cannot be readily converted to cash by the company. The acid test ratio also indicates the same trend like that of the current ratio with a decline from 0.74 in 2006 to 0.55 in 2011. In case of this ratio too, we can see a diminishing trend, which leads to similar conclusion, as in case of current ratio. An increasing trend in case of inventory also shows that the level of inventory or stock accumulation in the company is high, which is also a negative factor for the company. BAE System shows a negative liquidity position, so it is obvious that working capital is also declining. Appropriate supervision of the working capital helps the firm to continue its operations with sufficient cash balance, which helps in paying-off both short-term as well as long-term liabilities. However few measures can be recommended to the company, so that they can avoid the worst case of bankruptcy. 1. Accuracy of the receivables: The simple concept is to assess the amount of outstanding receivables. Though this is a complex task as it would require assessing the disputes, deductions, and other payment complexities, but it would provide critical information regarding the results of the working capital fluctuations within the organisation. 2. Tracking the payment behaviour of the customers: Keeping track of the customer payment behaviour is very important, as it would reflect the ability of the company to convert its near cash assets into cash efficiently. This would also reveal the risk level associated with the specific customers, and accordingly the amount of delay that the company has to face for those payments. These actions, such as the identification of such customers and maintenance of track record should be automated, and risks should be market with the help of red flags, so that it is understood by the concerned department within BAE systems. 3. Clear communication and avoidance of disputes: Proactive communication with the customers and revising the credit and discount terms with them would also reduce the credit sales and the cash engaged in such activities. This would increase the cash balance of the company, thus improving the liquidity position. Deductions and the disputes increase the amount of receivables in the financial statements. Understanding the root cause of such disputes and deductions, then systematically preventing the revenue leakage would also help BAE Systems. After knowing the cause of the deduction, the company can avoid such deductions in the future. Apart from this the credit terms and the discounts offers are also major causes for delays in payment and confusion. Reconsidering the credit terms, timings, and the conditions has to be confirmed and reconfirmed for authentic information. 4. Good Working Capital ratio even when revenue is down: BAE Systems can experience declining revenue and also maintain a sustainable working capital balance by supporting an efficient information system, good processes, delivering data timely and in an automated platform. The business cycle needs to be reengineered to improve the value and productivity of the resources. Increasing cash sales would also generate greater revenue in liquid form. The reduction in disputes and credit sales, and declining amount of inventory would also assist BAE systems to enhance liquidity or stable working capital. Answer 3 The net income that the company pays to the shareholders in dividend is known as dividend payout ratio. The dividend payout ratio can be calculated as: Dividend payout ratio = Dividend/ Net Income for the period The payout ratio of the company helps in providing an idea, as how well the earnings sustain the dividend payments of the company. The more mature the company is, the higher the payout ratio of the company should be (Puxty, Richard, and Wilson, 1988, p. 210-211). In UK the dividend payout ratio is known as dividend cover ratio. It can be calculated by dividing the dividend per share by earning per share. The dividend payout ratio is analyzed by the investors to evaluate the profitability of the company and its yearly revenue generation (Baker, and Powell, 2005, p. 426). The dividends can be easily forecasted for short run because they are usually stable and do not fluctuate much in the short run. However, it is not always necessary that companies which offer high dividend to the stockholders generate high revenue too. Many well-known companies generating high revenue do not provide high dividend to shareholder and save the profit as retained earnings for further business growth and expansion (Gildersleeve, 1999, p. 47). Even small firms pay higher dividends to attract the investors, but this high dividend is not the sign of stability. So dividend payout cannot be solely considered the sole indicator of profitability. Apart from this the forecasting for dividend payment requires to be done for the long-term, but usually long term projections cannot be made because the dividends might fluctuate. The payout ratio can be considered only when it is fixed to the value generated by the firm. This means the payout percentage is fixed to the earnings of the firm (Keown, 2003, p. 406). Next we come to dividend yield, which is yet another measure tool for dividend of a company. Dividend yields are used for calculating earnings on shares, which considers total dividend that has been declared by the company in the year. The analysis tools are different for different investors. For example if the investor is interested in high growth stocks from the technology sector, then he/she would be analysing the features of dividend payments. Otherwise if the investors seek value or dividend income, then they would go for evaluation of dividend yield. This depicts the percentage of dividend that the company would be issuing for the shareholders. Dividend yield is calculated by dividing dividend per share by the price of stocks (Whaley, 2006, 458). The dividend yield data is often provided to the investors of the company, so that they can estimate the total return. It is actually a trend of dividends for a company, which the investors analyse to check the average dividend payment trend of the company. However, dividend yield is useless for those companies which have an irregular trend in dividend payment, or do not pay dividend. Second, the owners of the company can also fake information to show an inflated trend, which will mislead the investors easily. Moreover, just like the dividend per share ratio calculation, dividend yield also does not reveal the true profitability of the company (Cohen, 2010, p. 318). Earnings per share involve allocation of company’s profits to each of its outstanding shares or stock. It indicates the profitability of the company. It is considered the single most variable that helps in determining the price of the share. EPS or Earnings per share ratio are also the major component for the price to earnings ratio. Earnings per share are calculated by first deducting the dividend on preferred shares from the net income, and then dividing it by the number of outstanding shares (Sinha, 2009, p. 467). There are two forms of EPS that are generally considered, first is the basic EPS and then the diluted EPS. In case of basic EPS, the calculation is done using the overall profit related to the shareholders, but in case of diluted EPS, the net profit related to the ordinary shareholders and the shares outstanding are taken in form of weighted averages. The shareholders use the EPS figures in order to estimate the growth and the future prices of the shares. However, it is said that on the basis of the historical earnings, the growth of EPS does not predict the growth of the profitability or value of the company in future. Moreover, it also does not take inflation into the account. The EPS is affected by the management’s decision, choices for the accounting policies, and also the capital structure of the company. The Price- Earnings ratio is the valuation ration which is utilized to understand the relationship between the price of the stock or shares with the earnings of the company. It is considered a very popular tool for analysing the stocks of a company. The investors spend time figuring out the prices of stocks based on their PE ratio. Unfortunately, the investors simply take a look at the share prices and determine the quality or value of the deal. The investors should consider the value of the stock for determining the quality of the stock. PE ratio is the easy was out for the investors to determine the stock prices and their earnings, but it cannot be assumed that a stock having a lower PE ratio is not a better investment. There are other factors such as the business risks associated, that is volatility of shares, company leadership. So just considering PE ratio to determine the stock or share prices of a company would not be a wise decision. It has been also observed that inflated PE ratios of companies confuse the investors and they incur high losses, so higher the PE ratio, higher the profit is not always true (Krantz, 2010). After discussing the nuances of dividend ratios, and valuation ratios, it is clear that just judging the dividend trend of a company or price and earning approaches of the company, its sustainability cannot be decided. BAE Systems in this case has a negative liquidity position. However, the company is formed from the merger of well know British multinational defence companies, so an analysis of the financial stability of these companies may attract investors to invest in the merger, as the sustainability of the individual companies would be a accumulated goodwill for BAE Systems. Answer 4 The process of repacking and pooling the standardized illiquid assets to marketable securities, which can be sold off to the investors are known as securitization. In other words it can be said that securitization involves transformation of the illiquid assets into liquid securities or stocks. A group of loan can also be transformed into debt securities. Since the securities are more liquid than the receivables or the underlying loans, so the process of securitization became popular. It also assists in gaining liquidity and recovers the economic competence. It has been noticed that the assets are valuable more than off the balance sheet than on it. In the recent times it has been seen that securitization has grown tremendously to reach an amount of $12 trillion in 2008. The choice of selling loans to the investors has changed the conventional function of financial mediators in mortgage market from just purchasing and holding to buying and selling. This was an apparent benefit due to the financial innovation called securitization, which enhanced the risk involvement and concentrated the cost of capital of the bank. Securitization assisted the lenders to finance their business resourcefully by selling their loans, that they have taken, rather than maintaining them as assets on the balance sheet of the company. This is also called spreading the risk of defaults by making the financial system stable. The process of securitization goes ahead with the creation of the financial instruments that correspond to the interests of the owner or protected by the separate income generating assets or the assets. These assets guarantee the securities. These assets are usually protected by the real or personal property, but in few cases they are unsecured. This process can be analysed in steps from origination of assets to sales of securities. These steps are explained below: 1. The assets originate from the company and are mentioned on the balance sheet of the company. 2. When a large amount of assets accumulate in the company, then it is regarded as a portfolio of the assets. Then these portfolios of assets are sold or allocated to a third party for specific funding purposes. 3. The administration of the assets is with the originator or the original company. 4. The company or trust formed for the portfolio of assets float securities of this asset portfolio in the security market. The performances of these securities are directly dependent on the performance of the asset portfolio of the company. 5. The investors analyses the performance of these securities and purchases them. 6. The cash flow increases on the assets and these can be utilized by the company or the trust to repay the funds to the investors of the securities. After understanding the process of securitization and the role it plays in the modern economic world, we would be discussing the motives behind securitization below: 1. Reducing the cost of funding: Through the method of securitization, the B grade companies which have A grade cash flow can also borrow at AAA rates. It has a tremendous impact on the borrowing costs. There is a difference of hundreds of basis point between the B grade and AAA grade debt. 2. Locking the profits: It case of securitization, the total profit or assets are not securitized, so a part of uncertainty can be reduced. Through securitizing the assets the assets can be removed from the balance sheet to maintain earning power. 3. Transferring the risks associated with loans or assets: Securitization assists in transferring risk from the entity that does not want to bear it to those who want to off course with valid interest. 4. Earnings: Securitization helps in increasing the earnings of the company even without an addition to the assets of the firm. When the process of securitization takes place it is considered to be a process of true sales that takes place between the parent company and the investors. 5. Liquidity: Reduction of receivables from the balance sheet of the company and enhancement in cash flows of the company improves the liquidity position of the company. 6. Reduces the mismatch of assets and liabilities: On the basis of the formation selected, it can be said that, securitization can propose ideal funding solutions by eradicating financial support in terms of duration as well as pricing. Basically, in majority of finance companies and banks the funding is from the borrowings. This frequently comes at a high cost, so securitization allocates such finance companies and banks to generate self-funded asset book (Banque-credit, 2012). Securitization like the other innovations has certain limitations too. This is a way of accessing money in an easy and cheap manner which encourages people and the companies to borrow funds even when they are capable of bearing themselves. A major flaw in securitization has been noticed during the subprime crisis (Department for Business Innovation and Skill, n. d.). The mortgage lenders were involved in riskier loans because they knew that after the process of securitization their burden would be borne by the public. In the real estate industry also the loans were securitized, so when the borrowers failed to repay the loans to the banks, it was the investors who suffered as they did not receive their funds or interests. This situation led to bankruptcy and insolvency of many banks and financial institutions. The most important issue that the global financial market is facing is the problem of principle-agent problems. The diversification of the risk is the mechanism that is also regarded as securitization. The traditional arguments states that the mortgage debts are generally based on the benefits that are derived from the geographical diversification and geographical arbitrage. However, it can be noted that securitization is off course an easy way out in the modern era, but excess utilisation of easy money generating procedures can be harmful and the results are before us (Public-Private Infrastructure Advisory Facility, 2001). References Baker, H. K., and Powell, G., 2005. Understanding Financial Management: A Practical Guide. New Jersey: John Wiley & Sons. Banque-credit, 2012. Advantages and Inconvenient Of Securitization. [Online] Available at: [Accessed 1 November 2012]. Chandra, P., 2005. Fundamentals of Financial Management. 4th ed. New Delhi: Tata McGraw-Hill. Cohen, A., 2010. Equity Asset Valuation. 2nd ed. New jersey: John Wiley & Sons. Department for Business Innovation & Skills, n. d. Raise Long-Term Funding Through Debt Capital Markets. [Online] Available at: [Accessed 1 November 2012]. Gallagher, T. J., and Andrew, J. D., 2007. Financial Management; Principles and Practice. 4th ed. Minnesota: Freeload Press. Gildersleeve, R., 1999. Winning Business: How to Use Financial Analysis and Benchmarks to Outscore Your Competition. Texas: Gulf Professional Publishing. Graham, J., and Smart, S. B., 2011. Introduction to Corporate Finance. 3rd ed. Connecticut: Cengage Learning. Keown, A. J., 2003. Foundations of Finance: The Logic and Practice of Financial Management. 4th ed. Beijing: Tsinghua University Press. Krantz, M., 2010. Price-To-Earnings Ratio (P-E) has Limitations, but it’s a Start. [Online] Available at: [Accessed 1 November 2012]. Public-Private Infrastructure Advisory Facility (PPIAF), 2001. Introductory Manual on Project Finance for Managers of PPP Projects. [Online] Available at: [Accessed 1 November 2012]. Puxty, A. G., Richard, C., and Wilson, M. S., 1988. Financial Management: Method and Meaning. London: Taylor & Francis. Siddiqui, S. A., 2006. Managerial Economics and Financial Analysis. New Delhi: New Age International (P) Ltd. Sinha, G., 2009. Financial Statement Analysis. New Delhi: PHI Learning Pvt. Ltd. Whaley, R. E., 2006. Derivatives: Markets, Valuation, and Risk Management. New Jersey: John Wiley & Sons. Read More