Finance an Investor Choosing Between Two Different Essay

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  • Subject: Business
  • Type: Essay
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Excerpt from Essay :

Finance

An investor choosing between two different companies must undertake several steps in order to determine the best investment. In addition to understanding the industry of the company from a strategic perspective, a thorough financial analysis should be conducted. The strategic analysis will help to understand the underlying trends of the financial assessment. The financial analysis should include a ratio analysis, and should focus on the key areas of liquidity, solvency, leverage and profitability. In addition, the performance of the company's equity should be analyzed, particularly in relation to the company's financial performance. This will help to determine if the current share price is good value. This report will analyze two different companies -- Marks & Spencer and Tullow Oil -- using these criteria. There will also be a brief corporate social reporting analysis.

Marks & Spencer Overview

M&S is a department store retailer based in the UK, but operating internationally. The company markets both in the clothing and household category and in the grocery category. M&S operates in 41 countries and territories and has over 76,000 employees. M&S group earned £9.5 billion in revenue in fiscal 2010 and turned a profit of £694.6 million in that time. As with most retailers, the company struggled during the nadir of the economic downturn, but has since begun to recover as consumer demand has recovered. The company has identified a new CEO in Marc Bolland to replace the outgoing Stuart Rose. In 2007, the company initiated what it terms Plan A, which is a strategy to improve the company's performance in terms of the environment and corporate ethics. This plan has become a critical component of M&S strategy in the past couple of years (Marks & Spencer 2010 Annual Report).

In response to the financial difficulties, M&S cut its dividend. This move was intended to give the company greater financial flexibility. The company did not close stores during the recession, including highly troubled stores in Ireland and Greece, but has instead focused its cost management in other areas. There have been no major strategic moves in the past few years with the company, only minor tactical moves intended to help it weather the economic storm and to position the company for continued profitability in the future.

Despite the downturn, M&S has a long-term upward trend in its revenues. Revenues in 2010 were £9.537 billion, up 5.2% from the previous year. Revenues had essentially flatlined in 2009, but in 2008 they had increased 5.05%. The recession did, however, have an impact on the bottom line. Net income in 2010 was £526 million, up 3.5% from £508 million in 2009, but down 36% from the high of £822 million in 2008. Throughout the recession, the company has been able to avoid taking on additional debt to finance its operations. Shareholder's equity has grown slowly but steadily over each of the past four years. Cash flow from operations was down 4.9% in 2010, and the 2009 level was around the same as the 2007 level. This indicates that the total size and cash flow of the firm's operations has changed little over the past four years.

Marks & Spencer Financials

Ratio analysis allows for insight to be made into the company's financial statements. Ratio analysis consists of the calculation of a number of different ratios and comparing them either to the company's historical performance or to industry averages. The different categories of ratios are solvency/liquidity, profitability, efficiency and investment. One of the major benefits of ratio analysis is that it can help with the comparison of firms in different industries. An external stakeholder such as a potential investor can better understand how different firms compare financially by bringing their numbers to common ratios that can be compared against one another. A caveat to the usefulness of such comparative ratio analysis is that the fundamental, structural differences between companies in different industries should also be understood when these comparisons are being made.

The solvency ratios refer to the ability of the company to meet its obligations for the coming year, as defined by the current liabilities. The current ratio for M&S is 0.8. In 2009 it was 0.6 and in 2008 it was 0.59. The quick ratio is 0.36, compared with 0.25 in 2009 and 0.24 in 2008. The cash ratio is 0.31, compared with 0.21 in 2009 and 0.18 in 2008. These figures are relatively weak, in particular the current ratio persistently below 1.0. However, the solvency ratios are improving at M&S, as the cash position improves the "other current liabilities" category is lowered. The numbers are mediocre, but the trend is positive.

Liquidity ratios refer to the ability of the company to meet its long-term obligations. The debt-to-equity ratio is 2.3, compared with 2.48 in 2009 and 2.66 in 2008. The gearing ratio -- measuring only long-term debt -- is 1.01, compared with 0.98 in 2009 and 0.95 in 2008. Times interest earned -- EBIT divided by the interest expense -- is 6.25 times, compared with 4.61times in 2009 and 9.42 times in 2008. In general times, these figures indicate that the company is able to meet its long-term debt obligations. The level of gearing is increasing with respect to long-term debt but total liabilities to equity is decreasing. The company does not meet its interest obligations to the same degree that it did before the recession, but this measure is improving as the company enjoys the benefits of the economic recovery. There is no indication in these figures that Marks & Spencer will have difficulty meeting its future obligations. That said, the company's balance sheet is not great. The acceptable capital structure for a company is in part dictated by the nature of the business in which it is engaged. Marks & Spencer is in capital intensive industry, but one that is characterized by maturity and intense competition. Growth prospects are more or less limited to grow in the overall economy, something that is reflected in the company's beta of 0.90. Firms in a mature, slow-growing industry should ideally by less highly leveraged than M&S is. This level of gearing represents a drain on the company's cash flow from operations and is perhaps one of the reasons why the dividend had to be cut so substantially last year.

The next set of ratios is the profitability ratios, which measure the pricing power the company has and its ability to control its costs. The gross margin for Marks & Spencer is 36.78%, compared with 36.15% in 2009 and 38.65% in 2008. The operating margin is 8.9%, compared with 8.45% in 2009 and 12.4% in 2008. The net margin is 5.5%, compared with 5.6% in 2009 and 9.1% in 2008. What the margins indicate is that over the past couple of years, the company has seen its pricing power erode. A slump in consumer demand associated with a recession is likely to result in discounting on the part of retailers in order to keep inventory moving. Indeed, inventories on the balance sheet have increased over the past couple of years in relation to revenues. Thus, the pricing power decline is likely related to the decline in consumer demand rather than any long-term trend towards reduced pricing power on the part of the company. It is worth noting that the operating expenses as a percentage of sales have also increased in the past couple of years, from 87.57% in 2008 to 91.07% last year. This affects the operating margin. Again, this increase is probably related to the discounting of goods and to the general slump in demand. That said, given that the company has not grown significantly larger in the past couple of years, that total operating expenses have increased at 9.9% while sales have only increased 5.7% is somewhat alarming. Given that the interest expense has declined in the past couple of years as rates have fallen to near bottom means that the decline in the net margin likely only reflects the trickle down affect of the demand slump and cost increases.

It is important to understand the company's operating efficiency as well. There are two categories -- turnover ratios and return ratios. Inventory turnover was discussed earlier because of its relationship to the gross margin. Inventory turnover in 2010 was 10.5 times, compared with 11.3 times in 2009 and 12.2 times in 2008. Receivables turnover was 80.5 times in 2010, compared with 75.8 times in 2009 and 75.8 times in 2008. Asset turnover was 1.3 times in 2010, compared with 1.25 in 2009 and 1.4 in 2008. These ratios show that turnover is lower in the past couple of years. In particular, inventory turnover has decreased steadily, which supports the conclusion that slumping demand is related to the decrease in the gross margin.

The return on equity is 24.8%, compared with 25.2% in 2009 and 45.6% in 2008. The return on assets is 7.3%, compared with 7.0% in 2009 and 13.1% in 2008. These figures illustrate how difficult the operating environment has become for…

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