5% of assets to 24.6%, with a corresponding reduction in liabilities. This has been achieved with a slight reduction in the company's borrowings from 42.65% of assets to 42.03%. While deferred taxes have increased, the company has seen its post-retirement benefits liabilities reduced. With respect to the structure of Diageo's assets, non-current assets have been reduced slightly. Non-tangible assets (primarily intellectual property) did not change significantly in value. Diageo was able to reduce its inventories slightly in 2010, in addition to reducing its receivables. These moves allowed Diageo to improve its working capital management -- a greater percentage of its assets are held in cash and equivalents.
Overall, the balance sheet shows that the company is growing steadily. Diageo's total assets have increased 21.6% over the past two years, with increases coming in many key categories. Of note is one category that has not grown, receivables, illustrating that Diageo has been able to tightly control its receivable levels over the past two years. The company's equity declined in 2009, but grew again in 2010. Diageo has effectively doubled its cash holdings in the past two years as well, showing a commitment to improving its financial strength and showing restraint with respect to increases in spending.
The statement of cash flows does not typically receive "common-size" treatment. Diageo was able to increase its cash flow from operations by 41.9% in 2010, a dramatic improvement over prior years. This performance belies that relative stability in evidence on the income statement. Cash generated from operations increased 19.5% and the company received substantially more interest in 2010. Diageo saw its cash outflow from investing activities reduced by 7.2% on the year, although the amount was not significant in terms of its entire cash flow situation. A 24.3% increase in cash outflow from financing activities was noted. Diageo increased its dividend, as noted in the Chairman's Statement, sending an additional £44 million to shareholders in 2010 over 2009 levels. The company increased its loans, so while borrowing as a function of capital structure was reduced, total borrowings increased. In addition, Diageo halted its share repurchase scheme that saw the company repurchase £1.088 billion in shares in 2008 and a further £354 million in shares in 2009.
The statement of changes in owner's equity also does not typically receive the "common-size" treatment for analysis. Diageo's equity improved significantly in 2010, following a decline in 2009. The company has generally held the book value of its equity steady through share repurchases, but this program halted in 2010 and that was the most significant factor in the sharp increase in book value of the firm's equity (23.5%). The other factors contributing to changes in the value of owner's equity have remained relatively stable over the course of the past four years, including comprehensive income and dividends paid. While these have changed, those changes have not significantly impacted on the book value of the owner's equity to the degree that the share repurchase program did.
The financial statements at Diageo do not reveal any significant shifts in strategy over the past three years, nor do they reveal any weaknesses in the company. A large company with a high level of geographic diversification would be expected to weather the economic storm that hit Diageo's large markets in the UK, the U.S. And Ireland, and that is precisely what has happened. In essence, there are no surprises in the Diageo financial reports. The company is performing as a mature company with a high degree of diversification would be expected to perform.
A financial ratio analysis can be conducted with respect to the firm's key ratios -- liquidity/solvency, profitability and efficiency being the most important. These ratios are best analyzed in the context of the company's own historic performance, to highlight areas of improvement and areas of weakness. It is also important to understand where these levels are with respect to the industry -- even an improving ratio may be at an unhealthy ratio or vice versa. Diageo's industry in alcohol beverages is a difficult one to benchmark. A substantial percentage of Diageo's sales comes from beer, a highly fragmented industry in which none of Diageo's spirits competitors operate. Among spirits operators, only Pernod Ricard has the type of diversification that Diageo has. It is the most similar competitor, although its wine business (Jacob's Creek) is more significant than any of Diageo's wine businesses. Other competitors such as Bacardi and Brown Forman (Jack Daniel's) are oriented towards one or two star products. On MSN Moneycentral, Diageo's industry is characterized as "Wineries and Distilleries," and some of the differences between Diageo's business and the wine business in particular should be taken into consideration. The year-over-year company analysis probably has more weight than the industry comparison analysis.
With respect to liquidity, Diageo has a current ratio of 1.76, compared with 1.52 in 2009 and 1.17 in 2008. The quick ratio is 0.93, compared to 0.75 in 2009 and 0.60 in 2008. The cash ratio has also improved, to 0.36 in 2010 from 0.23 in 2009 and 0.15 in 2008. The debt to equity ratio is 3.06 in 2010, compared to 3.65 in 2009 and 2.86 in 2008. In general, these figures point to a significant improvement in liquidity over the past three years for Diageo. This improvement has been registered in each year. When analyzed against the common size balance sheet, it is evident that the majority of the liquidity improvement has come from the improvement in the cash position. Inventory and receivable levels have not changed significantly. Cash is 7.47% of the balance sheet in 2010, compared with 5.07% in 2009 and 4.46% in 2008. The statement of changes in cash flow highlights that the cessation of the share buyback program has been the major contributor to the improved cash position. Thus, Diageo has specifically halted a strategy in order to improve its liquidity position over the past couple of years, by retaining more of its cash flow rather than diverting it towards propping up the value of the company's stock.
With respect to the profitability ratios, Diageo has an extra such ratio that incorporates excise. Net sales margin (Gross sales -- excise) declined slightly to 75.47% in 2010 from 75.80% in 2009. This was at 76% in 2008, highlighting a steady three-year declining trend in the net sales margin. The gross margin, best taken as gross profit / net sales rather than the usual gross profit/gross sales, was 58% in 2010, down slightly from 58.1% in 2009 and 58.8% in 2008. The company has therefore seen a slight decline in its pricing power, which is reflected both in the price it pays to suppliers and the price it charges consumers. The company has not noted in the annual report any decline in bargaining power over suppliers, but has noted that it needed to reduce prices in some markets to spur sales. Operating profits increased in 2010 to 19.86% from 19.69% but this figure was 20.7% for 2008. The slight improvement last year reflected some expense reductions, in particular operating expense. The net margin before tax was 17.38% in 2010, up from 16.20% in 2009. Thus, while the net margin after tax declined, this was only due to increased tax expense. On a pre-tax basis, Diageo's net profitability improved. This is almost entirely attributable to the reduction in operating expense.
Diageo's operating efficiency ratios generally showed mix performance in 2010. The receivables turn improved to 6.5 times from 6.15 times. Asset turnover fell slightly to 0.7 times from 0.72 times. The inventory turnover ratio was 1.29 times, down from 1.35 times. It was noted previously that Diageo moved to improve its collections, resulting in a decline in accounts receivable, but this was not matched by improvements in asset or inventory efficiency. In general, however, Diageo's performance against its own benchmarks was good. Diageo outperformed most of its benchmarks in 2010. Among those it did not outperform, there were not dramatic shortfalls in performance nor were there any major points of concern. No ratios are at danger levels that require immediate attention.
Despite the limitations of ratio analysis vs. The industry, there is some benefit to performing these comparisons. The company's current ratio is better than the industry average of 1.6. Yet according to the metrics provided by MSN Moneycentral (2011), Diageo has a higher debt-to-equity ratio than most of its peers in the industry. The company's interest coverage is also weaker and both of these factors, if unqualified could be considered cause for concern. However, given Diageo's strong and consistent operating cash flows and the company's recent balance sheet improvements, there is no reason to believe that Diageo is going to be faced with a liquidity crisis any time soon. The company's solvency is also a non-issue for investors.
In general, the company earns superior margins compared with its industry peers. Diageo outperforms the industry in gross margin, pre-tax margin and net profit margin and outperforms the S&P as well.…
Sources Used in Document:
Diageo 2010 Annual Report. In possession of the author