Finance#1

FINANCE FOR NON-FINANCIAL MANAGERS

 This report presents the financial analysis of Lescott Dynamics through the use of different financial tools and techniques. The financial analysis is helpful for both internal management and external stakeholders. In the first part of the report, ratio analysis for different categories including Profitability, Efficiency, Capital Gearing, Liquidity, and Investors have been performed. Along with the calculation of ratios of these heads, the critically analysis of financial performance of the company has also been done while suggesting the ways in which financial performance of Lescott could be improved.

The second part of the report talks about the company valuation methods, Lescott’s ten years strategic plans, synergies from Lescott takeover by Aguero Group and presents an estimated budget. The valuation method helps in understanding the different ways in which valuation of a company is done at the time of takeover or acquisition. Capital decision making techniques also support the company management in capital decision making. The estimated budget is also a step to define the company potential in near future on its cash inflows to support the investor capital investment decisions. In the end of the report conclusion of the analysis has also been given.

PART – I

Financial Analysis

Financial analysis of a company can be done by different methods to fulfill different purposes. Type of result needed from a financial analysis also decides way it should be conducted. Here, in case of Lescott Dynamics Ltd (Lescott) ratio analysis for the year 2011/12 (2012) and 2010/11 (2011) has been conducted to measure the financial performance of the company. The financial year for Lescott ends on 31 March. There are several types of ratios, but as per the purpose of ratio analysis only selected Profitability, Efficiency, Capital Gearing, Liquidity, and Investor ratio have been calculated.

Profitability

1)      Gross Profit Margin

To evaluate financial performance of a company, profitability ratios are most important and commonly used. Lescott has been performing very well over the years and in year 2011 its gross profit margin was 47%, while in 2012 it decreased slightly to 45%. In term of a company performance, it has been earning good profit for its shareholders. The gross profit margin at broader level can be improved by controlling and decreasing the cost of goods sold or the operational expresses (Tennent, 2008).

Return on Assets

At the time of investing in a firm, investors also look at return on assets employed by the firm. Lescott total assets have increased in 2012 compared to previous year but the net income has decreased. This has resulted into decrease in return on assets and it has decreased from 12.75% in 2011 to 11.13% in 2012. As the ratio is directly related to net income, so once the cost of goods sold would be less and profit would be high the return on assets would also increase.

Efficiency

2)      Receivable Turnover Days

The management efficiency in term of maintaining the company working capital is seems to be in control over the year as the company has low receivable turnover days to 49 days. The ratio has been consistent for both the years 2011 and 2012. This also means the management knows its responsibilities and has been follow it perfectly.

3)      Inventory Turnover Days

One of the factors to measure the operational efficiency of a company is its inventory turnover. Less the number of inventory turnover days more the efficient are operations. For Lescott inventory turnover days have increased from 43 days in 2011 to 45 days in 2012, though, it is still in control, there has to be continuous monitoring to keep inventory turnover in control. Lescott being a distributor company Inventory should have higher inventory turnover/ less number of inventory turnover days. The better the inventory turnover lessor would be need of working capital and less would be operational cost (Tennent, 2008).

Capital Gearing

4)      Debt-to-Equity Ratio

For investors, financial position of company is at most important. Debt-to-Equity ratio shows the level of debt on company against investors’ equity (Tennent, 2008). This ratio is slightly high for Lescott. The ratio for the company is 2.2 in 2012, as the company has accumulated huge current liabilities. Another reason for this is the fixed stockholders’ equity and increasing need of capital to run the expanding business.

5)      Equity Ratio

Though, Lescott has fixed, limited stockholders’ equity and has accumulated huge assets over the years through retained earnings. Equity ratio which is determined against assets of a company is very high for the company. It was 4.6 in 2011 which has further increased in 2012 to 4.9. Though, this is good for the company that it has been creating assets, it should not be built on increasing liabilities.

Liquidity

6)      Current Ratio

Liquidity condition is also one of the concerns for the investors. Investors are found eager to know the liquidity situation of a firm, which shows that capacity of firm to quickly repay its current liability (Tapiero, 2004). Lescott is in good position on this aspect and has been able to maintain its current ratio at 1.1 for both of the years under assessment. Lescott needs to keep the tab on its current liabilities to control its current ratio otherwise it would decrease in the coming years.

7)      Quick Ratio

Cash reserve or equitant is crucial for the operations of a firm. How quickly a firm is able to repay its current liability is measured through quick ratio. This is also call acid test ratio. On this parameter Lescott is doing very well and it has been below 1 in 2011 which further declined to 0.66 in 2012. This is good for a firm only upto a limit because very low quick ratio mean cash reserve which gives very low or nearly no return. So Lescott need to maintain a healthy quick ratio close to and below 1 for the efficient use of cash reserve and good return on its investment.

Investor Ratio

8)      Dividend Payout Ratio

Every investor wants return on their investment (Tapiero, 2004), higher the return happier would be the investor. But they want to keep their return with the firm if it is earning very good return. In case of Lescott the company has 0.53 dividend payout ratio in 2012, this mean Lescott has paid only 53% of its earnings and rest has been kept as cash reserve for future investment, as the company has investment plan in near future.

Part – II

Methods of Company Valuation

There are various methods used for the valuation of a firm. Some of them have been discussed here:

Discounted Cash Flow Method

Discounted cash flow (DCF) is a powerful analysis tool for knowing the value of company and also used during initial public offerings (IPOs) or to price other financial assets (Damodaran, 2006a). The usefulness and application of DCF method can be seen by its use widely in investment banks, finance managers and consultancies around the world. That’s why sometime it is called “the heart of most corporate capital-budgeting systems” (Luehrman, 1998).

The basis of DCF valuation method was laid by Bohm-Bawerk and Alfred Marshall in the early part of twentieth century in which they discussed the present value concept in their works (Marshall, 1907; Bohm-Bawerk, 1903). In this method free cash flows, after reinvestment needs and before debt payments, are used and the composite cost of all sources of capital financing is taken as the discount rate. The method can be better explained clearly through the below given figure:

DCF method is based on future earning data of a company, which requires prediction of several aspect of business situation and company. In the valuation method even if there is any minor change in the underlining assumptions, there can be large difference in valuation of the company (Damodaran, 2006a).

Free Cash Flow to Equity Method

Free Cash Flow to Equity Method (FCFE) is not completely different than the traditional DCF method, rather than using actual dividends, FCFE method uses discounted potential dividends. Cash flow after debt payments and reinvestment needs are measured a free cash flow by Damodaran (2006b) as given:

“FCFE = Net Income + Depreciation – Capital Expenditures – Change in non-cash Working Capital – (New Debt Issued – Debt repayments)”

On this Warren Buffett has argued that company should be judged based on ‘owner’s earnings’, which is defined as cash flows after working capital needs and capital expenditure. This method ignores cash flows generated through debt and measures free cash flows to equity (Hagstrom, 2004).

Lescott Budget 2012/13 & 2013/14

Budget presents a company’s income and expenses over a period of time. Budget on one side is helpful for the internal management to control its financial in order to have more profit, while on the other side it gives a direction to external stakeholders that from where the money is coming and where it is going (Tennent, 2008).

One of the easiest ways to prepare an estimated budget of a company is to look at its recent performance. The historic financials of company gives a snapshot of company’s future that how the business would be doing in the coming years (Tapiero, 2004). At time of preparing the budget estimation along with taking the expense and income date from the last year, past trends and knowledge of coming business scenario should also be taken into consideration.

Lescott Dynamics’ budget has been prepared based on the recent years’ company performance and expectation from market.

The above given budget estimation has been prepared based on the recent years’ (2010-12) performance of Lescott. As the information given, company management expected the revenue of £36.5 million for the year 2012/13 in the increasingly competitive market condition. In the same way with the estimated average increase of 8% in company turnover and 10% increase in company expenses the net income of the year 2012/13 comes out at £36.31 million. This shows that the estimates are correct. Further the information has been given the management expects and growth of 4.75% over the next four years. So with these inputs when estimates for 2013/14 have been made the expected net income is £39.51 million.

This show that the budget estimates for the 2012/13 & 2013/14 are near to realty and also matches the management predictions.

10 Year Strategic Plan Lescott Dynamics

Capital decisions are very critical, especial for the small and medium size firms (Tapiero, 2004). The reason behind the importance of capital decision making is that these decisions involves huge capital investment. In the situations where capital decisions go wrong, companies have to bear huge financial loss and a hit on its reputation (Tennent, 2008). To support the management in capital decision making there are some capital decision making techniques like net present value (NPV), Payback Period, Internal Rate of Return (IRR), (Tapiero, 2004) etc. These techniques by suggesting the future cash flow of present investment enables the management to take the decision to invest in a particular project or not. These techniques also helpful where there are multiple investment operations and management has to choose any of them. So based on these techniques management can choose the investment option with the highest return.

Lescott management strategic plan of next 10 years shows the company’s estimated cash inflows over the period per year. Lescott management itself has estimated that there are fluctuations in cash inflows for company. Though, this is difficult to say why there decrease in the cash inflows for three years, this can be the result of company expansion cost which it requires after a certain level.

Lescott net income for the year 2011/12 is £30.4 million, while it has estimated that net cash flow for the purchasing company would be about £42 million. Further for the next years the net cash inflow has been estimated to £46 million. But at our estimated budget for the company the net cash inflow for the next two years are £36.31 million and £39.51 million for the year 2012/13 and 2013/14 respectively. It shows that the 10 year strategic plan of Lescott is not based on realistic conditions and have been aggregated just to shows the high net cash inflow to the purchasing company.

Lescott Takeover by Aguero Group

Possible Synergies

There are few advantages and disadvantages with the size of the business. These vary from business to business and firm to firm, where there are some advantages for small firm which is operating in local market, there are also some other advantages for a firm which is operating in the international market (Tapiero, 2004). The possible synergies which are expected from the takeover of Lescoot by Aguero Group are listed below:

• Aguero Group has been operating in the international market, which fulfill the Lescott plan to expend its business in international market. This increase Lescott turnover in the coming years.
• International market would also average the risk market fluctuations and this will increase Lescott profit in the coming years by neutralizing the increasing domestic market competition.
• After the takeover Lescott would have the option to source the products from international market at comparatively low cost. This would decrease Lescott’s cost of goods sold and can boost the profit margin.
• Entry in the international market will also help Lescott to increase its business in international market based on the expertise of Aguero Group. This would be helpful for both the firms.

Potential Problems of Takeover and Remedies

Though, takeover is expected to bring synergy benefits, there can be few potential problems also (Tapiero, 2004) such as:

• There can be staff resistance against takeover, in view of strict management policies for decreasing operational cost. This can be managed by the management assurance from the Aguero Group that they also follow faire employment policies and employees concern would also be taken care.
• Increase in operational cost can also be the result of takeover in the initial few years. Once Aguero Group would take over Lescott operational cost can go up with the increased manpower to manage the business. This can be avoided by transferring management team from one unit to another to keep the same manpower which controlling the decision making power.

Conclusion

Conclusively it can be said that, based on ratio analysis, overall financial condition of Lescott is good and the company is earning good profit. There are few ratio categories on which Lescott is doing very good while on few aspects it has to take the corrective actions to control its financials for future. Lescott has been performing very well over the years and in year 2011 & 2012 its gross profit margin was very good. Lescott total assets have increased in 2012 compared to previous year but the net income has decreased. This has resulted into decrease in return on assets. Lescott has fixed stockholders’ equity and has accumulated huge assets over the years through retained earnings. Lescott is in good position and has been able to maintain its current ratio. The other ratios are also nearly in favor of the company.

There are various methods used for the valuation of a firm. But the most commonly used method is Discounted Cash Flow method. This is appropriate and suitable for Lescott to do the valuation analysis for taking financial decision. In the same way among the available several capital decision making techniques few are more relevant to the company management to take capital investment decision. The management decision to look for a firm to takeover Lescott also seems to be a good decision to available the benefits of synergies. The takeover by Aguero Group would bring several benefits to Lescott being in the same industry and having been operating in the international market.

Bibliography

Bohm-Bawerk, A. V. (1903), Recent Literature on Interest, Macmillan, London, UK.

Damodaran, A. (2006a), “Valuation Approaches and Metrics: A Survey of the Theory and Evidence”, Stern School of Business, New York University, New York, USA.

Damodaran, A. (2006b), Damodaran on Valuation, 2^nd Edition, John Wiley and Sons, New York, USA.

Hagstrom, R. (2004), The Warren Buffett Way, John Wiley, New York, USA.

Marshall, A. (1907), Principles of Economics, Macmillan, London, UK.

Tapiero, C. S. (2004), Risk and Financial Management: Mathematical and Computational Methods, John Wiley & Sons, Chichester, UK.

Tennent, J. (2008), Guide to Financial Management, John Wiley & Sons, London, UK.