Analysis Of Frater Ltd - Free Essay Example

Frater Ltd. is a private and family owned company, functioning in a electronic industry, formed by two brothers James and John Frater eight years ago when they resigned from their university posts, to use their academic research background in the manufacturing of electronic circuits. So they financed the company through legacy and through selling shares to other family members. Aerospace industry included both military and non-military as the prime customers of the Frater Ltd. Recently James and John invested in new robotics technology because they followed the market opportunity in developing new circuitry for flight control systems. But, due to their planned expansion they need more investment. So they consulted this idea with Kemp Sons (Chartered Accountants), the financial advisor of Frater Ltd and came up with the solution by asking their financial advisor to find the company which can take over and also invest the necessary capital required. Lastly, they found the large diversified company listed on London Stock Exchange, namely Global PLC which found to be interested in take over and also in injecting the necessary cash. Finally, in behalf of Global PLC we will be acting as an acquisition advisor and approach in the way to illustrate the possibilities of about acquiring Frater Ltd by comparing and analysing the performance of the company th rough the financial statements of last two years, with the help of ratios and will comment on its financial position and also will calculate its share valuation by using different methods. A brief overview Before we start our detailed look at the ratios for Frater ltd, it is helpful to take a quick look at what information is obvious from the financial statements. This will usually pick up some issues that the ratios may not be able to identify. It may also highlight some points that could help us in our interpretation of the ratios. The following points can be noted: Expansion of fixed assets These have been increased by about 43 per cent (from  £1,893k to  £2,702k). This could mean that not much benefit was reflected in terms of the additional sales revenue (turnover) or cost saving during 2009. Sales revenue, in fact, expanded by about 48 per cent (from  £5,941k to  £8,756), greater than the expansion in non-current or fixed assets. Major expansion in the e lements of working capital Inventories increased by about 64 per cent (from  £338k to  £554k), trade receivables (debtors) by about 73 per cent (from  £191k to  £330k) and trade payables (creditors) by 56 per cent (from  £352k to  £550k) between 2008 and 2009. These are the major increases and which are linked because the inventories are all sold on debt and bought on credit. Reduction in the cash balance The cash balance fell from  £8k (in funds) to a  £2k between 2008 and 2009. This could mean the overdraft (short-term borrowings or loan) fell by about 86 per cent (from  £70k to  £130k). The bank may be putting the business under pressure to reverse this, which could raise difficulties. Apparent dept capacity Comparing the fixed assets with the long-term loans or borrowings implies that the business may not well be able to offer security on further loans. This is because potential lenders usually look at the value of assets that can be offered as security when assessing loan requests. Lenders seem particularly attracted to land and, to a lesser extent, buildings as security. For example, at 31 December 2009, fixed assets had a balance sheet value of  £2,702k, but a long-term borrowing was  £2,730k (though there was also as overdraft of  £130k). On the other hand, land and building tend to have a market value same than their balance sheet value due to inflation in property values. Increase in operating profit Though sales revenue expanded by 48 per cent between 2008 and 2009, both cost of sales and operating expenses rose by a greater percentage as 34 per cent (from  £4,568k to  £6,113k) and 85 per cent (from  £1,024k to  £1,895k), respectively. The gross profit and, particularly, operating profit (profit before interest and tax) massively increased. Having had a quick look at what is fairly obvious without calculating the normal ratios, we shall now go on to calculate and interpret them. PROFITABILITY RATIOS: Financial Health check of Frater Ltd, Using Profitability ratios. 1) Return on ordinary shareholders funds (ROSF): The purpose of ROSF ratio is to show the profitability of the company in terms of the capital provided by the owners of the company, i.e. the ordinary shareholders. The ratio (which is normally expressed in percentage terms) is as follows: ROSF = Net profit after long-term interest and tax * 100 Ordinary share capital + Reserves The profit for the year (less preference dividend (if any)) is used in calculating the ratio, as this figure represents the amount of profit that is left for the owner. In case of Frater ltd, the ratio for the years ended 31 December 2008 and 2009 is: The ratio for 2008 is: ROSF = 268 * 100 = 20.2% 1000+326 The ratio for 2009 is: ROSF = 484 * 100 = 21.9% 1500+710 In view of this, the return on ordinary shareholders funds (ROSF) ratio is increasing in 2009 over 2008 by about 8 per cent; these means sufficie nt profit is available to shareholders. Broadly, business seeks to generate as higher value as possible for this ratio, provided that it is achieved at the expense of potential future returns by, for example, taking more risky activities. In Frater ltd the things are going nicely in 2009 in comparison to 2008. 2) Return on capital employed (ROCE): The ROCE ratio is a fundamental measure of profitability both for external assessment of the companies performance and for internal assessment of the efficiency of management. It measures the return on the total capital of the business regardless of how it is financed. The ratio is expressed in percentage terms and is as follows: ROCE = Profit before interest and tax * 100 Total assets less current liabilities Note, in this case, that the profit figure used is the operating profit (that is, the profit before interest and taxation), because the ratio attempts to measure the returns to all suppliers of long-term finance bef ore any deductions for interest payable on loans, or taxations (as the tax rules change from one year to the next), or payments of dividends to shareholders, are made. The ratio for the Frater ltd, for the years 31 December 2008 and 2009 is: The ratio for 2008 is: ROCE = 349 * 100 = 17.38% 1893 +115 The ratio for 2009 is: ROCE = 748 * 100 = 25.72% 2702+206 This ratio tells much the same story as ROSF; namely a good performance of Frater ltd as it is increased by 48 per cent in 2009 as in comparison to 2008. It indicates that the return on assets being more than the rate that the business has to pay for most of its borrowed funds. The ROCE is increased in the year 2009 because the Frater ltd improved their profit margins and made the same amount of capital as that generated more sales. 3) Net profit margin (NPM): The NPM ratio relates the operating or net profit for the period to the sales during that period and is expressed as follows: NPM = Operatin g profit *100 Turnover The operating or net profit (that is, profit before interest and taxation) is used in this ratio as it represents the profit from trading operations before the interest payable expense is taken onto account. This often regarded as the most appropriate measure of operational performance, when used as a basis of comparison, because differences arising from the way in which the business is financed will not influence the measure. For the year ended 31 December 2008 and 2009, Frater ltd NPM ratio is: The ratio for 2008 is: NPM = 349/5941 *100 = 5.87% The ratio for 2009 is: NPM = 748/8756 *100 = 8.54% As we can see the NPM is increased by about 45 per cent in year 2009, compared with that of 2008. The reason for rich net profit margin ratio is low level of opearting expenses relative to sales revenue. 4) Gross profit margin (GPM): The GPM ratio expresses a companys gross profit as a percentage of its sales revenue and is calculated as follows: GPM = Gross profit * 100 Turnover It would be very misleading to compare GPM ratio of two totally dissimilar businesses (e.g. a jeweller and a supermarket) but It is meaningful to calculate this ratio here because it compares a profitability in buying (or producing) and selling goods before any other expenses are taken into account. Cost of sales represents major expenses for many businesses; a change in this ratio can have a significant effect on the bottom line (that is, the profit for the year). For the year to 31 December 2008 and 2009, the ratios for Frater Ltd are: The ratio for 2008 is: GPM = 1373/5941 *100 = 23.11% The ratio for 2009 is: GPM = 2643/8756 *100 = 30.19% The huge increase in this ratio by about 45 percent means that gross profit was higher relative to sales revenue in 2009 than it had been in 2008 as well as this means that the cost of sales was lower relative to the sales revenue in 2009 than in 2008. This could mean that sal es prices were higher and that the purchase cost of goods sold had decreased. CONCLUSION OF PROFITABILITY RATIO: 2008(%) 2009(%) ROSF 20.2 21.9 ROCE 17.38 25.72 NPM 5.87 8.54 GPM 23.11 30.19 We can see that the increase in NPM was 45%, whereas that of GPM was 30 per cent. This can only mean that operating expenses were lower, compared with sales revenue, in 2009 than they had been in 2008. The increase in both ROSF and ROCE by about 8 per cent and 48 per cent, respectively were caused partly, therefore, by the business incurring lower inventories purchasing costs relative to sales revenue and partly through lower operating expenses to sales revenue. Therefore, profitability ratios tell that the opportunities for efficiencies in the future for Frater Ltd. B) LIQUIDITY RATIOS: Liquidity ratios are concerned with the ability of the business to meet its short-term financial obligations. The two major ratios are: Current ratio: It compares the liquid assets (that is, cash and those assets held that will soon be turned into cash) of the business with the current liabilities. The ratio calculated as follows: Current ratio = Current assets Current liabilities We are calculating this ratio here as if higher the ratio, the more liquid the business is considered to be. As liquidity is vital to the survival of a business, a higher current ratio might be thought to be preferable to a lower one. If a business has a very high ratio, however, it may be that funds are tied up in cash or other liquid assets and are not, therefore, being used as productively as they might otherwise be. As at 31 December 2008 and 2009, the current ratios of Frater Ltd are: The ratio as at 31 December 2008 is: Current ratio = 537/422 =1.27 : 1 The ratio as at 31 December 2009 is: Current ratio = 886/680 = 1.30 : 1 This means if all short-term creditors demand their money immediately then thir claim could be met higher in 2009 as 1.30 times if the current assets could be converted into cash immediately. While this is clearly unreasonable it does give an indication of liquidity, because under normal trading circumstances short-term creditors are unlikely to demand immediate payment. Though for an electronic company 2:1 is considered as standard which Frater Ltd has not maintained in both of the years which means it has not maintained its current assets efficiently and also was not efficient in meeting its liabilities. Although this is increased in 2009 but still not meet the standard one. So from current ratio point View Company is not performing well to meet its obligation. Acid test ratio (Quick ratio): This gives a better measure of liquidity as it eliminates stock the least liquid asset (that is, the most difficult to convert into cash quickly), from the current ratio, so providing a measure of the most liquid assets against short-term claims. The ratio is expressed as: Acid test ratio = Current assets Stock Current liabilities The acid test ratio for Frater Ltd as at 31 December 2008 and 2009 is: The ratio as at 31 December 2008 is: Acid test ratio = 537-338/422 = 0.47 : 1 The ratio as at 31 December 2009 is: Acid test ratio = 886-554/680 = 0.49 : 1 We can see that in 2009 the acid test ratio is almost constant as in 2008 and also it is not meeting the standard ratio as 1:1. It means that liquid assets do not quite cover the current liabilities so the Frater Ltd may be experiencing some liquidity problems. So it is said that stock cannot be easily converted into cash so company might not be able to meet its current liabilities on time. CONCLUSION OF LIQUIDITY RATIO: 2008 2009 Current ratio 1.27:1 1.30:1 Acid test ratio 0.47:1 0.49:1 Frater Ltd showed an unfavourable liquidity position in both of these ratios and to have weak current and acid test ratio, because long-term finance is difficult to acquire. The apparent liquidity problem may, however, be planned, short-term and linked to the expansion in fixed assets. It may be that when the benefits of the expansion come on stream, liquidity will improve. On the other hand, short-term claimants may become anxious when they signs of weak liquidity. This anxiety could lead to steps being taken to press for payment, and this could cause problems for Frater Ltd. C) EFFICIENCY OR ACTIVITY RATIOS: It examines the ways in which various resources of the business are managed. The main ratios are: 1) Assets turnover ratio: This ratio examines how effectively the assets of the business are being used to generate sales. It is calculated as follows: Assets turnover ratio = Turnover (sales) Total assets current liabilities For the year ended 31 December 2008 and 2009 this ratio for Frater Ltd is: The ratio for 2008 is: Assets turnover ratio = 5941/2008 = 2.96 times The ratio for 2009 is: Assets turnover ratio = 8756/2908 = 3.01 times This seems to be a significant improvement, since in 2009 as because assets are being used more productively in the generation of revenue. It provided that overtrading is not an issue and that the additional sales are generating an acceptable profit, this is to be welcomed. 2) Debtors collection period: A business will usually be concerned with amount of funds tied up in credit given and try to keep this to a minimum . The speed of payment can have a significant effect on the businesss cash flow. This ratio calculates how long, on average, credit customers take to pay the amounts that they owe to the business. The ratio is as follows: Debtors collection period (in days) = Trade debtors *365 Credit sales Debtors collection period for the year ended 31 December 2008 and 2009 this ratio for Frater Ltd is: The ratio for 2008 is: Debtor collection period = 191/ 5941 * 365 = 12 days The ratio for 2009 is: Debtor collection period = 330/ 8756 * 365 = 14 days It shows a increase in the collection period which is not good sign for Frater Ltd. It means that more cash was tied up in trade receivables in 2009 than in 2008. This increased in days may have been due to not chasing customers vigorously or as a result of incurring lower expenses, such as no discounts allowed to customers who pay quickly. 3) Stock holding period: Inventories often represent a significant investment f or a business. The stock holding period is a measure of the average days which elapse between acquiring an item of stock (inventory) and selling that item. The ratio is calculated as follows: Stock holding period (in days) = Stock held * 365 Cost of sales In the case of Frater Ltd, this ratio for the year ended 31 December 2008 and 2009 is: The ratio for 2008 is: Stock holding period = 338/ 4,568 *365 = 27 days The ratio for 2009 is: Stock holding period = 554/ 6,113 *365 = 33 days Frater Ltd is electronic company therefore stock holding period of about 30 days is reasonable. There has been a consistency in 2008 which tells it has efficient in turning its stock, than in 2009. This 33 days excessive stock should be avoided because these tie up the companys money unnecessarily and may require costly warehousing. CONCLUSION OF EFFICIENCY RATIO: 2008 2009 Assets turnover ratio 2.96times 3.01times Debtor collection period 12 days 14 days Stock holding period 27 days 33 days It shows that the increased assets turnover ratio seems beneficial, provided that the business can manage this increase. On the face of things, a greater receivables collection period is not desirable as these may have been achieved at the cost of a loss of the goodwill of the customers. The stock turnover period at the 2008 level might be reasonable but in 2009 it is increased that should be keep as little as possible. D) FINANCIAL GEARING RATIOS: Financial gearing occurs when a business is financed, at least in part, by borrowing instead of by finance provided by the owners (the shareholders) as equity. A businesss level of gearing is an important factor in assessing risk. The main ratios are: 1) Debt to equity ratio: It measures the contribution of long-term lenders to the long-term capital structure of a business and is calculated as: Debt to equity ratio = Dept * 100 Equity The gearing or debt to equity ratio for Frater Ltd, as at 31 December 2008 and 2009, is: The ratio for 2008 is: Debt to equity ratio = 158/ 1850 * 100 = 8.54% The ratio for 2009 is: Debt to equity ratio = 178/ 2730 * 100 = 6.52% Frater Ltd represents a low-risk investment for the ordinary shareholders in year 2009 than in 2008. So the company need not pay the loan interest and the preference dividend may mean that the ordinary shareholders will receive dividend at all. Furthermore, if Frater Ltd forced into liquidation, t here may be sufficient funds to repay the ordinary share capital after the loans. 2) Interest cover ratio: It measures the amount of operating or net profit available to cover interest payable and is calculated as follows: Interest cover ratio = Operating profit Interest payable The ratio for Frater Ltd for the year ended 2008 and 2009 is: The ratio for 2008 is: Interest cover ratio = 349/ 23 = 15.17 times The ratio for 2009 is: Interest cover ratio = 748/ 38 = 19.68 times The ratio shows the 4.51 times high figure in 2009 than with comparison to 2008. This indicates that lenders are in relatively secure position and that the companys profits could fall substantially before there was any likelihood that interest payments could not be met. Furthermore, lenders (and potential lenders) might gain confidence in the company. CONCLUSION OF FINANCIAL GEARING RATIO: 2008 2009 Debt to equity ratio 8.54% 6.54% Interest cover ratio 15.17times 19.68times This shows that the Frater Ltd becoming more low-geared as the debantures are redeemed. The interest cover ratio increased from a position where operating profit covered interest 15.17 times in 2008, to one where operating profit covered large interest 19.68 times in 2009. This was partly caused by the decrease in borrowings in 2009, but mainly caused by the increased profitability in that year. The gearing ratio at 31 December 2009 would necessarily be considered to be very low for Frater Ltd that was trading successfully. It is the high profitability for Frater Ltd. E) INVESTMENT RATIOS: This is mainly of interest to investors and may help these users to decide whether or not a business represents a worthwhile investment. The main ratios are: 1) Earnings per share (EPS): The EPS ratio relates the earnings generated by the business, and available to the shareholders, during a period to the number of shares in issue. This is calculated as: EPS = Profit after interest and taxation Number Of ordinary shares In the case of Frater Ltd we will assume the  £1 for each ordinary shares. So the EPS ratio for the year ended 31 December 2008 and 2009 for Frater Ltd is: The ratio for 2008 is: EPS = 268/1000 = 0.27 or 27pence per share The ratio for 2009 is: EPS = 484/1500 = 0.32 or 32 pence per share The EPS has gone up 5 pence in 2009 which is a positive sign for the investors and it indicates an increased financial performance of the Frater Ltd in 2009 than in 2008. The increase in EPS may be the fact of as company decrease in the number of ordi nary share and made more profit. 2) Dividend cover: It is a measure of the number of times that the ordinary dividend for a year could have been paid out of the available profits. This is calculated as follows: Dividend cover = Net profit after tax and preference dividends Ordinary shares This ratio for Frater Ltd for the year ended 31 December 2008 and 2009 is: The ratio for 2008 is: Dividend cover = 268/ 84 = 3.19 times The ratio for 2009 is: Dividend cover = 484/ 104 = 4.65 times This is to say that the profit available for dividend cover the actual dividend increased in 2009 that is 4.65 or 4 times which indicates the company is retaining a substantial part of its profits. High level of cover in 2009 means that profits are more and Frater Ltd is having no difficulty in maintaining an acceptable level of dividend. CONCLUSION OF INVESTMENT RATIO: 2008 2009 EPS 27p 32p Dividend cover 3.19times 4.65times Virtually EPS and dividend cover, both ratios indicate that the Frater Ltd is a good investment. The EPS goes up by 5p per share and dividend cover ratio also has shown improvement in 2009 which attract the investors to invest. And the reason for good investment in company may be due to the fact that Frater Ltd has controlled their expenses more in 2009 than in 2008. F) CASH FLOW INDICATOR RATIOS: It is designed ti aid users in making judgements on the amount, timing and degree of certainty of future cash flows. It has a further purpose that of helping to indicate relationship between profitability and cash generating ability, and thus the quality of the profit earned. The main ratios which are helpful in Frater Ltd analysis are: Cash margin ratio: It focuses the attention on the companys ability to generate cash as opposed to profit and shows the proportion of profits actually earned as cash. This is calculated as: Cash margin = Operating cash flows *100 Net sales For Frater Ltd this ratio for the year ended 31 December 2008 and 2009 is: The ratio for 2008 is: Cash margin = 769/ 5,941 *100 = 12.94% The ratio for 2009 is: Cash margin = 1,282/ 8,756 * 100 = 14.64% The ratio has increased considerably in 2009 from the previous year 2008, means greater the amount of cash margin, is better. This ability to generate a consistent or improving percenta ge comparisons are good sign for Frater Ltd in positive investment qualities. Interest Cover: This ratio tells how many times interest can be met from the profit of the company. Thus, telling how easily a firm can is able to cover its interest payment obligation. This is calculated as: Interest cover ratio = Operating cash flow Interest paid For Frater Ltd this ratio for 31 December 2008 and 2009 is: The ratio for 2008 is: Interest cover ratio = 769/ 23 = 33.43 times The ratio for 2009 is: Interest cover ratio = 1282/ 38 = 33.74 times It means the interest cover ratio is increased by about 1 per cent in 2009 than in 2008, means it is a good indication for Frater Ltd; they paid their loan and there is no interest due because of profit earned. Also they will gain the confidence of their lenders. Cash return on capital employed (CROCE): It measures cash return on total capital of the business and this is equivalent measure of ROCE and expressed as: Cash return on capital employed = Operating cash flow * 100 Capital employed In case of Frater Ltd, this ratio for the year ended 31 December 2008 and 2009 is: The ratio for 2008 is: Cash return on capital employed = 769/ 2008 * 100 = 38.3% The ratio for 2009 is: Cash return on capital employed = 1,282/ 2,908 * 100 = 44.1% This shows a huge improvement in Frater Ltd performance from 2008 to 2009 which means company used their capital in a productive and profitable way. The returns on capital to the investors are much higher in 2009. Cash flow ratio: The purpose of this ratio is expressed as the excess of cash revenues over cash outlays in a given period of time. This is calculated as: Cash flow ratio = Operating cash flow Current liabilities For Frater Ltd this ratio for the year ended 31 December 2008 and 2009 is: The ratio for 2008 is: Cash flow ratio = 769/ 71 = 10.83 times The ratio for 2009 is: Cash flow ratio = 1282/ 258 = 4.97 times. It indicates that Cash flow per share: This ratio tell us that the amount of cash which has been generated for each ordinary shares. Cash flow per share = Net cash flow Number of ordinary shares This ratio for Frater ltd for 31 December 2008 and 2009 is: The ratio for 2008 is: Cash flow per share = 688/ 1,000 = 0.69 or 69pence per share The ratio for 2009 is: Cash flow per share = 1,018/ 1,500 = 0.68 or 68pence per share The cash flow per share has gone down by about 1p in 2009 which is not a positive sign for investors. This may also lose confidence of their investors for the Frater Ltd. CONCLUSION OF CASH OF CASH FLOW INDICATOR RATIOS: 2008 2009 Cash margin ratio 12.94% 14.64% Interest cover 33.43times 33.74times CROCE 38.3% 44.1% Cash flow ratio 10.83times 4.97times Cash flow per share 69p 68p Virtually Frater Ltd performed better in 2009 than in comparison to 2008 except in case of cash flow per share ratio which has gone down in 2009 by about 1pence.