Financial Ratio Analysis - Risk Analysis and Capital Structure

Question: Describe about the Financial Ratio Analysis, Risk Analysis and Capital Structure ? Answer: Introduction Imperial Tobacco is the worlds fourth largest cigarette company as per market share. It is based out of Bristol and has significant markets in various European nations besides USA and parts of Asia. The company boasts of manufacturing facilities in over 51 locations and caters to customers in over 160 nations and thus having a global customer base (Imperial Tobacco, 2015). The aim of the given report is to list down the various business and financial risks associated with the company. Besides, the report also discusses the financial performance of the company through ratio analysis of the latest two year financial statements. Also, in wake of the current funding mix the future potential sources of financing along with the optimal capital structure have been also discussed in the given report. Business and Financial Risks The various significant business and financial risks that are relevant for the company are discussed below. Reduction in the legitimate tobacco market size There may be a reduction in the overall market for tobacco products which may be on account of the following reasons (Imperial Tobacco, 2015). The availability and underlying demand of tobacco products in various geographies is highly influenced by the extent and nature of government regulation due to the adverse impact of the tobacco based products. Excessive regulation may significantly alter the consumer demand and additionally also increase the compliance costs. There may be increases in the excise duty implemented at the behest of the government. This may be done with the intention of raising public funding or to limit the usage of tobacco. As a result of the above two measures, there is a growing illicit trade market in case of tobacco products. Also, the counterfeits are also on the increase as consumers seek cheaper alternatives and thus causing decline of legal tobacco market. Any significant economic slowdown experienced in major markets may reduce the disposable income of consumers and thus either there may be decline in the overall market coupled with an increasing market for smuggled illicit products that are available for cheaper prices. Legal and Regulatory Compliance There may be significant legal and compliance costs which may have adverse impact on the business because of the following two reasons (Imperial Tobacco, 2015). It is possible that the company may violate certain national and/or international laws and hence may have to incur significant penalties besides loss of reputation. The company faces a plethora of litigation from the users of tobacco and e-vapour products. These cases result in significant legal costs which adverse impact the business profitability. Downside to marketplace especially Europe The company has significant presence in the various mature markets of Europe and thus any significant downturn in these markets may have adverse impact on the revenue and profits of the company. Besides, the exit of various nations from the EU and the Euro valuation may also have adverse impact on the companys financial performance. The manufacturing and distribution operations may be negatively impacted in case of any disruptions due to political instability and/or civil unrest in these geographies (Imperial Tobacco, 2015). Financing Risk The company has significant outstanding debt and hence any fall in the credit rating would lead to an increase in the finance cost and thus adversely impact the profitability of the company operations. Besides, a significant downturn in financial markets such as the global financial crisis may lead to potential issues with regards to the refinancing of the debt which are due for maturity in the near term. As a result, the cost of raising debt along with the underlying cost may increase. Besides, there is always the risk of defaulting on the interest and the principal repayment due to declining business prospects (Imperial Tobacco, 2015). Recent Financial Performance In order to analyse the financial performance of the company, a ratio analysis has been conducted based on the consolidated financial statements of the company for the year FY2014 and FY2015. The various relevant ratios have been computed and the financial performance has been compared for the two most recent years. Profitability Ratios Analysis The various relevant profitability ratios are as shown in the following table (Imperial Tobacco, 2015). Ratio Formula FY2014 FY2015 Gross profit margin Gross Profit/ Revenue 19.58% 20.45% Net profit margin Net Profit/ Revenue 5.46% 6.81% Return on Assets Net Profit/ Total Assets 5.58% 5.72% Return on Equity Net Profit/ Total Equity 26.45% 30.25% Even though there has been a decline in the overall revenue due to a decline in the selected European markets that form the Markets South, but the profitability of the business has improved in the year FY2015 as compared to the corresponding previous year i.e. FY2014. The gross profit margin for the company in the year FY2015 has enhanced by 87 basis points on account of operational efficiency and cost management initiatives by the company. The net profit margin of the company has increased by 135 basis points primarily on account of increase in investment income, decrease in tax paid coupled with savings on account of cost management initiatives (Imperial Tobacco, 2015). The higher net profit in FY2015 also leads to significantly improvement in the return on equity and return on assets. Thus, it is apparent that the profitability in FY2015 for the company is higher as compared to FY2014. The profitability data for British American Tobacco (BAT) is shown below. From the above table, it is clear the profitability is higher for BAT in comparison with Imperial Tobacco. This is despite the drop in gross margins in FY2015 for BAT. The shareholders returns and net profitability for BAT have improved on back of decrease in operational expenses. Liquidity Ratios Analysis The various relevant liquidity ratios are as shown in the following table (Imperial Tobacco, 2015). Ratio Formula FY2014 FY2015 Current Ratio Current Assets/ Current Liabilities 3.35 3.30 Quick Ratio (Current Asset - Inventories)/ Current Liabilities 2.98 2.99 It is apparent from the above table that the current ratio for the company at the end of FY2015 is marginally lower than the corresponding value at the end of FY2014. This is primarily on account of higher percentage increase in the current liabilities as compared to the current assets. The disproportionate increase in current liabilities is due to the rise in short 1term loans from 429 million at the end of FY2014 to 1,957 million at the end of FY2015. The quick ratio on the other hand has marginally improved at the end of FY2015 primarily because of a slight decrease in the overall inventory level (Imperial Tobacco, 2015). However, it is evident that the short term liquidity isnt an area of concern for the company since the ratios despite slight variations continue to be robust (Damodaran, 2008). Turnover Ratio Analysis The various relevant turnover ratios are as shown in the following table (Imperial Tobacco, 2015). Ratio Formula FY2014 FY2015 Asset Turnover Sales/Total Assets 1.02 0.84 Inventory Turnover Cost of goods sold/Inventory 7.40 7.08 Receivables Turnover Sales/Accounts Receivables 9.58 10.31 Payables Turnover Cost of goods sold/Accounts Payable 3.06 2.96 It is apparent from the above table the asset turnover has witnessed a decline in FY2015 primarily on account of decline in the overall revenue in FY2015 due to slowdown in selected European markets (Imperial Tobacco, 2015). The impact of lower sales is also reflected in the lower value of the inventory turnover in FY2015. The receivables turnover ratio has significantly improved in FY2015 despite lower sales generated which clearly indicates that there has been a sizable drop in the receivable days which would reduce the overall cash cycle of the firm and thus lead to reduction in working capital requirements. The payables turnover has decreased in FY2015 which indicates that the company has a longer credit period and thus leads to shortening of the cash cycle (Ross, Westerfield Jordan, 2013). Gearing Ratios Analysis The various relevant gearing ratios are as shown in the following table (Imperial Tobacco, 2015). Ratio Formula FY2014 FY2015 Debt to equity ratio (Short term + long term debt)/ Total equity 1.81 2.49 Interest Coverage Ratio Operating Profit/ Interest Expense 1.91 1.64 Long term debt to equity ratio Long term debt/Total equity 1.73 2.15 It is apparent from the above table that there is a significant increase in the debt to equity ratio primarily on increase in both long term and short term debt. The short term debt has increased from 429 million at the end of FY2014 to 1,957 million at the end of FY2015. Further, the long term borrowings have increased from 9,462 million at the end of FY2014 to 12,250 million at the end of FY2015. It is evident that majority of the debt on the books of accounts is of long term (Imperial Tobacco, 2015). Further, owing to a significant uptick in the overall debt, the interest expense has also increased which has led to a decline in the interest coverage ratio in FY2015 (Brealey, Myers Allen, 2008). Debt capacity and sources of finance It is apparent from the above discussion on the gearing ratios that while the equity of the company has remained steady, the primary source of financing seems to be based on debt. As a result of usage of debt as the lone funding mechanism in FY2015, the total debt equity ratio has reached a tipping point which coupled with a declining interest coverage ratio raises uncomfortable questions with regards to the companys continued ability to carry on with a debt based growth. The total debt to equity has already reached 2.49 which implies that debt funding accounts for nearly 71% of the total capital while equity amounts to only 29% of the total capital invested in the business (Brigham Ehrhardt, 2013). As a result, it may be concluded that the company has limited capacity to raise further debt and hence must focus on enhancing equity financing as possible source of finance going forward. As the global capital markets improve with the retracting US economy, it may be fair to expect that raising equity at healthy valuation should not be an issue for a reputed company like Imperial Tobacco with established brands. This would strengthen the balance sheet of the company and reduce the financing risk associated with the fall in the credit rating especially considering the nature of the business which is prone to government regulation and litigation. Recommendation of optimal capital mix The optimal capital mix for a particular firm is dependent on a plethora of factors including the capital requirements of the industry, market share of the firm and the underlying tax structure. It is apparent from the balance sheet of the company that around 60% of the overall assets are essentially intangible assets such as copyrights and brand names. Other fixed assets such as plant and machinery form less than 10% of the total assets of the company as on FY2015. Thus, long term capital is primarily required only for acquisition for other brands and players in the tobacco industry so as to enhance presence in a particular geography (Damodaran, 2008). As a result, a high long term debt is not a matter of concern considering that financing requirements for normal course of business is limited. Further, the company is the fourth largest tobacco product manufacturer in the world and hence can afford to have a stretched balance sheet at the present. However, going forward the company should look at a mix of equity and debt for financing acquisitions and should aim for a 65:35 funding mix skewed in favour of debt especially because the company is able to raise long term finance at competitive rates. Conclusion Based on the above discussion, it is evident that the company faces significant business risks primarily in the form of shrinking legal market due to government regulation and taxes, legal and compliance issues along with economic downturn especially in key European markets. Besides, the company also faces financial risk primarily on account of sizable debt funding and the associated interest cost. The financial performance of the company in FY2015 in terms of profitability has improved as compared to the previous years. The amount of debt on the books of account has enhanced in FY2015 which limits companys ability to raise further debt and hence the emphasis should be more on equity financing so that an optimal mix of 65:35 in the favour of debt could be attained in the long term. This seems suitable for the given industry with high share of intangible asset coupled with the companys reputation and market share. References Brealey, R, Myers, S Allen, F 2008, Principles of Corporate Finance, 9th edn, McGraw Hill Publications, LondonBrigham, EF Ehrhardt, MC 2013. Financial Management: Theory Practice, 14th edn., South-Western College Publications, New YorkDamodaran, A 2008, Corporate Finance, 4th edn, Wiley Publications Pvt. Ltd, London Imperial Tobacco 2015, Annual Report and Accounts 2015, Imperial Tobacco Group Plc, Available online from https://ar15.imperial-tobacco.com/pdfs/full-annual-report-2015.pdf (Accessed on March 13, 2016) Ross, S, Westerfield, R Jordan, B 2013. Essentials Corporate Finance, 8th edn., McGraw-Hill/Irwin Publications, New York