Tweedie was found to be more profitable, efficient, and more liquid but has higher financial leverage than its competitor Bilton. Tweedie’s very high liquidity should have been used to improve its financial leverage. Despite this, there is still a good reason therefore to recommend the acquisition of Tweedie but with caution due to the higher risk than its competitor Bilton. The absence of a price offer for the acquisition and the price at which Tweedie should be acquired prevents a definite action to be taken at this point. This paper, therefore, recommends using capital budgeting techniques to help the client decide more on acquisition as the financial ratio analysis is limited to using the past of only predicting the future. A difference between cash and profit was also demonstrated in this paper.
This paper seeks to prepare an analysis of Tweedie plc by using relevant calculated ratios in evaluating the company’s profitability, efficiency, liquidity and gearing for the past five years from 2006 to 2010 as against its competitor Bilton plc for the past two years 2010. They will paper also includes a demonstration of understanding of the limitations of ratio analysis as applied to the company and with particular reference to information in the given case study and the needs of investors. This will also include an explanation about the difference between cash and profit using the case of Tweedie for illustration purposes. The resulting analysis of Tweedie is expected to be used to advise a large hotel company on whether the latter should acquire the former.
Analysis and Discussion
Financial analysis entails the use of relevant financial ratios to evaluate the company’s record for the past five years of Tweedie. For purposes of comparison with the data as against its competitor Bilton plc, the average profitability, efficiency, liquidity and gearing ratios for Tweedie will be compared with the average ratios of Bilton plc for the last two years.
Profitability and Management Efficiency
The average return on capital employed (ROCE) at 7.40% of Tweedie for the past five years shows better superiority about its past performance as against its competitor Bilton which had an average ROCE the last two years only at 4.35%. It can be argued that an average of about 7% return on equity would still attract investors, as it would mean that for every 100 British pounds, the investors expect returns of about 7 pounds. A rate of at least 7% could be viewed as still something high for a company like Tweedie given the present condition of the economy which is considered by some to be still recovering from the financial crisis that has begun in 2007. See Appendix A for the summary of financial data and ratios for more details.
It may be noted that return on capital employed equity uses the formula where net profit is divided by the total invested capital, which is computed by deducting total current liabilities from total assets. When compared to an average rate of 0.50% if money was invested in a bank, its present ROE makes the finding of offering more than tenfold and the rate is something not easy to find for investors. The 0.50% is the Bank of England base rate (Housepricecrash, 2010) that could represent the risk-free-rate investment in the United Kingdom as the same and could be used as the minimum bank rate.
Aside from profitability, it is also interesting to know whether the company management is efficient. To measure the latter, this paper uses inventory days and trade receivable days. Tweedie’s average inventory days for five-year average registered at 11 days as against Bilton’s at 10 days. This would indicate lower efficiency for Tweedie as it would take longer for the company to make its inventory to be moved or sold to customers. The same may be deduced in having a longer number of days for its trade receivables at 18 days as against Bilton at 14 days. However, the seeming less efficiency is balanced or corrected by the higher noncurrent asset turnover for Tweedie at average of 1.17 as compared with Bilton at an average of 0.60. See Appendix A.
Higher noncurrent asset turnover tells how more efficient management the company had in terms of revenues in relation to noncurrent assets employed in business. Impliedly this would mean that Tweedie did better in having its non-current assets producing more revenues than its working capital that comes from current assets. ROCE on the other hand measures how much management compensates resources invested by stockholders. By comparing the two ratios, it appears that Tweedie is still profitable and efficient as against its competitors.
The difference in evaluation in terms of which is more efficient may be further studied in the company’s average net operating margin and gross margin. The resulting operating profit margins for the last five years averaged at 7.23% for Tweedie against the two-year average of 6.95% for Bilton. Tweedie may appear now to be more efficient in the light of interpretation that despite the higher gross margin average for Bilton at 14% compared with 9.5% for Tweedie, the latter was able to produce a higher average net operating margin for the past five years. This necessary deduction can be explained by the fact that higher gross margin for the competitor should have normally resulted in higher net operating margin after considering operational expenses. Hence Tweedie managed to have saved a lot from having lower operating expenses in relation to sales. Thus it must be declared to also be more efficient in addition to being more profitable than Bilton.
The profitability ratios such as return to capital employed, gross margin and operating profit margin did show the capacity of the company from a historical perspective. However, believing whether past profitability and liquidity would continue is another question but can be argued that the company could repeat what happened in the past. For purposes of deciding to acquire Tweedie, it can be assumed that if the company was profitable for the past five years as against its competitors there could be a good chance the same performance may happen in the future.
Liquidity and Gearing
Tweedie’s liquidity is its ability to meet a company’s currently maturing obligations. It can be measured using the current ratio and the acid test ratio or quick asset ratio. In the case of the company, the information in Appendix A summarizes some of the information.
To compute the current ratio, current assets should be related or divided to current liabilities while acid test ratio is almost the same except that the inventory and prepaid expenses are being removed from the current assets to have a new numerator but the denominator is the same. Quick assets are stricter current assets and normally include only cash, marketable securities, and accounts receivable. This makes acid test ratio a finer measure than that of the current ratio.
As applied now to Tweedie, its computed average current ratio registered at 2.31 against 0.65 average of Bilton. Quick ratio of the company on the other was reflected at 0.77 as against its competitor’s average of 0.66. The current ratio of the company therefore improved to reach very high level in 2010 compared to earlier years where the company could excessively match its current obligations with every current asset.
It is generally accepted a current ratio of at least 1.0 can be still considered liquid as current liabilities is still matched by current assets of the company, hence, the company may be asserted to have so much excess working capital and it may have been used for other purposes such as improving its solvency or its efficiency to further improve profitability. The excessive liquidity could be a source of potential strength for Tweedie.
Gearing, on the other hand, measures Tweedie’s long-term capacity to keep up its stability over the long term. Normally measured by the debt to equity ratio, with the formula of having the total debt of the company divided by its total equity, a company’s gearing should assure investors that the company will not just survive the short term but it must also have a long life to recover long term investments which take years to produce the needed returns. The debt to equity ratio of Tweedie is 11.03% as against Bilton’s at 5.30% The solvency ratio makes it almost two times more than the competitor’s average and this means the value the company investments from stockholders is less strong for the company as against its competitors. This condition is unfavorable to company since it faces a higher risk.
It is therefore an evidence of a higher leverage capital structure (Helfert, 2001) for Tweedie, as the company would be considered uncertainly able to make further expansions in the future without falling to be further riskier than present competitors were. It means, in simple terms, that the company could have some difficulty managing its long terms risk that its profitability may have to provide funds to strengthen its leverage or take the excess liquidity to be channeled in this aspect of financial condition. It could affect also its ability to provide good amount of dividends annually to investors, to make future expansion since further debts would not be good as the company will become riskier.
Limitation of the ratios
The ratio analysis appears to be telling things about the past that may be used to predict the future (Bernstein, 1993). However, there are many factors that could cause the varying of happened in the past to what will going to happen in the future. For investment purposes, knowing the profitability, efficiency, liquidity and gearing ratios and their implications may not be enough in helping the decision-maker as the primary consideration is whether Tweedie is worth the price that it is willing to pay. However, the case study does not provide the price to acquire Tweedie and the issue is whether to continue with acquisition.
Assuming therefore that a price would be made available, the projected cash flows from acquiring Tweedie should be forecasted to several years in the future and the same must be discounted as an estimated cost of capital. If net present value (NPV) is positive after considering the proposed acquisition cost using the correct cost of capital (Brigham, and Houston, 2002; Van Horne, 1992), then the same is stronger reason to decide whether Tweedie should be acquired or not.
An explanation of the difference between cash and profit using Tweedie plc to illustrate points.
Cash is different from profit. This can be seen in the case of Tweedie plc. It may have a profit of £1.25 million for the year of 2010 but in that same year it has net cash of £2.57 million. The bigger net cash flow increase in 2010 was double the profit. For the company to consider as the net benefit for the period would not be correct since not all cash flows or collections for the year are revenues for the years. They may represent proceeds from the sale of investments that may have been done with loss on the sale or they may come from sale of stocks to raise capital. On the other hand, having a big profit does not necessarily mean higher cash or vice versa.
As to continued use of financial statements under accrual basis of accounting to measure profits despite the seeming more relevance of cash flows from the point of view of investors, it can be argued that one of the main reasons includes being the need to measure the benefits for period, which cannot be correctly measured in cash, but should be by revenues and expenses (Johnson, et al, 2003). The benefits of operating over a period cannot be safely measured by having more cash inflows than cash outflows per period as normally investment decisions involve cash outflows during the early years and it’s only after cash outflows are done that cash inflows will start to come and from which excess cash inflows have to be received.
It can be concluded that Tweedie is more profitable, efficient, and more liquid than its competitor Bilton. However, the company has higher leverage than its competitors. As revealed in the analysis, Tweedie’s very high liquidity should have been used to improve its financial leverage. Despite this, there is still good reason therefore to recommend its acquisition subject to the higher risk involved as a result of the higher financial leverage than its competitor Bilton. However, in the absence of a price offer for the acquisition and the price at which Tweedie should be acquired, a definite action cannot be done at this point.
It should be further concluded that there are indeed other non-financial factors that must be considered in making a decision whether Tweedie should be acquired or not. Since this study mainly emphasized the financial analysis of the proposed acquired company as against the latter’s competitor, the findings are focused on knowing which is more profitable, efficient, liquid, and solvent or which was has better financial leverage.
It does not however provide an estimated quantitative advantage in financial terms of what the acquiring hotel could have gained as result of the acquisition. This paper assumes the need to discount the cash flows using a discount rate which must be estimated from that the acquirer. The same cost of capital could then be used to discount the forecasted cash flows over a period when the acquired company is expected to be operated until liquidated.
Moreover, there are non-financial factors that must be given consideration in the making the decision include the way the senior managers will hear and decide the way the project is presented in consideration of other political factors in the organization. Furthermore, managers normally talk about the rates of return that they may get from the investment in comparison with what the company presently earns.
This paper, therefore, recommends the use of capital budgeting techniques to help the client decide on acquisition as the financial ratio analysis used in this paper is limited to use the past information and which can partly be used to predict the future with no clear indication on how much is the net advantage of acquisition. A difference between cash and profit was also demonstrated in this paper.
The managers are advised to use capital budgeting techniques like the NPV and Internal rate of return (IRR) method to help them decide on the proposed acquisition of Tweedie.
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