Financial Analysis Management and Valuation

Part one

Introduction

Financial statements analysis is a process of reviewing and analyzation of a company’s financial statements to construct better income economic decisions for the anticipated earn income in the future. The financial statements are analysed in a way that the expenses and the revenues are taken into account for the evaluation of the liquid financial position of a company, the analysis showing how a company is planning and coordinating its cash position. Comparing of past data and expected values shows a lot of difference in financial activity making the company take the necessary precautions for future financial obligations, the suggestion on how a company's current liabilities are being paid, how the repayment of the loan is designed, fixed assets replacement and making the relevant capital budgeting’s decision (Palepu at el.,2020).

Financial ratios evaluate a company’s information regarding finance and use to compare its operations. Parties such as consumers, lenders, shareholders, government, employees and their various competitors use financial ratios to compare their power with others. However, the analysis has some gap that hinders its effectiveness. This gap includes financial statements that are mostly analysed in aggregate forms, based on personal estimations, different procedures and techniques for analysis and reliance on the recorded historical data to project the future of the firm’s value (Easton at el., 2018). This report will consider two companies.

The Next Plc retail chain founded in 1982 in Leicestershire is a British store focused on producing fashionable clothes, footwear and later on targeted home commodities. Next Plc is currently one of the best stores that have an excess of 500 stores in the UK and Eire and almost 200 stores in different nations. In addition, it was capable to make £100 million in 1998 throughout its Next credit financing.

Marks and Spencer, established in 1884 is one of the leading retail chains of Britain and is the competitor of Next Plc. It is one of the oldest brands of England, which does not focus upon the clothing for people but also provides a wide variety of food items along with home products e.g. furniture, which has helped them to grasp a larger market share. M&S has approximately 450 stores in 30 countries.

Report Objective

The choices regarding investment and financial decisions of a business are key for the managers to run the activities and achieve a definitive objective of managing a business. With a specific end goal to emphasise and comprehend monetary administration. This report assesses the money related execution and position of Next Plc which is recorded under FTSE 350. Financial management is of significance to business because it helps the managers to make better decisions and to evaluate the current and future performance of a business by using financial tools. Therefore, it is important to understand the financial tools to demonstrate the profitability of Next Plc compared to Marks and Spencer (M&S). 

Methodology

Financial ratios are the tools used by the managers that help in decision making in evaluating the company’s performance and making comparisons within an industry. Once these ratios have been calculated, managers can further use them to highlight the strengths and weaknesses of the company and therefore form objectives that will be used to develop strategies to run the company efficiently and effectively. Thus for this purpose, to understand the performance of Next Plc, financial ratios for the year 2019 and 2020 are calculated. These ratios amongst these two different years are computed to see whether the company was able to improve its performance as compared to the previous year, 2019. Similarly, Marks and Spencer are chosen as the competitors for Next Plc and ratios for the same two years 2019 and 2020 for this company are computed. The major aspect is to compare which company performed better by analysing these ratios.

It is important to determine the value of the firm, valuation assumes a critical part in deciding whether the company is making profit or loss, which is a key segment of a speculation's aggregate return. For this purpose, Gordon’s Dividend growth valuation model is chosen for the valuation of Next Plc (Brennan, 1971). 

To calculate this dividend growth valuation model, we take the dividend for the next year, dividend growth rate and cost of equity. To calculate the dividend growth model, we will be using the earnings retention model to find the dividend growth rate and similarly, we will be using the capital asset pricing model to obtain the cost of equity.

Analysis and Discussion

The table above presents the profitability ratios, the gross profit ratio for M&S has been more than Next Plc in the year 2020. This means that M&S has been purchasing goods at cheaper prices from suppliers or sells at higher prices as compare to Next Plc.

Net profit for Next Plc is higher than that of M&S in the year 2020, it seems as if Next Plc cut down on its expenses hence they make more profit. The trend for net profit for M&S shows that they incurred more expenses in 2020 as compared to 2019. The same is the case with the operating profit, Next Plc has slightly more operating profit in the year 2020, while M&S seems to lack behind in 2020.

Talking about the overall profitability ratio, the ROA ratio for Next Plc is higher than M&S, which shows that the management of Next Plc is effectively managing all of its assets in the optimum manner possible as compared to M&S in the year 2020. Similarly, ROE for Next Plc is high as compare to M&S in 2020; meaning that Next Plc shareholders invested a lot of capital into the business and are getting a greater return and efficiently making use of the funds. M&S has fallen behind in all the profitability ratios except for the gross profit margin. 

Efficiency ratios are calculated to help the businesses to know their ability to manage their assets and liabilities to generate sales (Atrill, 2014). It is important to have a high working capital turn over which would mean that management is highly efficient in using its short term fixed assets and liabilities. Next Plc was doing better than M&S in 2020, while M&S was unable to improve its working capital turnover.

The average turnover period depicted that M&S was able to sell its stock more quickly in 2019 as compared to 2020. Also Next Plc lacked behind in 2020 in selling its stock compared to M&S. This means that Next Plc will have to bear the cost of keeping the stock affecting the firm’s profitability.

The average settlement period shows that both the companies have improved over the year to pay the money back. However, Next Plc is doing better than M&S, as it will take only 27 days to pay off all its creditors.

The average trade receivables have shown that Next Plc has given many goods to its credit customers, which will take 81 days to pay them off and in the case of M&S, they are doing better because their credit customers will pay them back within 4 days.

Shareholders’ investment ratios are shown in the table above to see the return to the shareholders from the money they have invested in the business. In 2020, Next Plc had a decline in its dividends as compared to M&S who have an ideal dividend pay-out ratio. However, this means that for M&S there would be less retained earnings available. Next Plc has a higher dividend cover ratio as compared to M&S, this means that they are using their profits to meet their financial requirements and M&S does not seem to do well. The dividend yield ratio helps the investors to forecast the cash return they will get from the investment; M&S is doing better than Next Plc that shows that M&S will be distributing more dividend income to its investors.

The price-earnings ratio reveals that both the companies have a decrease in their price-earnings ratio; this is because the stock price in the market in 2020 dropped. M&S seems to have a better price-earnings ratio in 2020 as compare to Next Plc. From the investor’s perspective, M&S seems to do well when it comes to returning to the shareholders.

The current ratio shows that M&S is doing better than the previous year 2019 and Next Plc has a lower current ratio, meaning that it will take more time to pay back its short-term debts. Similarly, the acid test ratio shows that Next Plc has a lower acid test ratio as compare to M&S, which it needs to work on to improve its liquidity.

The gearing ratio takes into account the capital structure and focuses on how the long-term liabilities are used to finance the money invested by the shareholders. A lower gearing ratio is considered better as it shows a lower proportion of the company’s debt as compared to the equity. Next Plc has increased its gearing ratio slightly in 2020 while M&S improved their ability to pay back its long-term loans, however; it seems to be very risky as compared to its competitor.

Part Two

NPV and IRR concepts are methods used to evaluate investment for new projects. Under limited circumstances, NPV and IRR are the same. According to Mackevičius (2010), it is prudent to distinguish between the figures returned by the NPV and IRR when analysing a typical project. In general, when two indicators are used to compare two different projects, contradictory results appear. NPV is the amount of future revenue and taxable income. While IRR is the discount rate, when the total value of the investment is equal to zero. Both NPV and IRR use discounted cash flow methods for financial projects to determine investment testing. The project is considered eligible for funding if NPV is equal to or greater than zero at the selected discount rate. The IRR uses a percentage rate and not a dollar value, as in the NPV, in determining potential investment profits. In the case of a single project, strategies always provide the same value. The topic focuses on the NPV and IRR concept used in investment testing. Determining NPV sometimes project analysis involves one task while at other times, it involves two projects (Jackson, 2014). For example, an entity may choose to provide protective gears or to provide masks based on analysis. Method of initiating / determining NPV. The firm uses a discount rate that reflects the risk of the project and its major costs to measure future cash flows and depreciation. Reducing all future good investments in the future to a single present value and subtracting this number from the initial outflow is necessary to provide the current value of the investment. If the NPV is zero or higher, then the project is approved.

Part Three

Valuation of the dividend growth model

The Gordon Growth Model is also known as the dividend growth model enables investors to determine the value of the stock by excluding the prevailing market conditions. This growth model is used, as the price-earnings ratio model tends to be lower during high inflation, which does not give a clear picture of stock valuation. To make the calculations we have to make a few assumptions. The ultimate purpose to calculate the dividend growth model is to determine the share price of the firm.

Assumptions

1. Dividend growth model remains constant throughout
2. Cost of capital and rate of return is kept constant
3. The retention rate remains unchanged
4. The life of the firm remains indefinite
5. The rate of the growth of the firms is constant

To further, elaborate the dividend growth model is calculated for Next Plc in the next year (2021).

Dividend growth valuation for 2021

CAPM

 = 0.80

Krf = 1.30

Km = 5.8%

Ko = Rf + (Km-Krf)

Ko = 1.30+ 0.80 (5.8%) = 1.3464

Dividend growth rate 5 years = 8.52%

 Dividend per share = 154p

=

=

= 132.50p

The market price of Next Plc in 2021 was 3830 pence while the value per share calculated is 132.50 pence. This shows a significant trend in the rise of the market price that is quite higher than the value calculated. The market price for the stock may be higher due to several reasons;

1. The demand for the shares may be too high and more and more investors are interested to purchase the shares; the main reason here is the high demand for shares that have overvalued the market price.
2. There could be a boom in the economy due to the economic changes that will fluctuate the market prices above what the actual value per share is.

We use this model to calculate the intrinsic value of the share as it is easy to calculate and easier to understand. Additionally, this model does not take into account the market conditions thus making it easier to make comparisons within industries. However, this model has its limitation; when we calculate K we assume that the growth rate increases at a constant rate, risk-free rate and beta would also remain constant however the value of the dividend per share keeps changing every year. It should be taken into account that all these market variables should keep on changing as the market fluctuates on daily basis, so this would affect the results of valuation (Atrill, 2014)

 Conclusion

Next Plc is doing better under the category of profitability ratios except for the gross profit margin because the company’s cost of purchasing goods was very high as compare to Marks and Spencer Plc. Similarly, efficiency ratios that relate to the management of inventory for Next Plc are quite better than its competitor is. Thus, Next Plc has a better profitable position in the future in terms of the management perspective.

Shareholders perspective ratios depict that Marks and Spencer are functioning better than Next Plc as they are giving out more dividends that are favourable. In addition to this liquidity, ratios show that Next Plc is easily able to pay its short terms debts so it is better to invest in Next Plc as the company’s financial position is stable. Moreover, the valuation of Next Plc for 2020 is 456.22 pence that is an intrinsic value i.e. lower than the market value of the company. It is easier to comprehend that Next Plc has overall outperformed Marks and Spencer PLC in the year 2020 as compared to 2019.

References

Atrill, P., 2014. Financial management for decision makers. 7th ed. Harlow, Essex: Pearson.

Brennan, M., 1971. A Note on Dividend Irrelevance and the Gordon Valuation Model. The Journal of Finance, 26(5), pp. 1115-1121.

Easton, P. D., McAnally, M. L., Sommers, G. A., & Zhang, X. J. (2018). Financial statement analysis & valuation. Boston, MA: Cambridge Business Publishers.

Jackson, T., 2014. Project Appraisal Techniques. In Encyclopaedia of Business Analytics and Optimization (pp. 1922-1934). IGI Global.

Lo, K. & Lys, T., 2000. The Ohlson Model: Contribution to Valuation Theory, Limitation and Empirical Applications. Journal of Accounting, Auditing and Finance, 15(3), pp. 337-367.

Mackevičius, J. and Tomaševič, V., 2010. Evaluation of investment projects in case of conflict between the internal rate of return and the net present value methods. Ekonomika, 89(4), pp.116-130.

Next plc - Company Profile, Information, Business Description, History, Background Information on Next plc.

Palepu, K. G., Healy, P. M., Wright, S., Bradbury, M., & Colton, J. (2020). Business analysis and valuation: Using financial statements. Cengage AU.

The influence of information, knowledge and technology management on the performance of manufacturing enterprises. (2016). Strategic Direction, [online] 32(11), pp.28-30.

Appendices

Profitability ratios

Gross profit margin = 

Net profit margin = 

Operating profit margin = 

Efficiency ratios

Working capital turn over =