Introduction to Financial Analysis
Managing financial resources forms an integral part of the organization. Financial decision making is supported by lot of analysis and evaluation. Business unit is responsible for taking appropriate decision for the future success of the organization. Decisions are related to acquiring finance through the source of financing that suits business requirement (Thomas, 2009). On other the optimum utilization of money available is also a crucial task. It involves assessment of financial viability of projects under consider so as to finalize best investment alternative. The report herewith describes all the related issues of financial evaluation. It covers all the aspects ranging from sources of finance available to financial analysis and capital budgeting methods. The research is supported by financial statements analysis of TUI Travel plc. The company operates across 180 countries and is one of the world’s leading travel groups. The research provides very useful insights for the manner in which financial resources are management and decision making is carried.
Sources of finance
Acquiring finance through option that is in accordance with the organizational objective is a crucial task and involves lot of analysis. The business unit has to analyze and evaluate all the alternatives available for raising funds. The company can arrange funds from within its premise and also from outside the boundaries of business. Based on the same; sources of finance are segregated into two parts; namely Internal sources and External Sources. In addition depending on the capability of financial sources to satisfy financial requirement; the sources are categorized as Long term sources and short term sources of finance. Some of the major sources of finance available and costs associated with them are described in brief underneath.
Issue of equity capital: All the publically listed companies have option to raise its equity capital by issuing more equity shares. The raising of capital by issue of equity shares involve has attached to it high floating cost. In addition it also results in dilution of ownership (Rashid, 2014).
- Issue of debentures and corporate bonds: Debt fund in the organization can be raised by issuing debentures and corporate bonds. The option although helps in meeting requirement of funds for business unit; it has highest cost associated with it. Issue of debentures and bonds involve large amount of floating cost in addition to regular payments of interest.
- Bank Loans: Every business unit irrespective of its scale of operation can raise the funds through Bank loans. It is a suitable alternative to meet medium and short term financial requirements. It requires following of simple bank procedures for grant of loan in return of payment of nominal interest on regular basis (Loayza, Levine and Beck, 2000).
- Retained earnings: The organizations always have option to utilize the surplus earnings saved in the form of retained earnings. Most of the companies usually follow the practice of saving certain part of income on annual basis; and these earnings assist in meeting the short term funds requirement of business unit.
- Sale of assets: The assets that are of no use for current business operations can be sold for the purpose of satisfying requirement of financial resources. Both of internal sources of funds are available free of cost to business unit.
Implications of sources of finance
Every source of finance caters to different requirement of funds. It is the nature of business and demand of present hour that determines the most suitable financing option. If the organization is in need of large amount of funds for long term; then raising funds by issuing equity or corporate bonds is suitable. In case firm has sufficient equity and no desire to dilute more of its ownership then debt fund is suitable. The business unit can also consider option to raise funds by bank loans. It is simple to access source of financing and is capable of meeting any kind of business requirement weather short or long term (Brigham and Ehrhardt, 2013). Internal sources of finance on other hand are suitable for the cases that require funds in emergency. The organization needs to assess its finance requirement effectively and raise funds through adequate source of finance.
Importance of financial planning
Financial planning is the task that not only involves future course of action but also justification of decisions on grounds of financial analysis. The planning that involves monetary value is the aspect that involves lot of efforts on part of the management (Greenwood, 2002). TUI group plc being one of the prominent travel groups in the country of United Kingdom. The company has operations worldwide in across 180 countries. It is responsible for managing all the branches in the manner that its financial resources are optimally utilized. The planning is necessary to answer following questions:
- How to be effective in order to fight the competition?
- How to be innovative in the industry?
- How much funds are required for expansion purpose?
- Which project is viable for investment purpose?
- From where to raise funds?
- How to make optimum utilization of financial resources?
The company since is in the hospitality sector and is a travel agency; it is necessary for the firm to always come up with innovative ideas to meet the competition prevailing. In addition the company if wants to expand operations the estimates of cash inflow and outflow should be presented. It has to justify investment options through the adoption of capital budgeting techniques. For raising funds company should consider raising its proportion of equity. The financial plan is established in order to achieve long term organizational goals. The decision making is done at different levels and by requires involvement of different group of people. Every group requires varied kind of information depending on the nature of purpose the decision is going to serve. As an illustration production department needs information on estimated future demand so as to produce budget for cost estimated to incur. On other side finance department needs the information regarding the finance requirement of each department so as to allocate funds efficiently. Setting a financial framework is a crucial task and demands valid facts and figures for the purpose of evaluation (Keller, 2013).
Appropriateness of the sources of finance
As discussed in Part 1, every source of finance caters to specific business requirement. The specific source of finance is appropriate under different situations and nature of the organization. In case of TUI travel plc the most appropriate source of financing arrangement is equity capital since the company already has high amount of debt fund. The funds required for short term or to meet working capital requirement can be arranged by the way of bank loans. For long duration the amount should be raised by issue of public offering (Neale and McElroy, 2004). It helps in increasing owners’ capital and at the same time acquiring funds. The equity is suitable since proportion of debt is comparatively high in total capital employed.
Impact of finance
The finances although can be arranged by different sources; it has one or other impact on financial statements. The funds raised by the way of bank loans leads to increase in liabilities; and the investment made by the same is reported as assets. In addition the interest expenses are deducted from Earning before Interest and Tax to arrive at Net profit. Issue of equity shares on other hand leads to increase in shareholders’ equity and corresponding affect on asset side in the form of investment or increase in cash/ bank balance. Floating cost for the same is distributed over a period of time and written off every year from Net Profit (Dimitropoulos and Asteriou, 2009). Debenture or corporate bonds again raises liabilities and the amount gets into increase assets. Floating cost and interest expenses is treated similarly that in the case of shares issue and bank loan respectively.
Financial Statements of different businesses
Financial statements are reported by the organizations on annual basis. The annual report in general comprises of income statement, balance sheet and cash flow statement. Income statement or profit and loss statement represent amount of income earned and expenses incurred during the year. Balance sheet on other presents the position of the organization as on date. It represents all the holdings of the enterprise and amount owed to the outsiders. Lastly, cash flow statement list all cash inflow and outflow under various heads during the year.
The business units differ from each other on the basis of its ownership structure and kind of establishment. However, mostly there are three kinds of business units; namely sole proprietorship, partnership and publically listed company. The different kind of business unit reports their accounts in different manner. Sole proprietor usually follows simple procedure and prepares financial statement in order to ascertain profit generated or loss incurred. Partnership firms majorly focus on segregating its partner’s capital in its accounts (Collier, 2012). However, publically listed companies report the financial statement as per the specific accounting standards of economy and international reporting financial standards. Accounts of the company are generally published with a view to cater information need of stakeholders. Henceforth, there presentation follows systematic procedure and provides deep understanding of busines nature and its performance.
The analysis of Ratio helps in judging performance of business unit with its efficiency in operating. The previous year financial statements are interpreted on the basis of calculation of ratios. The financial analysis for the TUI Travel plc brings the insights about company’s performance in the following manner.
Current Ratio: The ratio emphasizes on testing liquidity position of an enterprise. It determines the organization capacity to pay its short term obligations (Altman, 2012). The company has current ratio of 0.55 that lies below 1. It indicates that firm does not have sufficient current assets to pay its current liabilities.
Quick Ratio: It is calculated to judge very short term liquidity position of the enterprise. The ratio of 0.54 is very low and suggests that the organization will face issue in paying off its obligations due within near future. It suggests the company should infuse more of cash and its equivalents to improve its liquidity position.
Debt Ratio: The ratio measures the degree to which total liabilities of the organization is supported by total assets. The ratio of 0.84 suggests that the total assets of the company are sufficiently by its assets. It indicates sound credit paying capacity of the business unit (Giacomello, 2008.).
Gearing Ratio: It measures the proportion of Total Liabilities supported by shareholders’ equity. The ratio of 5.54 suggests that the company has relatively higher amount of liabilities in comparison to owners’ capital. TUI travel plc has to invest capital in the form of shareholders’ equity so as to have adequate equity in comparison to debt.
Times interest: The ratio calculates number of times earnings are generated within the organization in comparison to its interest expense. The ratio of 0.039 indicates that Net profit is significantly lower than its interest expense. The organization should either reduce its debt so as shrink its interest expenses or increase its profitability.
Interest Coverage ratio: The ratio emphasizes on measuring percentage of interest expenses covered by organization’s earnings before interest and expenses. It is the real measure of the company’s capacity to pay its interest obligations. The ratio of 0.18 indicates that around 18% of the interest expenses are covered by Earning before interest and Tax. The ratio since is notably lower signifies firm insufficiency in paying off its high interest expenses.
Net Margin: The profitability ratio that indicates the percentage of Net income is generated in comparisons to Total Sales of the company. For TUI travel plc the same is measured at 0.41% indicating that the firm is able to profit relatively lower margin of net income. The company should either its profit margin on revenue or deduct operating and non-operating expense.
Return on Capital Employed: Every amount that is invested in the business is with a view to generate sufficient return. It is the ROCE that justifies the investment made in the organization. TUI travel plc is able to generate 8.12% return on the capital employed. It is relatively lower since risk free rate in the economy is moving around 9%. Henceforth, the amount in the business unit is invested to generate more returns than at least risk free rate. But return of 8.12% is lower and indicates lower profitability.
Return on Equity: The ratio measures organization’s capacity to generate return on shareholders’ equity. The firm is generating return of only 4.27% that indicates its inefficiency in generating sufficient returns.
Total Assets Turnover ratio: It measures the number of times revenue is generated in comparison to Total assets. The ratio measures firm’s efficiency in utilizing its assets. TUI travel plc is able to generate 1.58 times of revenue in comparison to its Total Assets. The organization since has wide spread operations; ratio indicates it is able to make optimum utilization of resources.
Inventory Turnover ratio: The ratio calculates number of times inventory is revolved during the period within the business unit. The ratio of 235 times indicates efficient flow of the stock and fast generation of revenue.
The budget represents the anticipation of future earnings and expenditure. It generates a complete sketch of inflow and outflow of funds during the period of time (Lau, 2001). The sales budget for the period of six months is presented below as an illustration.
The budget shows that company is forecasting that its sales will increase on continuous basis till there is change in certain market related factors. It is anticipated that sales of the business unit increases for first four months thereby it decrease for next two months. Rationale behind the same is that demand in the month of November and December decreases since lesser number of individuals desire to travel at the time (Steed and Gu, 2009). The wages and other overheads are estimated to incur at same levels. Purchases on other hand have change corresponding to that of sales. The company follows policy to acquire services when they are in demand. The business unit is able to generate inflow of funds on monthly basis. Henceforth, there is accumulated surplus of funds every month. The budget provides complete overview of income and expenses during the period.
The manufacturing unit needs to measure the unit cost of its product and thereby fix the selling price. An example for calculation of cost price and selling price of single unit is mentioned below.
The cost price of each unit of production is calculated by dividing total cost of production by number of units produced. The cost of production includes both variable and fixed cost. In order to ascertain selling price the required profit margin is added to the cost of unit product (Palmer and Davis, 2005).
Investment Appraisal techniques
Investment Appraisal techniques are adopted to test the feasibility of projects under consideration. These techniques support an investment decision by the company. TUI Travel plc for expanding its business operations has the option to investment in one of the two projects available (Singh, Jain and Yadav, 2012.). The estimated cash flows of the projects are presented and their viability is assessed with capital budgeting techniques underneath.
Evaluation as per Investment Appraisal
The project available with TUI Travel plc has undergone the capital budgeting Analysis. Calculation of accounting rate of return, Payback period and Net present Value suggest the investment in project 2 because of the following reasons:
- ARR for the project 1 is measured at 50% and for project 2 at 55%. Since the project with higher ARR is considered viable option; Project 2 is appropriate for investment purpose.
- Payback period of the project 2 is 1 year and 6 months that is lower than Project 1. Therefore, Project 2 is suggested to be feasible option for investment
- Net Present Value of Project 2 is £ 390.55 million greater than Project. This implies as per NPV method too Project 2 is better option to put money into.
The report generated deep understanding of financial analysis in respect to the organization. It brings forth the degree to which financial planning is important. It also provides an overview of the manner in which financial analysis is carried. The application of ratio analysis adds flavor to financial statement analysis. Budget analysis on other hand forms the basis for planning for future outcomes. Finally capital budgeting tools are implemented to evaluate the projects. In case of TUI travel plc it is recommended that the company should raise equity capital and improve profitability. In addition as per investment appraisal tools Project 2 is recommended to consider for investment purpose.
- Altman, E., 2012. Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The Journal of Finance. 23(4).
- Annual report and Accounts, 2013. TUI travel plc. [pdf]. Available through: < http://tuitravelplc.com/sites/default/files/TUI_ARA2013_Interactive.pdf#page=5&zoom=auto,0,798>. [Accessed on 31st March 2014].
- Brigham, E. and Ehrhardt, M., 2013. Financial Management: Theory & Practice. Cengage learning.
- Chen, H. and Ward, C., 2000. Evaluating investment projects: The hurdle rate. Journal of Corporate Real Estate.
- Collier, P.M., 2012. Accounting for Managers. 4th ed. Wiley.