Financial Analysis of Electrocomponents - Free Essay Example

Sample details Pages: 9 Words: 2597 Downloads: 2 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Level High school Did you like this example? Brief: 193028 Title: Financial Analysis of Electrocomponents Electrocomponents is a distributor of electronic, electrical and industrial products to customers mainly in the research and development or maintenance field. The company was established as Allied Electronic in North America in 1928 and as Radiospares in London in 1937[1]. It floated as Electrocomponents plc on the London Stock Exchange in 1967. Don’t waste time! Our writers will create an original "Financial Analysis of Electrocomponents" essay for you Create order The company has a global presence with operating companies in 26 countries and distributors in many more countries. It trades as RS in most of Europe, Africa and Asia, Radiospares in France and Allied Electronic in North America. For the year ended 31 March 2006, the company had an annual turnover of  £828.5 million, an increase of 7.1% over the year ended 31 March 2005 (See Appendix I for details). Though the revenues increased by 7.1%, gross profits increased by 3.5% only indicating a drop in gross margin and tighter markets. Operating profits were lower by 32% due to higher marketing and distribution costs. Profits before tax were lower by 34.8% due to higher financial expenses and reorganisation costs. The profit after tax margin in the year 2006 was 5.3% while the corresponding figure in 2005 was 8.7%. This drop indicates lower profitability partially due to one-off reorganisation costs and partially due to marketing and distribution expenses. The distribution indus try is much segmented with a large number of small and medium players. One reason for large number of distributors is the presence of large number of small manufacturers who have entered exclusive distribution rights with different distributors. The company faces following main risks: Economic slowdown. Slowdown in global economy will reduce the demand of its products and hence profits. Fixed costs in terms of warehouse facilities canà ¢Ã¢â€š ¬Ã¢â€ž ¢t be scaled down easily impacting profitability more. Foreign exchange. As Electrocomponents operates worldwide, strengthening of Pound against Euro, US Dollar and other major currencies will lower its revenues and profits in Pounds. Interest rate. Increase in interest rate will reduce profits Chart I shows the two-year share price graph of Electrocomponents. After the end of last financial year in March 2006, share price dropped due to lower profits. But since Sep 2006, share price has again moved upwards expecting higher profits in future. Company announced six months results after Sep 2006. The after tax increased by 4.4% over the corresponding period ended Sep 2005. Increase in profits after a drop in the previous year gave confidence about the company and its share price has increased since then. Chart I à ¢Ã¢â€š ¬Ã¢â‚¬Å" Electrocomponentsà ¢Ã¢â€š ¬Ã¢â€ž ¢ share price movement (Source: Yahoo Finance, https://uk.finance.yahoo.com/q/bc?s=ECM.Lt=2yl=onz=mq=lc=) Electrocomponentsà ¢Ã¢â€š ¬Ã¢â€ž ¢ share price is 290.5 pence[2]. Price to earning ratio is 28 based on the financial year mar 2006. Even if Electrocomponent reaches 2005 earning per share of 15.5, P/E ratio will still be 20, which is high. 2) Appendix II shows the different sources of fina nce for the year ended 31 March 2006. Electrocomponents had total assets of  £703.3 million. These assets were financed by total liabilities of  £366.9 million. Liabilities represent 52.5 % of total assets meaning that out of every  £1 of asset, 52.2 pence is owed to non-shareholders. The company has borrowings of  £160.2 million only as most of the current liabilities are amount owed to trade creditors and non-interest bearing. Net borrowings are only  £120.8 million. As seen in appendix I balance sheet, Electrocomponents had  £133.8 million of tangible assets and hence lenders are fully secured through tangible assets. Gearing ratio = Net debt / (Net debt + Shareholders funds) = 120.8 / (120.8 + 336.4) = 26.4 % Electrocomponents gearing ratio of 26.4% means that financial gearing is moderate and there is not significant fear of bankruptcy due to high gearing. Also if need arises in future, it can take on more debt. Appendix II shows the 5-year dividend history of Electrocomponents. There was no change in dividend in the last financial year in spite of significant drop in earning per share. This is probably because the management thinks that the drop in earnings is temporary and earnings will increase soon. This is also a way of sending strong signal about future performance to the market. Also noteworthy is the fact that in all five years, dividend to earning per share ratio is more than 1. This is possible because cash flows from operations were more than the net profit and cash outflow was higher than cash inflow. Now we analyse the cost of capital which has two components à ¢Ã¢â€š ¬Ã¢â‚¬Å" cost of debt and cost of equity. Most of the debt was at 3.7%[3]. Since then the bank rates have gone up by 0.75%, so cost of debt, Rd = 4.45%[4]. Cost of equity capital = Re = Rf + Be*(Rm à ¢Ã¢â€š ¬Ã¢â‚¬Å" Rf) Risk-free rate, Rf = 4.96 %[5] (10-year yield on UK gilt) Expected market return, Rm = 12 % Beta = Be = 1.52, as calculated in question 4 Re = 4.96% + 1.52*(12% 4.96%) = 15.66% Cost of capital = R = Rd*(1-T)*D/(D+E) + Re*E/(D+E) Where E = Shareholders funds =  £336.4 million D = Debt =  £160.2 million Cost of capital, Re = 11.61% Appendix IV shows the working capital analysis. Current ratio (current assets / current liabilities), a measure of the liquidity, is 2.26 in 2006 which means for every  £1 of current liability, the company has  £2.26 worth of current assets. Current ratio of more than 1 means that current liabilities can easily be met without resorting to fixed assets. A more conservative measure of liquidity is quick ratio which is current assets minus stock divided by current liabilities. Electrocomponentsà ¢Ã¢â€š ¬Ã¢â€ž ¢ quick ratio is also more than 1 and hence liquidity is good. Debtor days have increased from 60 to 63 in 2006. The company is using more of its money in financing the business. Creditor days have also increased by 1 to 34 in 2006. As debtor days are higher, the company has positive working capital requirements and hence needs more external financing. 3) According to the efficient market hypothesis, it is impossible to consistently outperform the market. There are three main types of market efficiencies[6]: Weak-form efficiency. According to this, no excess returns can be earned by using investment strategies based on technical analysis although fundamental analysis may give better returns. Semi-strong form efficiency. Share prices adjust within small amount of time and in an unbiased fashion to publicly available new information and hence no consistent abnormal gains cane be achieved by fundamental analysis. Strong form of efficiency. Share prices reflect all information and no one can earn excess returns. Stock Market Efficiency is important for any firm where managers are different from the owners and can lead to principal-agent problem. Absence of SME will reduce the faith of owners and in such scenarios shareholders normally demand a discount in share price. Hence SME is important for the confidence of the shareholders and avoiding a discount in share price. SME is tested by the abnormal share price movement following an important announcement by the company. We check the abnormal share price movement on the day of announcement. Abnormal share price movement is calculated by finding the difference between the share price and expected normal returns based on the market value. Expected normal return is calculated by using beta of the share. If share price shows abnormal return, then all the news was not reflected in the price and hence a violation of the strong form of efficiency. The benchmark market return used for calculating the share priceà ¢Ã¢â€š ¬Ã¢â€ž ¢s abnormal ret urn is the FTSE 100 return as it represents the market by including companies from all sectors. The presence of large number of companies in FTSE 100 index diversifies the specific risk associated with the individual companies and hence gives only market risk. The top 5 price movements were selected on the basis of absolute abnormal share price movement with respect to the FTSE 100 index. Abnormal share price movements were the difference between the daily return on the share price and the expected daily return based on the FTSE 100 index. First we selected the top 10 share price movements à ¢Ã¢â€š ¬Ã¢â‚¬Å" 28 Sep 06 and 27 Sep 06 are treated as one event. Then we calculated the FTSE 100 returns on those days and abnormal returns using beta as below Abnormal return = Share return à ¢Ã¢â€š ¬Ã¢â‚¬Å" Beta * FTSE return Appendix V shows the results. The top five absolute abnormal returns are for the following dates 17 Jan 2007 06 Dec 2006 28 and 27 Sep 2006 28 Jun 2006 16 Mar 2006 To study the events and /or announcements on these days, we looked at the à ¢Ã¢â€š ¬Ã‹Å"Financial Timesà ¢Ã¢â€š ¬Ã¢â€ž ¢ and à ¢Ã¢â€š ¬Ã‹Å"Investegateà ¢Ã¢â€š ¬Ã¢â€ž ¢ website for the articles. Financial Times website gives all the market and company news along with their analysis of the announcements. Investegate website gives all the company announcements. 17 Jan 2007 No announcement in Investegate website and no news on Financial Times. As per any form of efficient market hypothesis there shouldnà ¢Ã¢â€š ¬Ã¢â€ž ¢t be an abnormal return on this day. 06 Dec 2006 No official announcement in Investegate. No news in Financial Times either. Again a case of failure of efficient market hypothesis. 28 and 27 Sep 2006 Release of trading statement on 27 Sep 2006 showing 9 % growth in revenues[7]. Market takes one more day, 28 Sep 2006, to adjust price. Hence semi-strong and strong form of efficiencies are not there. 28 Jun 2006 No new news released except for a formal announcement of posting of annual records[8]. Abnormal movement not justified by efficient market theory. 16 Mar 2006 No new news released and hence abnormal movement not justified by efficient market theory. The above abnormal share price movementsà ¢Ã¢â€š ¬Ã¢â€ž ¢ show the absence of strong and semi-strong form of efficiencies. Academics have presented various studies on market efficiency. Many have also presented market anomalies like January effect. Broader conclusion would be that market is overall efficient, though not strong form, but anomalies do exist. 4) Market risk is the risk associated with the economy as a whole and specific to any industry or a company. Interest rate, GDP growth and inflation represent some of the parameters of market risk. Though they impact companies also but their impact is not limited to some specific companies only. Market risk canà ¢Ã¢â€š ¬Ã¢â€ž ¢t be diversified away by forming a portfolio of companies. The risk that remains in the portfolio of all companies is called as market risk. It is also known as the systematic risk and is common to all securities. Beta is calculated by comparing the returns of the company with that of market. FTSE 100 index is taken as the representative of the market. We have used the monthly returns over the five year period for calculating beta. The monthly returns are calculated by comparing the share price or index with the share price or index level of the previous month. Then the share price returns are plotted on the Y-axis and market returns are plotted on the X-axis. Linear regression is used to plot the least square line and the slope of the line gives beta. The slope of the line is calculated by the regression analysis and the results are shown in Appendix VI. Beta value = 1.45 Adjusted R square of 0.34 indicates that 34 % of the share price movement is because of market movement. Another way of calculating beta is to compare the ratio of monthly returns of stock with monthly returns of the index. Appendix VII shows the values of monthly returns for the last one year. We find beta value for each month by dividing share price returns by FTSE 100 index return. We then take the average value of the betas. Beta value = 1.58 The results of the above two methods are not very different. Normally a 5-year period is used for calculating beta. The one year analysis shows the current movement in the beta compared to the whole 5 year movement and reflects the current trends. The higher value in the last one year indicates that Electrocomponentsà ¢Ã¢â€š ¬Ã¢â€ž ¢ share price moves more in response to movement in the market index. We now take the average of above two values as the beta of Electrocomponents. Beta = (1.45 + 1.58)/2 = 1.52 5) Portfolio effects Individual shares carry both systematic and specific risks. Specific risks relate to the company only whereas systematic risk relate to whole market. When we buil d a portfolio of shares, different shares have varying degree of correlation with each other. Suppose two shares have negative correlation, then a downward movement in one share would be countered by the positive movement in the other share. Because of the different correlations, the risk of the portfolio is reduced. So using a portfolio of assets, it is possible to increase the reward to risk ratio by lowering risk. This is portfolio effect. 6) We now once again look at section 2 for detailed analysis. Electrocomponents cost of debt is estimated to be around 4.5% whereas its cost of equity is 15.66%. When we include the tax deduction on interest payable, cost of debt comes down further. This means the company should use more of debt than equity. Since gearing ratio is only 26.4%. Electrocomponents should use more of debt than equity to fund future growth and return excess capital to shareholders to bring down total cost of capital. Electrocomponents is paying more dividend than cash generated from internal resources. If it reduces dividend, it will send negative signal to the market. But with the increase in earnings in future, it should try to grow dividend slowly than earnings growth to generate more dividend from within. Electrocomponents debtor days are almost twice its creditor days meaning that it has requirement of working capital. It is due to the nature of the business where it has to stock material before it can ship to its customers. It would be better if the company can increase creditor days and reduce debtor days. This would reduce the working capital and hence total funding requirement. 7) Electrocomponents is a distributor of electrical, electronic and mechanical products and has a global presence. It has grown over the year by expanding globally. The profitability of the business reduced in the year ended 31 Mar 2006 but has announced increase in six months profits for the period ended 30 Sep 2006. Gross margins are healthy at 50% plus and any increase in sales will boost profits. The company is moderately geared at 26% and can take up further debt either to expand or reduce cost of capital. Cash flow is an issue because of high dividend payouts. Electrocomponents also needs to manage its working capital because of debtor days being double of its creditor days. Though the company is again increasing profits, the high P/E ratio even on 2005 profits level makes it expensive. Also slow down in economy may have an impact on profits. BIBLIOGRAPHY AND REFERENCES Electrocomponents, Annual Report 2006 https://www.investis.com/ecm/reports/annual_report06/index.html, 13 Feb 2007 Appendix I Summary Financials Profit and Loss statement Balance Sheet Cash flow (Source: Electrocomponents, Annual Report 2006) Appendix II Sources of finance (Source: Electrocomponents, Annual Report 2006) Appendix III Dividend history (Source: Electrocomponents, Annual Report 200 6) Appendix IV Working capital analysis (Source: Electrocomponents, Annual Report 2006) Appendix V Abnormal return calculation (Source: For Electrocomponents share price https://uk.finance.yahoo.com/q/hp?s=ECM.L For FTSE 100 index https://uk.finance.yahoo.com/q/hp?s=%5EFTSE) Appendix VI Beta calculations (Source: For Electrocomponents share price https://uk.finance.yahoo.com/q/hp?s=ECM.L For FTSE 100 index https://uk.finance.yahoo.com/q/hp?s=%5EFTSE) Graph of Electrocomponents monthly returns and FTSE 100 monthly returns Regression Analysis Appendix VII Second way of calculating beta (Source: For Electrocomponents share price https://uk.finance.yahoo.com/q/hp?s=ECM.L For FTSE 100 index https://uk.finance.yahoo.com/q/hp?s=%5EFTSE) [1] https://www.electrocomponents.com/ecm/about/history/ [2] https://uk.finance.yahoo.com/q/hp?s=ECM.L, Date 13 Feb 2007 [3] https://www.electrocomponents.com/ecm/ir/reppres/reports/reports06/annual06/ar06indexed/p.pdf [4] British Bankersà ¢Ã¢â€š ¬Ã¢â€ž ¢ Association, https://www.bba.org.uk/bba/jsp/polopoly.jsp?d=141a=627 [5] https://specials.ft.com/siterefresh/stats/pdfs/tenyeargovbondspreads/SPR130207.pdf [6] Wikipedia, https://en.wikipedia.org/wiki/Efficient_market_hypothesis, Date 13 Feb 2007 [7] https://www.investegate.co.uk/Article.aspx?id=200609270700445241J [8] https://www.investegate.co.uk/Article.aspx?id=200606280924432822F