Ratio Analysis for Building Company

Ratio Analysis for Building Company Title: Ratio analysis for Bellway Company About Bellway plc The Bellway Group is one of the largest housebuilders in the U.K. It was established in 1946 by John T.Bells and his two sons[1].The Group’s operations are spread throughout the country. The key activities of the Group include: land acquisition, finance, planning, architecture, design, build management, marketing and customer service. Bellway builds low-cost homes and apartment blocks on disused or abandoned sites. Position and Strategy Bellway sells around 6,000 houses every year and has till date provided more than 100,000 homes. The houses are designed, built and marketed by local teams operating from regional offices. These offices are managed and staffed by local people. The company employs about 2,000 people with varying expertise. Corporate Social Responsibility The Group has adopted five principles in their day-to-day operations to minimise the environmental effects of the building process and create sustainable communities: â€Å"Protection of the environment Prudent use of natural resources Creating environments that have the potential to add to economic growth and employment opportunities Social considerations that recognise the needs for a changing and advancing population The creation of communities that will endure and where people will aspire to live† Source: Bellway p.l.c. Annual Report Accounts 2007 The Group reports on these five principles in its Annual Report. Performance Overview of Bellway Group The housing industry has been facing challenging market conditions since the last few months. However the Chairman of the Group has made the following statement in the Annual Report of the Group for the year ended 31 July 2007. â€Å"Bellway has, yet again, produced a very good set of results for the year ended 31 July. The Group continues to deliver organic growth in volumes and earnings despite the challenging market conditions experienced by the housing industry over the last twelve months.† The present paper attempts to examine the reality of the statement by doing a ratio analysis to assess the financial health of the Group based on its Annual Reports for the year ended 31 July 2007. Performance Overview The key highlights of performance in the year ended July 2007 over the previous year are given in the table[2] below: In the next section a detailed analysis of the financial performance and health of the Group has been examined on the basis of: Performance Ratios Working Capital Efficiency Ratios Investment Ratios Financial Status Ratios PERFORMANCE RATIOS Return on capital employed (ROCE) Profit before Tax and Interest Payable = x 100 Total Assets less Current Liabilities * This is taken as equal to operating profit plus interest income The ROCE of the Group is around 22% in the year ended 2007. Despite a 6.5% increase in the Profit before Tax and Interest Payable in 2007, the ROCE stands at the same figure as in 2006. This only indicates that the net assets have also increased in the same proportion as profits. However, there has been no improvement in the efficiency in employing theses net assets to generate profits. Moreover, ROCE for the Group is lower than five year average ROCE achieved by builders over UK which stands at 25–30%[3]. Thus, the efficiency in employing net assets to generate profits for the Group is lower than the Industry average. Asset turnover Sales Turnover = Total Assets less Current Liabilities The asset turnover ratio of 1.165 indicates that a sale of  £1.165 is generated from each  £ invested in assets by the Group. This ratio has increased by around 3.6% in 2007 over 2006 which is a good sign. The increase is primarily due to an increase in total assets and also a corresponding increase in the sales turnover. Net profit margin Profit before Tax and Interest Payable = x 100 Sales turnover *This is taken as equal to operating profit plus interest income Despite the increase in profit before interest and taxes and also sales turnover, there is a slight decline in the net profit margin from 19.5% in the year ended 2006 to 19.1% in the year ended 2007. The decline indicates that proportionate increase in cost of operations has been higher than the increase in sales. Thus, there has been a decline in the efficiency of sales to generate profits. Gross profit margin Gross Profit = x 100 Sales turnover There has been a decrease in the gross profit margin of the Group by 0.6% despite the increase in sales revenue. The decline in the gross profit margin has been due to a larger increase in cost of sales as compared to corresponding increase in sales. Sales revenue has increased by 9.2% over 2006. The corresponding increase in cost of sales has been 9.9%. The decline in the gross profit margin also explains to certain extent the decline in net profit margin. WORKING CAPITAL EFFICIENCY RATIOS Inventories (or stock) turnover Stocks and Work in Progress = x 365 Purchases (or Cost of Sales) The housebuilding industry by its very nature has slow moving stock / inventory. In 2007, as compared to 2006, there has been a decline in the number of days the stock takes to be converted into sales. The stock is getting converted into sales in 538.65 days in 2007 as compared to 552.16 days. This is an improvement of around 2.4% over 2006. Trade receivables (or trade debtors) turnover Trade Debtors = x 365 Sales Turnover * All sales are assumed to be on credit Though it takes less than 1 week to collect receivables, the increase in the time taken to receive payments from customers must be examined carefully before it gets out of hands. An increasing ratio also indicates that the company is taking more time for collecting its payments. Thus, each  £1 of its sales revenue stays tied up in trade receivables for a longer period. Trade payables (or trade creditors) turnover Trade Creditors = x 365 Cost of Sales ** All purchases are assumed to be on credit There has been a decline in the average settlement period for trade creditors by almost 17%. This is not a good sign as trade credit is a type of free finance available to a company. A declining ratio indicates that suppliers in the year ended 2007 gave a lower credit period to the Group as compared to the previous year. This becomes a bigger cause of concern as the Stock Turnover ratio for the Group stands at a high figure. It may also have adverse implications for the Group’s liquidity position. INVESTMENT RATIOS Earnings per share (EPS) Profit before Ordinary Dividend = No. of Ordinary Shares in issue EPS reflects upon share performance. Thus EPS trend of the Group highlights the investment potential of its shares. It also highlights the possibility that the company will pay a dividend[8]. There has been a 6.2% growth in the diluted EPS of the Group in the year ended 2007 as compared to 2006. This indicates that the potential of the shares of the Group is growing. This increase in EPS is primarily due to an increase in the profits with no corresponding increase in tax rates. Price earnings ratio(PE) Market Value per Share = Earning per share In general, if the PE ratio of a company is high it implies that investors are optimistic about the company’s future and are expectinghigher earningsgrowthin the future compared to companies with alower PE. However, the ratio can only be interpreted appropriately when compared to historical PE ratio or industry benchmarks. Group’s historical PE ratio The PE ratio for the Group has been constant over the previous two years. The ratio needs to be examined in light of the deteriorating industry scenario over the last two months. The PE ratio calculated above may not hold true today and would have declined substantially. This is because housebuilding is a cyclical business where earnings fall exponentially as sales prices decline. Recent times have seen a substantial decline in sale prices. If the PE is calculated at the share price of 713.5p[9] as on 25 April 2008, assuming earnings to be constant at 31 July 2007 level, it will be only 4.9. Thus, actual PE will be lower. Industry average The following diagram[10] highlights the PE ratios of 8 leading housebuilders in UK as on 21 July 2007. The diagram clearly indicates that Bellway is towards the lower end of the selected companies in the industry UK with regard to its PE ratio Dividend yield Latest Annual Dividends = x 100 Current market share price The dividend yield at the current price as on 25 April 2008 = (43.125 / 713.5) % = 6% However, the market price of shares for the Group is much lower than it was a year ago. Historically, the dividend yield has been as indicated in the table below: Dividend cover Profit on ordinary activities after taxation = Ordinary Dividend The dividend cover has fallen despite the fact that the profits have increased. A declining trend makes dividend less secure. However it is not a cause of concern for the Group as the dividend cover is much better than many other companies in the industry. For example, housebuilder Persimmon has cover of 2.69[11]. Thus, if the Group has a cover of more than 3, it could maintain its payout more than thrice over. Return on equity (ROE) Profit on ordinary activities after taxation = x 100 Equity shareholders’ funds The Group shows a decline in this ratio in 2007 over 2006. The decline may be primarily due to increase in equity shareholders’ funds. FINANCIAL STATUS RATIOS Working capital ratio (WCR) Current Assets = Current liabilities The accepted norm for the WCR ratio is that current assets should be double the current liabilities. However, the norm varies with industry. In the case of the Group the ratio has declined but it is higher than the accepted norm. However, a closer analysis indicates that the Group faces a liquidity crisis. A close examination of the current assets indicates that inventories constitute more than 95% of the current assets. This, added to a high stock turnover ratio, will not let the Group meet its current obligations. A clearer picture of the liquidity is provided by the Quick Asset ratio. Quick assets ratio (QAR) Current Assets Stocks = Current liabilities The norm for this ratio is 1: 1. However, it again varies from business to business. The ratio is far below the norm. In other words, the Group has no way of covering up its current obligations. This is a cause of concern and can lead to survival problems also if the condition persists. Gearing Long-term Debt + Preference Shares = Total Assets less Current Liabilities *These include preference shares of  £20,000,000 in both the years The gearing or dependence on debt has decreased by about 7% for the Group. Thus, there has been a decline in the Group’s risk as lesser amount is committed for periodic interest and repayment commitments. This is especially welcome in the time of deteriorating housing market conditions. Interest cover Profit before Tax and Interest Payable = Interest payable Despite the decline in gearing, the Group’s interest cover for the year ended 31 July 2007 also shows a slight decline. The decrease in interest cover from last year is due to a higher increase in net interest payable than increase in profit before tax and interest. Conclusion: To conclude it can be said that Bellway has performed well in the year ended July 2007 over 2006 in terms of profitability as well as increased sales. However, it faces a major short-term liquidity crisis. This is a cause of concern as the UKs housebuilding industry, in general, is expected to be facing more difficult times ahead due to credit crunch and declining consumer demand. References: Atrill Peter McLaney Eddie, Financial Accounting for Decision Makers, 5th ed. 2008 , FT Prentice Hall Barker Review Interim Report, The Housebuilding Industry, accessed from http://www.hm-treasury.gov.uk/media/2/9/barkerreview_interim_chapters4to6.pdf Bellway p.l.c. Annual Report Accounts 2007 Elliott B. and J. Elliott, Financial Accounting and Reporting, 11th ed. 2007, FT Prentice Hall HIFIC Barnard Report, Future Trends in Timber Construction and Implications for HIE Region, accessed from www.forestryscotland.com/pages/download2.asp?file=attachments/HIFIC_Forres%2007_Barnard.pdf Steed, Alison, Five ‘safe’ shares for hard times, The Sunday Times 20 April, 2008 Team Limited, The Cartel- Like Industry, accessed from http://www.teamlimited.co.uk/Assets/pdf/Building-Barriers.pdf Yahoo finance, accessed from http://finance.yahoo.com/q/pr?s=BWY.L Hemscott website accessed from www.hemscott.com Brief: 209439Page 1 of 13 [1] Source: http://finance.yahoo.com/q/pr?s=BWY.L [2] Source: Bellway p.l.c. Annual Report Accounts 2007 [3] HIFIC Barnard Report, Future Trends in Timber Construction and Implications for HIE Region, accessed from www.forestryscotland.com/pages/download2.asp?file=attachments/HIFIC_Forres 07_Barnard.pdf [4] Ideally average stock and work in progress figures should be taken for calculating the ratio as they give more accurate ratios as average inventory accounts for any seasonality effects on the ratio. However, in the case of house building industry seasonality effect is not there. Moreover due to non-availability of 2005 figures, end of the year figures are used. . [5] Ideally average trade debtors figures should be taken for calculating the ratio as they give more accurate ratios. However, due to non-availability of 2005 figures, end of the year figures are used.. Trade receivables do not include other receivables not arising from sales (Refer Note 13 of Bellway Annual Report pp 68) [6] Ideally average trade creditors’ figures should be taken for calculating the ratio as they give more accurate ratios. However, due to non-availability of 2005 figures, end of the year figures are used. Trade payables do not include other payables not arising from purchases (Refer Note 15 of Bellway Annual Report pp 69) [7] Diluted EPS is based on the total outstanding shares after all Options and awards have been exercised. [8] EPS only indicates the possibility of a dividend. However, dividend decision is a corporate decision and there is no rule of thumb regarding its size and frequency. [9] http://finance.yahoo.com/q?s=BWY.L [10] Based on PE ratios published on 21 July 2007 by www.hemscott.com [11] Steed, Alison, The Sunday Times, 20 April 2008