This business analysis report will help in providing an insight of the profitability, P/E Profit to earnings ratio and the recent trade performances of two established consumer retail apparel companies, Burberry which is listed in the United Kingdom (UK) and GAP Inc. which is listed in the United States of America (US). A financial analysis of any organisation helps in assessing the various determinants of the financial performance of the company by providing an evaluation for the strengths and weakness of the respective organisations providing with the directions where the management should concentrate for maximization of wealth.
Speciality Apparel Stores are considered as a subset for the retail industry where a customer can find clothing, accessories as well as footwear under one store. These stores typically sell only merchandise which has been manufactured by them. Typically one finds that such speciality apparel stores focus one type of customer where the overall assortment of the merchandise in the store has a common theme such as luxury goods.
Numerous discussions have taken place whether in conferences, in actuarial literature or individuals who have held interest in combating the various issues that are prevalent in what one calls providing a fair value to any organisation. One finds there are numerous bodies of literature present which explains the different practises for accounting, taxation, regulations and different financial ratio’s where each providing with their estimated fair value. Traditional approaches of financial ratios’ surprisingly today are termed as inadequate.
Primary conscientiousness of any organisation is to increase their profits and market share while striving to increase their market returns as well as maximization of wealth for their investors and shareholders. A large part of depends on the policies and strategies of the various organisations. Profitability ratios help in determining the efficiency of the operations and management of these organisations.
A peer analysis will help us in understanding the nature of business of the two companies and help create a portfolio which would distinguish the difference between the various profitability ratios of these versatile companies. Decomposition method for the various profitability ratios would be used in order to determine the financial and operating leverages both the organisation are able to use. For any organisation its profitability stands on two basic pillars which are ROA (Return on Assets) and ROE (Return on Equity)
A detailed reformulation of the income statement, balance sheet and key ratios of both the organisations helps us in studying the both the sustainability as well as diligence of the earnings of the organisations, their fundamental differences in accordance with their financial perspectives as well as their P/E ratio (Price to Earnings Ratio). Beaver and Morse (1978) and Penman (1996) have shown that P/E ratios, while definitely linked to prospective earnings growth but they are also found to be negatively connected to present earnings growth, showing empirically that the P/E ratio can be found to be affected by transient current earnings. Ou and Penman (1989b) have found that even though one finds that accounting fundamentals might explain P/E ratios but that is done primarily be dredging data.
The global and highly competitive worlds today assess the profitability of their competitors helps in determining the market power of the company. One finds that it is imperative for the any organisation to see that their returns not only help them cover the costs of replacing their assets but also any presence of excess profit year after year would lead to indication of existence of the high market power of these organisations as well as difficult entry barriers.
All the financial data that has been collected for Burberry and GAP Inc. has been collected through secondary sources which include the internal resources of the organisations such as annual reports of the respective companies. Some external sources were also used for the collection of data which include online journals and articles, company websites, yahoo finances, previous researches on decomposition method and Thompson One Banker. The reformulated income statements and balance sheets for both the organisations range from five year period of financial statements from 2007 to 2011. The various profitability ratio’s on the other hand as well as the industry average for both UK and US have been considered for the last ten years 2002 to 2012.
Ball and Brown (1968) and Beaver (1968), are considered to have initiated the various studies towards the financial analysis of financial statements in terms of accountability, profitability and efficiency. In order to determining the profitability, strategies and the various risks associated with various organisations, one finds constant evaluation of the current performance and the financial position of the organisation both over the time as well as across various companies.
One of the most elemental tools for financial analysis of any organisation is financial ratios. However in today’s competitive dynamic world where profitability and maximisation of wealth are the underlining words classical financial ratios namely asset turnover, profit margin, financial leverage etc have lost their importance in a market based empirical accounting methods. Instead of traditional profitability analysis alternative methods such as Penman Method and Palepu & Healy method are considered to be more accurate in determining the leverage an organisation can exert through their operations as well as financing activities.
Several scholars, conspicuously Nissim and Penman (2001) have now attempted in developing a structural and significant approach to the analysis of financial statements of an organisation in relation to their financial ratio to equity ratio. They have identified financial ratios various school of thoughts have investigated different compositions for the valuation and profitability of an organisation by numerous scholars. Some of the major contribution in this research comes from Fairfield and Yohn (2001), Penman and Zhang (2004) and Soliman (2004). Traditionally in order to understand the leverage an organisation has, the measure of total liabilities to equity was enough. However there was absence of any scope of distinguishing the operating liabilities from financial liabilities. As a result, explicit equations were composed which would not only differentiate between these two liabilities but would also help in understanding the fact that whether leverage from any of the liability would provide positive or negative result.
Freeman, Ohlson and Penman (1982) in their work proved that in order to make predictable future earning probabilistic a person needs to consider one just single element that is the book value to the current earnings, where the earnings were found to be temporarily directly proportional to the book value. Higher earnings led to momentarily higher book value and vice versa. Forecasting earnings got further complicated with introduction of additional financial statement ratio Ou and Penman (1989a). Lipe (1986) showed that in order to improve income state forecasts the line-item analysis was more accurate. Fairfield Sweeney and Yohn (1996) reported similar findings. One finds that there have an arrays of different works which shows a lack of structure among the different literary works but the overall result has lacked in development of innovative practices.
Penman and Nissim (2001) have identified various financial ratios such as leverage, RNOA (Return on net operating Assets) which are correlated to the market value of equity. They have based their methods on the model of residual earning valuation. Fairfield, Whisenant and Yohn (2001) related that the financial statement measures of growth to the estimation of diligence. Penman and Zhang (2004) on the other hand contributed in concluding that the use of RNOA helps analysts in forecasting stock returns to almost two years later whereas only one year future stock predictions can be found out by using the traditional asset turnover and profit margin. Soliman (2004) on the other hand studied the various market reactions to key financial ratios.
One finds a lack of study in the field that explains how analysis of financial statement would assist in determining the P/E ratios. Molodovsky (1953) gave the “Molodovsky effect” according to which P/E ratio has been found to be affected by transitory current earnings. Similar studies were obtained by Beaver and Morse (1978) and Penman (1996) for the variance of P/E ratios.
Conventional profitability ratios, i.e. ROE fails to reveal a wide array of questions such as how profitability is linked to operating activities in the organisation or how the taxation has impacted the profitability. ROE is also ambiguous in providing an answer whether sustainable growth can be achieved by any organisation or whether profitability can be increased by better asset management. For a better understanding for the above all questions decomposition of the various financial ratios has become important. ROE typically explains how profitability it employs assets and also explains the organisations assets base in accordance to the shareholder investment.
Traditionally in order to remove these conflicts, ROE was decomposed into three elements, SPREAD, ROA and financial leverage so as to compensate for both operating (ROA) and financial leverage (SPREAD, financial leverage) so as to obtain the core profitability of the organisation.
One of the ways of conveying ROE is
ROE A¼A ROA A¼”¹ Financial leverage Aƒ- SPREAD (1)
ROE = ROA Aƒ- Financial Leverage (2)
Financial Leverage = total liabilities/equity capital
While calculating FL, the numerator is total liabilities where it is including liabilities from both the financial and operating liabilities.
ROA = EBIT/ Total assets
One finds that while calculating ROA, the denominator is total assets which includes all types of assets which includes both operating and financial activities whereas ROA focuses on operating activities hence is called as a driver for operating factor.
Similarly, if we use SPREAD, since it is calculated by subtracting r from ROA, and already ROA is not differentiating between operational and financial activities SPREAD calculation also becomes inconclusive.
The above results show how important it is to reformulate the income statements and balance sheets and then decompose the various financial ratios so as to obtain a correct figure for the profitability of the organisation.
In order to determine the profitability of Burberry and GAP Inc. we will be using Penman Decomposition method of profitability which supports the theory that while calculating the profitability of any organisation it is important that the financing factor as well as the operating factors are analysed separately. This would help in absolving the traditional difficulties or problems of accounting the profitability of an organisation.
Reformulation of the income statements and balance sheet of both the companies are done in order to distinguish the incomes that come from operating activities while those that are derived from the financial activities. Profitability is calculated both for operating activities and financial activities separately and both the leverages (operational and financial) are then explained in order to obtain the overall profitability for the shareholders.
According to Penman method,
ROCE = RNOA + FLEV X SPREAD (3)
ROCE is “Return on Common Shareholders’ Equity” which is Penman’s equivalent to the profitability of the organisation. ROCE corresponds to the traditional ROE for profitability. One find that nancing debt levers ROCE.
ROCE = CNI/CSE (4)
(Acronyms as used in Penman Paper)
CNI equates to Comprehensive Net Income (CNI) and CSE is Common Shareholders’ Equity (CSE) or Common Equity (CE) which is equal to the equity capital. One finds that both the numerator and denominator are being affected by the leverage but which has been absolved by the reformulated financial statements. CSE can be calculated from the balance sheet
CSE = Net operating Assets – Net Financing Debt (5)
CNI = OI- NFE (6)
Operating Income (OI) cannot be found in standard income statement. Its value is derived by subtracting operating revenues (OR) from operating expenses (OE). In the normal income statement, operating income is calculated by subtracting operating expense from the gross margins. Operating income is produced through operations activities whereas the net financial expense (NFE) is incurred in the financing of such operations activities. It should be noted that all calculations for the net financial expense/income or the operating income of an organisation are done after tax.
ROCE can also be expressed as
ROCE = RNOA + FLEV X SPREAD (7)
RNOA = OI/NOA (8)
Net operating Assets (NOA) helps in distinguishing the financing factors from the operating factors. It is calculated by subtracting operating leverages (OL) from operating assets (OA).
RNOA calculates the profitability factor on the basis that only the assets used in the operations should be taken into consideration. It is seen that the value of RNOA becomes higher if the operating liabilities of an organisation in relation to their operating assets is higher but it is based on the assumption that the numerator of the RNOA has no effect on the operating income of the organisation.
RNOA = PM X ATO (9)
Profit Margin (PM) and Asset Turnover (ATO) where,
ATO = Sales/NOA (10)
FLEV = NFO/EC (11)
Net Financial Obligation focuses on the financial liabilities of the organisation and can be obtained by subtracting financial assets (FA) from financial obligations (FO). Equity Capital (EC) talks about the capital arranged through equity by the firm.
While calculating FLEV it is seen that it includes the financial assets which are the net against the financing debt but excludes operating liabilities. FLEV comes out negative when an organisation has financial assets much larger than their financial liabilities. It is FLEV which eventually shows which profitability of the organisation is due to financial activities and which are due to operational efficiencies.
SPREAD = RNOA- NBC (12)
NBC = NFE/NFO (13)
Net Borrowing Cost (NBC) represents the ‘r’ of the traditional method of profitability. NFO has already been calculated in equation (11) whereas Net Financing Expenses (NFE) is obtained by subtracting Finance Revenues (FR) from Finance Expenses.
SPREAD can be favourable (positive) or unfavourable (negative).
P/E Ratio = Price of Share/Earnings (14)
A comparison of the above financial ratios of both Burberry and GAP Inc have been done in order to demonstrate which firm is profitable than the other. There is also the comparison of both the firms within the country where they are listed.
Brief Introduction of Burberry and the Economic Conditions it operates in
Burberry was founded in the year 1856 by Thomas Burberry in Basingstoke, United Kingdom. It is primarily a leading global luxury brand house whose roots can be found in the British heritage. The global luxury sector in which Burberry operates has been largely estimated at a approximately 160 billion pounds. Burberry largely deals in designer clothing, fashion accessories and licensing fragrances which are designed, manufactured and market by them. Burberry is both listed and headquartered in London and is considered to have one of the most recognised icons in the world, with its Prorsum horse logo, trademark check and the trench coat (Burberry 2011a). Burberry uses a much diversified range of networks for its global distribution through wholesale, retail, digital commerce as well as licensing channels. It has been granted status of royal warrants and its trench coats are one of the world’s most famous iconic design. Currently Burberry is distributing its produces, in Americas, Asia Pacific and Europe through a three way means, precisely by channel, by region and by product.
According to their annual reports, the total revenue for Burberry for the year 2011 stands at 1857 million pounds an increase of 24% from the last year. The primary revenue is generated through their retail enterprise of approximately 1270 million pounds. Their wholesale enterprise has generated 478 million pounds in the last fiscal year.
There are five core strategies which the management of Burberry intends to follow in the current year Burberry’s five core strategies. The company already has an average space growth rate of 14% in their retail sector and aims at expanding at a similar pace both in new markets as well as older markets. In order to remain ahead of the competition, Burberry encourages tremendous design innovations so as to uphold their tradition of having a compelling wide array of products. Burberry as a brand continues to rise because of it backing by some of the most forward assessing digital marketing in the customer sector. IN order to build and strengthen it foundation more powerfully, there has been an active efforts by Burberry of increasing their presence in the new luxury markets such as Japan, China, India and Brazil. The company further aims in seeing that their operating activities are more efficient (Burberry 2011a).
A look at the Burberry group reveals that the success of the company is riding on its wide and highly diversified geographical presence and networks along with their strong branding. Burberry is finding a lot of growth opportunities with the increasing opening of avenues in the form of emerging markets where these luxury fashion goods are in increasing demand as well as the increase of internet penetration both in emerging and developed economies helping the company in establishing its presence in online retail.
Fashion retail has been referred as a typical consumer goods sector where some it common characteristics can be defined by the fickle every changing consumer preferences, a product with a very short life cycle, not only having various competitors but also numerous retail alternatives. The entry and exit barriers are relatively easy and one finds abundant manufacturing and marketing techniques in the (Richardson, 1996)
Currently Burberry is facing an extremely challenging external environment where the aftershocks of recession of the European market can be seen in the overall performance of the company. Less disposable income, discretionary spending on luxury goods, easy to substitute and weak efficiencies are some of the factors which is plaguing the company for a long time.
Burberry is also struggling maintaining customer loyalty as in today’s highly competitive globalised world one finds that the consumer preferences are changing constantly and companies are finding it difficult to retain their consumers. The fashion industry is seeing changes in the trends which are much faster in nature and there is always a risk associated that the consumers might like the new entrants better than established luxury houses(Burberry 2012a).
Luxury fashion houses have been almost immune to the global financial crisis in comparison to other industries primarily because they were able to sustain their profitability due increase in revenues from Asia pacific region specially China. But one sees that even in these rising economies are now being bogged down and their economic growth rate has seen a considerable decline from their progress for the last three or four years. Burberry has posted revenue of 408 million pounds for their quarter through June in 2012, which one sees that is slightly below the 416 million pounds forecast by analysts. Burberry had seen a astronomical 34% growth rate in their first quarter in the year 2011 while the gain for the first quarter in 2012 is has come down sharply to 11% in terms of constant currencies. 38 percent of the revenue of Burberry has been accounted by the Asia pacific region in the previous year of 2011. The overall growth of the company has also seen a fall from 67 percent last year to a meagre 18 percent in the current year. One finds that the company in addition to the above economic situations is also dealing with the natural disaster in Japan and the slow recovery of the US market from it recession (Burberry 2012).
Burberry’s operation activities are considered as some of the highly inefficient in the industry. They not only lack a proper vertical integration but also almost all their activities have been outsourced. The company is still finding integration in the retail business in rough weather even though it is trying to increase its presence. The company scores high in its low transactional exchange exposure and its licensing agreements in Japan and other countries are providing them with high return on their invested capital. One of the major risk associated with Burberry is it high dependence on the high end apparel segment for their overall profitability figures which faces enormous fashion risk and has a high chance of being copied (CSFB Research 2011).
Brief History of GAP Inc. and Economic Conditions it faces
The GAP Inc. was founded in the year 1969 by Donald G. Fisher and Doris F. Fisher is a global speciality apparel American company. Currently the company offers clothing, personal care products and accessories for men, women and children under the retail store method with approximately 3076 stores worldwide out of which it has almost 2551 stores in US alone. Gap is headquartered in San Francisco, California, United States and is listed in the New York Stock exchange. Gap currently operates in US, UK, France, Japan, China and Canada. Gap currently operates through five different brand names, precisely, Athleta, Banana Republic, Old Navy, Piperlime and the namesake GAP (GAP 2011a).
IT is interesting to note that even though GAP is a public listed company yet it is largely a family controlled business. GAP operates under two segments; one is the flagship retail store outlets and the online platform which is practised both internationally and domestically. The second segment is the franchise agreements through which it runs stores in Asia, Africa, Australia, Eastern Europe, the Middle East and Latin America. As a result it operates in almost 90 countries. GAP has generated 14.5 billion dollars in the year 2011 with its net income standing at 833 million in the same year (GAP 2011a).
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