Upholstery Markets

Chapter 1

1.1 Introduction

1.1 Market Trend

Before the early twentieth century, upholstered furniture was not common household furniture. In the later twentieth century, the household furniture started making headline. In upholstery, there are different types of fabrics and textiles, and there are varieties of product available.

1.2 The Upholstery Markets across the Globe

The global market for upholstery furniture, sofa and bed market has gone through series of trends in terms of growth. In recent years, the rate of growth of this industry has been greatly affected by the spending of the consumers and the condition of the housing market. During the period 2000 – 2002, consumers have experienced a great deal of confidence in this market because of the easy access to housing mortgage.

The wooden furniture trade was estimated at $45billions worldwide in 2000, and this was based on the selling price of the manufacturing. This is small when compared with the globe trade of woods that are primarily processed that was estimated at $240billions. Japan and USA are the two main countries where furniture market is substantial. These two countries account for 37% of the global trade. However, the Asia, Eastern Europe, and Latin American are very competitive in the domestic furniture market.

Enhancing the industrial productivity is the principal economic goal of a nation. Therefore, a way of doing this is to increase the competitiveness by employing the resources in an efficient manner.  The table below indicates the labour productivity figures in different countries in the furniture industry. It explains the value that is being added per employee is not as a result of the production input only, but also market and product ingenuity. In Asia, the value of value added attained is less compared to Italy, Germany, United States, and Taiwan.  The cheaper production of raw materials and labour in Taiwan has made it cost sustainable as one of the leading export countries in the world. The main strength in this country is as a result of the structural difference in the manufacturing strategy.

In Russia, the market for upholstered furniture is one of the most popular markets during the 2006-2007. The market tries to distinguish its market from other western world, and a main difference of this market from the rest is the fact that the manufacturers are required to think and develop. This makes them to develop and advance in the products they manufacture, and are able to produce varieties of upholstery product in a year and as a result, the sales go up. As a result of this, the number of furniture supermarket in Russia increased. However, the Russian market lacks the clarity. Its main concern is the companies’ revolution. The market lacks the authenticity of analysing information on manufacturer, as well as furniture realisation. Since the building boom in Russia in 2000, and in 2005, there was increase in the number of constructed apartment and as a result, the upholstery market experienced boom.

The United Kingdom upholstery market has experienced series of growth over the years, and in 2004, the rate was estimated to be around 2%. Due to the import rate in some part of the sector, price competition is curbing the growth in both the bed and upholstery market. During the period 2000 – 2004, the market experiences a high consumer confidence as a result of the buoyant housing market.  During the 2003, the market had experience an increase in growth, and 90% of it was from the domestic market while the rest of the 10% was from the hotel and leisure sector. Some parts of the sector are responsible for this growth.

1.3 Analysis of companies in the same industry

It is important to analyse three other companies in the same industry as SCS Upholsteries. The companies identified are King Fisher Plc, Carpet Right Plc, and Home Retail Group. These three companies are also in the upholstery furnishing industry and their analysis will help as a bench mark for SCS Upholstery.

Kingfisher plc is the leading home improvement retailer in Europe and Asia, and the third largest in the world.
Carpet right plc is Europe’s leading specialist floor covering retailer. Since the first store was opened in 1988 the business has followed a controlled store expansion programme developing both organically and, in recent years, through acquisition within the UK and other European countries.

Home Retail Group, the UK’s leading home and general merchandise retailer, which comprise both Argos and Home base in the annual report. Its first Annual Report for the financial period ended 3 March 2007. The financial period is shorter than a full year due to the change in year-end and it also includes certain financial impacts of GUS plc’s ownership of Home Retail Group up to the point of demerger on 10 October 2006. In 2006, there was a major step in transforming GUS, with significant disposal, acquisitions and organic investment.

1.4 About SCS Upholstery Plc

SCS Upholstery Plc is a national retailer that has been in existence for more than 100 years and specialises on selling in lounge room sofas and chairs.

They are positioned in the middle-market of the upholstery retail sector offering excellent value, choice and service to their customers.

The increased the number of stores from 70 in 2005 to 95 stores nationwide in 2007, 91 of which are in prime out of town retail park locations with a high quality fit out and mezzanine floor. Their branches network has developed through regional clusters supported by 11 distribution centres, designed to deliver cost synergies in distribution and through effective use of national media.

The company do not manufacture but source their products from 15-20 principal suppliers with whom they have developed good working relationship.

The company employ the best people in whom they invest heavily in training with a focus on customer service. Remuneration packages, which contain significant incentives based upon sales and profits, provide the focus on maximising profits and managing costs and support the successful implementation of strategy.

1.5 Financial Review

Financial overview for four years

Revenue was £183.8 million for the ten months ended 28 July 2007 (twelve months ended 30 September 2006: £195.8 million), although there has been significant increase compared to 2004 and 2005. The drop in revenue in 2007 reflected the extremely tough trading conditions which prevailed.

The balance sheet remained very strong with net assets of £36.1 million (2006: £37.6 million) and no borrowings. Comparing these two years to 2004-2005 net asset, there has been has increase of about 73% in net assets from 2004-2006, and 27% increase from 2005-2007. The increase in the net asset over the years is as a result of acquisition of property, land and equipment.

The strong balance sheet and significant operating cash flow generation of the business enabled a continuous expansion strategy and the refurbishment programme whilst supporting the payment of dividends at appropriate levels, all of which is financed from the company’s resources.

The Group had changed its accounting reference date from 30 September to the nearest Saturday to 31 July in order to alleviate the logistical issues created by annual supplier holidays falling during August and the change has taken effect from the current financial period. As a result the comparative figures in the Income Statement, Balance Sheet for 2007 is for ten months and will be assumed to be for twelve months.

Summary Table

	2007	2006	2005		2004
Sales (million)	183,794	195,828	158,295		139,503
Trading Profit (million)	6.6	15.9	14.4		13.8
Gross  margin	47.40%	48.1	48.08		48.33
Earnings per share (pence)	13.68	35.12	38.15		29.76
Dividends per share (pence)	19.0	9	16.5		14
Dividend as a % of earnings (%)	138.89	54.10	43.25		47.00
net asset	36.1	37.6	29.1		21.7

The trend of the profit before tax and the earnings per share is shown is shown in the diagrams below.

The balance sheet remained very strong with net assets of £36.1 million (2006: £37.6 million) and no borrowings.

The financial statement select suitable accounting policies and then apply them consistently; make judgments and estimates that are reasonable and prudent; state whether applicable UK Accounting Standards have been followed, subject to any material departures disclosed and explained in the financial statements; and prepare the financial statements on the going concern.

Business risk

Revenue was £183.8 million for the ten months ended 28 July 2007 (twelve months ended 30 September 2006: £195.8 million). This reflected the extremely tough trading conditions which prevailed during the financial year. The trading profit has dropped for about 58% from 2006 to 2007. The corrective action taken included spare capacity in distribution, which has led increase in the distribution cost to take 5.6% of the 2007 revenue (2006: 4.7%). Also expansion (opening of new stores) and pre-opening and launch cost for the new stores, staff recruitment cost that been taking place has a negative impact on the company’s revenue.

Chapter 2

2.1 Accounting Policies

Basis of preparing the annual reports

SCS Upholstery

The SCS Upholstery financial statement has been prepared according to the IFRS as adopted for European Union use which applies to the group financial statements for the ten month 28 July 2007 and applied accordance with the provision of the company Act 1985. The full details of the accounting policies can be found on the company’s annual report on page 32-34.

The following new standards and interpretations are not applied

The following standards and interpretations have been issued by the IASB and IFRIC with an effective date after the date of these financial statements:
International Accounting Standards (“IAS/IFRS”)
IAS 1: Amendments to IAS 1: Presentation of Financial Statements: Capital Disclosures 1 January 2007
IFRS 7: Financial Instruments: Disclosures 1 January 2007
IFRS 8: Operating Segments 1 January 2009
IAS 23: Amendment to IAS 23: Borrowing Costs 1 January 2007
The Directors do not expect that the implementation of these standards and interpretations will have a material impact on the Group’s financial statements.

Goodwill

Goodwill represents the excess of the cost of acquisition of a business unit over the fair value of the identifiable net assets acquired at the date of acquisition Consolidated goodwill in respect of acquisitions made prior to 1 January 1998 was written off directly against reserves. Future goodwill will be shown as an asset (in accordance with FRS 10) and amortised over its useful economic life. Goodwill previously eliminated would be charged or credited to the profit and loss account on subsequent disposal of the business to which it related.

Going concern

Having made appropriate enquiries, the Directors have a reasonable expectation that the Company and the Group have adequate resources to continue in operational existence for the foreseeable future and for this reason they continue to adopt the going concern basis in preparing the financial statements.

Taxation

The taxation expense is calculated on the basis of the Director’s estimate of the tax rate (annual) which is added to profit for that period. The effective rate for the period is calculated to be 34.3%, and for 12 months till September 2006 is 31.5%.

Operating leases

the operating lease is in accordance with IAS 17.Rentals payable under operating leases are charged in the income statement on a straight line basis over the lease term.

Carpet Right

The company in the past was using the United Kingdom Generally Acceptable Standard (UK GAP). After the European Union issued directive in 2002, the group in July 2002 started preparing its consolidated financial statements in accordance with International Financial Reporting Standards (“IFRS”). In 2007 the financial statements have been prepared in accordance with International Financial Reporting Standards (IFRSs) and International Financial Reporting Interpretations Committee (IFRIC) interpretations endorsed by the European Union, together with those parts of the Companies Act 1985 applicable to companies reporting under IFRS. Financial statement of Carpet right represents 52 weeks ended 28 April 2007, and for 2006 was 52 weeks ended 29 April 2006. The financial statements have been prepared in accordance with International Financial Reporting Standards (IFRSs) and International Financial Reporting Interpretations Committee (IFRIC) interpretations endorsed by the European Union, together with those parts of the Companies Act 1985 applicable to companies reporting under IFRS.

Exceptional items

Transactions which are material by virtue of their size or incidence such as profits or losses on disposal of property, plant and equipment and investment property are disclosed as exceptional items.

Goodwill

Goodwill is capitalised based on the excess of the fair value of the consideration paid over the fair value of the separable net assets acquired. It is carried at cost less accumulated impairment losses.

King fisher

The consolidated financial statement in 2005-2006 is prepared according to the International Accounting Standard Boards (IFRS) as the European Union (EU) directed as well as the International Financial Reporting Standards issued by the International Accounting Standards Board (IASB), and with those parts of the Companies Act 1985 applicable to companies reporting under IFRS. The 2007 consolidated financial statement as also been prepared in accordance with EU standard, as well has IFRIC interpretations and those parts of the Companies Act 1985 applicable to companies reporting under IFRS. The consolidated financial statements have been prepared under the historical cost convention, as modified by the revaluation of certain financial instruments.

Home Retail Group

The Home Retail Group (then ARG) before prepares its financial statement for 12 months to 31 March except for the results of Home base Limited which were included for the 12 months to 28 or 29 February each year, with adjustments to reflect the balance sheet movements in cash to the end of March. This was done to facilitate comparability of the income statement by avoiding the distortions that would arise relating to changes in the timing of Easter.

The accounting policies that are applied to prepare the financial statement are set below. These policies have been consistently applied to all the periods presented, unless otherwise stated, and are in line with the listing particulars.

Home Retail Group separated from its parent company, GUS plc in 10 October 2006.  Home Retail Group companies which were owned by GUS plc prior to demerger were transferredunder the new ultimate parent company, Home Retail Group plc, and prior to 11 October 2006. The introduction of this new ultimate holding company constitutes a group reconstruction and has been accounted for using merger accounting principles. Therefore, although the Group reorganisation did not become effective until 10 October 2006, these consolidated financial statements of. In the prospectus, funding balances between the Group and GUS plc which were interest bearing and had the characteristics of debt, were presented as debt in the balance sheet, with the interest taken to the income statement. Prior to demerger, the net funding balances were reduced by £240.0m by means of a capitalisation and the financial statements reflect this capitalisation as having taken place just prior to 31 March 2005.

Changes in accounting standards

A number of new standards, amendments and interpretations have been put in place at the short period ended 3 March 2007, but have had no material impact on the results of the Group. The impact of IFRIC 4 ‘Determining whether an arrangement contains a lease’ has been reflected through both the current period and prior year within Notes 8 and 31. At the balance sheet date a number of IFRSs and IFRIC interpretations were in issue but not yet effective. The Group has not early adopted IFRS 7 ‘Financial instruments: Disclosures’ and the ‘Capital disclosure amendment’ to IAS 1 ‘Presentation of financial statements’, which are applicable for accounting periods commencing on or after 1 January 2007.

2.2 Financial Ratios

The financial ratio is a simple and better means of assessing the financial position of a firm. The use of ration is useful in comparing the financial position of different companies and also to the industry average. Ratio is grouped into different types, and each explains the financial performance of the company.

2.3 Profitability Ratio

It measures the firm’s use of its assets and control of its expenses to generate an acceptable rate of return. They express profit made in relation to other key figures in the financial statement.

Return on Capital Employed (ROCE): This is used as a measure of the returns that a company is realising from its capital employed.

The company under review with its competitors have shown to have the ROCE above the industry average for the periods under consideration.

For SCS Upholstery, there was a great decline in profit in 2007 and this had affected their returns by a total difference of 22.68%. This is due to the significant shortfall in sale being experienced in 2007. As sales reduce, and overall cost of sales increases, there will be a significant effect on the overall profit. The price at which the company is selling its product is not sufficiently covering its cost. Carpet right has had a stable ROCE for two year period (2006-2006), although there was a great decline of 27% in figure from 2005-2006. This is attributed to the decrease in the operating profit. Looking at King Fisher, the figures have not been stable over the periods especially during 2005 when there was 110% increase in the operating profit. Home Retail Group also experienced an upward trend.

In comparing the ROCE figures with those of the peer companies, Carpet Right appears to main a stronger position, although all the companies including SCS Upholstery exceeded the industry average.

Return on Equity: This ratio helps to match up the amount of profit available to the owner during the period under consideration. There has been decline in the ratio for all the companies in 2007. This is due to the fact that the companies have all issued more equity compared to the profit before tax they all made. ROE figures for the peer companies offer mixed results, which gives an industry average which is influenced by the good performance of Carpet Right. Both SCS Upholstery and Carpet Right have their figure for all the periods greater than the industry average except for the 2007 figure for SCS Upholstery that is below the industry average and this is as a result of the reduced profit caused by the capital expenditure incurred.

Gross profit percentage: This measures the percentage of sales available to pay overhead expenses of the company. It is the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit cost, requires covering overheads and providing a buffer for unknown items.

Observing the gross profit ratio, it is noted that Carpet Right like before outperforms the other companies including SCS Upholstery for all the periods. In 2007, the gross profit ratio of Carpet Right is 29% above that of SCS Upholstery. But SCS Upholstery seems in line with the industry average. Both King Fisher and Home Retail group have their ratios below the industry average.

For SCS Upholstery, no substantial change in the ratio, but it can be seen that the gross profit was lower relative to sales revenue in 2007 than it had been in 2006. The reduction in gross margin reflected the impact of lower average order values. This is attributed to the logistic issue which resulted in a smooth delivery experience around March period. The cost of these actions and of the spare distribution capacity to protect against peak trading period is reflected in increase in distribution cost as a percentage of sales were. This strategy was rolled out across all warehouses over a period of time, to increase flexibility for delivery to customers and ensure success in realising economies of scale and increasing profitability.

2.4 Liquidity ratio

This provides information about the firm’s ability to meet its short term financial obligations. They are of particular interest to those extending short-term credit to the firm.

Current Ratio: This is one of the best known measures of financial strength. This is a financial ratio that measures whether or not a firm has enough resources to pay its debt over the period of time.

This means that for every £1 the company owes, it has its equivalent current ratio in form of current assets. The summary of this is that for every £1 SCS Upholstery owe, it has £1.05 in 2007 (£1.21 -2005; £1.01 2006) available in current assets. This indicates that the firm holds most of its assets in non current form. The makes most of its sales in cash, and generates a lot of cash sales revenue. Comparing this ratio to its pairs and the industry average, the company has to find a way of increasing its current assets in relation to the current liabilities because the industry average figures are higher.

The current ratio of Carpet Right has shown a very strong trend compared to its pairs and the industry average. Also Home Retail has maintained a good current ratio despite the fact that the gross profit, returns on capital ratios have not been impressive. King fisher current ratio is also seen to be below the industry average suggesting that it has more current liabilities in relation to current assets. It is likely that king fisher is facing liquidity issues.

Acidic test ratio: This measures the ability of a company to use its near cash to immediately extinguish or retire its current liabilities. The Acid Test or Quick Assets Ratio provides a more prudent measure of short-term liquidity.

Carpet Right has the highest ratio and it’s the only one that has its ratio above the industry average suggesting it is able to meet its short term liquidity. It can be seen that the liquid current assets of SCS Upholstery do not quite cover the current liabilities. There is a subsequent need to reduce the purchase of noncurrent assets (property, plant and equipment) and intangible assets as seen on the balance sheet in 2007 to have taken a huge sum. The company need to keep some of its asset in liquid form to meet any unforeseen obligations that may arise. Home Retail is not doing well in this ratio, but King Fisher having relative low ratio might be faced with liquidity problem.

2.5 Efficiency ratio

This examines the ways in which various resources of the business are managed. It is also related to the liquidity ratio and gives an insight to the effectiveness to the company’s management of the components of working capital.

Stock turnover: the stock turn often represent a significant investment for business. This ratio reveals how well inventory is being managed. It is important because the more times inventory can be turned in a given operating cycle, the greater the profit.

The ratio analysis for the four companies shows that King Fisher has the highest number of stock turnover, followed by Home Retail. This explains why King Fisher has had very low profitability ratio compared to its pairs. Also Carpet Right has the lowest stock turnover suggesting that they sell their stocks sooner than the rest and this also reflects in their sales revenue. 

Looking back to the Acidic Ratio of SCS Upholstery, is can be finalised that problem might arise in future if this figure is not monitored. The firm is a retail market and order their products from their suppliers. They can afford not to invest so much in inventory (sofa) as this can be ordered from their suppliers.

Debtor’s turnover: this indicates the percentage of the company’s assets that are provided via debt. The ratio indicates how well accounts receivables are being managed.

Analysis of the debtor turnover shows that both Carpet Right and King Fisher have been managing its credit control with their figures below SCS Upholstery and Home Retail, as well as the industry average. SCS Upholstery figures for 2004 and 2005 were not impressive given the industry average and the stock turnover, but there was a turnaround in 2006-2007. This is done by doing more of cash sales than credit sales. In fact, it started doing most of its business in cash sales and this holds true for most retail stores.

Creditor’s turnover: measures how long on the average, the business takes to pay its creditors.

It can be understood from the analysis that of the 2 years that there is no significant change. While the company does a lot of cash sales, it tries to delay making payment to its suppliers. The ratio for the period under study has been consistent with the industry average. This is equivalent to taking out a free interest loan to finance working capital. The success has been attributed to the developing and maintaining effective, long term working relationship with suppliers and was able to negotiate exclusively on all product lines. They are able to negotiate and affect a good repayment plan with suppliers.

Carpet Right has produced a large Creditor Turnover Ratio in all the years round. The ratios for 2006-2007 are higher than the industry average. The implication of this is that the company may lose its credibility, and the suppliers may decide not to supply credit goods unless cash is paid. Home Retail have its ratios for the three years below the industry average, this means that most of the goods are bought with cash. This is not a good strategy for the company as it may enjoy an interest free loan, and the fund can be employed for other purposes.

Working capital

This gives an indication of the length of time cash spends tied up in current assets.

As said earlier that the company can generate cash more quickly because they make a lot of cash sales, then a negative working capital signifies that is company is being efficiently managed. They order goods from their suppliers making a deal that they will sell them in 58 days (55 days in 2006) and sold to customers before then. Since they do not have to pay the money right away, they can invest the money further, and even earn some interest on it, until payment day arrives.  Also, some customers pay upfront and so rapidly, the business has no problems raising cash. In this company, products are delivered and sold to the customer before the company ever pays for them. The high negative figures for 2004 and 2005 stem from the high trade payable days.

The Working Capital Cycle figures for King Fisher and Home Retail are positive compared to SCS Upholstery and Carpet Right. This explains that those companies with negative working capital have better cash flow than later. Lower ratio is beneficial to the financial health of the company.

2.6 Financial gearing

This occurs when a business is financed, at least in part, by borrowing, instead of by finance provided by the owners (shareholders). A business level of gearing is an important factor in assessing risk. Where a business borrows heavily, it takes up a commitment to pay interest charges and also make capital repayment. This analysis will only focus on gearing ratio and leaves out the interest cover ratio because there is no borrowing that yielded interest.

Gearing Ratio: measures the contribution of long-term lenders to the long-term capital structure of a business. The idea is that this relationship ought to be in balance, with the shareholders' funds being significantly larger than the long term liabilities. The gearing ratio of SCS Upholstery firm is the lowest compared to its pairs and the industry average. This indicate that there is less debt in relation to the equity issued by the company especially when compared with Home retail that has its gearing ratio even higher than the industry average. Although in 2006 the ratio is times three of 2005 and in 2007, it is almost times four. The reason for this in 2004 and 2005, the only form of liability used in the calculation is the amount due to creditor that is over a year compared to 2006 and 2007 that has more debt.

The company only has 19.8% of shareholders funds in the business. In future, if the company is facing any liquidity problem, it can still raise more capital for the company.

2.7 Investment Ratio

There are different types of ratios under the investment ratio, and they are analysed below.

Dividend yield: this is a measure of the proportion of earning that is being paid out by a firm to its shareholders as dividend. The dividend yield for SCS Upholstery has increased by 79% from 2006 to 2007, and it is even higher than the industry average. It is generally believed that with high dividend yield, there is a danger of the future dividend not meeting the level paid in previous year and the dividend may outgrow the earnings. Carpet right ratio has been consistent over the years, and Home retail has the lowest compared to the to the industry average.

Earnings per share

This relates the generated earnings by a firm and the one paid to share holders to the number of share issue at a particular period in time. This is also used used to measure the performance of share. It is not really fundamental to comapre different company’s earnings per share because different company employ different capital structure. The earnings per share of SCS Upholstery is relatively higher than the industry average.

Price-earnings ratio

This relates the earnings per share to the market value of the share. It indicates the market confidence of the future earning power of the firm. Also the accounting policies of different company have an impact on this ratio.

It shows that the capital value of SCS Upholstery share is 14 times higher than the present level of earnings. The company has the highest price earnings ratio when compared with its pairs and the industry average for the period under study. This indicates that investors will be more confident in the future earning power of carpet right.

Dividend payout ratio

It measures the amount of earning being paid out by a firm to its shareholders as dividend. The analysis shows that in 2007, SCS Upholstery has the ratio greater than the industry average. This reason for this is that the dividend paid in 2007 is higher than the earnings and this is the reason the same amount of dividend paid in 2006 is paid in 2007. Also this can be explained in terms of the cut in profit as the company embarked on capital project in order to expand its capital base. King fisher had a very high ratio in 2006 when compared to the industry average. Carpet right has had stable ratio over the time period, and only the 2005 ratio is higher than the industry average.

2.8 The capital Structure of SCS Upholstery

Form of financing

The capital structure will explain the equity financing in the operation of the company. There are two mainly types of firms raising funds, which are; debt and equity financing. Using debt to raise fund lowers the cost of capital, has an impact on increasing shareholders rate of return and also increases the risk of returns. Also, the risk of bankruptcy (firm’s asset fall short of debt value) will be introduced when gearing is employed relative to equity in financing.  When debt is employed in capital structure, it is seen as splitting into two the risks and the earnings generated where one goes to the equity shareholders, and the other to the debt holders.

However, if a firm is financed by equity, the shareholders stand the risk of bearing the loss of the company, and can only claim the net cash flow. If this should happen, the market value of the firm will depend on the nature of the cash flows.

Although SCS Upholstery has no form of borrowing on their balance sheet, there is however trade credit that has been due for over a year. In order for me to analyse the capital structure (as an investor), the trade payable and amount due to creditors over a period of one year will be regarded to a debt.

Capital structure theory

Although gearing promises a higher expected rate of return, but it exposes the shareholders to higher risk. It is vital to consider the trade-off between risk and return before concluding if the use of debt is better or not. For the debt holders to have a lower risk exposure, the equity holders have to absorb more risk. It is imperative to note that manipulating capital structure of a firm cannot in any way increase the value of the firm.

Modigliani and Miller

The theory of capital structure was first introduced by Modigliani and Miller (1958), and they proposed that firm’s value is dependent on the risk and the level of earnings. Modigliani and Miller analysis of capital structure is based on the assumptions that the capital markets are perfectly competitive. These assumptions are as follows:

• there are no taxes;
• information is available and its is costless;
• there are no transaction costs;
• interest rate available for both the investors and the firms is the same;
• Market participants are the price takers and posses no market power.

Although in real life, the capital market is not competitive, but the formal model can be loosened up so that analysis can incorporate the real life situation. Therefore, employing gearing in the capital structure of a firm is cheaper the equity financing.

Debt-equity ratio

The use of debt equity ratio helps a firm to have an idea the amount of fund the company can borrow over a long period of time. This is done by looking the total debt which includes short and long term debt against the total equity of the firm.

The table below shows the debt-equity ratio of SCS Upholstery and the other three firms and these are compared with the industry average to know how the debt-equity ratio has been over the years compared to the other firms and the industry average.

Company Name	2007	2006	2005
SCS Upholstery	0.39	0.41	1.15
carpet right	0.34	0.59	1.00
king fisher	0.38	0.37	0.23
home retail group	0.07	0.43	0.55
industry average	0.30	0.45	0.73

The table shows that the debt-equity ratio of the firm has dropped dramatically over the years. This indicates that less debt has been incurred compared to equity from 2005-2007, and it is in line with the industry average. The reason for this change is for the fact that during 2006 and 2007, the company did not employ long term trade payable, unlike 2006. This indicates that the company is trying to have its debt equity ratio in line with other companies in the same industry as well as the industry average.

2.9 Capital structure and bankruptcy

When a firm adopts more debt in relation to equity, threat of bankruptcy is likely to be faced by such firm especially when the firm's assets fall short of the debt value. A firm faced with threat of bankruptcy will have its assets allocated to the creditors and its equity owners bearing the loss (interest of equity holders is eliminated).

In assessing the balance sheet of SCS Upholstery to know if there is threat of bankruptcy faced by the firm, the total assets will be assessed against the equity capital and the total liabilities.  Looking at the 2007 balance sheet of SCS Upholstery firm, it can be seen that the company is not faced with any threat of bankruptcy even though financial trading is proving difficult for the financial year.

If a firm is faced with bankruptcy, the equity holders suffer the loss and therefore on the balance sheet, the equity capital becomes zero. For the periods under consideration for SCS Upholstery balance sheets, it can be seen that each value of the non current asset or the noncurrent asset is sufficient to cover for the loss of equity capital. It can therefore be concluded that the firm is not faced with threat of bankruptcy.

It is important to know that the SCS Upholstery has no interest payable for the period under consideration and there has not been any form of long term loan incurred. As a result, the company is not faced with any threat of bankruptcy.

Business risk

Revenue was £183.8 million for the ten months ended 28 July 2007 (twelve months ended 30 September 2006: £195.8 million). This reflected the extremely tough trading conditions which prevailed during the financial year compared to 2004-6. The trading profit has dropped for about 58% from 2006 to 2007. The corrective action taken included; spare capacity in distribution. This has led increase in the distribution cost to be 5.6% of the 2007 revenue (2006: 4.7%). Also expansion (opening of new stores) and pre-opening and launch cost for the new stores, staff recruitment cost that been taking place has a negative impact on the company’s revenue.

2.10 Dividend policy

The Lintner 1956 dividend policy model

The dividend model proposed by lintner in 1958 has helped to develop a better understanding of how the managers of a firm make their dividend decisions. Based on the interviews with some management of different firms suggested that the dividend to be paid in present year is compared in relation to the one paid in the previous year even if the earnings have fallen, and this dividend increases as earnings increase over time. Increase in dividend will be as a result of difference between the long run target and the dividend paid the last time. This suggests that even if the earnings reduce, the dividend paid may not necessarily reduce. The most important factors in the dividend change are the adjustment to the change in earnings and the payout ratio.

Earnings per share/dividend

	2007	2006	2005		2004
Earnings per share (pence)	13.68	35.12	38.15		29.76
Dividends per share (pence)	19.0	19	16.5		14
Dividend as a % of earnings (%)	138.89	54.10	43.25		47.00

After applying the lintner model to explain the dividend policy of SCS Upholstery for the period 2004-2005, the adjustment factor (s) is calculated to be a negative coefficient of (-0.055), and the long run target payout ratio (z) was is calculated to be a negative coefficient of (-0.81). This therefore means that the Lintner model will not be applicable to SCS Upholstery Plc.

Looking at the trend of the earnings per share, dividend per share and the dividend as a percentage of earning, it can be inferred that dividend paid from 2004-2007 has been increasing although, the same for both 2006 and 2007. The earnings have not been stable over the years and this can be attributed to the logistic issues of capital expenditure that is carried out in 2006/2007.

The company can be said to take into account the implication of reducing the dividend paid even with reduced earning, and in 2007 even though the earnings per share is significantly small compared to previous years, the company still maintained the same amount of dividend paid in the previous year, and this is paid from the retain earnings. Any reduction in dividend may suggest to the investors that the company is having some financial problems.

Chapter 3

Valuation of the company

3.1 Dividend Valuation Model

The dividend valuation model presumes the market of a company’s share is calculated using the discounted value of the dividend per share that shareholders are expecting to get. The cash flow is made up of the expected dividend for the period and the proceeds expected from share sale at the end of that period to determine the present cash flows, the discount rate is used.

Where:
                  represent the market value of a share;
                  dividend expected to be paid in period t;
                  price of the share expected at the end of period N;
            r          is the discount rate and r; and
                  is the number of years planned for the period.

The firm share price will be undervalued if the current share price is less than the estimated value of the share, and therefore investors will see good prospects of buying the company’s share. As investors are seeking undervalued shares and will therefore take advantage of any market error that occur even if it is not for long.

Applying the above first equation, it is necessary to find the anticipated share price at the end of the period N, the discount rate (r) and the growth rate (g).

The first calculation is based on the growth rate which is expressed as;

            g = b * k

Where
        b = retention ratio; and
        k = rate of return on equity (average for the four years)

The retention ratio is calculated by subtracting the average payout ratio from one.

The dividend per share for 2007 will not be employed in this analysis because the earnings per share for that period are higher. Therefore, the payout ratio will only be calculated for a three year period.

The payout ratio which is calculated using the formula;

 Dividend for the periods
 Earnings per share

The retention ratio is calculated as
            b = 1 – payout ratio;

In calculating the growth rate using the formula,
             b = 1 – 0.48 = 0.52

Therefore, the growth rate gives;
             g = 0.52 * 0.306
                = 0.159

Looking at the dividend per share paid in relation to the earnings per share for the period under study, the earnings per share in 2007 is relatively lower than the dividend paid. It explains why the same dividend paid in 2006 is paid in 2007. This implies that is company is having issues (even though it’s still paying the same dividend) with its level of earnings. This is however a matter of concern as to the financial position of the company. Therefore, in calculating the expected dividend, instead of using the calculated growth model (0.159), the average percentage change in dividend for the period is used calculated as (0.11).

Year 1 = D1 = Do (1 + g)
                    = 19 (1 + 0.11)
                    = 21.09

Year 2 = D2 = 21.09 (1 + 0.11)
                     = 23.41

Year 3 = D3 =   23.41 (1 + 0.11)
                     = 25.99

Year 4 =D4 = 25.99 (1 + 0.11)
                    = 28.85

The dividend growth rate has increased by 11% from year one to year two, and from year three to year four, there is an increase of 11%. The growth rate has been consistent and this can be explained with the fact that there has been drop in the earnings of the company in 2007.

The cornerstone of modern finance is the Capital Asset Pricing Model, CAPM. Investor who wants to invest in the market portfolio must be prepared to earn some level of risk. Because of the investor’s risk adverse nature the portfolio is chosen in the manner that the risk is minimised to its barest minimum and maximise the expected return. To calculate the discount rate (r), the Capital Asset Pricing Model is adopted and the expected rate of return is expressed as;

                r  =  Rf  +  [E(Řm) –  Rf]β                                                   (1)

Where;
Rf = risk free rate of interest at a given period;
E(Řm) = return of the market portfolio return expected in a given period; and
β = measurement of risk
[E(Řm) –  Rf] = historical risk premium in UK (0.042)

The risk free of interest rate is calculated by finding the annual average of the risk free FT All-share in UK for the period January 1990-december 2008 which gives 0.0624.

The beta β (3.66) that measure the risk is calculated by running a regression of the company’s excess return against the excess market return. The company’s excess return is calculated using the historical share prices for the period January 2003- June 2008. The UK FT All-share of the excess market return for the same period is used as the as the excess market return. Comparing the calculated beta to the one on yahoo finance which is 3.83 (with industry average of beta 0.63), then it is in line and I decided to use the beta that I regressed because of the time period considered for them market share price.

	2007	2006	2005	2004	average
payout ratio		0.54	0.43	0.47	0.48
return on equity	0.43	0.35	0.13	0.31	0.306

The discount rate of return r is calculated as follows:

                r  =  Rf  +  [E(Řm) –  Rf]β
                   = 0.0624 + (0.042) * 3.66
                   = 0.21612

This high figure of the discount rate of return is as a result of high beta risk of the company.

PO =    21.09             +    23.41            +    [      25.99           *        1            ]
        (1+0.21612)         (1+0.21612)2          (0.21612-0.159)  (1+0.21612)3 

It is important to note that the number of periods employed is three years are used in the valuation. This is because it is assumed that investors may not believe in the long term prospects of the company due to its latest low earnings.

Constant rate growth model

Estimating the dividend indefinitely is not viable, it is therefore necessary to establish a regular dividend model. This model is not necessarily have to follow one period to the other, but at least start at some point. For dividend to be constant for a period of time, the equation for the valuation will be taken in form of perpetuity.

However, the retained earning of a company’s is usually to finance some long term investment so far the dividends, assets, and earnings are expected to produce a constant growth rate referred to as (g). In the constant dividend growth model, the dividend paid in future is expressed in terms of the dividend that will be paid now, as well as the growth rate.

In adopting the equation below, the discount rate must be greater than the growth rate of the company r>g, otherwise the equation gives a share price that is infinite.

The model implies that dividends can be paid out from generated earnings without having any impact on the future earnings generating capacity of the firm’s assets. It means that in calculating the earnings, the amount charged to depreciation will be equal to the reinvestment that is needed to maintain the asset base of the company.

The constant rate of growth model is represented as follows:

                P1 = Do( 1 + g)
                          r – g

                      
               PO =    19(1+ 0.11)
                       (0.21612 – 0.159)

               PO = 385.52

                P1 =     Do
                           r – g

                     =   19/ (0.21612 – 0.159)
     
                     = 332.63

Also, explaining in terms of the growth rate (g), that is:

                 g = b * k

With the assumption that dividends are not growing it is also possible to assume that the company will not be able to grow. Earnings are no longer retained and therefore there will be little prospects for growth. Also, as growth rate is a factor of retention ratio which is now zero, then it is safe to assume that the growth rate for the firm is zero:

           P1 =     Do
                         r

                = 19/0.21612
                   
                = 87.9

3.2 Earnings Valuation Model

The earnings valuation model is important because investors/shareholders have the right to the company’s earning. This could either be in form of dividend or used in financing further investment. Since dividends are paid from earnings, the firm’s earning power determines the market value.  In the share valuation of the company, the level of earnings and the investment play crucial role.

The earnings model helps in differentiating between the contributions of firm future investment from its existing contribution of assets. The investment of the firm has to guarantee higher rate of return for the shareholders in order for the market value to go up.

The net value of a company’s investment after deducting the cost associated is given by the net present value. Since the basis of this analysis is on the future contributions of the investments to the present share value, it is imperative to discount the expected net present value back to present which gives the present value of growth opportunities (PVGO).

Earnings model does not depend on the constraint on the type of investment that is being undertaken by the company. It is not necessary to state the investment lives, and the cash flows may either be irregular or constant. This is because of the assumption that investments are in perpetuity form in order for earnings model to be comparable to the dividend model.

The Gordon Model assumptions are as follows:

• The investments of the company are financed from retention;
• Retained earnings are the same;
• The same amounts of dividends are paid out (1-b);
• The earnings produced from the assets are constant in perpetuity;
• Rate of return (k) is constant; and
• A constant cash flow is produced by all investments in perpetuity.

The earnings model valuation can be written and calculated as:

Vo = E1 + PVGO
         r     

where:

PVGO = present value growth opportunity

 Vo = E1 + E1[b(k/r – 1)]
           r             r - g

 E1 = EPS (1+g)
                  = 13.68 (1 + 0.11
                   = 15.185

Therefore:

             Vo =   15.185      +   15.185[0.52(0.306/0.21612) – 1)]
                        0.21612                (0.21612 – 0.159)

                  = 127.75

The figure is low but it is understandable because of low 2007 earnings compared to the dividend paid. As noted earlier, the company does not really have any prospects for growth and hence it is also be assumed that the share value is a function of earnings and discount rate.

Vo = E1
         r 

      = 15.185/0.21612
      = 70.26   

3.3 The valuation multiplier model

The valuation multiplier is analysed in terms of the analyst’s appropriate price-earnings ratio for share. The valuation model is equivalent to the prevailing price-earnings ratio when the market is assumed to value share correctly. The valuation multiplier model is expressed as:

=      P/E * NET earnings
     Number of ordinary shares

The price-earnings ratio used in this analysis is the 2007, and this is assuming that hence forth, there is no growth as the earnings in 2007 is lower than the dividend. Substituting into the equation, the value gives:

= 14.26 * 4616
        33753

 = 1.95

If I also assume that there is growth rate in 2007 and after this period, the rate becomes the same. This means that (1+g) will be added to the analysis.

=    P/E * NET earnings (1+g)
     Number of ordinary shares

 =  14.26 * 4616 (1+0.11)
              33753

  =  2.17

3.4 The free cash flow valuation

Another method of the valuation model is the free cash flow valuation, and it is the cash flow that is accessible to the equity share holders and the firm net of capital expenditure. Any firm can use the free cash flow model because it gives a better picture of the value of the firm beyond the constant growth model. A way of doing this is by discounting the free cash flow for the firm at the weighted cost of capital in order to get the firm’s value, after which the then-existing debt value is subtracted to get the equity value.

The free cash flow of a company (FCFF) is given as:

In the case of SCS Upholstery, there is no interest payment because the company did not incur any debt, so as a result, the weighted average cost of capital (WACC) cannot be determined so the return on equity will be used as the WACC.

The table below shows the figures for net earnings, depreciation charge, capital expenditure and total property, plant and equipment PPE.

		2007	2006	2005		2004
net earnings		4616	11808	12651		9606
depreciation charge		4002	3358	2979		2979
capital expenditure		8826	14356	4369		4924
total PPE		40256	36113	25635		23432

The valuation of the cash flow involves calculating the net cash flow for the period under consideration. The net cash flow is summarized in the table below and the net cash flow is calculation using the formula:

Net cash flow = net earnings + depreciation – capital expenditure

	2007	2006	2005	2004
net earnings	4616	11808	12651	9606
depreciation	4002	3358	2979	2979
capital expenditure	8826	14356	4369	4924
net cash flow	-208	810	11261	7661

It is necessary to forecast the earnings, the capital expenditure and the depreciation charge into the future. For the purpose of this analysis, a 5-year forecast is analysed. In order to forecast the net earnings into the future, the net earnings growth using the net earnings is used and the average is calculated. The average will be use to project the future forecast.

2004-2005		30.73%
2005-2006		-6.66%
2006-2007		-60.91%
average		-12.28%

For capital expenditure, it is necessary to relate the purchase of property plant and equipment for the year to the total property, plant and equipment (PPE) of the company. The analysis gives:

2007		21.92%
2006		39.75%
2005		23.78%
2004		21.01%
average		26.62%

Applying the same analysis to depreciation by relating the depreciation for the year to the total PPE, the percentage is used to forecast depreciation for the period of 5 years.

2007		9.94%
2006		9.30%
2005		11.62%
2004		12.71%
average		10.89%

It is also necessary to find average growth rate on property, plant and equipment PPE from 2004-2006.  This average growth is used to forecast the capital expenditure and the depreciation for the next 5 years and it is analysed by relating the values of the total PPE from year to year.

2004-2005	9.40%
2006-2006	40.87%
2006-2007	11.47%
average	20.58%

The 5-year forecast

The 5-year forecast will be for the net earnings, capital expenditure, and the depreciation charges. This will therefore be from 2008-2012.

Earnings forecast

Recall that there has been a negative growth in the net earnings and therefore, for the purpose of forecasting the earnings, an assumption is made that after 3-year forecast (2008-2010), the company will start regaining its financial position back to what it was, so the same rate at which the earning has dropped (-12%) will be assumed to be the same rate it will pick up for the next 2 years (12%). As a result, the forecast gives:

2008 = -12% * 4616 = 4062
2009 = -12% * 4062 = 3575
2010 = -12% * 3575 = 3146
2011 = 12% * 3146 = 3523
2012 = 12% * 3523 = 3946

year	2004	2005	2006	2007	2008	2009	2010	2011	2012
net earnings	9606	12651	11808	4616	4062	3575	3146	3523	3946

Looking at the previous earnings (2005-2006), there has been sustainable growth from 2004-2006, and a substantial decline in 2007. The graph below shows the rate of growth with the forecasted figures from 2008. It can be seen that the same rate at which the earnings decline from 2007 is the same rate at which it starts regaining its original position.

PPE forecast

In order to forecast the depreciation charge and capital expenditure, it is necessary to forecast what in the PPE will be in the next 5 year, and this is done using the average growth rate of PPE (20.6%) on the total PPE FOR 2007 (40,256).

2008 = 40256 (1+ 0.206) = 48549
2009 = 48549 (1 + 0.206) = 58550
2010 = 58550 (1 + 0.206) = 70611
2011 = 70611 (1 + 0.206) = 85157
2012 = 85157 (1 + 0.206) = 102700

Capital expenditure CAPX

The forecast above can then be used to find the capital expenditure and the

2008 = 48549 * 0.266 = 12914
2009 = 58550 * 0.266 = 15574
2010 = 70611 * 0.266 = 18783
2011 = 85157 * 0.266 = 22652
2012 = 102700 * 0.266 = 27318

Depreciation

To be able to forecast the depreciation rate into the future, the depreciation rate of 10.9% is multiplied with

2008 = 48549 * 0.109 = 5292
2009 = 58550 * 0.109 = 6382
2010 = 70611 * 0.109 = 7697
2011 = 85157 * 0.109 = 9282
2012 = 102700 * 0.109 = 11194

Net cash flow

Net cash flow = net earnings + depreciation – capital expenditure

2008 = 4062 + 5292 – 12914 = -3560
2009 = 3575 + 6382 – 15574 = -5617
2010 = 3146 + 7697 – 18783 = -7940
2011 = 3523 + 9282 – 22652 = -9847
2012 = 3946 + 11194 – 27318 = -12178

The forecasted net cash flow gives negative figures, and this is as a result of the rate the huge amount of capital expenditure incurred during the 2006-2007. This has resulted in the negative forecast. Applying the capital expenditure to forecast the cash flow pose a big problem. Therefore, the percentage growth in the capital expenditure (from the cash flow statement) for 2006-2007 is applied.

 = 14356 – 8826
                    14356
           
 = 0.3852
    Rate = 1 – 0.3852
            = 0.6148 = 61.4 %

This rate is then used to multiply the capital expenditure for 2007 in order to forecast for 2008. I am also assuming that the company will not want to spend much on the CAPX in future, so the same rate is applied throughout for the cash flow forecast. This will enable me to have forecasted positive cash flow analysed below:

2008 = 61.4% * 8826 = 5419

New cash flow forecast

2008 = 4062 + 5292 – 5419 = 3935
2009 = 3575 + 6382 – 5419 = 4538
2010 = 3146 + 7697 – 5419 = 5424
2011 = 3523 + 9282 – 5419 = 7386
2012 = 3946 + 11194 – 5419 = 9721

The cash flow forecasted is then discounted to find the value of the company.

V0 =   CF1    +    CF 2     +     CF3     +   CFn     +    Vn   
          (1+r)       (1+r)2         (1+r)3       (1+r)n      (1+r)n

 V0 =   CF1    +    CF 2     +     CF3     +   CF4     +    CF4   *   1
        (1+r)       (1+r)2         (1+r)3       (1+r)4        (r-g)     (1+r)5

The weighted average cost of capital (WAAC) because no interest charge on the financial statement. This is due to the fact that the company did not incur any borrowing. Therefore, the average return on equity is (k=r) is used as WAAC. The value of the company is computed using the formula above:

V0 = 28.052.61

To get the share price per share, the value of the company is divided by the number of outstanding shares in 2007.

Share price/share = V0/N0

Share price/share =    28,052.61
                                      33,753

                           = 0.8311
                           = 83.11 pence

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