Financial management and financial decision management

Aim

1) To understand the principles and techniques used for basic financial operations and analysis.

2) To understand the basic framework of financial decision-making.

3) To interpret and analyse basic financial instruments such as balance sheet, income statement and cash flow statement on a company and compare it with a rival company from the same industry.

4) To analyze the profitability of these two companies.

5) To find the share price of the company using two theoretical models and compare it to the market price.

Methodology

This assignment aims at providing understanding of the accounting and financial management to get us familiar with the concepts of financial decision management and broad framework of financial decision-making.

The first part of the essay is about analysing the financial statements of a company and comparing the same with a rival company. This required me to select any two rival companies in the same industry and procure financial data for both the companies for any given year. Further, it required this data to be analyzed and obtain the profitability position of both the companies through analysing for of the key ratios and provide with insights from the investor point of view.

The second part of the assignment is about finding the share price of the selected company using any two models and comparing it with the market price on the given date. For this purpose, I choose Gordon's Dividend Discount Model and Price to Book Value method to find the share price as on 31st January 2009 and compare it to the market price

Introduction

Financial statement shows the overall transactions that flow through the business. Financial statement of a firm is recorded in three different forms. They are,

1. Income Statement

2. Balance Sheet

3. Cash Flow Statement

Income Statement

“The income statement contains data about the company's revenue, earning, earnings per share etc.; it records the company's spending and the cash inflow over a specific period of time. It helps in measuring the company's performance.

Balance Sheet

In this sheet, all the details regarding the company's assets, liabilities and equity are registered for a given period of time. This just highlights the financial condition of the company. It is also sometimes called the Statement of Financial Condition.”

Cash Flow Statement

Cash flow statement records the cash transactions over a period of time. It gives the picture about the firm's ability to pay for all its operations and for future growth.

Analysing these financial statement and finding the key ratio is very important for any investor. It is good to know about the company's financial performance for the past few years before taking the investment decision and also the shareholder's relay on the financial statement to see the broader picture of the business. It helps the management in taking investment decisions.

Industry Background

Apparel Stores is a part of the retail industry. Stores that sell clothing, footwear and accessories fall under this category. The apparel retail industry is a highly competitive industry. There are about 45 companies which fall under the apparel stores sector in the US (NYSE).

Fashion is a highly volatile business. Consumer trends change very quickly and the firms have to al so be quick in adapting to this change. The firms need to choose the right design and style for the season and that is why designers and trend analysers play a very important role in the fashion industry. If they get the wrong merchandise, they would have to markdown the price resulting in loss on profit margin.

Company Background

GAP Inc.,

GAP Inc is on the largest apparel retailer in the world. “The company has five different brands operating under its parent company; Gap, Banana Republic, Old Navy, Piperlime and Athleta”. Athela was one of GAP new acquisition in 2008. Gap has its presence in over 25 countries and is still expanding. “GAP has over 3100 stores and revenue of over $ 14.5 billion”

GAP caters to various categories like Men's apparel, women's apparel, Kids wear, Babies, accessories and personal care products. Gap runs it stores in six countries, US, Canada, UK, France, Japan and Ireland and runs through franchisee in other parts of the world. GAP employees about 134,000 people including both part and full time employees.

Abercrombie And Fitch Co ( A&F / Anf)

A & F was incorporated in the year 1892. The company is known as a speciality retailer catering to specific customer segment. Like Gap, the company operates under different brand names, catering to different group of customers. The brands are Abercrombie & Fitch, Abercrombie, Hollister, RUEHL and Gilly Hicks. The company has about 1125 stores across five major countries, US, UK, Canada, Italy and Japan and revenue of over $ 3.5 million.

Inference:

From the above calculations, we can see that GAP has sound liquidity ratios. The assets are higher than the liquidities, which means that in short term crisis, the company could convert assets into cash to keep the business running. The increase from the year 2007 is only marginal one.

Also the assets of the company have decreased by about 3.5%, which was effectively due to the closure of stores and reduction of about 45% in short term investment. There was also a considerable decrease in the liabilities (about 10%); the majority of it was due to the reduction in short term debt (about 34%) and long term debt (about 78%).

The growth in the working capital for the year 2008 means that the company has enough cover to pay the creditors and keep the business running. Also GAP has about 62 days of inventory or buffer stock. Should anything go wrong, they can still keep the business running for few days. Although this seems to be a good number, it is not a good sign as the apparel business is a highly seasonal business with each season lasting only about three months. Any stock or inventory leftover has to be sold at a discounted price to avoid it from converting into dead stock.

Under the prevailing economic downturn the company seems to have a good liquidity position. But from investor's point of view, it is not possible to conclude that the company is profitable with just the liquidity ratio analysis.

Inference:

These ratios reflect the share of profit in relation different elements (Sales, Capital Employed, Net Worth, etc.). Higher the percentage healthier is the company's position.

The company has shown marginal growth in profit for the year 2008 but there is a decline in asset turnover. The reason for the decline in the asset turnover is the considerable drop in sales revenue. This could be due to the economic crisis that developed during the year 2008, which eventually forced the firm shut down few of its operations. Economic crisis / slowdown in sales in US also led to a sharp fall in sales across all its brands in the region. This could also imply that the company was forced to sell it products at a discounted price.

The company has a better ROCE compared to last year. Higher ROCE means that the company has got cash reserves to re-invest into the company. And also there is slight increase in the return on shareholders' funds. This ROSF of the company shows that the management has effectively utilized the companies

Inference

The debt ratio and debt to equity ratio of the GAP has slightly improved over the year. The debt ratio of the company tells that it is less leverage to borrowings and has good equity position. “The debt to equity ratio also show the companies leverage”. The lower the number the better in the companies leverage. The reason it has improved is because GAP did not invest the earning in the year 2008, which could have been snow bowled by the economic crisis.

Assets turnover has decreased by about 4.5%, which could be due to the considerable decrease in the total sales. The reason for this is the same as mentioned earlier, poor sale in the last quarter of the financial year (2008).

Inference

The sales per employee per employee have dropped from 2007 but the important thing to note is the drop in the number of employee. GAP reduced the number of employees by about 7000 in order to effectively manage cost.

Competitor Analysis

Financial Structure

The two below graphs show the asset distribution of both the companies. Both companies seem to have equally high percent of its assets in property & equipment. The significant difference is that GAP's Total assets have reduced in 2008 compared to 2007, whereas Abercrombie and Fitch have invested in new stores adding to its assets. Both companies seem to have equally high cash reserves and inventories.

The graphs above shows the distribution of assets and from these it is very clear that GAP is pretty large company compared to ANF in terms of assets. But GAP has been showing a decline in net sales for the last four consecutive financial years (about 10% lost sales), which could be a gain in market share for the competitors.

Inference

From the above calculations it is very clear that Abercrombie is better of the two companies. This is directly to do with the selling prices of these firms. Abercrombie is more a fashion brand and the prices are quite higher compared to GAP. Also Abercrombie has got a better operating efficiency than GAP. GAP has large number of stores than Abercrombie, which could be one of the reasons for the GAP's operating margin being low. GAP is more a conservative company, playing on its turnover and volume of sales, where as Abercrombie has been the high risk company with low volumes, high price catering to different set of customers. Both the firms have experienced reduced net sales especially in the fourth quarter of 2008 due to the economic crisis. Abercrombie's Inventories increased by about 10% compared to 2007 which is not a good sign. They would be forced to sell the goods at a discounted price, resulting in the loss in profit margin.

Inference

From the above calculation, in case of short term liquidity issues both the companies are having enough cover. In fact Abercrombie has these ratios in excess of 2:1 ratio which meant that they are not efficiently using their assets as GAP.

Inference

Both companies are paying dividends at a fair rate of about 25 % which is quite good. And the balance could be used by the companies to re-invest or as retained profits. The P/E of GAP is better than Abercrombie, but the yield in higher in Abercrombie. So it is difficult for one to identify the best company to invest in.

Conclusion

Both the companies seem to have a strong position in the market, GAP Inc being a bigger player than Abercrombie. GAP Inc seems to be a conservative company, being about 40 years in the industry. Abercrombie is older than GAP though but did not diversify as much as GAP did. But given the conditions, I would invest in Abercrombie, reasons being the stability of the company and higher cover on investments as well and a higher dividend and increasing dividend payout ratio. Also Abercrombie went against the tides and opened about 90 new stores in the last quarter of the year when the competitors were suffering due to the economic downturn. This is a positive sign because the shareholders' of the company are confident about the performance of the company.

Valuation Of Shares

Introduction

There are various methods of analysing the share price. Three main classification of the valuation methods are,

1. Dividend Discount Model

2. Price / Earning Ratio

3. Free Cash Flow Model.

In this assignment, I have choose to use Gordon's Dividend Discount Model and Price to Book Value (P/B) method

Market Price of Share as on 31st January 2009 = 11.28

Dividend Discount Model - Gordon'S Model

This one of the various methods used to calculate the stock Value. It is a specialized case of equity valuation, where the value of equity is the present value of expected future dividends. The Gordon growth model can be used to value a firm that is in a”steady state” with dividends growing at a rate that can be sustained forever.

“The Gordon growth model relates the value of a stock to its expected dividends in the next time period, the cost of equity and the expected growth rate of dividend.

Value of stock = DPS1 / Ke - g

DPS1 = Expected dividends next year

Ke = Cost of equity

g = Growth rate in dividend forever”

Based on the information available in the financial statement of GAP inc 2008 and certain details picked from the website for the return of equity, risk free rate etc., I have calculated the share price. The details of the calculations are as below,

Earnings per Share = 1.35

Dividend Payout Ratio = 25.37%

Dividend per Share = 0.34

Return on Equity = 21.34%

Estimated Beta = 1.15

Risk Free Rate = 5%

Market Risk Premium for the Industry = 12%

Cost of Equity = 5% + 1.15(12%) = 18.8%

Expected Growth = (Retention Ratio) (Return on Equity) = (1- 0.2537) (21.34%) = (0.7463) (0.2134) = 15.93

Value of the Equity Stock = Expected Dividend / (Cost of Equity - Growth Rate) = 0.34(1+0.1593)/ (0.188-0.1593) = 0.3942/0.0287 = 13.74 Share Price = $13.74

Market Price of Share as on 31st January 2009 = 11.28

Inference:

The value calculated using this model shows that the price of the share should have been $13.74 instead of $11.28. As an investor, I would buy the shares of the company because according to calculation I arrive at a price higher than the market price. This means that the company has under priced its shares. The reason for the shares being sold at a lower price could be due to the poor economic condition in 2008. Also GAP had lost on sales in the last quarter of the year, maybe due to the close of about 55 stores (mostly in US-56) which could have brought down the credibility of the firm. The market share price reflects all these elements in its price and the decrease in the share price was also during the last four months of the financial year, when GAP was losing out on sales. So, the market reacted quickly to the information available which could have lead to the slump in the share price.

Price To Book Value (P/B)

In this approach the value is found by “comparing the market price of the share with the book value of the equity. The equation is as below

“P/B = Market Price of the Share / Book Value of the Equity”

Book Value of the equity is calculated by the value of the assets, which is difference between the book value of assets and liabilities

Total Assets = 7564 millions

Total Liabilities = 3177 millions

Total Shares = 719 millions

Book Value of the Equity = (7564 - 3177)/719 = 4387/719 = $ 6.10

Market price of the Share is 11.28

P/B = Market Price of the Share / Book Value of the Equity = 11.28 / 6.10 = 1.85 times

Inference

From the above calculation of the share price shows that the company is selling its shares twice the price of the actual price. From investor's point of you, it is not a good sign as the market price of the share is nearly twice more than what it should have been. The increased priced could be due to the factor that the market overvalued the firm's assets. Also it could be that that the investors are confident that about the company's performance and preferred to take the added risk.

Conclusion

Thus I conclude by saying that there is no efficient market and it is not possible for someone to predict the exact future price of a share. Every model uses different set of information and any change in the information will lead to change in price. Neither historic price analysis nor fundamental analysis will provide the exact price of the share. Thus investing in shares has a huge risk attached to it and one needs to evaluate the exact

Reference

[1] All the calculations except number of share and par values are in $ millions

[2] All the calculations except number of share and par values are in $ millions

[3] All the calculations except number of share and par values are in $ millions

[4] Note: ANF - Stands for Abercrombie And Fitch

[5] Data used from Historic Prices of GAP Inc. on Yahoo! Finance: http://finance.yahoo.com/q/hp?s=GPS

[6] Data used from Key Statistics of GAP Inc. on Yahoo! Finance: http://finance.yahoo.com/q/ks?s=GPS

[i] McClure, Ben, Introduction to Fundamental Analysis, 2007, available at: http://www.investopedia.com/university/fundamentalanalysis/ [accessed on 14th January 2010]

[ii] All information in the below paragraph have be interpreted from wiki invest, 2010, Apparel Stores, [internet], available at: http://www.wikinvest.com/industry/Apparel_Stores#_note-0 [accessed on 24th January 2010]

[iii] All data in under the below heading have been extracted from the Annual Financial Statement of GAP Inc, 2008

[iv] Gap (clothing retailer), available at: http://en.wikipedia.org/wiki/Gap_(clothing_retailer) [accessed on 25 January 2010]

[v] Information taken from the Annual Financial Statement of GAP Inc, 2008

[vi] All the financial information under this topic are from the consolidated balance sheet of GAP Inc, http://www.gapinc.com/public/documents/GPS_AR_08.pdf [accessed on 14 January 2010]

[vii] McClure, Ben, Value By the Book, [internet],available at: http://www.investopedia.com/articles/fundamental/03/042303.asp [accessed 14 January 2010]

[viii] Brealey, Myers and Marcus, 2009, Fundamentals of Corporate Finance, sixth edition, New York:McGraw-Hill Irwin, P 196-198

[ix] McClure, Ben, Value By the Book, [internet],available at: http://www.investopedia.com/articles/fundamental/03/112603.asp [accessed 14 January 2010]

[x] Financial information in the below calculation have been used from the Annual consolidated financial statement of GAP Inc. 2008: see Annexure

[xi] Arnold, Glen, 2008, Corporate Financial Management, Fourth Edition, Essex, Pearson Education Ltd, P 755

[xii] Data used from Historic Prices of GAP Inc. on Yahoo! Finance, Available at: http://finance.yahoo.com/q/hp?s=GPS [accessed on 14 January 2010]

[xiii] McClure, Ben, Value By the Book, [internet],available at: http://www.investopedia.com/articles/fundamental/03/112603.asp [accessed 14 January 2010]

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