Pearson is an international media and education company with investments in education, business information and consumer publishing. In this following work we have analyzed the company's performance and financial health by looking at profitability, liquidity and efficiency ratios and comparing it to the nearest competitor, McGraw-Hill. In the second part of this document we have analyzed the cash flow statement to understand the various operating, investing and financial activities of Pearson PLC. In the third part we have looked two important Investment ratios, namely the Earnings per Share ratio and Price/ Earnings Ratio which helps investors in determining if the company is worth investing in.
Return on Capital Employed
Investments were higher in 2008 compared to 2007 and the ROCE ratio is lower for 2008 than 2007, this indicates that the Pearson is not maximizing its investments. A reason could be a short-term contract that resulted in losses for the company.
McGraw-Hill is 3% lower than Pearson. This is probably caused by McGraw-Hill's 1.37 times high net profit before tax but the 1.63 times more of Pearson's' capital employed. This indicates that Pearson is less efficient in managing the equity.
Return on Ordinary Shareholders Funds
For Pearson although net profit for 2008 (323m pounds) is higher than 2007 (310m pounds), a lower ROSF ratio in 2008 could be because of the losses of 90m pounds that Pearson suffered in 2008 due to discontinued operations.
McGraw-Hill is higher in this ratio. The slight 0.53% difference can probably be caused by McGraw-Hill's 1.57 times more in shareholder's funds compared to Pearson but 1.7 times more in returns. This means McGraw-hill's business is more profitable to shareholders or investors.
Operating Profit Margin (OPM)
The increase in the OPM for Pearson in 2008 suggests that the company has been able to generate higher revenue through controlled costs. In 2008, although the overall cost of selling goods is gone up by 12%, the sales revenue has shown a rise of 13.5 % indicating that the sales are rising faster than the costs associated.
Pearson is 7% lesser in operating profit margin than McGraw-Hill while the industry average is 6.73%. This can be caused by Pearson's 9.8% more in sales turnover but 27% less in operating profit. This indicates that MGH is better at managing the selling processes and cost-relevant issues.
Gross Profit Margin (GPM)
This rise in GPM in 2008 could be a result of the fixed costs being distributed more efficiently across the costs of goods produced probably because of economies of scale.
Pearson's 33.5% leading in gross profit margin over McGraw-Hill could possibly be caused by McGraw-Hill's 8.9% less in sales revenue and 35% less in the gross profit. In addition, McGraw-Hill's 1.58 times more in cost of goods sold has also negatively contributed to this ratio.
The increase in the ratio in 2008 indicates that Pearson is able to meet its short-term obligations and its liquid assets have gone up during the term. Ideally a 2:1 CR is preferred, it would not be apt to blindly apply this rule to all companies as the current ratio measures quantity of assets and not quality and that different kinds of businesses prefer a higher or lower ratio as per the nature of their business. The Acid Test ratio will give us a clearer indication of the liquidity of the firm.
Compared to McGraw-Hill, Pearson is 2.06 times more in current assets while 1.12 times more in current liability than McGraw-Hill. Normally 2 is the best value in current ratio and the industry average for Pearson and McGraw-Hill is 1.4. This means that Pearson is more capable in managing the current assets and paying the debts and McGraw-Hill is in trouble to cover its liabilities.
Acid Test Ratio (ATR)
The ATR has gone up in 2008 to 1.41, which is in sync with the Current Ratio indicating that Pearson has sound liquidity. Comparing this ratio to the Average Settlement Period for Trade Payables, it has gone up from 65 days in 2007 to 75 days in 2008, suggesting that Pearson has more time to pay of their trade payables, thus increasing liquidity.
The industry average is 1.19 implies that Pearson is in a healthier position, financially, than McGraw-Hill. This is probably caused by the Pearson's 2.06 times more in current assets and only 12% more in current liability than McGraw-Hill.
Average Inventory Turnover Period (AITP)
The rise in AITP from 2007 to 2008 could be due to higher production of goods in 2008 than in 2007 and less demand for the goods. This means that Pearson's funds have been held up in the inventory, an indicator being the increase in raw materials in 2008 (31 million pounds) compared to 2007 (24 million pounds) and finished goods in 2008 (441 million pounds) compared to 2007 (314 million pounds)
The figures indicate that McGraw-Hill is much better at coping with their inventories. The differences can be caused by McGraw-Hill's 1.58 times higher cost of sales, including investing in promoting or distributing activities. Normally firms prefer a lower stock turnover period.
Average Settlement Period for Trade Receivables (ASPTR)
The increase in ASPTR for the year 2008 could have two reasons. Firstly, a delay in payment from a few large customers could have affected the settlement period for Pearson. Second, the significant sales increase in 2008 maybe due to large credits sales due to sales promotions, which in turn has affected the ASPTR.
Pearson is also less able to collect from the creditors, which may lead to a bad cash flow turnover and increased risk of bad debts occurrence. This is caused by Pearson's 1.84 times more in creditors and only possessed 1.1 times more of credit sales amount compared to McGraw-Hill, for example some deferred payment from major customers.
Average Settlement Period for Trade Payables (ASTP)
An increase in the ASPTR from 2007 to 2008 indicates the company now has higher liquidity due to a longer time to pay off their short-term obligations compared to last year. However, we cannot ignore that this may be because Pearson might have paid delayed payments to its large debtors which could result in a loss of goodwill amongst its creditors.
The later figures indicate that, Pearson is less capable to pay its debts comparing with McGraw-Hill. Possibly this can be attributed to the 1.93 times more in debtors and the 63% in credit purchase quantities.
Interest Cover Ratio (ICR)
An increase in ICR in 2008 reflects interest payable decreasing in 2008 by 7% and the Operating Profits rising by 14% during the term. This could be because of Pearson paying off a significant loan or many small loans in 2008.
In addition, the industry average is 1.49. The later comparison shows that Pearson is less capable to pay the interests. The reason of the differences can be attributed to McGraw-Hill's 1.38 times more in PBIT and 51% less in interest payable.
Q2. CASH FLOW STATEMENT ANALYSIS
Cash flow statement analysis is a method of analyzing the financial, investing and operating activities of a company. Cash flow measures real money flowing in to or out of, a company's bank account.
The main flows of cash are:-
- Cash flows from operating activities.
- Cash flows from investing activities.
- Cash flows from financial activities.
In cash flow from operating activities, the net cash generated from operations has improved from£679m in 2007 to £894m in 2008.The net effect of acquisitions and disposalsadded £199m to sales and £35m to operating profit, largely in the education business, where Pearson integrated the testing and international division of Harcourt, acquired from Reed Elsevier. Currency movements added £320m to sales and £76m to operating profit. Since amortization has increased, the income tax has decreased from £222m in 2007 to £209m in 2008
More net cash earned by the company means that, the company got enough money to invest more, can buy more assets, can declare more dividends to the shareholders. Cash adequacy ratio of 2.69 indicates that the company's operating activities produces sufficient cash to meet all necessary business obligations. The business of Pearson has increased with subsidiaries, which are clearly evident from amount of money that was received this year rather than the amount that was paid out in the previous year. This shows that the subsidiaries are doing good business this year. The interest paid has declined from the previous year, which evidently shows that the company has paid some of its debts. With the above figures and data it shows that the net cash flow from operating activities has increased from £463m to £718m in the year 2008.
Secondly, proceeding with the net cash flows from investing activities has a unfavorable figure which is in deficit. As given in the consolidated cash flow, the figure in 2007 shows a deficit £61m whereas in 2008 shows a deficit of £369m. Pearson purchased investments, properties, plant and equipments worth £76m, which is lower than previous year, which was £86m. Discontinued operations in 2007 relate to the sale of Pearson's subsidiaries, which resulted in a loss of 90 million pounds. The company has not acquired any new subsidiary neither has disposed any old ones in the year 2008, the sole reason being recession as the company wouldn't have got a proper cash inflow from the sale of subsidiaries and vice versa.
Cash flow statement for financing activities ofPearson includes proceeds from issue of ordinary shares, which accounts to £6m, which was lower than in 2007 by £6m. Pearson purchased treasury shares worth £47m, which was lower than £72m spent in 2007. Pearson issued $350m 5.5% Global Dollar Bonds 2013 and $550m 6.25% Global Dollar Bonds 2018. The income was used to pay back outstanding debts of £275m. Cash flow was strong, butnet debt was prominent with the impact of acquisitions and disposals (net impact of £285m) and the year-end vigor of the dollar on Pearson's largely dollar-denominated debt (net impact of £410m).
Due to recession in 2008 Pearson received a nominal amount from the issue of ordinary shares as the market did not have that much cash to invest in the company due to which the proceeds has declined by £6m. Similarly Pearson has not purchased more treasury shares in 2008 as they felt it was risky due to the recession funds. The company has borrowed less from the previous year and repaid the borrowings as much as possible by the funds it has received from other activities. Even though the market was unstable and investors were losing hope in the market, the company was able to pay higher dividends to the shareholders, which are a positive sign as this move will attract more investors and keep a long-term relationship with the current investors. Another significant point in the cash flow is the currency exchange due to which the company has taken a set back as 60% of the revenues are in US $. Due to market fluctuation in 2008 and weakening of the home currency has led to significant amount of cash going out in US $ which is not a healthy sign for the company. In spite of the financial crisis in the market Pearson was able to put up a decent performance, which is evident from the cash equivalent at the end of year, which rose by £97m.
Q3. INVESTOR RATIO ANALYSIS
Earning Per Share Ratio
Earning Per Share (EPS) means 'the earnings generated by the business and available to shareholders during a period to the number of share in issue' (Atrill & McLarney, 2004) In general, EPS is the result of the company's profitability. Higher EPS can demonstrate the company's ability to generate profit per capita, which also shows the company's abilities in implementation, management, technologies or so on.
It can be seen that there is a slight increase in EPS for Pearson. It could be seen as a good trend as it indicates within this certain period of time Pearson is on a positive track of managing its business and is seen as a good signal to investors who is interested in Pearson.
Comparing with McGraw-Hill, Pearson is far more less in EPS. This only indicates that, under the same conditions, McGraw-Hill is more efficient to generate profits.
However, it is not always 'the higher the better'. Some limiting factors need to be noticed
- The single EPS only shows the earnings of each common share, without considering other factors such as the volumes of common share, or the earnings. In 2008, Pearson has issued 797 million common stocks, which is 2.5 times more that McGraw-Hill. In addition, Pearson's earning is only 36.5% of McGraw-hill. McGraw-hill seems to be more 'bright' than Pearson, however, the gross profit margin of Pearson is 55% while the McGraw-hill is 21.32%. Investors need to focus more on all the perspectives of the firm rather than sticking on a number reflecting price of a certain period of history.
- EPS cannot predict the risk behind the investment. For example, a poor investment program maybe launched without serious consideration. It may have no impact on EPS however but may increase the risk.
- Different firms may have different ways and methodology of calculating the EPS which can lead to varied results. For example, Pearson has used GBP as the standard while McGraw-Hill's is USD which could have an affect on EPS due to exchange prices.
Therefore, to investors, some recommendations can be made:
- Extending the time horizon of analysis. As can be seen from Pearson and McGraw-Hill's table above, it's difficult to make final decision about which one to choose for investment. Pearson and McGraw-Hill are both large corporations generating significant amount of revenues from multi-regional departments or un-core business, for example. Pearson has 7 main business sectors. By extending the time horizon of financial reports, investors can understand regularity and possible reasons of those historical data to assist the decision-making.
- Combining other financial indicators, EPS cannot totally reflect the financial performance and cash flow status of the company. Therefore, ratios and industry averages should be all included as the investor's references.
Price/Earnings Ratio Analysis
A P/E Ratio looks at the relationship between the stock price and a company's earnings. It suggests how much an investor is willing to pay for a company's earnings. A high P/E may indicate that investors have high expectations from the stock and are thus over-bidding the price.
The fall in the P/E ratio for Pearson can be largely accounted to the recession in the economy. Since the EPS in 2007 and 2008 is almost the same, the fall in the P/E ratio is attributed to the drastic fall in the market share price of Pearson from 999p in 2007 to 657p in 2008, a drop of almost 35%. Investors speculated a drop in the P/E ratio further in 2009 to 14.52, probably because they were still pessimistic about the market conditions. Another reason for the drastic drop in the market share price was probably because it had originally been overvalued and although Pearson grew in profit by 4%, they had to bring down the value of their share prices in order to be in sync with their growth and investor expectations.
In comparison, McGraw Hills' growth rate of it's P/E ratio is around 37% compared to its revenue which has declined by 6% from 2007 to 2008. It seems that the McGraw Hill Stocks are over priced and it requires some correction immediately.
Some recommendations that can be made to investors are:
- Investors need know about the overall performance of the company and industry, not only P/E.
- Knowing about the consistency of the performance growth vs the growth/ decline in the P/E ratio is a significant indicator of the health of the company.
- Sometimes it is difficult to say if the P/E ratio for a company is high or low. A P/E ratio, as mentioned above, should be in sync with the company's growth. If the ratio is much higher then the share price is higher than the historical price and vice versa.
- Finally, it is always good to compare the P/E ratio to the industrial average. A technology based company will have a much higher ratio than a manufacturing company.
In conclusion, looking at all the above calculations and analysis, it would be fair to say that Pearson PLC is in good financial health when compared to its largest competitor and industry averages. A consistent Current Ratio and Acid Test ratio suggests that the company has enough liquid assets to pay of their short-term obligations. Investors look for company who can increase profit margins, the operating profit margin for Pearson suggests that although costs have increased for Pearson, profits have been increasing too which again is good for investor confidence and that too at the time of a recession. Looking at the Debt to Equity ratio, where total borrowings for Pearson in 2008 was 2363m pounds and total equity was 4750m pounds, the Debt to Equity ratio is around 0.50:1 which means that Pearson has twice the equity than its debts. This is a very good indicator when looking to invest in a company. Finally, The P/E ratios are within range of the industrial average in 2008 and fell in 2009, but so did the industrial average. This means that Pearson's share prices are being well adjusted to suit market speculations and investor confidence, which again is a good indicator of a company's financial health and investor's confidence in them.