Introduction
According to the Enterprise Theory of Accounting, a company is considered as separate legal entity having the rights to make decisions independently; despite the fact that company’s capitals might be “rented” from banks or stockholders. Regardless of being the true owners of company’s assets, stockholders cannot interfere with company’s operations without approvals of the executive leaders. Only in certain periodical meetings, the CEO will address stockholders, reporting management’s performance and performance results during the period.
This principle has logically created sound issue of agency, which constitutes the concerns of whether managers and directors using the powers invested in them in the light of stewardship or not. Methods are developed in order to give owners of the company certain level of assurance regarding management’s performance.
Financial Statements is the company’s way to communicate with the world. It is their way to elaborate the company’s condition trough the financial period. Questions like, how is the company growing? Is it using its resources wisely? Is it safe to invest our money in it? , will be answered by paying attention to the small numbers of financial statements diligently. Financial statements are like companies’ report cards after a year in “the school” (Schuller).
The main parts of a financial statement (Balance Sheet, Income Statements, Cashflow and Retained Earnings Report) are figures describing the company’s performance over the period. But how could we asses the company’s performance over numbers? How could numbers form some explicit meaning causing it to describe the company’s overall condition? The answer is financial ratios.
Financial ratios are imperative analysis tool to define management performance and how best have the exploit available resources to maximize shareholders value. The ratios can be compared to similar industry or internal financial figures over a period of time (trend analysis). Beside its function as a tool of historical measurements, the ratios, to some extent, can be functioned as predictive tools also, especially to make suggestion on investment opportunities and risks (“Analyzing”). In this particular analysis, we will display a trend analysis of a garment and accessories distributor by the name of NEXT Group plc. Final suggestion of the definitive company performance will be stated in the final and conclusion chapter.
Historical Background
NEXT is a provider of quality clothes and fashion accessories retail shop. The company starts by opening a series of retail store in 1982 which turned out to practically re-shape the future of fashion retailing. The first store was for women wear and accessories, but the male collections and the children wear quickly followed. Today, NEXT have 380 stores in UK and Eire, and 80 franchise stores overseas (“NEXT-Background”).
Financial Analysis
As stated above, the solvency analysis displayed a downhill trend of NEXT’s long term and short term liquidity performance. Over the past 9 years it solvency ratio has declined over 40 %. The current ratio has also declined almost 40 % while the quick ratio displayed a 22% decrease over the past 9 years. The current and quick ratios present a significant decrease in the company’s ability to pay its current debt, while the solvency ratio might describes a high level of risk to shareholder. Lower liquidity performances suggest a higher investment risk, but they could also suggest that the industry (or the company) is under a high state of growth which required management to collect more cash-inflows to finance its developing business activities. To properly assess the company’s true condition, we cannot rely simply on these liquidity ratios (“Financial ratios”).
Efficiency ratios present a highly positive trend as the days required to receive payment over sales, to pay short term debt and to keep merchandise on storage growing significantly shorter. The ratios indicate that the company is growing vastly in its capability of efficiently manage its financial affairs.
Profitability analysis shows that the company presented an amazing increase during the year 2003 where its return on shareholder’s fund displayed a number of 121%. The profit margin drop significantly until the year 1999, afterwards, it displayed a relatively slow increase. As we could see, the profit margin and the return on shareholders fund did not suggest the same performance tendency. Despite the slow increase of profit (which could also mean that the company is under a state of expansion) (“Financial Ratios”), for the past 2 years, the company presented a remarkable profitability over shareholders value.
The company’s investor-related ratios display a quite positive trend. The EPS showed only one lack of performance, which is during the year 1998 where the EPS was lowered about 8%. Other years displayed a very positive performance measurement. The year 2003 even recorded a 34 % increase of EPS. The dividend per share ratio displayed a stable increase and an attractive performance. These ratios suggested a positive trend where its performance of company stewardship should encourage investor to make a quite profitable investment.
Z-Score Analysis
The Analysis was developed by Professor Edward I. Altman in order to define company’s health. The model which was developed in the late 1960’s incorporated five weighted financial ratios to measure company’s changes in doing business (“Z-Score Described”). Dr Altman is known to be the expert of statistical effort in predicting company failure (“The Altman Z-Score Analysis”). The performance on NEXT group plc between 1996 and 2004, under the Z-Score Analysis is as follows.
Under the Z-score analysis, a company is considered healthy if the total scores (Z) > 2.60 and considered unhealthy if the total scores (Z) < 1.1. Relating to the analysis results stated above, the company is considered to be in a very healthy condition. The best performance according the Z-score analysis was in the year 1998, where the total score equals 5.58.
X1 Component
The x-1 component (Working capital/Total asset) represents the operating performance of a company. A company which experienced repeated operating losses would generate a decrease in its working capital compared to its total assets (“Z-Score described”). The idea of the component is to measure the net liquid assets of the firm relative to the total capitalization. The working capital as the difference between the current asset and current liabilities is considered the most valuable analysis to describe the firm’s liquidity and operating performance. The other known ratios of liquidity (current and quick ratio) have proven to be less helpful and have been found to deceive investor in investing for a failing company (Altman).
During the 9 period performances, Next plc described good, but rather unstable results. It experienced significant increases during the first four years, but dropped immensely by the year 2000 where the weighted ratio fell from 2.82 to 0.46. The drop in the year 2000 could result from a significant decrease in short term market demand due to certain economy-disturbing external events. This was later justified by having the performances raised again in 2001 and 2002.
However the significant decrease on the year 2003 and 2004 were not likely to be the result of the same event in the year 2000. Because the decreasing pattern stays for 2 years in a row, the company must also experienced internal changes in the way it handled the business. Relating to the previously stated positive trend of stewardship, the decrease of liquidity is most likely an effort of obtaining more capital for company expansion plan.
X2 Component
The X2 performance (Retained Earnings/Total Assets) describes the strength of the firm relating to its ability in maintaining surplus performance. What must be noted while using this ratio is the possibility of “manipulation” using quasi reorganization and stock dividend declaration. The usage of this ratio must also incorporate the consideration of the firm’s age. A recently established company might be discriminated by this ratio due to its young age which allows it no chance of building cumulative profits yet. But due to the fact that most ‘new’ companies fail in its first years, the usage of this ratio is considered relevant by many (Altman).
Next plc displays a moderate fluctuation in its X2 component performance, which suggested an unstable profitability. The pattern of the fluctuation is somewhat similar to the X1 component where the sudden decrease occur somewhere between 1999 and 2000 and then quickly bounced back. The significant profitability decline during 2003 and 2004 also describe a considerable change of company strategy.
X3 Component
The X3 (EBIT/TA) component displays the productivity of a company. The ratio is said to be the true measure of a company’s efficiency in using its assets. This ratio is incorporated in this Z-score failure analysis because the earning power of a company is its ultimate indication of success or failure. This ratio in its practice; has outperform other profitability measures like the cash flow measurement (Altman). Next plc produces a relatively stable performance of the mentioned ratio. The best performance is recorded in the year 1996 when the ratio shows a number of 1.21. Afterwards the company experienced a stable decrease until 1999 when the performance ratio number remain until 2004.
X4 Component
The X4 component describes a comparison between the combined market value of all equity of the company to the total liabilities existed. It is a measure of how much a company can decline in its assets’ market value before it became lower that the total liabilities and the company became insolvent. This ratio is used in this Z-score failure detection because in provide an insight of how much a company would survive in case of a crisis (Altman). Next plc delivers an increasing trend as the ratio number increase stably from 1996 until the year 2000; afterwards, the ratio suggested a light decrease until 2003. On 2003, the ratio displayed the similar trend displayed by other ratios. This ratio also dropped significantly.
Conclusion
From the efficiency ratios, we can conclude that the company presents an effective management performance. The numbers indicate that merchandises are quickly sold and receivables are quickly paid. A high number of receivable and stock turnover suggested that the company is having a healthy cash flow and profitability performance.
The company also displays a highly positive trend of the return of investor’s fund. Despite fluctuation in liquidity and profitability performance, dividend distributed and EPS growth showed a rather significant increase. The condition suggests that despite its ups and down, the company posses a high sense of responsibility toward its shareholders.
From the profitability and especially the liquidity performance, the company displays a negative trend where existing pattern described that the year 2003 and 2004 present a significant change in the way the company performs its operations. Economist and business analyst often mentioned that a company within expansion efforts usually displayed a rather downward shift over its liquidity performance, but remain overall profitable. The symptoms are similar to what has been experienced by the Next Group plc.
An indication of failure should start by the low performance of efficiency where the poor management results decreasing profitability, minimum cash flow and in the end draining company’s retained earnings and destroying liquidity. This case is not what happens to the Next Group plc. The company maintains a very high efficiency performance despite its downtrend liquidity performance. In several cases, this condition is usually the result of a major capitalization within the company. If managed successfully, the new resources would most likely present an increase in future performance of profitability.
Professor Altman’s method of detecting company failure, the Z-score analysis confirms the conclusion by displaying a very high performance under the analysis. The method -being a way to detect risks of company collapse- focus to some extent in the analysis of liquidity. Therefore, the analysis still displays a pattern of downward shift by the end of the periods. But the number still way above the crisis point (the lowest performance 1.33, while the crisis point is 1.1).
The company displays a very attractive performance relating to its efficiency performance, its EPS growth, dividend per share and P/E ratio. As a company’s main purpose is to increase shareholder’s value, we concluded that despite the short term decrease over liquidity performance, the company still poses as a profitable investment strategy.
Bibliography
- “Analyzing Your Financial Ratios.” N.d. Retrieved May 28, 2005 from http://www.va-interactive.com/inbusiness/editorial/finance/ibt/ratio_analysis.html
- Altman, Edward I. “Predicting Financial Distress of Companies.” 2000. Retrieved May 28, 2005 from http://pages.stern.nyu.edu/~ealtman/Zscores.pdf#search=’zscore%20analysis
- “Financial Ratios and Quality Indicators.” 2001. Online Women Business Center. Retrieved May 28, 2005. from http://www.onlinewbc.gov/docs/finance/fs_ratio1.html
- “NEXT-Background.” 2005. NEXT. Retrieved May 28, 2005 from http://order.next.co.uk/aboutnext/history.asp
- “NEXT Annual Report and Accounts.” 2005. NEXT. Retrieved May 28, 2005 from http://order.next.co.uk/aboutnext/CompanyResults/index.asp
- “The Altman Z-Score Analysis.” 2004. Jaxworks. Retrieved May 28, 2005 from http://www.jaxworks.com/zscore3.htm
- “Z-Score Described.” n.d. Sourcing Decision Support, Inc. Retrieved May28, 2005 from http://www.sdsnotebooks.com/finz.htm
