What is finance Managing?
It is all about undertaking planning, organizing, directing and controlling financial activities involving procurement of finance till their optimum utilization in order to maximize wealth of capital contributors and various investors. When decisions related to mergers and acquisitions are concerned, acquiring company usually carry out a due diligence review of the company under acquisition assessing company’s past performance, its organizational structure, its future sustainability and growth prospects. Further financial performance of the company is ascertained through analytical tools involving ratios and variances analysis, comparing company’s financial performance with industry standards (Hillier, and et. al., 2010). In this report, we have assessed various aspects to be considered in due diligence review of Frater Ltd. which is to be acquired by Global plc.
Due Diligence Review Of Frater Ltd
Financial due diligence is conducted to give acquirers greater certainty about the nature of business and Characterstics of its cash flows of the company under acquisition. This will also help them in making better pricing decisions and easily determines the level of gearing the structure will support (Culp, and Heaton, 2010). Due Diligence review will involve evaluating and assessing following under mentioned aspects:
Capitalization of the company
Acquiring Company’s value has to be assessed for determining maximum price that Global Plc would be willing to pay. Capitalization is nothing but determining value or worth of the firm, which is determined through various stock valuation methods being net asset value method, Book value multiplier method, market capitalization method, discounted cash flow methods (Fernandez, 2013). Valuation of share of Frater Ltd. has been ascertained through below mentioned methods and justification for using the same has been explained along with:
Net asset value is highly recognized for valuation of shares of the company, specifically while signing off mergers and acquisition deals. Net asset value determines value of share of the company by determining individual current market values of all assets including Goodwill and liabilities and eventually ascertaining net assets value by subtracting value of liabilities from value of assets (Hitchner, 2011). The value arrived is divided by no. of shares of equivalent value to gain value per share.
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By using net assets value method, management of Frater Ltd can come to know about the actual value of shares or assets. It leads to increase brand image of the firm and increase number of buyers. It leads to attract large number of investors that aid to raise long as well as short term money for Frater Ltd. It can be critically evaluated that valuation method may prove to be wrong because of uncertainty future business activities and uncontrollable environment.
In context to Frater Ltd. we have ascertained value per share of the firm by using above formula. Fixed assets being land & buildings and Plant have been taken into calculation with their given market values as of 31/12/2013. Book values of other assets and liabilities have been assumed to be their current market value in absence of additional information (Fridson and Alvarez, 2011). Further, while valuing firm, Goodwill is also taken into account to derive absolute value of firm, but here in absence of information, Goodwill calculations are not taken into account due to lack of information. As per this method, Frater Ltd. can expect at least 3.752 £ per share as sale consideration.
Value of company’s share can also be ascertained through using PE multiple (Koller, and Wessels, 2011). Market price can be ascertained through PE ratio using under mentioned mathematical formula:
Market Price Per share = PE Ratio x Earnings Per share
Above formula has been used in deriving Frater Ltd’s current market price. As far as Earnings per share are concerned, E.P.S of past 5 years has been taken into account. Respective years number of shares outstanding have been considered. In 2013, additional shares were issued for consideration in cash in 2013. It has been assumed that shares were issued at the beginning of the year, so equivalent no. of shares has been assumed to be 1500000. As far as PE multiple is considered, an average PE has been worked out using figures of similar companies in the industry considering their data for 3 years for working out the average. Based on above discussion and workings referred, Frater Ltd. has market price per share worth 2.051573 £. This method is also recognized as Book value multiplier.
Revenue, Profit and Margin trends
Under this approach, revenue and income trends for the past 2-3 years should be assessed. Trends are identified to check whether they are consistent or unusual. It assist management of firm to bring improvement in the present work environment and facilitate to increase overall rate of return.
It can be assessed that profits of Frater Ltd. shows unusual increasing and decreasing trends, more in 2013, which has increased by at most 80.6%,against previous year increase by 41.05%. Such unusual trends may be due to reasons of accruing abnormal gain, more on account of sale of assets far beyond their cost, or due to exceptional items of non-recurring nature. However, in context to forecasted Earnings, it has been given that profit after tax for four subsequent years post 2015 have been estimated to 8% increase uniformly. In absence of cost of capital of Frater and Global Ltd. respectively forecasted earnings of Frater Ltd. cannot be used to determine share value of the firm using discounted cash flow method or earnings capitalization method. By the help of trend of profit, it is found that, at present firm is performing very well that assist firm to grab the opportunities. Here, revenue for Frater Ltd is continuously increasing but in 2012 it went down. In 2012 the rate of return was 41.05% whereas it is 80.60% in 2013.
Assessing financial performance through ratio analysis (Delen, Kuzey, and Uyar, 2013):
%.1.Current Ratio = Current Assets/ Current Liabilities
%.2.Acid Test Ratio: Quick Assets/ Current Liabilities
On evaluating above ratios, it is revealed that company maintains good liquidity ratios. Standard current ratio is generally considered to be 1. Thus company maintains current ratio on the basis of determined policies and regulations which indicates that company has good liquidity position preventing itself from working capital block age. Bank overdraft facilities are sanctioned by banks based on how effectively working capital has been managed. Even company has enough liquidity to meet its short term obligation that facilitate to ensure smooth flow of production and deliver good quality of services to large number of buyers.
From the analysis, it can be said that, firm is performing good in the current year in comparison to 2012. it because in 2013 it has 1.3 times current ration where the same was 1.27 times in the 2012. It shows that at present corporation is utilizing its assets in an effectual manner.
I.Gross Profit Ratio= G.P*100/ Sales
II.Net Profit Ratio = N.P. *100/Sales
= 484 *100/8756
Profitability ratios indicate operational performance of companies’ business activities. How well the company is managing its business activities can only be accessed through determining the surplus or deficit it made in the reporting period tabulated in profit and loss a/c. Profitability ratios indicate return of company’s efforts. In context of Frater Ltd, it is observed that though company maintains low margin of 8.54% but a net profit ratio of 5.53% indicates company has less administrative and indirect expenses which aid to increase overall rate of return. It is quite usual in companies, that their indirect expenses are huge which absorbs substantial amount of their gross profit leaving behind minor returns for investors or capital contributors for distribution.
From the two years analysis it can be said that Frater Ltd is generating higher profitability in 2013. it because in 2013 it has 8.54% return whereas in 2012 it had 4.87. It depicts that management of Frater Ltd has improved financial performance that motivate investors to invest their money in Frater Ltd. In addition to this, net profit of company has increased in the current year.
Asset Turnover Ratio
%.I.Fixed Asset Turnover= Turnover/ Fixed Assets
= 3.24 times
Asset turnover indicates how well the company’s turnover covers its different category of assets. Fixed assets turnover indicates with the given amount of fixed assets, to what extent company utilizes its fixed assets to generate turnover, or to what extent fixed asset contributes to generate revenue from operations (Persons, 2011). On the other hand, stock turnover ratio indicates to what extent company’s turnover exceeds average stock held for the period. In context to Frater Ltd, Company’s fixed asset turnover is worked out to 3.24 times, which is generally considered to be good in the industry in which it operates. Because it depicts that firm is managing its assets in an effectual manner that facilitate to reduce cost of production and increase overall rate of return. As far as stock turnover ratio is concerned, company has been maintaining tremendous ratio amounting to 19.63 times, which is considered to be worth in industry to which Frater ltd belongs.
From the analysis it is found that, Frater Ltd is utilizing its assets in more effective way that aid to increase overall rate of return and deliver good quality of services to large number of buyers. From the analysis of two years it can be said the in the current years firm is performing comparatively good.
Cost of Capital< Return on Investment (Assets), Retain more and distribute less.
Cost of Capital>Return on Investment (Assets), Retain less and distribute more.
Return on Investment
I.Return on Assets = (Net Income + After tax cost of interest)/ Average total assets
= (484+154)/ (3588+2430)/2
II.Return on Equity= Income for equity shareholders *100/ Equity
Return on Investment assesses operational performance of company’s business activities. The higher the return, the more the investors and other capital contributories will attract. Return on assets indicates how well the company has utilized its assets and eventually leading to positive results in form of high returns (Welch, 2011). On similar lines, return on equity identifies how effectively the capital of equity contributories is utilized. In context to Frater ltd, company has optimally utilized its assets and also the equity shareholders fund giving returns amounting to 21.2% and 17.73% respectively, which indicates that neither the company’s assets nor the capital invested by equity contributories is eroded which shows positive attitude of company’s business activities towards growth and sustainability.
From the the review of financial performance of Frater Ltd it is found that, return on equity has increased in the the current and the rate of increase is 3%. It shows the present position of firm is much better than previous years that leads to increase level of satisfaction of different stakeholders.
Evaluationof Frater Ltd’s Valuation And Ascertaining Range In Which Prospective Investors May Negotiate
Based on calculations and analysis made above considering various aspects for valuation of Frater Ltd, it has been ascertained that overall the company has positive operational performance, despite having its past profits showing unusual trends (Introduction to Financial Ratios, 2014). Company even may not suffer from cash loses during the past two years, which is an important aspect for managing working capital effectively. It assist management of firm to ensure consistent flow of production so as to cater need of different types of buyers. Company has been running profitably since 2009, and it is also estimated that company’s profits for subsequent years post year 2015 will show an increasing trend of 8%, for which Global Plc will place more concern. Financial ratios calculated above, being widely used approach used by investors to make investing decisions, also revealed positive operational performance of Frater Ltd (Financial Performance Indicators (FPIs, 2014).
However, and based on valuation of the company done through Net Asset method and PE multiple approach, investors will be reluctant to pay more than higher of the amounts ascertained through such methods. Acquirers often adopt discounted cash flow approach while determining purchase consideration, in absence of cash flow after tax and cost of capital of both the firms, valuation under DCF approach could not be determined. As far as investor’s willingness to pay is concerned when valuation under Net Asset method and PE multiple approach is made investor would pay not less than 2.051573£ per share and not more than 3.752 £ per share.
Total valuation under Net Asset Value Method= No. of shares x Net asset value per share
= 1500000 x 3.752£
= 56, 28,000 £ (Maximum)
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Limitations of various methods under valuation:
Net Asset Value:
- This method can under estimate the value of intangible assets especially Goodwill, which cannot be easily determined.
- This method does not at all take into account future changes in revenue and its related income.
- Balance sheet may not accurately reflect all assets.
PE Multiple approach:
- PE ratio is little bit hard to calculate because of several types of variations the denominator of EPS.
- When earnings show unusual trends, PE multiple changes respectively and cannot be applied to estimated earnings, in that, industry standard PE is to be adopted.
Discounted Future Earnings:
- Projections for cash flows are not guaranteed, it is based on prevailing circumstances, which may change drastically in future.
- It may underestimate the value of balance sheet assets (Hitchner, 2011).
Earnings capitalization method:
- It may overlook value of assets being tangible and intangible assets.
- Placing reliance on post earnings may ignore potential future growth (Fernandez, 2013).
At last, it can be concluded that Frater Ltd has positive growth and sustainability prospects for which Global Plc will be willing to pay worth price based on its own evaluation of above findings. Frater Ltd can even make public offers for raising further capital for funding its investment proposal in view of its positive operational performance since 2009.
- Delen, D., Kuzey, C., and Uyar, A., 2013. Measuring firm performance using financial ratios: A decision tree approach. Expert Systems with Applications.
- Fernandez, P., 2013. Company valuation methods. Available at SSRN 274973.
- Fridson, M. S., and Alvarez, F. 2011.Financial statement analysis: a practitioner's guide. John Wiley & Sons.
- Hillier, D. J. and et.al., 2010.Corporate finance 1st European edition.1st Ed. McGraw-Hill.
- Hitchner, J. R., 2011. Financial valuation: applications and models. John Wiley & Sons.
- Koller, T., Goedhart, M., and Wessels, D., 2011. Valuation: measuring and managing the value of companies. John Wiley and Sons.