About the report
The objective of this report is to assist One-World Investment Consortium, who is planning to invest £150 million in Thomas Cook PLC, a British global travel company listed on the London Stock Exchange under the ticker sign of ‘TCG’. We duly understand the impact of our professional recommendation on Consortium’s final decision making related to investment, and therefore, we intend to be comprehensive in the approach our analysis.
As for the structure of this report, it will be a two-part report. In the first section of the report, we will evaluate the past 5 year(2007-2011) financial performance of the company using necessary ratios related to liquidity, profitability, solvency and efficiency. It is considerable that a comparative analysis between multiple years will help us to understand the rising trend and to track performance indicators. However, in order to add more credibility to our work,we will also explain the financial performance using horizontal and vertical analysis of the financial statements. In addition to the financial analysis, we will also provide a brief overview related to non-financial performance indicators, which in alignment with the outcome of the financial analysis, will help us in framing a rationale recommendation for One-World Investment Consortium.
Second part of this report will be a core theoretical explanation discussing various investment appraisal techniques such as NPV, Internal Rate of Return(IRR), Payback Period and Accounting Rate of Return. In this section we will compare these appraisal methods on the basis of their suitability for long-term projects and cash flow under unconventional patterns.
Common Size Financial Statements
-Horizontal Analysis of Income Statement
Following the horizontal income statement and balance sheet for the five years, we see that from the glorious years of 2007-08, the company has succumbed to the gloom of poor financial run by the end of 2011. It was noteworthy that until 2008, the company witnessed a remarkable run with a 37.2% increase in the revenue figures. However, following this, the company lost momentum and witnessed a significant fall in the revenue figures during 2009 and 2010, though it managed a 10.34% rise during 2011. The effect of tidal and pessimistic trend in the revenue figures was visible on the growth of gross profit figures, which witnessed a meteoritic fall from 32.33% in 2007-08 to 0.75% in 2010-11.
However, following a controlled growth in the operating expenses, which declined consistently from 40.57% in 2007-08 to -0.53% in 2010-11, the operating income did increase following a significant downside during 2008-09.
Unfortunately for the company, the benefit of controlled operating expenses could not reach the bottom line figures because of consistently growing interest expenses and most importantly, because of the paramount of non-operating losses, which since 2007 had increased by more than five times growing from £85 million to £498 million. Accordingly, the net income of the company plummeted from £152 million in 2007 to -£521 million.
-Horizontal Analysis of Balance Sheet
Since the balance sheet of the company reveals the financial position of an entity, the horizontal analysis of the balance sheet confirms a poor financial run of Thomas Cook over the period of the past five years, i.e. from 2007-2011. Beginning with the current assets, following the consistent decline until 2010, the current asset base of the company surged by 16.42% during 2011 on account of 5.59% increase in the cash position and 25.30% in other current assets. However, out of the total cash position, since £200 million was sourced from loan facilities, we cannot rate this as a sustainable increase in current asset position overall. Another concerning trend was witnessed in the fixed asset position, where we witnessed a consistent fall in the growth of the fixed asset base, plummeting from 15.40% in 2007-08 to -8.37% in 2010-11.
Overall, the growth in the asset base declined consistently from 21.07% in 2007-08 to -3.07% in 2010-11.
As for the liabilities position, a consistent decline was witnessed in the current liabilities base until 2010, following which, the current liabilities surged by 11.76%. However, the most notable trend was witnessed in long-term liabilities, which over the period of five years, increased manifold from £359 million to £1030 million.
Finally, for the equity portion, the consistent decline in the retained reserves confirmed the bearish financial run of the company. Until 2011, the retained reserve of the company decreased to almost half to what was company holding during 2007.
-Vertical Income Statement
Referring to the vertical income statement of the company, we witnessed the real reason behind the poor financial run of the company. To what we witnessed, while the revenue figures of the company have been highly sluggish over the five year term, the company did managed to maintain almost a constant proportion of cost of sales, to sales figures, and this helped the company to sustain the gross profits to an extent.
However, consistently higher proportion of operating expenses ranging from 19% to 22% of the revenue figures, and ever growing non-operating losses, resulted in a significant decline in the net profits of the company, which by the end of 2011, had transformed to a net loss of -1.30%.
-Vertical Balance Sheet
Vertical balance sheet revealed the declining proportion of current asset in percentage of total assets. Most importantly, it was the cash figures, which relative to total assets kept on diminishing from 10.71% in 2007 to 5.31% in 2011.
However, to what may sent a tremor to the investors is the proportion of total liabilities to total assets, which surged from 63.49% in 2007 to 82.33% in 2011.
Ratio Analysis
While the previous section dealt with the common-size financial statements of the company, in this section we will run the raw financial figures through the microscope of financial ratios. Highlighted below are the multiple financial ratios of Thomas Cook for the past five years:
-Profitability Ratios:
The ability of the company to use its resources profitably, is reflected in the profitability ratios. Below we have calculated multiple profitability ratios for Thomas Cook followed by a comprehensive discussion:
a)Year on year Sales growth:
As noted from the above figures, while the company witnessed strong growth in the sales figure during 2008 with 37.72% increase in the sales figure, it could not hold on to the momentum and witnessed consistent fall during 2008-09 and 2009-10. However,during 2011,owing to a strong performance by Northern Europe, Central Europe and Airlines Germany operating segments, the company was able to record 10.34% increase in the sales figure, though poor performance in UK segment remained a concern.
b) Gross Profit Margin:
The above calculations reveals that until 2010,the Gross Margins of Thomas Cook were relatively constant within the range of 23%-24%. However, during 2011, even though the company managed to increase the sales figure by 10.34%, but this came at the expense of higher proportion of cost of goods sold in percentage to the sales figure rising from 75.98%in 2010 to 77.98% in 2011, and thus eroding the gross margins of the company to 22.02%.
c) Operating Profit Margin: Operating Income/ Revenue
The higher proportion of cost of goods also imposed a pessimistic effect on the operating margins and despite of controlled operating expenses, the operating margin kept on declining year after year and got settled at 2.79% during 2011 compared to 5.50% during 2007.
d) Net Margin: Net Income/ Revenue
The bottom line margins, i.e. net profit margins indicates the profits available to the company after accounting for all the expenses. Referring to the above table, we witness that year-after-year, the company is losing its net margins. While the declining revenues and increasing proportion of costs of goods sold is a dominant factor behind the decreasing net margins, non-operating losses, which over the past five years have increased by five times, are also contributing towards net losses of the company in the recent year
e) Return on Equity: Net Income/ Total Equity
We are sure that just like One World Investment Consortium, eve the shareholders of the company will not be pleased to view the ongoing trend in the ROE multiple. As we witnessed, since 200, the ROE multiple is declining consistently and by 2011, owing to net losses, the ROE multiple plummeted to -10.82%.
f) Return on Capital Employed(ROCE): Net Income/ (Total Assets- Current Liabilities)
ROCE multiple indicates the amount of return being generated on the total amount of capital employed. Unfortunately, even this profitability ratio reveals the same saga of bearish financial run in the company with the multiple falling from 4.76% to -4.40%. This clearly reveals that the management is unable to use the capital resources appropriately and in fact, are facing capital erosion.
-Dupont Analysis
Dupont analysis provides us the opportunity to decode the ROE multiple and see the components that are leading the change in ROE. Our calculation revealed that a significant proportion of the ROE multiple of the company is being sourced from financial leverage while it struggles to generate profits despite of assuming high risk profile. This is a clear sign of financial bizarre in the company.
-Efficiency Ratios:
a)Debtor Turnover: Revenue/Total Receivables
b) Days of debtor turnover: 365/ Debtor Turnover
The above two ratios indicates the level of debt collection efficiency of the company. Referring to the above table, we can see that compared to 2007, it now takes more time for the company to collect their debts, thus adding further holes to the already tarnished liquidity position of the company.
c) Creditor Turnover: Cost of Goods Sold/ Account Payable
d) Days of Payables: 365/Creditor Turnover
The above two ratios reveal the payment turnover of the company, i.e. in what times the bills are cleared by the company. Our calculation revealed that since 2007, every year, the company is delaying its payment and the duration has now reached from 50 days to 54 days approximately by the end of 2011.
e) Inventory Turnover: Revenue/ Total Inventory
f) Days of Inventory: 365/ Inventory Turnover
While Thomas Cook is predominantly a service provider and inventory turnover does not matter much, however, the trend in the above two ratios were yet again against the company revealing that compared to 2007, it takes more time for the company to sell its inventory.
-Liquidity Ratios:
a) Current Ratio: Current Assets/ Current Liabilities
Current ratio indicates the proportion of current assets held by the company relative to the current liabilities. The table above reveals a dismal liquidity situation of Thomas Cook, something which the Chairman had also reveled indirectly in his statement. As noted, the current ratio multiple has declined significantly from 0.58 in 2007 to 0.45 in 2011. Important to note, even though the ratio multiple has increased marginally during 2010 and 2011, however, with current ratio less than 0.50, we cannot rate this situation as sustainable.
b) Quick Ratio: (Cash+ Receivables)/ Current Liabilities
Quick ratio happens to be a stringent liquidity ratio and here, the trend in quick ratio confirms poor liquidity situation of the company citing a consistent fall in the ratio multiple.
Overall, the outcome of current ratio and quick ratio confirms that Thomas Cook is not in a strong position to honor its short-term obligations.
-Solvency Ratios:
a) Gearing Ratio: Total Debt/ Total Equity
The above ratio reveals the changing proportion of debt to equity in the company, and analyzing the trend we can witness that over the period of the past five years, the ratio has surged from 0.23 to 1.04, indicating towards shift of the capital structure towards a highly levered environment.
b) Interest Coverage Ratio: Opertaing Income/ Interest Expense
Interest coverage ratio reveals the ability of the company to honor interest payments associated with debt borrowings. Referring to the above table, we can see that in line with the reducing operating income of the company and increasing interest expense, the interest coverage ratio of the company declined consistently from 4.69 in 2007 to 1.61 in 2011. This confirms that while the company is opting for highly levered capital structure, it is not in a position to bear the risk associated with the additional debt funding.
Discussion of Chairman’s concern over budgetary system
The chairman of the company profoundly expressed his concerns on losing ground over budgetary control systems in the company. The chairman has succinctly expressed the concern of operations managers and how they are feeling frustrated over the system of budgeting in the company. Doing so, he has also notified the shareholders about the importance of an efficient budgetary control system in the travel industry, and about the need to review the current system and consult on alternative approaches.
In his message to the shareholders, the chairman has indirectly pointed towards the inefficiency of budgetary controls by highlighting towards the unexpected £200m loan facility, which was acquired by the company to sustain through the cash low point at the end of December. The chairman then points toward the inefficiency of the management and how their poor performance negatively affected cost and cash position of the company, thus requiring an immediate remedial action.
Discussion of non-financial performance
While the financial factors are not in favor of the company at all, non-financial factors do give some optimism. Most importantly, the company is experiencing strong brand equity and high preference by the customers, particularly for all inclusive holidays.
However, considering the poor past leadership, we believe that it will take much time for the company to transform these non-financial factors into financial gains
Conclusion: Do not invest
Considering the overall analysis powered by common size statements, ratio analysis and non-financial indicators, we confirm that One World Investment Consortium should strongly refrain from investing in Thomas Cook. As we witnessed through the analysis part, the company has now finally entered the loss making sphere after suffering the financial bizarre from 2008-2010, and has already trimmed its retained reserves to half while it is consistently adding more and more debt every year despite the fact that its profitability position do not allow too bear the additional interest burden.
Part 2: Investment Appraisal Techniques
About Investment Appraisal Techniques
Million dollar investments have a huge impact on the future earnings and survival of an entity. It is a no hidden fact that for a number of good reasons, capital projects and their appraisal is the most important task to be performed by a financial manager. Moreover, once approved, it is either impossible or costly to revoke the capital projects and thus may incur humongous losses to the entity. Therefore, any capital investment involving such amounts of expenditure should be appraised rationally using appropriate techniques. Below we have detailed and compared four investment appraisal techniques under two different scenarios:
-Net Present Value
Rated as the most sophisticated investment appraisal techniques, NPV method incorporates the concept of time value of money while appraising the investment projects. The method involves discounting of future cash inflows to the present value using an appropriate discount rate,which is generally the cost of capital of the company so adjusted according to the risk of the project,and then setting off against the initial cash outflow. In other words, NPV is the sum of the present value of incremental cash flows related to the project.
Important to note, a project is only accepted if the NPV is positive. Another important consideration here is that the positive NPV multiple is directly related to the shareholder wealth,i.e. a project with positive NPV is expected to increase shareholder wealth and thus, the stock price of the company. The selection criteria related to NPV method can be expressed as:
NPV > Zero= Accept the Project
NPV < Zero= Reject the Project
Even though NPV owns wide credibility to its name from a wide number of academicians, however, its high cost of implementation and inability to compare projects of different sizes adds to its limitations.
-Internal Rate of Return
Another modern day investment appraisal technique and generally favored next to the NPV Method, IRR is the rate that makes the present value of expected incremental cash inflows equal to the cash outlays. In other words, it is the rate that sets the NPV of the project at zero level and is thus considered to be the benchmark rate for the company to consider while investing in the project. Stated otherwise, if the IRR of the project is greater than the required rate of return, the project is accepted, else it is rejected. The selection criteria related to NPV method can be expressed as:
IRR> Required rate= Accept the project
IRR< Required rate- Reject the project
Important to note, while academic books suggest use of trial and error method and interpolition method to calculate IRR, however, the same can be easily calculated using the solver function in excel
-Payback Period
Payback period is one of the most traditional investment appraisal methods and as the name implies, this method indicates the number of years, it will take for the company to recoup their investment amount from the project. Accordingly, if the payback period of the project is within the time set by the management, it is accepted, and if not, the project is rejected. Important to note, one of the serious disadvantage of the payback period is that it does not consider the time value of money. However, because of its simplicity, majority of the small and medium scale companies are still using the payback period for investment appraisals
-Accounting Rate of Return
ARR is yet another traditional method of investment appraisal that estimate the expected return of the project based on the net income in relation to cash outlay for the project. One of the most prominent disadvantage of this method is that it is based on accounting profit and not the cash flows, thus completely disregarding the concept of time value of money.
Evaluating appraisal techniques for multiple cash flow pattern
While the traditional methods such as Payback and Accounting Rate of Return are not affected by multiple cash flow patterns over the project life, it is the Internal Rate of Return(IRR) that is most affected. Important to note, in addition to the initial cash outflow, if a project has multiple cash outflows during the life of the project, it is said to have an unconventional cash flow pattern, and in such case, we may witness multiple IRR, and accordingly, it raises a confusion for the manager as which IRR leads to zero NPV multiple.
Evaluating appraisal techniques for risk associated with long-term project
While sophisticated appraisal techniques such as NPV and IRR consider the cash flows for the entire life of the project, it is the payback method that suffers from the serious limitation of ignoring cash flows post the benchmarked time period set by the management. Therefore, this method does not consider the terminal or salvage value of the project and is thus, not a good measure of project profitability. On the other hand, NPVand IRR can be used for project with any term and do suffer any serious limitation as the payback period.
Conclusion
Following the critical evaluation of all the investment appraisal methods and considering their validity at the time of multiple cash flows and projects with long-term tenure, it is clearly evident that non-traditional methods such as NPV and IRR have a plethora of academic research support and are said to be prudent methods to use at the time of project appraisal. Moreover, since thesprojects, considerer time value of money, it also makes sense to use them to appraise million dollar projects.
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Appendix:
Part 1:
Horizontal Income Statement
Vertical Income Statement
-Horizontal Balance Sheet
-Vertical Balance Sheet
