Introduction
The aim of this report is to analyse the accounts of the house builders Westbury plc and Persimmon plc in order to give substantiated conclusions as to whether they are a good investment or not. This will be conducted through the analysis of their financial reports, and the application of financial ratios to the accounts. External factors will also be examined in order to get an overview of both companies.
Persimmon plc is one of the largest house building companies in the UK. During the last few years the firm has acquired many house building companies, their main acquisition being a rival company called Beazer for £610 million. As a result of the company’s success and acquisitions, they managed to increase their turnover over a 5 year period from £695.9 million in 1999 to £1883 million in 2003. This is a turnover growth of 171% over the 5 year period.
Westbury plc operates within 40 counties in England and Wales. They have also achieved growth over the last few years with the help of some acquisitions. In 1998, they made a takeover of John Maunders which had a strong presence in North West England where they had been weak. In 2002, they acquired their rival Prowting for £141 million. Consequently they increased turnover from £475, 929, 000 in 2000, to £878, 987, 000 in 2004. Over the five year period they achieved turnover growth of 85%.
Market Positioning and Economy
In the past the construction industry has been directly affected by any significant changes in the economy. Therefore, in recent years of economic growth, the construction sector has also benefited.
The main reason for the buoyancy in the market is due to lower levels of taxation and historically lower levels of interest rates increasing consumer spending power. Interest rates have been so low because of low inflation.
The increase in consumer spending power has encouraged house moving. As a result of the demand for new housing, there is now a supply-demand imbalance which has enabled profit margins on homes to be increased. The cost of property increased by 15% during 2003, and in March 2004 prices were 7.8% higher than in March 2003. It is estimated that approximately 4 million homes will have to be built in the next 20 years in order to meet the increasing demand for homes
However, the Bank of England started to raise interest rates to 4.5% in 2004 in order to slow consumer borrowing and to stop house prices from rising. This will probably have the effect of slowing down the growth of the house-building industry over the next few years.
Financial Ratios
Profitability and Performance
Return on Long-term Capital Employed
This shows how effectively funds invested in the business are being generated into profits.
Figure 1: Return on Capital Employed
* Workings and Formulae in Appendix
Over the two year period Persimmon was able to maintain an ROCE (Return on Capital Employed) higher than that of the industry average, and also increase it slightly from 23.3% in 2003 to 26.1% in 2004. This is because they benefited from increased sales, and decreased long term loans from £351 million to £330.4 million over the two years.
Westbury, however, had a decrease in ROCE over the two years, although it remained comparable to the industry average in 2004. The reason for the decrease in Westbury’s ROCE is because of the sizeable increase in long term loans that they accrued which increased from £69.4 million to £216.2 million. This money was raised through a ‘US private placement’, but unfortunately there is no explanation in the accounts for the purpose of this large loan.
Operating Profit Margin
The operating profit margin measures the profitability of the business relative to the level of business done.
Figure 2: Operating Profit Margin
* Workings and Formulae in Appendix
Both Persimmon and Westbury have managed to increase their operating profit margin over the 2 years. This indicates that they are keeping tight control over their expenses, and also indicates the higher mark-ups on their sales. The companies are making much higher returns than the industry average of 9.3% in 2004.
Total Asset Turnover
This measures how well the assets of the business are being used to generate sales.
Figure 3: Total Asset Turnover
* Workings and Formulae in Appendix
Westbury’s decrease in the total asset turnover ratio from 1.8: 1 in 2003, to 1.4:1 in 2004, is affected for the same reason as the decrease in ROCE; the increase in long term loans.
Persimmon retained the same ratio of 1.3: 1 over the two years, which shows consistency in their efficiency to generate sales with the amount of capital employed.
The industry average of 2.6: 1 was significantly higher than both companies in 2004, which could imply that both Westbury and Persimmon are failing to generate sales as effectively as the rest of the industry over the same period with the same proportion of capital employed.
Gross Profit Margin
The Gross Profit Margin reflects the mark-up made by the company on sales, and also how well costs of sales have been controlled.
Figure 4: Gross Profit Margin
* Workings and Formulae in Appendix
This ratio should remain similar from year to year. Both Persimmon and Westbury were able to increase their gross profit margin over the two years by about 2% each. From examining the cost of sales figure, it can be seen that it did not drop proportionately to sales; therefore they have made this increase by making more of a mark-up on sales, and increasing profit. This could be indicative of the supply-demand imbalance, that they are able to charge more for their properties.
Both companies maintained a gross profit margin significantly higher than the industry average, of about 10% more each year.
Liquidity
Current Ratio
This ratio gives an indication of the short term solvency of a company, and it shows its ability to meet its debts as they fall due.
Figure 5: Current Ratio
* Workings and Formulae in Appendix
A ratio of 2:1 of assets to liabilities is considered prudent, but it does depend on the type of business as to what level is considered acceptable. Therefore, both of the companies could easily afford to pay their short term debts as they fall due as in both years. In 2004, the ratio is above 3:1 for both companies, which compares favourably to industry average of 1.9:1
Persimmon had a small increase in the current ratio, which is due to the increase in stocks and work in progress being larger than the increase in current liabilities. This is mainly due to more land being held as stock.
Westbury had a significant increase in the current ratio, which was caused by the firm paying off a large sum of money in their short term bank loans and overdraft as the figure dropped by 81% (£228,393 to £43,086). It is not mentioned in the notes to the accounts why they decided to reduce their current liabilities, although it could be that some of the increase in long term loans went to paying off the debt at a better rate of interest.
Acid Test Ratio
A limitation of the current ratio is the assumption that all current assets can be easily converted into cash. In the acid test ratio, stock is excluded from the numerator to recognise that it is not easily converted into cash.
Figure 6: Acid Test Ratio
* Workings and Formulae in Appendix
A ratio of 1:1 is usually considered desirable. Both companies’ ratios are well below the 1:1 ratio at 0.15:1 for Westbury, and 0.22:1 for Persimmon in 2004. However, this is not necessarily a sign that they are unable to pay the debts they incur, as it seems a ratio below 1:1 is normal in the house building industry. However, both companies do have a very low ratio compared to the industry average of 0.62:1 in 2004, and this could be something of a concern, as although they are profitable companies, if they have all of their cash invested in stock, they run the risk of not being able to pay their short term debts as they fall due.
Control of Working Capital
Stock Holding Period
Stock should be kept for the shortest period possible in order to minimise the associated holding costs. However, this needs to be balanced with stock being adequate to meet demand.
Figure 7: Stock Holding Period
* Workings and Formulae in Appendix
It can be seen that it takes well over a year on average before a house is sold, and this is indicative of the house building industry. The reason for the increase in stock holding period in Persimmon is the larger amount of land being held at the end of the 2004 compared to 2003.
Compared to the industry average, both Persimmon and Westbury are not turning over their stock as efficiently. Therefore, they need to assess the demand for houses more adequately in order to make sure they do not have all of their money invested in stock.
Debtor Collection Period
This shows the average length of time the business takes to collect its debts.
Figure 8: Debtor Collection Period
* Workings and Formulae in Appendix
Both Westbury and Persimmon have very good credit control compared to the industry average of about 30 days in both years. They also managed to decrease slightly the time taken to collect debts.
Persimmon takes slightly longer to collect their debts than Westbury (around 5 days), but this is probably because they are a larger company, and therefore have more debtors.
This ratio indicates that Persimmon and Westbury do not have money tied up in debtors when it could be more effectively used elsewhere.
Creditor Payment Period
Figure 9: Creditor Payment Period
* Workings and Formulae in Appendix
The longer a company can take to pay its creditors, the longer they can invest it elsewhere for higher returns for shareholders. Therefore the longest credit agreement is favourable.
From the reports it is not possible to ascertain the credit agreements, but it is possible to see from earlier ratios that they are able to pay their debts as they fall due.
Persimmon’s creditor payment period increased over the 2 years, from 47 days to 52 days, and this may be due to a sizeable increase of 13% to £199.6 million in the trade creditors’ amount owed. This allows Persimmon to invest their money elsewhere in the company for longer periods of time before paying their creditors.
Westbury’s creditor payment period decreased significantly from 98 days to 71 days in 2004. A possible reason for this is the decrease in the amount of money owed to its trade creditors. This is shown by the stock holding period (see figure 7) which decreased, as they are able to assess more efficiently how much stock they need to meet demand.
Capital Structure and Long Term Solvency
Gearing
This ratio measures the extent to which the company is financed by debt compared to equity capital.
Figure 10: Gearing
* Workings and Formulae in Appendix
The gearing ratio for Persimmon dropped significantly, due to a sizeable decrease in long term loans overall owed by the firm from £322.2 million to £295.6 million in 2004, which represents a decrease of 9%.
Westbury’s gearing ratio increased significantly from 18.6% to 50.2% in 2004 due to the large long term loan that was taken out. This makes Westbury’s gearing figure more than double the amount of Persimmon.
The industry average fluctuates significantly over the two years, and therefore it is not really a good measure to compare the two companies with. This makes Westbury a more risky option for shareholders. However, the advantage to a highly geared company is that when it is trading successfully and generating increased profits the ordinary shareholders stand to reap disproportionate rewards
Interest Cover
Interest cover indicates how many times a company can cover its current interest payments out of current profits. An interest cover of more than 7:1 is considered safe, and more than 3:1 is acceptable.
Figure 11: Interest Cover
* Workings and Formulae in Appendix
The interest cover rose significantly for Persimmon due to the decreased interest charged, and the increase in operating profit. Persimmon has managed to pay off some of its loans by nearly 10%, which resulted in lower interest payments. Therefore, in this case, Persimmon is a much less risky investment as it is able to cover current interest payments from its current profits extremely easily, with a ratio above the recommended ratio of 12.7:1.
Westbury’s ratio was comparable for both years. The figure is lower than in Persimmon, but a ratio of 5.7:1 in 2004 of operating profit to interest is still enough to cover the interest payments comfortably. Therefore, although Westbury is more highly geared, this does not represent a problem to them in servicing the debt.
The Operational Cash Flow
Cash Generated From Operating Activities
This ratio looks at the extent to which operating profit has been converted into cash. Movements in this ratio will often be due to working capital movements.
Figure 12: Cash Generated From Operating Profit
* Workings and Formulae in Appendix
Both companies had quite a significant drop in the amount of cash generated from ordinary profit. This could be because they have got a lot more cash held in stock than last year, and therefore, their liquidity levels have decreased by a bit less than half.
Cash Interest Cover
This is a more immediate measure of the ability of a company to service its debt than the interest cover worked out previously.
Figure 13: Cash Interest Cover
* Workings and Formulae in Appendix
Both companies’ ratios have remained similar over the two years, and yet Persimmon has more than double the proportion of cash available to pay loan interest than Westbury. This ratio reflects the fact that Westbury is more highly geared than Persimmon as they are paying more interest. However, yet again, it shows that interest payments do not represent a burden to Westbury.
Investor Ratios
Return on Equity
This ratio shows the return to ordinary shareholders, after paying the business expenses (including interest and taxation).
Figure 14: Return on Equity
* Workings and Formulae in Appendix
Compared to the industry average, both Westbury and Persimmon aren’t able to pay back as much to their shareholders after expenses. However, both companies were successful over 2004, and this resulted in their return on equity improving by 2004.
In this case, Persimmon is a more desirable company for investment because they are able to give higher returns (dividends) to shareholders.
Earnings Per Share
This ratio measures the earnings per ordinary share, whether or not the earnings have been distributed.
Figure 15: Earnings Per Share
* Workings and Formulae in Appendix
In Persimmon, the Earnings per Share (EPS) increased from 63 pence per share to 83 pence per share in 2004. This is due to the larger increase of ‘Net Profit after tax’ compared to the number of ordinary shares in total.
In Westbury, the earnings per share also increased in line with Persimmon from 50 pence per share in 2003, to 63 pence per share in 2004.
Therefore, yet again, Persimmon is able to give a higher return per share than Westbury.
Dividend Cover
The dividend cover shows the number of times that the current year’s earnings cover the ordinary dividend. It indicates the future possibility of the company being able to maintain the level of dividends, and yet still retain money for the business to grow.
Figure 16: Dividend Cover
* Workings and Formulae in Appendix
Westbury and Persimmon’s ratios are nearly exactly the same over 2003 and 2004, increasing from 0.42:1 to 0.46: 1 and 0.45:1 respectively. Therefore, proportionately, they are able to maintain the same proportion of dividends as each other.
Price/Earnings Ratio
This ratio gives an indication of how much an investor is prepared to pay for a share, given the company’s EPS. It therefore gives an indication of the confidence of investors in the expected future performance of the company.
Figure 17: Price/Earnings Ratio
* Workings and Formulae in Appendix
Westbury is receiving more interest from investors as the share price has risen, and there are greater expectations of increased profitability. Westbury has an increased Price/ Earnings (PE) ratio of 7.3 in 2004 compared to 6.3 in 2003.
However, the PE ratio decreased from 6.8 to 6.5 in 2004. This is not due to less interest in Persimmon, as the share price is higher than Westbury’s, it is an indication that it is unlikely to be able to achieve higher profitability than 83 pence per share (see figure 15) which is extremely high.
Conclusion
Both Westbury and Persimmon improved turnover significantly and also profitability. This is because they were able to charge more on sales and make higher profit margins. This is probably due to the supply –demand imbalance.
Westbury had a large number of current liabilities in 2003, of which most were paid off in 2004. However, they increased their long term loans significantly, which in turn increased gearing to almost double the proportion of Persimmon. Through further analysis of whether they could pay the interest it was found that they could do this quite easily and the debt is not a burden to Westbury.
Both companies have very good credit control. However they both had a lot of money tied up in stock which affected the amount of cash they had in order to pay their current liabilities. The industry average’s acid test ratio was much higher.
The investor ratios show that Persimmon is able to pay more to its shareholders from operating profit, due to higher turnover, and also a lower level of gearing. However the PE ratio indicates that it investors doubt they could increase their profitability levels any further.
Future Prospects
After review of the chairman’s statements it can be seen that both companies are aware of the effect that rising interest rates could have on their profitability. There is still demand for new houses which is not being met currently. However, consumers may not be willing to pay such high margins for houses in the future. Therefore, both companies plan to grow from increasing volume sales.
Recommendations
If investing in either company, it would be necessary to pay close attention to the state of the economy, and interest rates, as this could affect the profitability of these companies significantly.
Persimmon is a less risky company to invest in, as it is lower geared than Westbury, and therefore shareholders stand to make more returns from their investment, because dividends are paid after interest.
However, Westbury’s shares are only half the price of Persimmon’s at only £3.85 per share on 30th November 2004, compared to £6.17 (Thomson ONE Banker Analytics, 2004). Therefore, more returns stand to be made with Westbury’s shares after the cost of shares is deducted, especially if they are very successful as higher returns could be made because they are more highly geared.
Therefore, after analysis of Persimmon Plc and Westbury plc and the house building industry, it is advised that investment in either company should be profitable for the medium term.
Bibliography
FAME (2004). Retrieved on 30 November 2004 from the World Wide Web: http://fame.bvdep.com/cgi/template.dll?checkathens=1&product=1&user=oxb03169614&pw=%3cQbQpcwNxnm2oTZbP7A%3e.
Mintel (2004). ‘House Building (Industrial Reports)’. Marketing Intelligence Reports, September.
Persimmon Plc, (2004). Annual Report: December 2003. York: Persimmon Plc.
Thomson ONE Banker Analytics Website (2004). Retrieved on 30 November 2004 from the World Wide Web: .
Watson, D & Head, A (2001). Corporate Finance: Principles and Practice. 2nd Ed. Essex: Pearson Education Limited.
Westbury (2004). Annual Report 2004. Cheltenham: Westbury Plc
Appendix – Calculations of Ratios for Westbury plc and Persimmon plc
