Operating Cycle
As Pizza Express Plc is in the restaurant industry, one may expect the operating cycle to be relatively short. The operating cycle is the recurring transition of a firm’s working capital from cash to inventories to receivables and back to cash. One could identify the group to have an operating cycle of 35 days (Appendix 1). One may also identify that the group has a policy to pay creditors every 83 days. This implies that the group has a margin of 48 days. This could be seen to be consistent with the group having a negative net working capital. Therefore, one may assume that management has been effective in their operations. Moreover this could be the reason why management believe in having more short-term creditors than having long-term creditors.
Debt
In examining the books of Pizza Express Plc, one may identify that they are financing only with short- term capital rather than long-term capital. The debt to equity ratio is 41% in 2002 (45% in 2001), this implies that for every £1.00 the company owes its stockholders £0.41 in debt. “The debt – equity ratio indicates the establishment’s ability to withstand adversity and meet its debt obligations.” (Schmidgall and Damitio, 1996, p.444) However, various arguments exist on what level of debt a company should have. The main benefit of financing the company’s assets through interest-bearing debt may be that interest payments are tax deductible and therefore lowers the cost of debt, hence “making more earnings available for investors” (Gitman, 2000, p.405) and retained earnings. Raising funds through equity may be more expensive than through debt as potential investors may find equity to be a higher risk investment than debt. However, increased debt may lead to an increased probability of bankruptcy if the business and financial risk is not determined correctly. In the case of Pizza Express Plc, if the eating out market declines, as has been the case recently, the business risk of not being able to cover operating cost increases, consequently affecting the financial risk of the company not being able to cover its financial obligations. However, since Pizza Express Plc has such a low level of debt, their financial risk is relatively low. This may imply that the company may be able to obtain new loans at relatively low interest rates. At present the company has a times interest earned ratio of 124 times (197.5 times in 2001), which means they are able to pay their interest 124 times out of their earnings before interest and tax. However, one should also caution that the earnings before interest and tax is not made up of only cash, and therefore does not give a completely true figure of how much interest could be covered. Nevertheless, the times interest earned ratio can be seen as being sufficiently high to assist the company in obtaining favourable rates of interest on debt and may facilitate the group in moving quickly in obtaining such debt. One may argue that, “the value of the firm is maximised when the cost of capital is minimized” (Gitman, 2000, p.408). Therefore, it may be beneficial for the company to increase debt levels, in order to maximise shareholder wealth.
Recommendations
Within the restaurant sector one may identify a decrease in the casual eating out sector, which could indicate an increase in buyers bargaining power according to Porters five forces model (Appendix 3). However, Pizza Express Plc has increased their sales by 15.14 %, which may be seen to be consistent with the sales growth strategy over the last five years according to the trend analysis (Appendix 6). Nonetheless, this could be as a result of the large investment in fixed assets. Conversely, the return on owner’s equity ratio indicates a decrease of 5%. By looking at the Du Pont analysis, giving a full picture of the financial structure, this decrease could be seen to be affected by the net profit margin which decreased by 2.6%, even though they have a good operating cycle and negative net working capital. In order to improve the net profit margin one may argue that the group could take on more long-term debt, thereby decreasing tax. The leveraging within Pizza Express Plc may be identified as not being optimised. Due to the low levels of debt and the high times interest earned ratio, the company may be able to obtain loans at favourable rates in order to take advantage of market opportunities.
2 March 2004
References and Bibliography:
Coltman, M.,M., (1994), Hospitality Management Accounting, 5th ed., Van Nostrand Reinhold, USA
FLS Daily, (2004), Financial Times, [Online], Available from : , [Accessed on : 29/02/2004]
Gitman, L. J., (2000), Managerial Finance Brief, Addison Wesley, US
Schmidall, R., S., (1997), Hospitality Industry Managerial Accounting, 4th ed., Educational Institute AH & MA, Michigan
Schmidall, R.,S., and Damitio, W., J., (1996), Hospitality Industry Financial Accounting, Educational Institute AH & MA, Michigan
The Econimist, (2001), The Party is Over ,The Economist, [Online], , [Accessed on : 22/02/2004]
Bibliography
Glynn, J. et al., (2003), Accounting for Managers, 3rd ed., International Thomson Business Press, Australia
Appendix
- Ratios
- DuPont Analysis
- Porters Model of Forces Driving Industry Competition
- Comparative and Common size analysis of Balance sheet and Income statement
- Statement of Cash Flow
- Trend Analysis of Turnover
Ratio Analysis and calculation Analysis
DuPont system of analysis
DuPont system of analysis is the system used by management to dissect the firm’s financial statements and to assess its financial condition. The system merges the income statement and balance sheet into two summary measures of profitability that are return on total assets (ROA) and return on equity (ROE).
DuPont formula could be argued as follow:
ROA = net profit margin x total asset turnover
Where the ROA is the product of the net profit margin and the total asset turnover. Later the formula is modified to:
ROE = ROA x FLM (financial leverage multiplier)
It relates the firm’s return on total assets (ROA) to its return on equity (ROE) using the financial leverage multiplier (FLM). Where FLM is the ratio of the firm’s total assets to stockholders equity.
The major advantage of this system is that it breaks the firms ROE into three parts: a profit-on-sales component (net profit margin), an efficiency-of-asset-use component (total asset turnover), and a use-of-leverage component (FLM).
In Pizza Express Plc., (2002) the net profit margin is 12%, whereas the total asset turnover is 1.14 times of sales to £1 of total assets contribution. According to the DuPont formula
ROA = 12% x 1.14 = 14%
In order to evaluate that if ROE is greater than ROA, the formula is modified to
ROE = 14% x 1.41 = 20%
One can conclude that ROE is higher than the ROA, this indicates that the increased reflected in the ROE may be due to higher leverage from the shareholders fund compare to last year 1999. Or it can also point out that the company is reinvesting its profit into its assets, which also result to higher ROE. Higher ROE could also reflect in a way that employees, creditors, shareholders and etc contributed positively to the company. By analyzing and seeing the figures in Income statement and Balance sheet one could easily identify that the Assets are used very efficiently into the resources, which shows the good indication in running the business specially in fast food sector.
Industry Analysis : Analyzing the Task Environment
Porters Model
The collective strength of the forces determines the ultimate profit potential in the industry, where profit potential is measured in terms of long-run return on invested capital. In carefully scanning its industry, the company must asses the importance to its success of each of the six forces ;
1. Threat of new entrants :
The barriers of entry in the industry can not be considered high, with the exception of the large capital expenditure required to open a Pizza Express, but by expanding and gaining economies of scale the company is gaining an increasingly large market share. Product differentiation may increase their strength and thus barriers to entry.
2. Rivalry among existing firms :
There are numerous competing firms but the rate of industry growth is still high and the market is far from saturation. In comparison to the competitors thay seem to have a very strong market position.
3. Threat of substitute products or services :
It seems the group is efficient as monitoring its environment and acting proactively.
4. Bargaining power of buyers :
As the competition increases in the industry, the bargaining power of buyers should also increase because they can change to the competitor if their needs are not met.
5. Bargaining power of suppliers:
The bargaining power of suppliers should decrease as the size of the business increases, which is the case in this company.
6. Relative power of other stakeholders :
The relative power that governments, local communities, and other groups wield over industry activities. As the competitors of Pizza Express Plc are national as well as international, they are working under different local requirements. However, this does not seem to be percieved as a problem.
The stronger each of these forces, the more limited companies are in their ability to raise prices and earn greater profits.
A high force can be regarded as a threat because it is likely to reduce profits.
A low force can be viewed as an opportunity because it may allow the company to earn greater profits.
In the short run these forces can act as constraints on a company's activities.
In the long run, however, it may be possible for a company, through its choise of startegy, to change the strength of one or more of the forces to the company's advantage.
Consolidated profit and loss account for the year ended 30 June 2002
Consolidated balance sheet for the year ended 30 June 2002
Cash Flow Statement for the year ended 30 June 2002
Trend Analysis of Turnover
