Business and Financial Risks

Discuss about the Principles of Corporate Finance for Imperial Tobacco .

Imperial Tobacco is a UK based company with headquarters in Bristol and primary listing on LSX. It has global presence with manufacturing locations spread across 51 worldwide locations and customer base in excess of 160 countries. The key markets for the company are EU and other European countries along with US and Asia (Imperial Tobacco, 2015). The current report aims to highlight the myriad risks that are prevalent in the business and also financing of the same. The financial performance is analysed by deployed ratio analysis tool for the consolidated financial statements for FY2014 and FY2015. Besides, the current capital structure of the company is critical analysed and suitable recommendations have been extended for an optimal funding mix going forward.

Akin to other businesses, the company also has sizable exposure to a plethora of business and financial risks. These are highlighted as shown below.

Reducing size of the legitimate tobacco market

An overall reduction in the tobacco products market is happening primarily because of the below mentioned reasons (Imperial Tobacco, 2015).

The demand of products containing tobacco and their availability in most geographies is regulated towards government intervention due to the negative impact that these products have on human health. This regulation if increased in the near future would adversely impact the consumer demand and also enhance the costs for compliance.

The government typically increases the excise duty levied on tobacco products which serves twin objectives. It increases the price of these products and thus limit the underlying usage while also enhancing the funds available for generating public awareness against such products.

The above two measures give rise to a flourishing illegal trade market where tobacco products are imported from regimes which attract less taxation. Further, the counterfeits for various brands are on the rise in order to satiate the demand for tobacco products through cheaper substitutes.

Besides, any slowdown in the economy particularly in prominent markets would adversely impact the income levels and thus would reduce the size of the legal market as consumers would decrease smoking or shift to cheaper alternatives in the form of illicit market.

Regulatory and Legal Compliance Costs

Due to the underlying nature of the business, there are sizable costs related to legal suits and compliance cases that negatively impacts the profitability of the business primarily because of the below mentioned reasons (Imperial Tobacco, 2015).

Recent Financial Performance

Considering the wide geography of customer market which spans almost the globe, there are instances where the domestic law or the international laws are violated and the company has to pay financial penalties along with reputation loss.

The users of tobacco products along with the e-vapour segment tend to file litigations against the company on account of the harm caused and hence sizable legal costs need to be expensed by the company in managing these, thus diminishing overall prof

Markets downside risk particularly in Europe

The company is present in various European markets in a very big way and hence its fortunes are related to the market conditions in these geographies. Any significant disruption in the stability of these would have profound impact on the sales. In case of any civil unrest or sustained instability in the region such as issues within the EU or exit of any particular nation, the business operations of the company would be hampered (Imperial Tobacco, 2015).

Financial Risk

It is evident that there is sizable debt in the books of account and hence decrease in the credit rating can result in higher finance costs thus acting as a drag on profitability. Further, sustained financial downturn in key financial markets may limit the refinancing capacity of the company and thus may require higher costs to service debts which are about to mature in the near future. Also, there is default risk especially if the business diminishes particularly to government regulation and thus default risk may go up which would lead to higher interest costs (Imperial Tobacco, 2015).

The financial ratios have been computed using the consolidated financial statements for the two most recent years. This serves as the basis for the comparison of the financial performance of the company in the recent times.

The requisite profitability ratios are summarised in the tabular format shown below (Imperial Tobacco, 2015).

It is evident that gross profit has improved from 19.58% to 20.45% primarily to improvement in operational efficiency driven by the various initiatives for cost management undertaken by company. The increase in net profit margins is primarily due to hike in income from investment coupled with decline in tax outflow besides margin gains at gross level (Imperial Tobacco, 2015). The improvement in ROA and ROE is being driven by the increase in net income in FY2015.

The comparable profitability ratios for BAT (British American Tobacco) are given below.

Profitability Ratios Analysis

It is apparent that BAT has superior profitability margins as compared to Imperial Tobacco. However, in the recent year there has been a sharp decline in the gross profit margins for BAT. But the profit margins continue to rise on back of cutting down on operating expenses. Hence, Imperial Tobacco has improved its profitability but more needs to be done.

The requisite liquidity ratios are summarised in the tabular format shown below (Imperial Tobacco, 2015).

It is evident that at the end of FY2014, the current ratio was higher as compared to the corresponding value at FY2015 end. This is because the % increase in current liabilities was comparatively higher than % increase in current assets in FY2015. The current liabilities increase can be explained on account of the increase in short term loans from a mere £429 million at FY2014 end to £1,957 million at FY2015 end. Quick ratio underwent marginal improvement at FY2015 end as the inventory level decreased marginally (Imperial Tobacco, 2015).

The requisite turnover ratios are summarised in the tabular format shown below (Imperial Tobacco, 2015).

It is evident that in FY2015, the asset turnover has declined because of the decrease in revenue caused due to lacklustre performance of some European markets (Imperial Tobacco, 2015).  This drop in sales has resulted in the decrease inventory turnover for FY2015. However, the trend is opposite for receivables turnover ratio which has improved even though sales are lesser primarily because receivables days have become less which leads to drop in the cash cycle and hence diminishes working capital requirements. The cash cycle is further shortened since there has been a decrease in payables turnover in FY2015 which in turn provides a larger credit period for the company (Ross, Westerfield & Jordan, 2013). Therefore, all turnover ratios besides the asset turnover and inventory turnover are favourable for the company since it amounts to better liquidity.

The comparable ratios for BAT are given below.

Even though BAT has seen a drop in asset turnover, but it continues to be superior than Imperial Tobacco indicating better usage of assets for BAT. The inventory turnover for BAT continues to be marginally higher than corresponding value for Imperial Tobacco. The receivables turnover for BAT is higher than Imperial Tobacco which indicates that BAT is able to recover money from its debtors in a shorter time.

The requisite gearing ratios are summarised in the tabular format shown below (Imperial Tobacco, 2015).

Liquidity Ratios Analysis

It is clear from the above values that the contribution of debt has increased which is on account of increases in both term borrowings and current borrowings. The long term borrowings have undergone an increase from £9,462 million at FY2014 end to £12,250 million at FY2015 end. The short term or current borrowings have undergone an increase from £429 million at FY2014 end to £1,957 million at FY2015 end. It is apparent that a major proportion of the outstanding debt is long term in nature (Imperial Tobacco, 2015).  Besides, due to an increase in the total amount of debt, the finance cost has also risen which is responsible for the declining interest coverage ratio for FY2015 (Brealey, Myers & Allen, 2008).

It is clear that the company has not generated additional funds through equity issue but has instead relied on debt for its funding requirements. The debt equity ratio in FY2015 had touched a crucial level and when seen in light of the declining interest coverage ratio, it poses pertinent questions on the ability of the company to raise more debt for its growth and business operations. Based on the existing capital structure, it is apparent that debt funds about 71% while the remaining is contributed by equity. However, this seems to be acceptable in the industry as BAT also boasts of debt funding of about 77% while the equity component being only 23%.

However, the ability of the company to increase the debt levels further may not be wise since owing to greater risk the financing cost may increase thus eroding profitability of the business. It is advisable that the company raises more equity especially as the global markets are steadily improving and as a result, Imperial Tobacco can expect reasonable valuations in case it goes for dilution of holding for raising money. This move would enhance the balance sheet strength and would provide comfort to the lenders who are weary of increasing debt especially in a business where frequent government regulation and legal litigation are a big concern (Brigham & Ehrhardt, 2013).

Any firm’s optimal capital mix is driven by a host of variable such as firm’s size and market share, composition of balance sheet, tax regulations, requirement of capital etc. In order to ascertain the capital requirement, the balance sheet and particularly the composition of assets is a critical factor. For imperial tobacco, about 60% of the total assets comprises of the intangible assets namely copyrights, brand name etc. The fixed assets contribute close to 10% to the overall company assets as per FY2015 balance sheet.  As a result, any capital is requisite for acquisition purposes of either local player in growing markets along with other brands (Damodaran, 2008). Additionally, for BAT which is a peer group company, nearly 10% of the total assets is in the form of fixed asset and nearly 30% of the total assets is on account of intangible assets.

It can be logically derived from the above that the outstanding debt should not be of grave concern keeping in mind that the company has limited requirements of capital for day to day business. Besides, considering the size, market share and global presence, the company can very well afford a balance sheet which is little stretched without causing any discomfort to lenders who would feel secured. But despite that, the company in the near future should aim for limiting the debt and may be bring it to a little lower level. A funding mix of 65 (debt):35(Equity) is advisable for the company going forward so as to ensure that balance sheet is not over leveraged.

Conclusion

It may be concluded that Imperial Tobacco has exposure to various business risks on account of government intervention in the form of duties and taxes besides battling legal issues and compliance with laws.  Further, any disruption in select Europe markets may adversely impact the company. Also, on account of significant funding from debt, there is financing risk particularly if this trend goes on. The overall performance of the company has improved in FY2015 as compared to FY2014 as evident from ratio analysis. Currently, the balance sheet seems little stretched but considering the market reputation, global presence and nature of capital requirements, it is not worrisome. However, going forward a capital contribution of 65:35 is recommended so as to ensure business sustainability without too much dilution of equity.

References

Brealey, R, Myers, S & Allen, F 2008, Principles of Corporate Finance, 9^th edn, McGraw Hill Publications, LondonBrigham, EF & Ehrhardt, MC 2013.

Financial Management: Theory & Practice, 14^th edn.,

South-Western College Publications, New YorkDamodaran, A 2008, Corporate Finance, 4^th edn, Wiley Publications Pvt. Ltd, London

Imperial Tobacco 2015, Annual Report and Accounts 2015, Imperial Tobacco Group Plc, Available online from https://ar15.imperial-tobacco.com/pdfs/full-annual-report-2015.pdf (Accessed on March 23, 2016)

Ross, S, Westerfield, R & Jordan, B 2013. Essentials Corporate Finance, 8^th edn., McGraw-Hill/Irwin Publications, New York