Evaluating business performance is crucial in order to ascertain whether a business is moving towards accomplishing its purpose. Financial analysis is one of the most appropriate tools for evaluating business performance. It involves using the financial statements to assess relevant performance trends. Financial analysis is carried out to accomplish specific goals and to meet the interests of specific stakeholders. The shareholders rely on financial analysis to comprehend the performance of their investment. It helps them to compare the current performance with the past trends past years and also understand business performance compared with the industry and benchmark. Financial analysis also helps lenders and investors to understand the viability of a business thus assess the risk of lending their money or investing in the business. By assessing key ratios financiers and investors are able to make informed decisions. Financial analysis forms the basis for planning. Managers can only establish sound plans after understanding the organization’s performance trends. Financial analysis also assists other stakeholders to understand the performance of a business. Suppliers, employees, government, and strategic partners use financial analysis data to ascertain the performance of a business thus forming a basis to determining the nature of relationships between these stakeholders and the business. Financial analysis is therefore important as it is useful to different classes of stakeholders.
Rationale for choosing Easy Jet PLC
Easy Jet is a British low cost carrier that operates both domestic and international flights. The company flies in 820 routes operating in more than 30 (Jones 2005). Easy Jet was formed in 1995 and has registered immense growth(Jones 2005). There are specific reasons for choosing Easy Jet. The fact that it is a publicly traded company influenced the choice. Public companies are governed by complex corporate governance regulatory framework that seeks to protect the interests of different stakeholders. The regulatory framework ensures proper and accurate reporting to ensure information disseminated to the public is not misleading. The integrity information available regarding the company, therefore, meets the highest integrity threshold as specified by the regulators. Public companies are also required to make public their reports to ensure the public is can access relevant and accurate information about the company. Accessing credible information about the company’s financial performance is therefore easy, and this influenced the choice. The second major reason for choosing the company is its age. The company has been in existence for 22 years, and this guarantees the existence of financial data for past years. Effective financial analysis requires comparing financial data over the years. Lastly, the company’s industry influenced the choice. The airline industry is characterized by stiff competition that drives weak players out of the market. The fact that Easy Jet has survived the market for the past twenty two years implies implementation of effective strategies.
Analyzing Easy Jet’s performance will consider key ratios for the past five years. The company’s financial data is readily available at Morning Star and Market Watch. Some of the main ratios analyzed include the profitability ratios, capital ratios, stock performance ratios, and liquidity ratios. Each category has specific ratios that are explained in details to give a clear picture of the company’s performance. The figures used computations are in billion UK pounds.
Gross Profit Margin
The gross profit margin evaluates the performance of sales as well as the ability to control costs. Sales refer to the total revenue earned from selling the company’s services. At Easy Jet, sales are the total amounts charged to customers. Cost of sales refers to those expenses that are directly related to the sales. The gross profit ratio is computed by dividing the gross profit and total sale (Edmister 2001). An increase in the gross of sales margin is caused by an increase in sales, a decrease in the cost of sales or both. A high gross profit margin signifies better performance.
The company’s gross profit margin has dropped by over 9% since the year 2013. This drop was caused by an increased cost of sales since the total revenue has been on the rise. This trend is an indication of inefficiency in cost management.
Net Profit Margin
The net profit expresses the profit after tax as a proportion of sales. It provides an objective way of evaluating profitability as it puts into consideration both direct and indirect costs. It measures the company’s ability to manage costs and the performance of sales. An increase in net profit margin is caused by a sales increase or a reduction in costs or both (Nissim & Penman 2001). A high net profit margin signifies better performance.
In the past five years, the company has registered mixed performances regarding net profit margin. The margin was highest in 2014 at 11.69% which was a major improvement from 2013’s 9.35%. The margin dropped to 6.04% in the year 2017 which was a sign of poor performance emanating from high operating costs.
Return on Assets
The return on assets ratio compares returns with total assets. This analysis helps to evaluate the company’s ability to exploit its assets. An improving return on asset signifies effectiveness in the use of the company’s assets. This ratio is computed by dividing the profit after tax by the total assets (Ahrendsen & Katchova 2012). Data regarding the total assets is readily available in the company’s balance sheet while income after tax data is contained in the company’s comprehensive income statement.
The company’s return on asset has decreased persistently in the past three years. The ROA for the year 2017 was 5.32% compared to 11.77% of the year 2014. This reduction by half is substantial and cannot be ignored. It shows the company’s ability to generate cash from its assets has been decreasing.
Return on Equity
Return on equity expresses net income as a percentage of equity. It enables the shareholders the yield on their equity (Cull & Morduch 2007). Data about equity and net income are available in the company’s statement of financial position and income statement respectively. Higher return equity compared to other years show an improving performance.
The company’s return on equity has been decreasing persistently since the year 2015. The ratio for 2017 was 11.06% compared to 24.79% of 2015. This decline is an indication of poor performance as the shareholder’s wealth is increasing at a decreasing rate.
Capital structure ratios provide an objective perspective to evaluating the fitness on a firm’s capital structure. The capital structure of an organization is comprised of equity and long term debts. Equity is made of retained earnings, common stock and preferential stock (Higgins 2012). Capital structure management seeks to maintain the optimal combination of these elements to minimize the cost of capital.
Debt – Equity Ratio
Debt to equity ratio expresses the total debt as a percentage of total equity. This ratio helps to identify the amount of debt and equity injected into a company. A high debt level is risky as it exposes the company to cash flow risks. Debts commit a company to periodic cash commitment emanating from loan obligations. On the other hand, debt has a tax advantage since interest charged is an allowable expense. Debt and equity data is found in the company’s financial statement.
Easy Jet’s debt to equity ratio was highest in 2017, and this emanated from the sharp increase of the long term debt. It is worth noting that the level of short term debt had reduced to zero in the same year. The decrease could not improve the debt-equity ratio since the long term debt registered a greater increase. From a risk perspective, a debt to equity ratio of 27.4% is considered acceptable. The company is therefore safe regarding debt since the rate is below 40% which in most cases is considered the optimal level.
Long Term Debt to Capitalization
Long term debt capitalization considers the proportion of long term debt in relation to total capitalization. Capitalization is the sum of debt and equity. The higher the ratio, the more the company is exposed.
The company’s long term debt to capitalization ratio has increased persistently since 2015. The ratio for 2017 was 21.54% compared to 2015’s 8.12%. This trend is a clear indication that the company exposure is on the rise.
Total Debt to Capitalization Ratio
Total debt ratio analyzes the debt position of a company by comparing the total debt and capitalization. Total debt includes both short term and long term debts. This analysis supports the identification of the exact debt level in the capital structure.
The company’s debt to capitalization ratio was lowest in 2015 at 12.24%. The ratio increased to 27.45% in 2017. This sharp increase cannot be ignored since it portrays a higher exposure. Although debt has a tax advantage, too much of it leads to cash commitments that can compromise the company’s ability to meet other obligations.
Stock Performance Ratios
Stock performance ratio supports the assessment of the company’s shares. It helps potential and actual investors to assess the performance of shares. The main stock performance ratios are the earning per share and the dividend payout ratio (Cull & Morduch 2007). They show attributes that support the assessment of the stock performance, and this enables investors to compare different shares in the market.
Dividend Payout Ratio
Dividend payout ratio shows the extent to which a company distributes its earnings to the shareholders. Earnings are either retained to finance the company’s activities or distribute to the shareholders as dividends. A high dividend payout ratio implies that the company is distributing a large portion of the earnings to the shareholders (Cull & Morduch 2007). Companies facing cash flow problems reduce dividend payout to safeguard the business from running out of cash.
The company’s dividend payout ratio has been increasing since the year 2015 despite the falling income. The payout has doubled since the year 2015 where it has increased from 8.8% to 21.3%. This increase was aimed at restoring the shareholders’ confidence in the light of falling income.
Earnings Per Share
Earnings per share ratio seek to ascertain the number of earnings attributed to each share. It is obtained by dividing the total earnings less preferential divided by the total number of outstanding shares. This analysis helps the shareholders know the amount of profit associated with their stake, and this helps to assess the value of shares. An increase in earnings per share signifies a greater value for the shares. The data needed in calculating the EPS is readily available in the company’s financial statements.
Easy Jet’s earning per share has registered a downward trend since the year 2015. This movement is influenced by the declining profit since a decline in profit decreases the earnings per share. EPS was lowest in the year 2017, and it is worth noting that profit was also lowest during this year.
Liquidity ratios measure the ability of a company to meet obligations as they fall due. Liquidity problem is serious as organizations affected by this problem cannot meet their short term obligation and these are key to supporting daily operations (Nissim & Penman 2001). Liquidity differs substantially from financial position and profitability. A firm with a strong balance sheet can face liquidity problems since some assets are hard to convert into cash. A healthy organization maintains reasonable liquidity to ensure short term liabilities are met on time. Quick and current ratios are the main liquidity ratios.
Current ratio compares the current liabilities and current assets. The ratio is calculated by dividing the current assets and current liabilities. A ratio of one and above signifies a strong liquidity position implying that a firm can meet current liabilities without difficulties (Cull & Morduch 2007). A ratio of below one implies a weak liquidity position.
The company’s current ratios for years 2013 and 2017 were 1, and this signifies a favourable liquidity position. Years 2014, 2015, and 2016 were characterized by a weak liquidity position.
Quick ratios compare current assets excluding the inventory with current liabilities (Nissim & Penman 2001).
The company’s quick ratio has been below 1, and this implies that the company has been heavily relying on inventory to pay its liabilities.
Limitations of Ratio Analysis
Ratio analysis plays a crucial role in analyzing business performance. However, it has some limitations that compromise its usefulness. The impact of inflation is one of the major impediments of the effectiveness of ratio analysis. The rate of inflation has a substantial impact on the financial statements. Accounting principles and assumptions do not put into consideration the impacts of inflation on the financial statements. The balance sheet does not portray the true and fair view of the firm’s financial position in a country characterized by a high inflation rate (Higgins 2012). It implies that the use of balance sheet and income statement figures to compute ratios compromise objectivity in the analysis process due to inflation errors. The overreliance on historical data to carry out ratio analysis is another shortcoming. Ratio analysis is based on the assumption that the future will comply with the past trends. This is not always the case because business environment is dynamic and this leads to a variation in business performance. The interpretation of ratios is another area of contention in ratio analysis. Ratios have diverse meanings depending with the prevailing conditions (Higgins 2012). For instance a current ratio of over 1 may be as computed before the company settles a big liability. In other word, such a ratio will not depict the actual liquidity position of an organization. Diversity of accounting policies is another issue facing ratio analysis. The accounting profession is governed by different accounting policies. Although GAAPS and IFRS are the main financial reporting standard, regions come up with their own regulatory frameworks to make accounting practices reflect the local environment. As a result, comparing performance across companies become difficult. Diversity of corporate strategies is another limitation facing ratio analysis (Higgins 2012). Ratio analysis requires comparing the ratios of a company with those of competitors. This practice makes the analysis ineffective if the concerned companies are pursuing different strategies.
Ratio analysis is one of the most effective tools for evaluating business performance. Using ratios to analyze Easy Jet reveals poor performance in key aspects. Ratios are broadly classified into profitability ratios, capitalization ratios, liquidity ratios, stock performance ratios. Profitability ratios measure the ability of a company to generate profit. Profitability ratios include gross profit margin, net profit margin, return on assets and return on equity. Capitalization ratios assess the capital structure of a company. Capitalization ratios include debt-equity ratio and long term debt to capitalization ratio. Liquidity ratios include the quick ratio and current ratio. The main stock market performance ratios include the earning per share and the dividend payout ratios. Ratio analysis is faced by limitations that from inflation, reliance on historical data, diversity of accounting regulations, and differences in corporate strategies. Profitability, liquidity and capitalization ratios paint poor performance of Easy Jet. On the other hand, share performance ratios paint a favourable performance.
- Rethinking the cost structure-the company should examine its cost centres with the aim of cutting costs.
- Reduce dividend payout ratio-reducing the payout ratio will enable the company to reduce borrowing as retained earnings will be used to finance operations.
- Put a borrowing cap-the company’s long term debt has been rising at an alarming rate and this shows a weak financial position.
List of References
Ahrendsen, B.L. & Katchova, A.L., 2012. Financial ratio analysis using ARMS data. Agricultural Finance Review, 72(2), pp.262-272.
Cull, R. & Morduch, J., 2007. Financial performance and outreach: a global analysis of leading microbanks. The Economic Journal, 117(517).
Edmister, R.O., 2001. An empirical test of financial ratio analysis for small business failure prediction. Journal of Financial and Quantitative analysis, 7(2), pp.1477-1493.
Higgins, R.C., 2012. Analysis for financial management. McGraw-Hill/Irwin.
Jones, L., 2005. EasyJet: the story of Britain’s biggest low-cost airline. Aurum Press.
MorningStar 2017, easyJet PLC ADR ESYJY. Retrieved fromhttp://financials.morningstar.com/ratios/r.html?t=ESYJY®ion=usa&culture=en-US&ownerCountry=USA
Nissim, D.& Penman, S.H., 2001. Ratio analysis and equity valuation: From research to practice. Review of accounting studies, 6(1), pp.109-154.
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