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Analysis And Evaluation Of Firm Profitability Finance Essay

This business analysis report has been developed so as to study which firm out of Burberry and GAP Inc. is more profitable and efficient in its operations through the use of Penman’s decomposition method in calculating and evaluating the profitability of firms. This paper reformulates the income statement and the balance sheet of both companies and calculates the ROCE using the factors such as financial leverage, Spread and RNOA. The report sees the comparison of the various factors between the companies and finds GAP Inc. is performing much better than Burberry whether it is in terms of ROCE or RNOA. Even during financial leverage, GAP due to its lesser financial leverage ability is able to meet its financial obligations whereas the financial leverage for Burberry is very volatile. In terms of p/e ratio, both Burberry and GAP are showing similar ratio for the current year with high investor motivation.

Introduction

This business analysis report has been developed in order to help us understand and provide an insight of the profitability, P/E (Profit to earnings ratio) and recent trade performances of two established consumer retail apparel companies. Burberry which is listed in the United Kingdom (UK) and GAP Inc. which is listed in the United States of America (US). A financial analysis of the organisation and its competition will help in assessing the various determinants of the financial performance of the company by providing an evaluation of their strengths and weaknesses.

Speciality apparel stores are considered as a subset for the retail industry where a customer can find clothing, accessories as well as footwear under one store. Typically such speciality apparel stores focus on one type of customer where the overall assortment of the merchandise in the store has a common theme such as common goods or luxury goods.

Especially after the recent credit crunch, financial crisis, and recession that saw the fall of what were supposedly the safest corporations to invest, several discussions have taken place whether in conferences, in actuarial literature or by individuals who have held interest in combating the various issues in providing an accurate method for firm evaluation. There are numerous bodies of literature present, such as the comparable method, venture capitalist method and the net asset value method, which try to explain the different practises in accounting, taxing, regulating or differencing financial ratios where each method provides their estimated fair value of a firm. Some traditional approaches of financial ratios do not provide financial results as effective as others.

Primary conscientiousness of any organisation is to increase their profits and market share while striving to increase their market returns as well as maximization of wealth for their investors and shareholders. A large part depends on the policies and strategies used. Profitability ratios help in determining the efficiency of the operations and management of these organisations.

A peer analysis will help us in understanding the nature of business of the two companies and help create a portfolio which would distinguish the difference between the various profitability ratios of these versatile companies. Penman’s decomposition method would be used in order to determine the financial and operating leverage to further understand the risks a firm may be exposed to. The analysis of a firm and its profitability generally stands on several basic pillars, which include Return on Assets (ROA) and Return on Equity (ROE).

A detailed reformulation of the income statement, balance sheet and key ratios of both organisations and their market sample, help us in studying the sustainability of their earnings, their structural differences as well as the negative correlation of the Price to Earnings ratio (P/E) to some aspects of a firm’s financial accounts.

Beaver and Morse (1978) and Penman (1996) have shown that P/E ratios, while definitely linked to prospective earnings growth but is also found to be negatively correlated to present earnings growth, showing empirically that the P/E ratio can be found to be affected by transient current earnings. Ou and Penman (1989b) have found that even though one finds that accounting fundamentals might explain P/E ratios but that is done primarily be dredging data.

Literature Review

Ball and Brown (1968) and Beaver (1968), are considered to have initiated the various studies towards the financial analysis of financial statements in terms of accountability, profitability and efficiency. In order to determining the profitability, strategies and the various risks associated with various organisations, you may find constant evaluation of the current performance and the financial position of the organisation both over the time as well as across various companies.

One of the most elemental tools for financial analysis of any organisation is through financial ratios. In today’s competitive dynamic world where profitability and maximisation of wealth are the drive of financial ratios, such as asset turnover, profit margin, financial leverage and more, have some importance in a market based empirical method of accounting. Instead of traditional profitability analysis alternative methods such as Penman Method and Palepu & Healy method are considered to be more accurate in determining the leverage an organisation can exert through their operations as well as financing activities.

Several scholars, conspicuously Nissim and Penman (2001) have now attempted in developing a structural and significant approach to the analysis of financial statements of an organisation in relation to their financial ratio to equity ratio. They have identified financial ratios various school of thoughts and have investigated different compositions for the valuation and profitability of an organisation by numerous scholars. Some of the major contribution in this research comes from Fairfield and Yohn (2001), Penman and Zhang (2004) and Soliman (2004). Traditionally in order to understand the leverage an organisation has, the measure of total liabilities to equity was enough. However there was absence of scope in distinguishing the operating liabilities from financial liabilities. As a result, explicit equations were composed which would not only differentiate between these two liabilities but would also help in understanding the fact that whether leverage from any of the liability would provide positive or negative result.

Freeman, Ohlson and Penman (1982) in their work proved that in order to make predictable future earning probabilistic a person needs to consider a single value that is the book value to the current earnings, where the earnings were found to be temporarily directly proportional to the book value. Higher earnings led to momentarily higher book value and vice versa. In some cases the ability to forecast earnings got further complicated with introduction of additional financial statement ratio Ou and Penman (1989a). Some methods of valuation are more effective in some occasion according to Lipe (1986) when he discussed that in order to improve income state forecasts the line-item analysis was more accurate. Fairfield Sweeney and Yohn (1996) reported similar findings. It is possible to find that there is a selection of different works which show a lack of certainty among the different literary works but the overall result is far from perfect and still has room for innovation.

Penman and Nissim (2001) have identified various financial ratios such as leverage, RNOA (Return on net operating Assets) to be correlated to the market value of equity. They have based their methods on the model of residual earning valuation. Fairfield, Whisenant and Yohn (2001) pointed out that movement in the financial statements of a firm can be correlated to the trend of its market industry. Penman and Zhang (2004) on the other hand contributed in concluding that the use of RNOA helps analysts in forecasting stock returns to almost two years later whereas only one year future stock predictions can be found out by using the traditional asset turnover and profit margin while Soliman (2004) studied the various market reactions expressed through the use ofkey financial ratios.

More literatures in the field of the P/E ratio and its relationship to a company’s financial structure are needed to explain how the analysis of different aspects of a firm’s financial statements are inter-related. Molodovsky (1953) gave the “Molodovsky effect” according to which P/E ratio was found to be affected by transitory current earnings. Similar studies were obtained by Beaver and Morse (1978) and Penman (1996) for the variance of P/E ratios.

Conventional profitability ratios, i.e. ROE fails to reveal a wide array of questions such as how profitability is linked to operating activities in the organisation or how the taxation has impacted the profitability. ROE is also ambiguous in providing a concrete answer whether sustainable growth can be achieved by any organisation or whether profitability can be increased by better asset management. ROE ratio broadly describes the profitability and the organisations assets base in accordance to the shareholder investment.

For a better understanding, the decomposition of various financial ratios is important in more effectively understanding the success of a firm and financial ratios.

Data Collection:

All the financial data that has been collected for Burberry and GAP Inc. has been collected through secondary sources which include the internal resources of the organisations such as annual reports of the respective companies.

Some external sources were also used for the collection of data which include online journals and articles, company websites, yahoo finance, previous researches on decomposition method and Thompson One Banker. The reformulated income statements and balance sheets for both the organisations range from five year period of financial statements from 2007 to 2011.

Methodology

In order to determine the profitability of Burberry and GAP Inc. we will be using Penman Decomposition method of profitability which supports the theory that while calculating the profitability of any organisation it is important that the financing factor as well as the operating factors are analysed separately. This would help in absolving the traditional difficulties or problems of accounting the profitability of an organisation.

Reformulation of the income statements and balance sheet of both the companies are done in order to distinguish the incomes that come from operating activities while those that are derived from the financial activities. Profitability is calculated both for operating activities and financial activities separately and both leverages (operational and financial) are then explained in order to obtain the overall profitability for the shareholders. Such a method of decomposition also helps in isolating any inconsistency found in financial statements and makes the appropriate corrections.

Through the use of Penman’s decomposition method, ROE was decomposed into three elements, SPREAD, ROA and financial leverage in order to isolate potential error of data for both operating (ROA) and financial leverage (SPREAD, financial leverage) to obtain the core profitability of the organisation.

The ROE can be calculated as follows:

ROE = Return on Net Operating Assets + Financial leverage × SPREAD (1)

Or

ROE = ROA + Financial Leverage (2)

Where,

Financial Leverage = Financial liability/Shareholder’s equity

While calculating FL, the numerator is total liabilities where liabilities include both the financial and operating liabilities.

ROA = EBIT/ Total assets

We find that while calculating ROA, the denominator is total assets which includes all types of assets which includes both operating and financial activities whereas ROA focuses on operating activities hence is called as a driver for operating factor.

Similarly, if we use SPREAD, since it is calculated by subtracting r from ROA, and already ROA is not differentiating between operational and financial activities SPREAD calculation also becomes inconclusive.

The above results show how important it is to reformulate the income statements and balance sheets and then decompose the various financial ratios so as to obtain a correct figure for the profitability of the organisation.

According to Penman method,

ROCE = RNOA + FLEV X SPREAD (3)

ROCE is “Return on Common Shareholders’ Equity” which is Penman’s equivalent to the profitability of the organisation. ROCE corresponds to the traditional ROE for profitability. One find that financing debt levers ROCE.

Where,

ROCE = CNI/CSE (4)

CNI equates to Comprehensive Net Income (CNI) and CSE is Common Shareholders’ Equity (CSE) or Common Equity (CE) which is equal to the equity capital. One finds that both the numerator and denominator are being affected by the leverage but which has been absolved by the reformulated financial statements. CSE can be calculated from the balance sheet

CSE = Net operating Assets – Net Financing Debt (5)

CNI = OI- NFE (6)

Operating Income (OI) cannot be found in standard income statement. Its value is derived by subtracting operating revenues (OR) from operating expenses (OE). In the normal income statement, operating income is calculated by subtracting operating expense from the gross margins. Operating income is produced through operations activities whereas the net financial expense (NFE) is incurred in the financing of such operations activities. It should be noted that all calculations for the net financial expense/income or the operating income of an organisation are done after tax.

ROCE can also be expressed as

ROCE = RNOA + FLEV X SPREAD (7)

Where

RNOA = OI/NOA (8)

Net operating Assets (NOA) helps in distinguishing the financing factors from the operating factors. It is calculated by subtracting operating leverages (OL) from operating assets (OA).

RNOA calculates the profitability factor on the basis that only the assets used in the operations should be taken into consideration. It is seen that the value of RNOA becomes higher if the operating liabilities of an organisation in relation to their operating assets is higher but it is based on the assumption that the numerator of the RNOA has no effect on the operating income of the organisation.

Alternatively,

RNOA = PM X ATO (9)

Profit Margin (PM) and Asset Turnover (ATO) where,

ATO = Sales/NOA (10)

FLEV = NFO/EC (11)

Net Financial Obligation focuses on the financial liabilities of the organisation and can be obtained by subtracting financial assets (FA) from financial obligations (FO). Equity Capital (EC) talks about the capital arranged through equity by the firm.

While calculating FLEV it is seen that it includes the financial assets which are the net against the financing debt but excludes operating liabilities. FLEV comes out negative when an organisation has financial assets much larger than their financial liabilities. It is FLEV which eventually shows which profitability of the organisation is due to financial activities and which are due to operational efficiencies.

SPREAD = RNOA- NBC (12)

Where,

NBC = NFE/NFO (13)

Net Borrowing Cost (NBC) represents the ‘r’ or ‘rate’ of the traditional method of profitability. NFO has already been calculated in equation (11) whereas Net Financing Expenses (NFE) is obtained by subtracting Finance Revenues (FR) from Finance Expenses.

P/E Ratio = Price of Share/Earnings (14)

A comparison of the above financial ratios of both Burberry and GAP Inc have been done in order to demonstrate which firm is profitable than the other. There is also the comparison of both the firms within the country where they are listed.

The mean and standard deviation for the apparel industry is calculated using four companies Beneton, Hugo Boss, Hermes International S.C.A. and Nisshinbo Holdings Inc. for which the calculations can be seen in the appendices.

Brief Introduction of Burberry and the Economic Conditions it operates in

Burberry was founded in the year 1856 by Thomas Burberry in Basingstoke, United Kingdom. It is primarily a leading global luxury brand house whose roots can be found in the British heritage. The global luxury sector in which Burberry operates has been largely estimated at a approximately 160 billion pounds. Burberry largely deals in designer clothing, fashion accessories and licensing fragrances which are designed, manufactured and market by them. Burberry is both listed and headquartered in London and is considered to have one of the most recognised icons in the world, with its Prorsum horse logo, trademark check and the trench coat (Burberry 2011a). Burberry uses a much diversified range of networks for its global distribution through wholesale, retail, digital commerce as well as licensing channels. It has been granted status of royal warrants and its trench coats are one of the world’s most famous iconic design. Currently Burberry is distributing its produces, in Americas, Asia Pacific and Europe through a three way means, precisely by channel, by region and by product.

According to their annual reports, the total revenue for Burberry for the year 2011 stands at 1857 million pounds an increase of 24% from the last year. The primary revenue is generated through their retail enterprise of approximately 1270 million pounds. Their wholesale enterprise has generated 478 million pounds in the last fiscal year.

There are five core strategies which the management of Burberry intends to follow in the current year Burberry’s five core strategies. The company already has an average space growth rate of 14% in their retail sector and aims at expanding at a similar pace both in new markets as well as older markets. In order to remain ahead of the competition, Burberry encourages tremendous design innovations so as to uphold their tradition of having a compelling wide array of products. Burberry as a brand continues to rise because of it backing by some of the most forward assessing digital marketing in the customer sector. IN order to build and strengthen it foundation more powerfully, there has been an active efforts by Burberry of increasing their presence in the new luxury markets such as Japan, China, India and Brazil. The company further aims in seeing that their operating activities are more efficient (Burberry 2011a).

A look at the Burberry group reveals that the success of the company is riding on its wide and highly diversified geographical presence and networks along with their strong branding. Burberry is finding a lot of growth opportunities with the increasing opening of avenues in the form of emerging markets where these luxury fashion goods are in increasing demand as well as the increase of internet penetration both in emerging and developed economies helping the company in establishing its presence in online retail.

Fashion retail has been referred as a typical consumer goods sector where some it common characteristics can be defined by the fickle every changing consumer preferences, a product with a very short life cycle, not only having various competitors but also numerous retail alternatives. The entry and exit barriers are relatively easy and one finds abundant manufacturing and marketing techniques in the (Richardson, 1996)

Currently Burberry is facing an extremely challenging external environment where the aftershocks of recession of the European market can be seen in the overall performance of the company. Less disposable income, discretionary spending on luxury goods, easy to substitute and weak efficiencies are some of the factors which is plaguing the company for a long time.

Burberry is also struggling maintaining customer loyalty as in today’s highly competitive globalised world one finds that the consumer preferences are changing constantly and companies are finding it difficult to retain their consumers. The fashion industry is seeing changes in the trends which are much faster in nature and there is always a risk associated that the consumers might like the new entrants better than established luxury houses(Burberry 2012a).

Luxury fashion houses have been almost immune to the global financial crisis in comparison to other industries primarily because they were able to sustain their profitability due increase in revenues from Asia pacific region specially China. But one sees that even in these rising economies are now being bogged down and their economic growth rate has seen a considerable decline from their progress for the last three or four years. Burberry has posted revenue of 408 million pounds for their quarter through June in 2012, which one sees that is slightly below the 416 million pounds forecast by analysts. Burberry had seen a astronomical 34% growth rate in their first quarter in the year 2011 while the gain for the first quarter in 2012 is has come down sharply to 11% in terms of constant currencies. 38 percent of the revenue of Burberry has been accounted by the Asia pacific region in the previous year of 2011. The overall growth of the company has also seen a fall from 67 percent last year to a meagre 18 percent in the current year. One finds that the company in addition to the above economic situations is also dealing with the natural disaster in Japan and the slow recovery of the US market from it recession (Burberry 2012). Market performance is forecast to decelerate, with an anticipated compound annual growth of 4.6% from 2009-2014.

Burberry’s operation activities are considered as some of the highly inefficient in the industry. They not only lack a proper vertical integration but also almost all their activities have been outsourced. The company is still finding integration in the retail business in rough weather even though it is trying to increase its presence. The company scores high in its low transactional exchange exposure and its licensing agreements in Japan and other countries are providing them with high return on their invested capital. One of the major risk associated with Burberry is it high dependence on the high end apparel segment for their overall profitability figures which faces enormous fashion risk and has a high chance of being copied (CSFB Research 2011).

Brief History of GAP Inc. and Economic Conditions it faces

The GAP Inc. was founded in the year 1969 by Donald G. Fisher and Doris F. Fisher is a global speciality apparel American company. Currently the company offers clothing, personal care products and accessories for men, women and children under the retail store method with approximately 3076 stores worldwide out of which it has almost 2551 stores in US alone. Gap is headquartered in San Francisco, California, United States and is listed in the New York Stock exchange. Gap currently operates in US, UK, France, Japan, China and Canada. Gap currently operates through five different brand names, precisely, Athleta, Banana Republic, Old Navy, Piperlime and the namesake GAP (GAP 2011a).

The five brand show the diversification method which GAP has adopted in order to compete in the market. The economy price consumer is targeted with its branding called Old Navy whereas the middle-market consumers are targeted through GAP. The upscale consumers which require premium price items are targeted through their brand Banana Republic Piperlime brand is through which GAP promotes its online merchandise with the product range including retail handbags along with shoes. Athleta is the sport brand for GAP where one finds the target audience to be females looking out for athletic sportswear (Gap Inc., 2011a)

IT is interesting to note that even though GAP is a public listed company yet it is largely a family controlled business. GAP operates under two segments; one is the flagship retail store outlets and the online platform which is practised both internationally and domestically. The second segment is the franchise agreements through which it runs stores in Asia, Africa, Australia, Eastern Europe, the Middle East and Latin America. As a result it operates in almost 90 countries. GAP has generated 14.5 billion dollars as revenue in the year 2011 with its net income standing at 833 million in the same year (GAP, 2011a). There is tremendous brand awareness for the company in the US and since it follows economies of scale it has an enormous opportunity for sourcing as well as effective inventory management.

The external environment in which GAP operates has seen tremendous changes both economically and environmentally. There has been a radical shift in the various economic powers of economy. While US and the European region has been under global financial crisis and reeling under recession resulting in less disposable income and a shift in attitude of a consumer of spending conservative amount of money on clothes. There are new emerging markets such as China, where the recession has not hit the roof and people have the purchasing power to spend on clothes. There spending power has increased and they have become a dominant player in the global market. Not only in terms of sale China has became attractive but also in terms of manufacturing with their fast growing economy, government support, various tax and other incentives, low cost for both labour and material. It has provided a competitive edge which many countries are finding hard to fight back.

There is a rapid change in the industry trends since primarily the industry is considered to be in a mature stage of lifecycle with a saturation point reached, GAP is improving its margins, through the presence of the large number of stores in US while trying to enhance their brand image along with the penetration in newer markets.

Taking stock of the various strength which have resulted in the growth of GAP are the increasing presence of stores both through retail outlets as well as franchisee outlets which gives them an opportunity to cater a wider range of population. The store has some one of the best well balanced portfolio of products present with the growing presence of upscale brands. Internet penetration is another catalyst of the growth story of GAP with the opportunity to expand further since the company is seeing positive trends. They have some of the best margins as compared to their other competitors. GAP has a huge opportunity in the form of Chinese retail market where the largest population of the world would provide any company an enormous base for their future consumers.

Some of the key issues for the management of the company are the high dependence of the organisation for the supply of products on outside vendors which makes places it under huge socio, political and economic risk. The cost of the apparel could increase on the account of import restrictions or due to increase in import tariff. Since GAP is dependent on using cheap labour of Asian countries there is huge possibility of increase in the cost of apparel as there is bound to be increase in the labour cost GAP has shown a low productivity level in their retail outlets where their inventory growth has not been able to keep pace with their sales growth. Today the most challenging aspect of any organisation with modern technology is counterfeiting of their products which are cheaper in price and attract large consumers.

The ability of Europe and US have shown a considerable slowing down in their spending power and there apparel industry is seeing a highly competitive nature which might squeeze their profit margins as a result GAP is strategically moving towards healthy merchandise as there are prospects of improving sales and better margins. They have to be innovative in gauging the changing trends and mood of the industry since the consumers today are very fickle minded in their selection and are constantly innovating in the apparel tastes. The multiple branding of GAP for differentiating its various price senstivie customers can also result in increased cannibalisation risk.

Findings

The profitability of both the companies as well as the financial ratios for the last ten years for both Burberry and GAP Inc. have been tabulated in the tables below. We have also calculated the Mean of US and UK industry so as to give us an indication as to how the two companies are fairing in their respective countries where they are listed.

 

ROE

 

GAP

US Mean

Burberry

UK Mean

2002

-0.52%

37.25%

0.35%

1.90%

2003

13.34%

30.97%

0.30%

1.58%

2004

23.32%

30.31%

-0.54%

2.60%

2005

23.27%

31.34%

-1.09%

2.04%

2006

22.10%

29.02%

-0.58%

0.92%

2007

13.90%

30.15%

0.18%

0.51%

2008

17.63%

26.00%

1.19%

0.55%

2009

25.73%

26.03%

1.17%

0.62%

2010

22.57%

26.13%

0.78%

0.22%

2011

27.01%

53.21%

0.16%

0.96%

Table 1: It shows the ROE for Burberry and GAP Inc along with US and UK Mean.

From the above table it can be seen that from the year 2003 TO 2004 Burberry finds a decrease in its ROE 0.30% to (–) 0.54% as a result of the decrease in the returns generated by the operating assets of the company. In 2008 its ROE saw a substantial increase from a marginal 0.18 percent to 1.19% because the high financial leverage drew the ROE higher. For two years Burberry maintained an ROE above 1 percent but then in the year 2010 again came the decline and has come sown to a measly 0.16% in 2011 for which recession can be attributed as one major factor resulting in negative leverage and also because of the low RNOA which will be seen in the subsequent table. It is also interesting to note that Burberry has acted very differently from the UK mean. One sees that Burberry has done well when the industry average has been weak and has performed weakly while the industry in the UK has performed well.

MEAN 

2011

2010

2009

2008

2007

ATO

1.89992

1.657701

1.472921

1.70643

1.634042

PM

0.012209

0.01952

0.005923

0.005675

0.008377

ROA

0.019265

0.019186

0.013657

0.012064

0.00825

CLEV

1.158224

1.347345

1.706942

1.347489

1.078713

ILEV

1.709662

1.005767

0.98411

2.113272

2.15229

ROE

0.01904

0.015823

0.025978

0.020396

0.009166

ROA

0.023544

0.029911

0.013226

0.013834

0.010664

Borrowing Rate

0.037483

0.088463

0.006719

0.027482

0.039176

SPREAD

-0.01394

-0.05855

0.006507

-0.01365

-0.02851

FLEV

0.261348

0.430895

0.780776

0.430646

0.172107

LS

-0.0045

-0.01409

0.012752

0.006562

-0.0015

ROE

0.01904

0.015823

0.025978

0.020396

0.009166

Table 2: It shows the mean for the apparel industry for the last five years.

GAP Inc. on the other hand has performed well specially in the last three years. One sees that the ROE of GAP has increased steadily from the year 2002 where it was (-) 0.52% to an impressive 27%. GAP has seen a decline in its ROE in only two of the years (2007 and 2008) which were affected due to the US facing the worst recession of the decade leading to a negative leverage for the organisation. RNOA has been considered the main driver for the slow and steady increase in the ROE of GAP Inc. If we take the US market into consideration, one finds that the ROE of the US industry is much higher than that of GAP and in comparison ROE of GAP has shown a lot of fluctuation in the last decade. The US industry average has shot up to 53 percent from 26 percent from the year 2010 to 2011 which shows there are tremendous growth opportunities in the industry which GAP has failed to recognize and capture.

 

RNOA

 

GAP

US Mean

Burberry

UK Mean

2002

1.51%

53.57%

0.64%

2.35%

2003

15.20%

45.90%

0.57%

2.99%

2004

33.61%

46.16%

-1.26%

1.32%

2005

42.90%

49.88%

-2.85%

1.38%

2006

39.79%

46.16%

-1.24%

1.07%

2007

23.45%

44.72%

0.31%

0.58%

2008

28.22%

42.14%

1.91%

0.63%

2009

42.59%

43.19%

1.03%

0.72%

2010

42.43%

39.98%

1.69%

0.18%

2011

51.13%

66.97%

0.49%

0.41%

Table 3: It shows the RNOA for Burberry and GAP Inc along with US and UK Mean.

Burberry shows a fluctuating RNOA where for three consecutive years from the year 2004 to year 2006 it has shown a negative RNOA. From the year 2008, Burberry again shows a steady increase in its RNOA which has now again dropped considerably in the year 2011 to a marginal 0.49 percent from 1.69 percent in the previous year which clearly shows that Burberry is not utilising its assets in the most efficient and profitable manner. Even the industry in UK has shown a steady decline in their RNOA percentage from the year 2002 to 2011 where the percentage of RNOA has fallen from 2.3 percent to 0.41 percent.

 Standard deviation

2011

2010

2009

2008

2007

ATO

0.965175

0.872175

0.497907

0.643351

0.725978

PM

0.00908

0.017355

0.013229

0.016832

0.014097

CLEV

0.390124

0.60038

1.219287

0.626997

0.308803

ILEV

0.044122

2.223561

0.086845

0.066222

0.046528

ROE

0.02208

0.039201

0.053321

0.043801

0.012481

ROA

0.026932

0.025963

0.027682

0.040259

0.020669

Borrowing Rate

0.035447

0.138963

0.018212

0.022975

0.018445

SPREAD

0.0095

0.128666

0.009516

0.025062

0.007413

FLEV

0.345187

0.542653

1.102248

0.564795

0.269738

LS

0.004965

0.032915

0.025676

0.009228

0.008498

ROE

0.02208

0.039201

0.053321

0.043801

0.012481

Table 4: It shows the standard deviation for the apparel industry in the last five years.

Return on Net Operating Assets (RNOA) is higher the more of each dollar of sales ends up in operating income, and the more sales are generated from the operating assets. The higher is asset turnover, the lower profit margin is (negative relationship). Looking at the table above, profit margin plays a very important role in increasing or decreasing the return on operating assets. The higher it is (0.61% in 2010), the higher the RNOA is (1.69% in 2010) and the lowest it is ( (-) 1.26% in 2005) the lower is the RNOA ( (-) 2. 85% in 2005). The profit margins for Burberry have declined considerably in the year 2011 while their asset turnover can be said to be almost equivalent to their 2002 year level (Tables can be seen in the Appendices)

GAP Inc. has shown a steady increase in its RNOA percentage. It has shown a whopping 8.7 percent increase from the year 2010 to 2011 to a staggering more than 51 percent. In the year 2009 also GAP had shown an increase of almost 14 percent in its RNOA from 28.22 percent to 42.59 percent. GAP has shown a fall in its RNOA in only two years, precisely 2006 and 2007 where the RNOA was eventually down to 23.45 percent. In terms of RNOA, the US market is outperforming GAP Inc. as they have a RNOA of 66.97 percent However, in the year 2010, it was seen that GAP slightly surpasses the market performance in the US, where it is seen to perform marginally better than the US market but the market in 2011 again start to rapidly grow and is now outperforming GAP substantially.

The assets turnover ratio (ATO) helps in revealing the sales revenue per British pound of the net operating assets put in place by Burberry. It also helps in measuring the ability of NOA to generate sales. If either the sales decreases or the net operating assets decrease, then the asset turnover of the company also decreases. In 2010 the sales (1185.1) and the NOA (426) decreased from last year amount ( 1201.5) and ( 530.1) resulting in a decrease in the ATO for Burberry.

On the other hand for GAP, one sees that its profit margin and asset turnover both of them increased by 0.42% and 78.39% respectively for the year 2010 to year 2011, resulting in an increase in RNOA of 8.7%. in the year 2011. In the year 2009 the increase in its sales and NOA figure help the company in leading to an increase in their asset turnover ratio by 84.38%. However in 2010, the company felt the pressure of slow recovery of the market from recession, the asset turnover ratio was found to be decreased due the overall decrease in sales of the company. But again one finds that the increase in sales in the next year increases the asset turnover ratio.

 

SPREAD

 

GAP

US Mean

Burberry

UK Mean

2002

-6.29%

47.64%

3.78%

-1.39%

2003

-11.72%

42.15%

1.79%

-5.86%

2004

47.67%

40.98%

-2.47%

0.65%

2005

46.50%

47.04%

-4.83%

-1.36%

2006

38.80%

41.68%

-3.06%

-2.85%

2007

21.50%

40.36%

-5.56%

-2.12%

2008

25.52%

39.97%

-12.70%

-1.07%

2009

41.18%

40.14%

6.48%

-0.78%

2010

42.25%

36.46%

3.50%

-0.46%

2011

50.73%

57.44%

0.77%

0.99%

Table 5: It shows the SPREAD for Burberry and GAP Inc along with US and UK Mean.

One finds significant differences in the trends of GAP and Burberry which is probably one of the reasons for the huge difference in return on equity between the two organisations. GAP has been able to produce a much higher ROA with their current financial costs unlike Burberry which has been experiencing high financial costs occasionally, sometimes which are even higher than its ROA. Taking into account the last three years value of SPREAD for both GAP and the US industry mean one finds that there is stability between them in spite of an occasional alteration from the market.

Graph: Comparison of spread between Burberry and GAP.

On the other hand both Burberry and UK market show a highly volatile spread line from each other. Burberry in the future if the trend continues would find that its ROA is not able to cover its financial costs if the downward trend continues which would eventually lead Burberry into underperforming than the market average.

FLEV

GAP

US Mean

Burberry

UK Mean

2002

32.15%

-0.89%

-7.54%

26.13%

2003

15.82%

4.76%

-15.08%

43.09%

2004

-21.59%

14.37%

-29.14%

78.08%

2005

-42.21%

2.29%

-36.39%

43.06%

2006

-45.59%

-4.47%

-21.56%

17.21%

2007

-44.41%

-1.94%

-2.27%

15.16%

2008

-41.46%

-11.47%

5.68%

18.44%

2009

-40.94%

-15.89%

2.16%

21.80%

2010

-47.03%

-14.21%

-25.75%

24.59%

2011

-47.55%

-11.15%

-42.19%

27.92%

Table 6: It shows the FLEV for Burberry and GAP Inc along with US and UK Mean.

With the help of FLEV we can see that GAP has been for years followed the trend of using less and less leverage in financing as compared to the use of equity. It was only in the early years of 2002 and 2003 one sees a positive FLEV. Even the US apparel industry as a whole follows a trend of using less financial ratio but GAP has a much lower leverage when compared to its market. As a result, GAP has the ability to meet its financial obligations with much greater ease than its market counterparts.

Graph: FLEV comparison for GAP and Burberry

While Burberry has shown a mixed trend of using financial leverage in spite of the fact that one sees that there has been quiet a trend in the UK industry of using leverages. In 2004, the UK mean for FLEV was at an astounding 78.08 percent which is very high. Burberry has in the last ten years shown both and upwards as well as downward trend which makes one believe that they might repeat history and might start depending more and more on debt again. Burberry will face less strain from debtors and provide a more favorable climate to meet its financial obligations.

Using the FLEV ratio we are able to distinguish that GAP has a trend to use less and less leverage in financing compared to the use of equity. While on the other hand Burberry shows a mix trend of upward and downward trend that may start depending on debt if history repeats itself. A significant difference between GAP and Burberry’s spread is noticeable. Gap is able to produce a much higher ROA with its current financial costs unlike Burberry experiencing high financial costs occasionally higher than its ROA

 P/E Ratio

GAP

Burberry

2008

9.58

14.39

2009

15.13

-201.3

2010

10.62

38.01

2011

10.99

24.51

2012

19.8

24.78

Table: P/E Ratio for Burberry and Gap

Analysis of the P/E ratio for both the companies one sees that again Burberry has shown a very volatile pattern in its P/E ratio whereas GAP has shown a very stable curve. Today the markets are full of expectations with Burberry but in order to maintain its excellent reputation Burberry has to work in top gear since there are possibilities of Asian downturn and increasing discretionary spending. GAP with its troubled past seems to have finally found a path with its increasing international presence and its strategy in cutting down the square footage of their wholly owned stores. The below graph shows that share price of GAP has shown mild fluctuations and has steadily increased in the last two years. It is currently trading at 35.8 dollars.

http://markets.money.cnn.com/cgi-bin/upload.dll/file.png?z028a110az3a3f06938f8d48028d602dd3639c1937

Graph: Share Price for GAP Inc. from 2007 to 2012

Source: Yahoo Finance

Graph: Share Price of Burberry for the last five years

Conclusions

Burberry sells its products both through retail and wholesale channels whereas GAP primarily sells through retail and franchisee outlets. Burberry Group has a market capitalisation of 5.83 billion dollars whereas GAP Inc. on the other hand currently has a market capitalisation of 16.85 billion dollars. After comparing the various profitability ratios between the two companies we can easily conclude that the US based company GAP is performing significantly better than the UK based Burberry group in the apparel industry while taking into account their Return on Common Equity (ROCE). WE have broken down the ROCE into various drivers for a better understanding such as financial leverage, spread, Return on net operating assets (RNOA).

WE find that even in terms of ROA, Burberry Group has been found to performing poorly in comparison to GAP INC. Such is the contrast that while the ROA for GAP has been found to increase for 0% to 40% over three years from year 2002 to 2005, Burberry has seen a major decline in its ROA in the same time period gap of 2002 to 2005. While Burberry has shown a flat rate for ROA in the last ten years, the ROA for GAP has been found to be fluctuating with a point of deflection in the year 2007 where it saw a decrease in its ROA but since then again there has been a noticeable increase in its ROA. GAP we conclude is able to produce a much higher ROA with its current financial costs unlike Burberry which has been found experiencing high financial costs occasionally higher than its ROA.

Recommendations

People have high expectations out of Burberry by it should not only decrease it financial leverage but should also try uses its funds more efficiently in order to provide better margins. The company should be cautious in its approach in China or other emerging markets since there economy is highly volatile and is currently facing a slight downfall. One has to be also be prepared for the fact that luxury fashion fads change overnight and the midterm margins of the company might be less than anticipated.

GAP was once the biggest cloth retailer in the US market but it is now facing intense competition from Espirit, H&M, Fast Retailing and Inditex. They also have been struggling in increasing their productivity level per store which is performing below market average. The continuously face high international exposure since they are highly dependent on other vendors for the procurement of products. The company has also suffered in terms of its advertising strategies which have failed miserably. The more colourful and youth centric approach has not helped GAP achieve the previous levels of stature in the retail cloth business. There is an urgent need for the correction and rectification of the same.


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