Report for the Chairman of Marks and Spencer.
This report is based on the Marks and Spencer (M&S) group latest annual report for the period ended 2nd April 2005.
A) Capital Structure and Financial Instruments
The table 1 gives a synopsis of M&S balance sheet on 2nd April 2005. The total assets of the group were £4,285 m. These were financed by a combination of liabilities and shareholders funds, i.e., the money due to shareholders after paying off everyone else due.
Most of the assets, 87.8 percent are financed by liabilities with total liabilities standing at £3,763 m. Liability includes money owed to creditors of material and senior lenders. Current liabilities are acquired during the normal operation of the business and are balanced by current assets.
Table 2 shows the maturity profile of interest bearing debt instruments. 43 percent of debt is payable after 5 years and this gives financial stability to the company. M&S uses a variety of long, medium and short term debt instruments to finance its purchase of assets.
The company also diversifies the risk by using debt instruments denominated in various currencies. The company has swapped its floating interest bearing debts with fixed rate interest dents. This allows the company to budget interest costs and not to worry about the fluctuations in interest costs due to varying interest rates.
B) M&S could use floating interest bearing debts with collars. Collars are used to fix the lower and upper interest rates. This allows M&S to limit the maximum interest costs that it will have to pay even if interest rates go to any level. It also allows the company to enjoy lower interest costs if interest rates fall than at the time of entering in to a debt agreement. The downside of this type of instrument is that if interest rates fall even lower than the lower limit of the collar, the company will still have to pay interest costs at the lower collar rate.
Liquidity is M&S’s ability to pay obligations. M&S uses a series of financial instruments with varying maturity to match the profile of asset being financed. Short term bank borrowings and commercial paper are used mainly for financing trade creditors. Medium term loans and securitization are used to finance fixed assets like stores. Then the group also has retained profits to meet shortfall in funding of assets. The above range of maturity in debt instruments offers flexibility to match the life of asset with the instrument used to finance it.
M&S has foreign currency risk due to exports arising from UK to its international subsidiaries and imports to UK from its international suppliers. The sales realization from its exports takes time and M&S is exposed to movement in foreign currency in the meantime. Similarly if it is paying in fixed local currency for imports, the time between order placement and payment may result in different value of the order in UK Sterling.
M&S copes with foreign currency risk in exports by hedging 80 to 100 % of expected sales through forward currency contracts (Annual Report, 2005). Similarly non-UK Sterling denominated import contracts are hedged through forward currency contracts. Hedging on one hand limits its exposure to movement in foreign currency but it also exposes M&S to some risk depending on the variation between expected and actual sales. If forward contracts were for amount more than the sales, than M&S paid unnecessarily extra hedging costs. Also M&S loses out if the movement in foreign currency would have increased UK Sterling revenues.
The other foreign currency risk is because of ownership of assets and liabilities in foreign currencies. M&S has assets in foreign countries as well as foreign currency loans. The foreign currency loans are not significant as compared to total loans. These assets and liabilities are translated into UK Sterling at the end of each period for accounting. If assets and liabilities are not matching, as an example if foreign currency denominated loans were not fully used to finance purchase of foreign assets, then movement in foreign currency will cause movement in balance sheets. These movements are non-cash movement unless actual sale of assets takes place.
Table 3 shows the currency and interest rate exposure of M&S. Out of £2,444.3 m of debt, only £1,357.6 m, i.e., 55.5 % is floating interest bearing. And almost all of it is in UK Sterling. 1 % increase or decrease in UK interest rates will increase or decrease interest payment by £13.5 m.
M&S purchases stocks, especially clothing, from a large number of countries. A substantial part of its clothing comes from China and India. It is very important that latest fashions and styles arrive in stores in time. Recently China exported more than its allowed annual quota of clothing to Europe. Further shipments from China were stranded in ports for weeks before allowed in after a new agreement that will reduce its exports next year. M&S should establish more suppliers in different countries to avoid facing clothing shortages due to above kind of crisis.
Tax and Accounting
EU has adopted International Accounting Standards. M&S being a listed company will have to comply with the ruling and will have to report its accounts in line with international standards. Though UK FRS accounting standards are being aligned with international standards over time, yet there are differences, some of them significant between UK and international accounting standards.
M&S has already stated the main differences in balance sheet of the group due to application of international standards. The main challenge here is to educate investors, many of them not financially sophisticated, about how implementation of IFRS will change the financial state of the company.
D) The post-tax weighted average cost of capital is the post-tax average cost of funding of assets. It includes the proportional cost of both debt and equity. The debt cost is calculated post tax as interest payments are tax deductible.
Post-tax weighted average cost of capital is calculated by using the following formula
WACC = (1-td)*rd*D/A + re*E/A
td = Average tax rate
rd = Average interest rate on debt
D = Net debts
E = Book value of equity
A = Assets = D + E
re = Return on equity
Return on equity, re is calculated using the following formula
re = rf + B*(rmp)
rf is the risk free rate
B is the beta of M&S stock. This measures the relation between the percent movement in share price of M&S with respect to the percent movement in share market.
rmp = Market premium. This is the expected return of the market as a whole.
The following assumptions or facts were used in the calculating WACC
- The tax rate in 2005, td = 28.5 % (Annual Report, 2005)
- Average cost of borrowing, rd = 5.7 % (Annual Report, 2005)
- Net debts, D = £2,099m
- Equity, E = £521m
- Assets = D + E = £2,620m
- The beta for M&S share, B = 0.385 (Source: UK Yahoo finance website)
- The risk-free rate, rf = 5 % (Based on the long term, 10 year, average treasury bills)
- Market risk premium, rmp = 8.5 % (Brealy & Myers, 2000). Market risk premium was calculated for the period 1980s to mid 1995 rather than a very long period to reflect latest trends.
Using the above numbers, the return on equity is
re = rf + B*(rmp) = 5 % + 0.385*8.5 % = 8.27%
Post-tax weighted average cost of capital,
WACC = (1-td)*rd*D/A + re*E/A
= (1-0.285)*5.7*(2099/2620) + 8.27*(521/2620)
= 4.91 %
The average post tax cost of funding M&S’s assets is 4.91 %. It is a weighted average of cost of debts and equity.
E) The net debts outstanding on 2nd April 2005 were £2,099m. The gearing ratio is the ratio of net debt to total assets. It measures how much of each asset is financed by debt and how much by equity.
Gearing ratio = Net debt / (net debt + book equity) = 2099 / (2099+521) = 80.1%
The above ratio shows that 80.1 percent of M&S were financed by debt and only the remaining 19.1 percent by equity.
F) Current ratio
Current ratio is a measure of liquidity and is a ratio of current assets to current liabilities. Current assets like stock and amount due from customers can easily be converted in to cash as compared to other assets like property or intangible assets. Current assets along with cash can be easily used to repay current liabilities.
M&S had total current assets of £837.5m and total current liabilities were £1,289.3m.
Current ratio = 837.5 / 1289.3 = 64.9%.
The above current ratio means that if the company has to pay its current liabilities, it can pay only 64.9 % of that from current assets.
Foreign Currency exposure risk
The group is paying forward currency contract fees on both exports and imports related to foreign transactions. On each forward contract, transaction spread and fees reduce M&S earnings. If M&S is importing and exporting from the same country, then the company should enter into forward currency contracts only for the net of export and import amounts. This will reduce transaction costs. It is highly likely that the origins of export and import are different. M&S imports a significant part of its clothing from China. China has pegged its currency to US dollar with very little movement allowed. M&S can net off imports from China with exports to US.
M&S has £1,357.6 m of floating interest bearing debt and almost all of it is denominated in UK Sterling. Any increase or decrease in the UK interest rate would cause similar movement in the interest costs. As an example, if the interest rates increase by 1 %, the annual interest costs would go up by £13.5 m. The post tax increase in interest costs would be £9.5 m based on 30 % average tax rate. Movements in interest rate, significantly higher than 1 % would cause substantial increase in interest costs. M&S is generating sufficient earnings before interest taxation depreciation and amortization for interest cover. Yet any increase in interest costs without adding further debts lowers shareholders value.
The company should use collar financial instrument to limit the interest costs. The use of upper interest rate collar will limit the highest interest rate the company will pay irrespective of floating interest rate level. The purchase of such collar instrument will result in additional costs but they are only a fraction of a percent. The benefit of such instrument is that it will give clear visibility to future earnings and also assure the market that the company is not going to face financial distress or covenant breakage situation if interest rates move up rapidly. Stock markets like companies with predictable and strong earnings. By using interest rate collar instruments, M&S would be reduce the variability in earning and increase value for its shareholders.
Table 1 – Synopsis of Marks and Spencer Group’s Balance Sheet
Long Term Liabilities
Creditors due after one year
(Source: Annual Report, 2005)
Table 2 – Marks and Spencer Group: Maturity Profile of Debt
Repayable within one year
Repayable within one to two years
Repayable within two to five years
Repayable after five years
(Source: Annual Report, 2005)
Table 3: Marks and Spencer Group - Interest Rate and Currency Profile of Debt
(Source: Annual Report, 2005)
Bibliography and references
Annual Report (2005). Marks and Spencer Group Annual Report 2005
Brealey, R.A. and Myers, S.C. (2000). “Principles of Corporate Finance”, Sixth Edition, Mcgraw-Hill Publishing, 2000.
UK Yahoo finance website (http://uk.finance.yahoo.com/q/tt?s=MKS.L)
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