Accounting Essays - BT Cashflow Changes

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BT Cashflow Changes.

BT Group (BT) is the leading UK company providing landline telecommunication services and equipment. It also had the mobile telecommunication business which was subsequently sold as MMO2. After the sale of mobile business, BT's profile has now changed from a growth company to a mature cash generating company.

Financial performance
The most common objective assessment of the financial performance of a firm is the return it generates on its assets and the quantity and quality of the returns.

Quantity is measured by the absolute and percent change in total profits. The profit and loss account of an organisation and its analysis are the prime and first indicators of a firm's financial performance. The latest annual results of BT is for the period ending 31 March 2005. Appendix I shows the summary of key profit and loss figures over the last three years.

BT's turnover and profit after tax in 2005 have increased as compared to 2004 but are still lower than those in 2003. The turnover has declined by 5.7% only whereas profit after tax has declined by 32.7% over the two year period. This shows that the business has very low variable costs which is in line with the heavy fixed cost investments normally made by telecommunication companies in establishing their networks and subsequent very low variable costs in carrying data.

While turnover increased in 2005, operating profits have declined. This indicates that the business is facing some pricing pressures or is spending more on advertisement as the operating profit declined by 0.5% only.

BT's 2005 profit after tax was £1,820m and was substantially higher than £1,406m. Though the absolute profit is very high number compared to most of the businesses and indicates that the company is in strong financial position, it also shows that BT has high financial leverage. The company paid a significant high interest and if revenues and operating margins come under more pressure, it could have trouble paying interest costs.

BT is aware of this issue and has focused on reducing its net debt. After facing tough times in early 2000s, it has sold many previous investments to raise money for repaying debt. BT's share price rose after it announced its strategic decision to reduce net debt by raising money through divestments. The net interest payments have declined from £1,439m in 2003 to £801m in 2005. Not only that, the net interest payment has declined from 49.5% of operating profit to 29.0% from 2003 to 2005. The reduction in net interest as a percent of operating profit is an important improvement as it gives investors comfort that even if operating margins come under pressure, the company would still be able to meet its interest liabilities.

One quick way to analyse a company's performance is to look at the earnings per share pattern. The earnings per share had also a change pattern similar to that of profit after tax. It first decreased from 31.4p in 2003 to 16.4p in 2004 before increasing to 21.4p in 2005. The 2005 increase in earnings per share highlights the improvement in performance. Though the profits did decrease in 2004, BT kept on increasing total dividend paid to shareholders. This shows the management's faith in business going forward and its ability to meet higher dividend expectations in future.

The returns generated on assets is measured by Return on Capital employed (ROCE). Appendix II shows the calculation of ROCE for BT. BT had a healthy ROCE of 19.0% and 20.7% in 2004 and 2005.

The quality of returns is measured by their consistency and by the spread of profits, i.e., the percent of profits being generated from different divisions and locations. The less reliance of profits on any one division and/or location means the company is in better shape to withstand downturns in its markets.

None of BT's business contributed more than 50% in its turnover in the year ended 31 March 2005 (BT, 2005). This indicates that BT Group is reasonably well protected from the declines in a business line. The situation is slightly different if we look at the operating profits where BT Wholesale division contributes more than 50% of net operating profits. Any more margin pressures in this business could reduce future earnings. Most of BT's earnings originate from UK and hence it earnings are susceptible to changes in UK economy.

Financial position
The financial position of a company covers its financial structure, its assets and liabilities, its liquidity and risk management approach (Accounting Standards 2004/2005). Appendix III gives the highlights of BT Group's balance sheet from 2004 to 2005. The total fixed assets have increased by £639m in the last year. While total fixed assets have increased, the total current assets have decreased by £254m, so total assets have increased by £385m. The lower increase in total assets as compared to increase in fixed assets is mainly due to decrease in cash and investments.

The major change in financial structure has occurred on the liabilities side. The total current liabilities have gone up by £3,938m due to increase in current loans and borrowings of £3,227m. This shows that BT is financing much more of its assets from current borrowings.

The massive increase in current loans and borrowings has reversed the net current assets (liabilities) position. BT had net current assets of £2,027m in 2004 and had net current liabilities of £2,165m in 2005, a net decrease in current assets of £4,192m.

While the current liabilities have increased, the long term creditors have decreased by £4,335m. If we just look at long-term creditors, the reduction is impressive and it gives more confidence to the investors that company is in better financial position now. But when we combine the decrease in long term creditors with the increase in current liabilities, the net change is very less. And the fact that changes in current liabilities is mainly due to borrowing instead of increase in trade creditors means that the financing of assets has merely shifted from long term borrowings to short term borrowings.

The current assets to current liabilities ratio has declined from 1.24 to 0.83 in the last one year, a sign of concern in terms of liquidity especially when the increase in liabilities is not mainly due to higher trade creditors.

Debt to equity ratio indicates the financing of assets. BT had total debt of £13,697m in 2004 and the corresponding figure for 2005 was £12,589m, a decrease of £1,108m. If we now exclude cash and short term investments from total debt, BT's net debt was £8,425m and £7,786m in 2004 and 2005 respectively. The net debt to book value of equity ratio declined from 2.75 in 2004 to 2.02 in 2005. This means that debt finances almost twice assets as being financed by equity. Higher amount of debt results in lower weighted average cost of capital as debt is cheaper equity. But as BT reduces more debt, its weighted average cost of capital will increase. The increase would be partially offset by lower cost of equity due to lower chances of bankruptcy.

Risk of bankruptcy is measured by interest cover ratio which is defined as the ratio of cash available for interest payments to net interest. Appendix IV shows the EBITDA calculation and interest cover ratio. The interest cover ratio has increased from 6.1 in 2004 to 7.0 in 2005. The healthy interest cover ratio shows that BT has further reduced the risk of bankruptcy and is in better financial position now. The debt level is now very much within manageable levels and is more like a cash rich mature company.

Companies normally tend to follow certain dividend trend to signal market of their assessment of future earnings. Dividend declaration is also part of risk management as it is based on management's assessment of future cash generation and expenditure expectations. The hike in dividend in 2004 and 2005 inspite of decline in profits in 2004 shows the management assessment of future low risks to cash flows.

Financial Adaptability
An entity's financial adaptability is its ability to take effective action to alter the amount and timing of its cash flows so that it can respond to unexpected needs or opportunities (Accounting Standards 2004/2005, page 26). Appendix V shows the main elements of consolidated cash flow statement of BT Group. BT Group is generating high amounts of cash inflow from operating activities. During the year ended 31 March 2005, the company generated £5,900m of net cash from operating activities. BT is in telecommunication business which demands relatively high level of absolute investments. It spent £2,408m on capital expenditure during the year ended 31 March 2005. Even if we believe that all of capital expenditure was required under normal operations, BT was still left with £2,282m of surplus cash in 2005.

As we can see from the Appendix III that BT has now focused on repayment of loans. During the last three years, the company has reduced borrowings by £7,395m. Though BT is able to generate significant amount of cash before disposals but that was not enough in 2003 and 2004 to repay loans. The company then sold some of its investments to generate cash for loan repayments.

BT also pays a significant amount of dividend to its shareholders. So if its net cash from operations do decrease in future, it has still some buffer in terms of dividend payments to take care of loan repayments.

The objective of financial statement is to provide information about the reporting entity's financial performance and financial position that is useful to a wide range of users for assessing the stewardship of the entity's management and for making economic decisions (Accounting Standards, 2004, page 22).

The compliance of an entity's financial reports with UK's Accounting Standards can be gauged over two main areas - content and format. Content is important to give true and correct picture of a firm's financial performance and position. Different users need different information. Financial statements are used by investors to base their investment decision. So it is important that financial statements have the right content to help achieve this goal. It is also important to have right format of presentation. Investors are more likely to feel comfortable if they see familiar presentation style and can then evaluate the company easily.

We will look at the content and major financial statements to see whether they comply with UK Accounting Standards. We will then also at few additional notes to financial statements to see whether they are also in line with true and fair principle and give the readers a clear picture of the entity.

First of all we compare profit and loss statement with FRS 3 'Reporting financial performance'. BT's consolidated profit and loss statement clearly shows the total turnover and share from joint venture and associates, and in doing so gives more clarity of its earning base.

The financial statement format is similar to the example formats shown in Accounting Standards 2004/2005. BT's 2005 Annual Report however doesn't show share of turnover and profits from discounted operations (BT, 2005). It is because BT didn't sell any business in 2005. If we look at the 2002 Annual Report (BT, 2002), it shows the turnover and profits from discounted operations also.

The financial statement also has statement of total recognised gains and losses in line with FRS 3 practices. So the accounts meet profit and loss statement UK Accounting Standards in terms of both content and format.

We now compare BT's cash flow statement with the format prescribed in FRS 1 'Cash flow statements'. BT's cash flow statement has not only got all the headings but they are also in the same order as mentioned in FRS 1. BT report also gives sub-categories under the major headings and hence is a genuine effort to educate investors as much as possible on the generation and use of cash flows. BT cash flow statement uses the format prescribed for the 'Group' accounts. The notes to financial statement also has detailed reporting on reconciliation of operating profit to operating cash flows, analysis of net debt, acquisition and disposals in line with formats for the 'Group' accounts.

The next section we analyse is on segmental reporting and check its comparability with SSAP 25 'Segmental Reporting'. SSAP 25 says that a public limited company should provide segmental analysis on lines of business class and geographical location. The notes to financial statement section in the 2005 Annual Report has a section on segmental reporting wherein BT shows the turnover, operating profit/(loss) and net assets/(liabilities) of different business lines. It also provides the above data based on the geographical location of reverse generation. The above meets SSAP 25 requirements and also helps investors make a better judgment of risks faced by BT.

BT is in telecommunication business where technology change is rapid. BT has acquired many companies in recent years to keep pace with the technological developments. So it is important to analyse the acquisition policies and disclosures are in line with the UK Accounting Standards. FRS 6 'Acquisitions and Mergers' and FRS 7 'Fair values in acquisition accounting' govern the acquisition accounting policies. BT's annual report under 'Notes to financial statements' gives detailed disclosure of total and fair value of the acquisitions made by it. BT's financial statements not only give the book and fair value of acquisitions but also a detailed explanation of them for each acquisition.

The clear and easy to understand format of financial statements and the depth of information in them signals that BT not only just do the minimum to meet UK Accounting Standards but also follows them in true spirit.

Appendix I - Highlight of BT Group's profit and loss accounts

(Source: BT Annual Report and Form 20-F;

Appendix II - ROCE of BT Group

(Source: BT Annual Report and Form 20-F;

Appendix III - Highlight of BT Group's balance sheet

(Source: BT Annual Report and Form 20-F;

Appendix IV - Interest cover ratio

(Source: BT Annual Report and Form 20-F;

Appendix V - Highlight of BT Group's cash flow statements

(Source: BT Annual Report and Form 20-F;

Bibliography and references

Accounting Standards 2004/2005 - Extant at 30 April 2004 (2004); Wolters Kluwer (UK) Limited.

BT (2005); BT Annual Report and Form 20-F for the year ended 31 March 2005;

BT (2002); BT Annual Report and Form 20-F for the year ended 31 March 2002;