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Strategic Financial Management

Introduction

This assignment is divided into two parts. The first part is about the history of ROLLS ROYCE that includes significant growth since its commencement. It also evaluates a clear description of the ten year's record of the company and indicates how ROLLS-ROYCE is financed through gearing level and capital sources along with its rationale. It also evaluates the gearing level in comparison to other companies in the same industry and also offers an assessment that how the gearing level influences the past financial performance of the company. Moreover, the second part discusses the advantages and disadvantages accomplished through the use of debt and its insinuations to equity holders regarding the capital structure

Part 1            

History and significant developments of ROLLS-ROYCE

Rolls-Royce was a luxury car of the UK and later on, it was turned into aero-engine manufacturing business formed in 1904 in Manchester, the UK with the partnership of Henry Royce and Charles Rolls. The reputation of Royce was developed as a reputation for enhanced engineering through the manufacturing of the "best car in the world". The company was established through an enduring reputation for manufacturing and development of engines for civil aircraft and defence. In 1960, Rolls-Royce became hopeless due to the mismanagement of the expansion of its progressive RB211 jet engine with the resulting cost over-runs and was proved to be a great success (Rolls-royce.com, 2020). In 1971, the owners were grateful to discharge their business and the beneficial portions were incorporated by a new government-owned company and it continued the core business. Later on, it sold the holdings to British Aircraft Corporation (BAC) (Annual report, 2020). The company was nationalised till 1987 and after that, it was renamed as “Rolls-Royce plc" and was sold to the public. The company became a subsidiary of German Group BMW in 1998 and the company has different car products that include Phantom, Ghost, Cullinan, Wraith, and Dawn. Rolls-Royce plc is an FTSE-100 company and listed in the London Stock Exchange (Rolls-royce.com, 2020). 

Sources of capital and financing of the company

Based on the ten years record of Rolls-Royce plc, it has been identified that the operations of the company are funded from the funds of different shareholders, bonds and notes, and bank borrowings. The sources of capital of the company clearly show that it has a suitable balance of funding. The funding is protected by the company that continue to access to the international debt markets. Moreover, Feng et al. (2018) identified that the borrowings are funded in different currencies through the use of derivatives to accomplish a required interest rate and currency profile. The goal is to get sufficient monetary investments and undrawn amenities to make sure that the company can meet its medium-term operative promises and cope with unforeseen opportunities and obligations.

The company holds cash and short-term investments that are with undrawn dedicated facilities to enable the company to manage its liquidity risk. Rolls-Royce plc increased the maturity of £2,500 million facilities of bank borrowing from 2023 to 2024. Rolls-Royce plc also repaid £1.1bn borrowings during the year and at the end of the year, the company also retained the accumulated liquidity £6.9 billion with cash and cash equivalents of £4.4 billion, and undrawn borrowings of £2.5 billion (Annual report, 2019). The profile of maturity of borrowing is examined regularly and that ensure that the levels of refinancing are manageable for market and business conditions (Miroshnychenko et al. 2017). There are no proper triggers of rating in any facility of borrowing that need the facility to be repaid and accelerated because of a negative movement in the credit rating of the company. The company also conducted some portion of its business through different joint ventures (Chen et al. 2018). Through the assessment of last ten years financial statements, it is evident that most of the part of the funding of the company is from debt and because the company has a good credit rating, it is getting the funds from creditors promptly. To evaluate that how much funds Rolls-Royce plc is getting in the form of debt, the debt to equity ratio has been calculated that is a form of gearing ratio. It is mentioned below:

Year

Debt to equity ratio

2020

-5.08

2019

-10.62

2018

-31.28

2017

3.86

2016

12.70

2015

3.45

2014

2.48

2013

2.66

2012

1.97

2011

2.63

Table 1: D/E ratio of Rolls-Royce plc for ten years

Based on the above table, it has been identified that the D/E ratio for the last ten years of Rolls-Royce plc is more than 1 that shows that the company is debt-oriented. The company is not generating funds from equity, but it is generated funds through debt.

The above values are shown through the graph as well:

Figure 1: Trend analysis of D/E ratio Source: macrotrends.net, 2020

            As far as the gearing level of automobile industry of the UK is concerned, it has been identified that the debt of equity ratio is very high for Rolls-Royce plc as compared to the industry average of automobile sector of the UK. The reason of debt financing for Rolls-Royce plc is that the debt financing is the least expensive source of capital if the company is at growth stage and also the company can also achieve its growth and maintain ownership because it enhances the control on business (Haque, 2017). However, the D/E ratio of Rolls-Royce plc is very high as compared to the industry average and must reduce it significantly. The D/E ratio of automobile industry of the UK is calculated below:


 

Year

Debt to equity ratio

2020

2.67

2019

3.44

2018

3.56

2017

3.33

2016

3.80

2015

3.79

2014

3.24

2013

2.69

2012

2.51

2011

2.07

Table 2: D/E ratio of automobile industry of the UK for ten years

How gearing level affects the historical performance of Rolls- Royce

Since a decade, it has been identified that Rolls-Royce has a greater degree of gearing ratios and it is suitable for those organisations that have steady and reliable profits and also the earnings of these organisations have to be sufficient enough to cover interest payments (Khan and Qianli, 2017). While evaluating the financial performance of 2019 of Rolls-Royce, it has been evaluated that the net income and earnings per share (EPS) is not at a higher pace for the company and also the company incurred a net loss in 2019 as a result, a higher level of gearing influences the monetary performance of the company. The reason is that the company is not profitable and might not be able to cover its interest payments and also might not be able to pay its debt (Chen et al. 2018). The debt financing is very risky for Rolls-Royce and it is recommended that the company must go for a mixed approach that includes debt and equity financing. Moreover, Rolls-Royce needs to decline its D/E ratio to be as per industry ratio. In this regard, the financial ratios of Rolls-Royce for 2019 are calculated below:  

Ratios

Formula

Calculation (2019)

Gross profit margin

Gross profit/sales * 100

942/16587 * 100 = 5.67%

Net profit margin

Net profit/sales * 100

(1311)/16587 * 100 = -7.9%

Return on capital employed

EBIT / Total assets – current liabilities

(891)/32266 – 14976 * 100  = -5.1%

Operating margin

Operating profit/sales * 100

(852)/16587 * 100 = -5.76%

Current ratio

Current assets / current liabilities

16054 /14976 = 1.07

Acid-test ratio 

Current assets – inventory / current liabilities

16054 – 4320 /14976 = 0.78

Trade account payables

 

8450

Trade account receivables

 

5065

Inventory turnover

Cost of goods sold / average inventory

15645 / 4320 = 3.62

Asset turnover

Revenue / assets

16587 / 32266 = 0.51

Market capital in millions as of 09-11-2020

 

3.978 billion (£)

Table 3: Ratio analysis of Rolls Royce of 2019

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Part 2

Capital structure theory

In the field of financial management, the capital structure theory is focused on the technique of systematic approach to finance the activities of business through the amalgamation of equities and liabilities. Various theories of capital structure explore the linkage between the market value of company and equity and debt financing. Ardalan (2017) stated that though there have been disadvantages of debt, still the use of debt in the capital structure offers a greater return to the values of company and shareholders. The organisations while returning the value to the shareholders require to endure to invest in capital in various initiatives that not the only reserve and help the shareholders to raise (Le and Phan, 2017).

If the companies incur more debt it is not good news and the threshold of debt is judicious and is a nuanced exercise. The tax rates vary from one situation to another situation and that affect the lure of debt. Moreover, Sheikh and Wang (2014) stated that debt needs repayment with interest and if it is not repaid according to the contract, then the company can be forced for bankruptcy.

Benefits for the use of debt

The debts are given by different commercial banks and the borrowers must forecast the amount first that how much they have to repay in a defined period. Akyüz (2017) mentioned that equity financing is more expensive as compared to debt financing as the investors of equity expect a return on investment by overcoming the inherited risk with the investment. Considering the element of individual wealth, the optimisation of a wise amount of debt shows that the equity investors have fewer chances of net-worth and must focus in confidentially possessed and illiquid asset.

Disadvantages of the use of debt

According to Koetsier (2017), the higher debt cost for privately-owned firms results in the rationale of monetary reporting that indicates that the creditors control these firms at a greater level of interest rate because they do not provide much information as publicly owned firms. This has also enhanced the risk of liquidity sources and possesses higher rates of default experienced by various privately-owned firms. Moreover, the monetary flexibility is also regarded as an important defence against the monetary issues that promote a firm to file bankruptcy. The more use of debt is based on the practice of business that results in challenges for retrieving capital quickly on palatable terms at the time of economic issues. Dwyer et al. (2018) further mentioned that at the time of economic issues, the constraints of capital lead to scale down the plans of operation that leads to the reduced value of the firm. Moreover, there are also chances that the debt used become least effective when the business owners and management reduce and eliminate strategic initiatives conservatively operated by the business and make the decision not to capitalize on the current opportunities based on the effort not to disturb agreements of debt and reserve liquidity.

The implication of debt used to equity holders

Bharath and Hertzel (2019) stated that organisations without debt have a minimal level of monetary risk because there are no such threats of needed payment and bankruptcy. If there is no control in the capital structure of the firm then it might assist the shareholders to focus on wealth that is held closely and does not offer sufficient risk-oriented return to the equity shareholders. Moreover, the utilisation of debt in capital structure might be a way to return additional value to shareholders, but for business owners, the use of debt can be a sentimental problem. Kumar et al. (2017) mentioned that if the organisations do not want to obligate creditors and have instability of cash flows during challenging times then there are chances that it might cause the business owners to take an extremely careful method to decline the cost of capital and reduce the return to shareholders. Moreover, the business people who do not escalate the financial leverage risk take the organisation to the impractical expectations that show how much a bank might give money to the firm. These companies must use debt and equity to reduce the weighted average cost of capital (WACC) so that the market value of the company can be increased (Chatzinas and Papadopoulos, 2018).

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Conclusion

In this assignment, the monetary performance of Rolls-Royce by evaluating the source of capital for the company and also its gearing level. Moreover, the second part of the assignment is about the benefits and downsides of the use of debt and its insinuations to equity owners.

References

(2020) Rolls-royce.com. Available at: https://www.rolls-royce.com/~/media/Files/R/Rolls-Royce/documents/annual-report/2019/2019-full-annual-report.pdf (Accessed: 9 November 2020).

Akyüz, E., 2017. Advantages and disadvantages of nuclear energy in Turkey: public perception. Eurasian Journal of Environmental Research, 1(1), pp.1-11.

Ardalan, K., 2017. Capital structure theory: Reconsidered. Research in International Business and Finance, 39, pp.696-710.

Bharath, S.T. and Hertzel, M., 2019. External governance and debt structure. The Review of Financial Studies, 32(9), pp.3335-3365.

Chatzinas, G. and Papadopoulos, S., 2018. Trade-off vs. pecking order theory: evidence from Greek firms in a period of debt crisis. International Journal of Banking, Accounting and Finance, 9(2), pp.170-191.

Chen, C.J., Guo, R.S., Hsiao, Y.C. and Chen, K.L., 2018. How business strategy in non-financial firms moderates the curvilinear effects of corporate social responsibility and irresponsibility on corporate financial performance. Journal of Business Research, 92, pp.154-167.

Chen, F., Ngniatedema, T. and Li, S., 2018. A cross-country comparison of green initiatives, green performance and financial performance. Management Decision.

Dwyer, R.E., 2018. Credit, debt, and inequality. Annual Review of Sociology, 44, pp.237-261.

Feng, M., Yu, W., Wang, X., Wong, C.Y., Xu, M. and Xiao, Z., 2018. Green supply chain management and financial performance: The mediating roles of operational and environmental performance. Business strategy and the Environment, 27(7), pp.811-824.

Haque, F., 2017. The effects of board characteristics and sustainable compensation policy on carbon performance of UK firms. The British Accounting Review, 49(3), pp.347-364.

Khan, S.A.R. and Qianli, D., 2017. Does national scale economic and environmental indicators spur logistics performance? Evidence from UK. Environmental Science and Pollution Research, 24(34), pp.26692-26705.

Koetsier, I., 2017. The advantages and disadvantages of different pension system designs. In Public or Private Goods?. Edward Elgar Publishing.

Kumar, S., Colombage, S. and Rao, P., 2017. Research on capital structure determinants: a review and future directions. International Journal of Managerial Finance.

Le, T.P.V. and Phan, T.B.N., 2017. Capital structure and firm performance: Empirical evidence from a small transition country. Research in international business and finance, 42, pp.710-726.

Miroshnychenko, I., Barontini, R. and Testa, F., 2017. Green practices and financial performance: A global outlook. Journal of Cleaner Production, 147, pp.340-351.

Our History (2020). Available at: https://www.rolls-royce.com/about/our-history.aspx (Accessed: 9 November 2020).

Rolls-Royce Holdings Financial Ratios for Analysis 2005-2020 | RYCEY (2020). Available at: https://www.macrotrends.net/stocks/charts/RYCEY/rolls-royce-holdings/financial-ratios (Accessed: 9 November 2020).

 

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