Executive summary
The main purpose of this report is to relay its two parts. Part one contains financial performance analysis of Aviva Life Insurance Company for the financial years 2006 and 2007. The analysis was conducted using financial ratios.
The following are the applied ratios in the analysis: current ratio, quick ratio, interest cover ratio, capital gearing ratio, gross profit margin, return on capital employed, asset turnover, dividend yield, dividend cover and earnings per share.
The second part of the report contains a detailed discussion on determinants of sources of finance that include cost, risk, flexibility and control. A large company like Aviva Life Insurance has various reasons for obtaining funds; some of the reasons are discussed in this part.
The report has given a discussion of both internal and external sources of funds. Some of the internal sources are ordinary and preference share.
The external sources discussed are debt finance, Bills of exchange, Lease finance and debenture finance. Lastly, is the proposal of which source of finance is suitable for the company, with a complete rationale.
Introduction
This report’s main objective is to relay to you analysis of Aviva Life Insurance Company. The company is a public limited type that has its shares traded in the stock market (it is listed).
The analysis is done in two parts and the first part consists of a two-year (2006 and 2007) financial performance of the company from investors’ point of view.
The following ratios have been used in the analysis: dividend yield, dividend cover, earnings per share, current ratios, quick ratio, gross profit margin, operating profit margin, return on capital employed and capital gearing. This part of the report also includes non-financial information of the company under consideration.
Part two of the report consists of a comprehensive analysis of different sources of capital and a proposal of the best source to select considering variables involved.
Company’s profile (non-financial information)
The company is based in the U.K. It was created after a merger between Commercial Union and General Accident, which took place in the year 2000. In the same year, the company’s name was CGNU but, later on in July 2002, through shareholders’ decision, its name was changed to Aviva Plc.
In its move to expand, the company executed a strategy that involved £1.1 billion acquisition plan; the company acquired was RAC plc.
Aviva Life Insurance Company through its foreign market entry strategy acquired AmerUS Group, a Company based in the U.S. Aviva Life Insurance Company is dealing with insurance products such as life insurance scheme, Pension schemes, investment management, funds management and General insurance.
It has a global market coverage which it attained by establishing its subsidiaries. Some of the countries in which it has its subsidiaries are Poland, U.S.A., China and Canada (Eckett 2005, p. 215).
Financial analysis
Financial analysis is a process-conducted by financial managers of identifying the financial performances of a company by comparing the items in profit and loss account and those in balance sheet.
This is so because the items in the profit and loss account emanate from those in the balances sheet (Shim and Siegel 2007, p. 213) For example, the values of assets found in the balance sheet are responsible for sales, revenues and expenses to be found in the profit and loss account.
The process involves activities like comparison of sales levels for different financial periods. The process also involves conducting ratio analysis, for example, quick ratio analysis, to say the least.
The information is important to various stakeholders including, shareholders, lenders, the government, suppliers and the company’s management team. Shareholders or actual owners are interested in a company’s both long and short-term life.
For this reason, they are interested in ratios such as profitability ratios (which seek to establish the viability of a company) and dividend ratios (which seeks to establish returns to owners in form of dividends (Wilson and Machugh 1987, p. 177).
Creditors of a company are interested in a company’s ability to meet its short-term obligations as and when they fall due. They will need like liquidity ratio (which seeks to measure a company’s liquidity position) and current ratio (which measures a company’s quantity of current assets against current liabilities.
Long-term lenders to a company have both long and short-term interest in a company’s ability to pay both interest and principal amount of debt as and when they fall due.
They therefore use liquidity ratios (to assess short-term ability to meet current obligations), profitability ratios (to ascertain whether a company can pay its principle), gearing ratio (to gauge a company’s risk in an investment) and investment coverage ratio (to ascertain the company’s safety as regards the payment of interest to the lenders) (Johnston 1992, p. 229).
Directors and management of a company are interested in its efficiency to generate profits, the company’s viability from the investor’s point of view, the company’s ability to generate sufficient returns to investors and gearing ratio to gauge the safety and risk associated with the company.
Potential investors of a company are interested in a company’s both long and short-term ability to generate acceptable return on their money. The government is interested in a company’s profitability levels in order to ascertain the levels of tax liabilities.
A company’s competitors are interested in its performance as reflected by the market share and will use ratios that portray the company’s competitive strength, like sales on return ratios. Customers are interested in the company’s ability to provide goods and services both in long and short-term (Gill and Chatton 2001, p. 222).
Financial analysis is important because it measures the company’s past performance and change in performance, whether to favourable or unfavourable side.
Such comparison is then used to interpret the company’s performance, bearing in mind the factors that influence both the present and past performances. Financial analyses are also important because they indicate the average performance of various companies in a given industry (Kwok 2008, p. 275).
Financial ratios
Dividend yield (1.99% in 2007, 1.83% in 2006)
Dividend yield shows the percentage dividend returns to investors. The company’s shareholder dividend yield increased by 0.16. The increment is linked to increase in the dividend per share.
An increase in the market price per share could also cause the increase. An increase in dividend yield is a strong point of attraction for prospective investors. Therefore, the higher the dividend yield, the more attractive a company is in the eyes of invertors (Shim and Siegel 2007, pp. 273).
Dividend cover (2.69 in 2007 and 2.39 in 2006)
Dividend cover shows the number of times dividend could be paid out of available profits of a company. The ratios show an increase in the dividend cover by 0.3 in the financial year 2007.
This increase could be due to the increase in the profitability levels of the company. Aviva Company seems to have had a high operational efficiency that resulted in the increase in profit (Wilson and Machugh 1987, p. 277).
Earnings per share (0.71 in 2006 and 0.74 in 2007)
EPS shows the returns on each share held by shareholders. Aviva Life Insurance Company records an increase in EPS by 0.03.
The increase is attributed to increase in net profit. In the investors’ view, a company experiencing increase in EPS is more attractive than that which has stable or decreasing EPS (Wilson and Machugh 1987, p. 278).
Asset turnover (1.21 in 2006 and 1.32 in 2007)
Asset turnover of a company indicates a level of utilization of assets to generate revenue. Aviva Life Insurance Company records an increase of 0.11 in the utilization rate of its assets, between the two financial years. The increase led to an increase in earnings before interest and tax.
Return on capital employed (13.83 in 2006 and 14.04 in 2007)
ROCE indicates the return investors earn from every £ they invest in a company. Aviva Life Insurance Company records an increase in its ROCE by 0.21. The increase is attributed to the increase in earnings before interest and tax (EBIT).
It should be noted that ROCE is a function of assets turnover, financial leverage and profit margin. Therefore, financial leverage and asset turnover are the prime factors behind Aviva’s profitability levels.
If the company’s ROCE levels continue in the same trend, then it will definitely be capable of paying back its loan principle plus interest as and when they mature (Wilson and Machugh 1987, p. 280).
Gross profit margin (18.92 in 2006 and 19.31 in 2007)
GPM indicates a Company’s ability to control its cost of sales. It also refers to the profit earned by the company from every £ of its sales. Aviva Insurance records an increase in its GPM due to increase in revenue. A company can partially manage its cost of sales. Therefore, its influence in the value of GPM is insignificant.
Gearing ratio (15.32 in both periods)
Gearing ratio indicates the portion of total capital that is comprised of fixed charge debt and share capital. Aviva Company records stable 15.32%. This ratio means that only 15.32% of the total capital of the company is contributed by share capital and the remaining 84.68% are sourced through borrowing.
This analysis indicates a heavy reliance on debt as a source of capital by the company. It should be noted that a highly leveraged company faces high risk. This is because debt repayment process should continue regardless of prevailing economic condition.
Therefore, if a company’s levels of cash flow are not sufficient for loan repayment, then the company could face bankruptcy charges.
Interest coverage (12.98 in 2006 and 13.22 in 2007)
Interest coverage ratio shows the number of times a company is able to pay its fixed charges with earnings before interest and tax before they become exhausted. Aviva Insurance Company’s interest coverage ratio increased by 0.24 times, from 12.98 times to 13.22 times. The increase is attributed to increase in EBIT.
Current ratio (2.02 in 2006 and 2.54 in 2007)
Current ratio indicates the number of times a company can pay its current liabilities with its current assets before they get exhausted. It also shows how capable a company is of paying its short-term obligation as and when they fall due.
Aviva Company has recorded an increase in its current ratio by 0.52 from 2.02 times in 2006 to 2.54 times in 2007. This increase could be because of increase in the company’s accounts receivables and decrease in payables.
The company is in the industry that deals majorly with service provision, therefore, inventory levels is the least influence to the value of current asset (Wilson and Machugh 1987, p. 285)
Analysis of sources of capital
Determinants of sources of finance
According to Shah (1995, p. 123), there are numerous sources of funds including equity capital, debt finance, bills of exchange, lease finance, overdraft sources, debenture finance, venture capital and retained earnings, ordinary share and preference share.
Some of the factors that determine the choice of a source of finance are risk, cost of the source, control and flexibility.
Cost
Every source of finance has some cost attributable to it. For example, in comparing the cost attributed to equity source of finance and debt source, the tax allowable characteristic of debt finance renders it less costly as compared to equity source.
Therefore, for the companies that seek to minimize the cost of borrowing funds, debt finance is the way to go (Shah 1995, p. 124).
Risk
Every company that is operational stands a chance of encountering some elements of risk. For example, debt source of finance is so risky because, during tough financial times, a company could default to serve the loan interest and thus risks being rendered bankrupt (Mahagaonkar 2009, p. 153).
Control
Control of the management and decision making in a company are affected by the levels of debt finance of a company. Shareholders who are determined to maintain the control over the company should use debt finance to a limited level.
Flexibility
In the current highly dynamic financial market, organizations should adopt a dynamic financial structure to facilitate a flexible financial performance. During financial deficiencies, companies need funds to meet operational needs.
A highly leveraged company is highly inflexible and faces difficulties in generating funds. As a result, for flexibility, a company should limit its use of debt finance (Magoon 2008, p. 204).
Areas of interest when considering a loan application
Every organization that seeks for a loan has an investment project. Loan applications are made by entities with deficit finances, to entities with surplus finances. Lending institutions can be commercial banks, hedge funds, Federal Reserve institution, World Bank and International Monetary fund.
The lending process begins with an application made by the borrower to the lender. The lending institution, upon receiving the application, conducts an approval process to ascertain qualification of the borrower for loan consideration (Seabrooke 2006, p. 115).
The main areas of concern are credit assessment, business assessment and capacity to pay.
During credit assessment, the lending institution will be interested in determining whether the borrowing entity has guarantors and if yes, whether the guarantors meet credit eligibility requirements, the current debt level of both the borrower and the guarantor and what use have the past-borrowed funds been put.
A guarantor is the party to loan contract who will be responsible for the full payment of loan amount in the event of failure on the part of the borrower (Pogson 1969, p. 98). This information is important to provide an assurance to the lender that the lent amount will be recovered according to the terms of the contract.
The business assessment process involves ascertaining the feasibility of a project, whether the borrower is the manager of the project and whether the terms of the loan suit the purpose for which it is sought. This process helps the lender to avoid making investments in impractical projects.
It also has connection with the assurance of recovering the lent amount. During ability to pay assessment, the lending institutions are interested in ascertaining whether the borrower will be able to pay back the loan by evaluating his personal and business financial information.
The lending institution would be looking for the financial status and credit history of the lender. The lender is very much interested in the historical payment trend of the borrower because that signifies expected future payment behaviour.
A borrower with credit history characterized with continuous default in loan payment has a very slim chance of qualifying for a loan consideration.
In other words, a borrower with a good credit history has a good chance of loan approval, whereas, a borrower with bad credit history stands a slim chance of loan approval (Pogson 1969, p. 99). The lending organization would also be looking at the capacity of the borrower to repay the loan.
The projected cash flow statement of the project will reflect the same. Another important area that should be given more weight is collateral. An asset (fixed asset) serves as a secondary security to the loan. In case of default in loan repayment, the lender would recover the amount by liquidating the assets.
The lender will also conduct an evaluation of whether the project to be funded meets all the applicable Federal, state and local planning, environmental and programming requirements.
Following loan evaluation is the approval or rejection. If the loan is approved, the parties sign the agreement document and the contract becomes legally binding. The last process is the disbursement of the amount requested to the borrower according to the arrangements (Seabrooke 2006, p. 144).
Purpose of obtaining finance for large companies
According to Seabrooke (2006, pp. 233), operational activities of a business need funds to facilitate the processes.
Large Companies like Aviva Life Insurance Ltd would therefore obtain finances for the following reasons: to finance working capital, growth, expansion of businesses, obtaining of assets, seeking for an alternative source of finance and t acquisition of equity.
Businesses borrow to finance working capital, companies like Aviva Life Insurance should borrow funds and invest in inventories and other working capital before revenues are due to be collected from customers.
This works this way, the company borrows funds and uses them to buy inventories that are then converted into cash. The cash is, therefore, used to pay for the cost of purchasing the inventories.
Companies can also borrow funds to manage the levels of growth. Return on equity analysis can be done on the company to ascertain the levels of the company growth without obtaining more external funding.
When the company‘s growth rate is higher than it can manage, it needs to borrow from an external source to finance the growth. This is true because when a business is increasing its market coverage or opening up new subsidiaries in different locations, it will need substantial amount of funds (Pogson 1969, p. 178).
These funds may not be available from the internal sources like retained earnings, and thus should be sought from the external sources and used to finance the growth activities of a company.
If a company cannot easily obtain funds from either internal or external source, it should control its growth activities to manageable levels. Unfortunately, if a company’s growth levels are not managed, the resultant could be major business fallout.
Expansion of a business is another issue that requires an external source of finance. A part from seeking for external funds to finance a company’s growth activities, it can be to finance a sudden company’s expansion. Aviva Life Insurance Company would plan to make a quick expansion through acquisition processes.
The process needs a substantial amount of money that would not be available internally. This kind of investment decision is considered to increase the value of the acquiring firm (Pogson 1969, p. 134).
Pogson (1969, pp. 299) asserts that a company could also borrow to finance acquisition of an asset or an equipment to facilitate its activities. Although, there is another way of possessing equipment – through leasing, though some companies do not prefer this process because it lowers a company’s credit rating.
Companies have indefinite life span. Shareholders, on the other hand, can change their shareholding positions in various companies. If a major shareholder in a company quits by withdrawing the ownership, then the company could resort to borrowing in order to finance the amount by which the remaining equity is deficient.
Internal sources of finance
For small companies, this is personal savings (contribution of owners to the company). For large companies, equity finance is made of ordinary share capital and reserves (both revenue and capital reserves). Equity finance is divided into the following classes:
Ordinary share capital
This is raised from the public through the sale of ordinary shares to the shareholders. This source of finance is available to limited companies. It is a permanent source of finance, as the owner/shareholder cannot recall this money except under liquidation.
It is thus, a base on which other finances are raised. Ordinary share capital carries a variable return (ordinary dividends). These shares carry voting rights and can influence the company’s decision-making process during Annual General Meeting (Gowthorpe 2005, p. 123).
Reasons why ordinary share capital is attractive despite being risky
- Shares are used as securities for loans (a compromise of the market price of a share).
- Its value grows
- They are transferable at capital gains
- They influence the company’s decisions
- Carry variable returns – is good under high profit
- It is a Perpetual investment – thus a perpetual return
- Such shares are used as guarantees for credibility
Advantages of ordinary share capital
- They facilitate projects especially long-term projects because they are permanent.
- Its cost is not a legal obligation.
- It lowers gearing level – reduces chances of receivership/liquidation.
- Used with flexibility – without preconditions.
- Such finances boost the company’s credibility and credit rating.
- Owners contribute valuable ideas to the company’s operations (during AGM by professionals).
Preference Share Capital (Quasi-Equity)
It is also called quasi-equity because it combines features of equity and those of debt. It is preference because it is preferred to ordinary share capital that is:
- It is paid dividends first – preferred to dividend
- It is paid asset proceeds first – preferred to assets.
Unlike ordinary share capital, it has a fixed return. It carries no voting rights. It is an unsecured finance and it increases the company’s gearing ratio (Gowthorpe 2005, p. 125).
External sources of finance
Debt Finance
Debt finance is a fixed return source of finance as the cost (interest) is fixed on the par value (face value of debt). It is ideal to use if there is a strong equity base.
It is raised from external sources to qualifying companies and is available in limited quantities. It is limited to value of security and liquidity situation in a given country.
Advantages of Using Debt Finance
- Interest on debt is a tax allowable expense and, as such, it is reduced by the tax allowance.
- The cost of debt is fixed regardless of profits made and, as such, under conditions of high profits, the cost of debt will be lower.
- It does not call for a lot of formalities to raise and, as such, its ideal for urgent ventures.
- It is usually self-sustaining in that the asset acquired is used to pay for its cost, i.e. leaving the company with the value of the asset.
- In case of long-term debt, amount of loan declines with time and repayments reduce its burden to the borrower.
- Debt finance does not influence the company’s decision since lenders do not participate at the AGM.
Disadvantages
- It is a conditional finance, i.e. it is not invested without the approval of lender.
- Debt finance, if used in excess, may interrupt the companies’ decision making process when gearing level is high, creditors will demand a say in the company, i.e. and demand representation in the BOD.
- It is dangerous to use in a recession and, as such, a condition may force the company into receivership through lack of funds to service the loan.
- It calls for securities that are highly negotiable or marketable, thus, limiting its availability.
- It is only available for specific ventures and, for a short term, which reduces its investment in strategic ventures.
- The use of debt finance may lower the value of a share if used excessively. It increases financial risk and requires a rate of return by shareholders, thus, reduces the value of shares (Gowthorpe 2005, p. 123).
Bills of Exchange
Bills of Exchange are a source of finance in particular in the export trade. A bill of exchange is an unconditional order in writing addressed by one person to another requiring the person to whom it is addressed to pay to him/her as the order a specific sum of money.
The commonest types of bills of exchange used in financing are accommodation bills of exchange (Gowthorpe 2005, p. 123).
Lease Finance
Leasing is a contract between one party called lessor (owner of asset) and another called lessee where the lessee is given the right to use the asset (without legal ownership) and undertakes to pay the lessor periodic lease rental charges due to generation of economic benefits from use of the assets.
Leases can be short term (operating leases) in which case the lessor incurs the operating and maintenance costs of the assets or long-term (finance leases) in which the lessee maintains and insure the assets (Gowthorpe 2005, p. 126).
Debenture Finance
A form of long-term debt raised after a company sells debenture certificates to the holder and raises finance in return.
The term debenture has its origin from ‘DEBOE’ which means ‘I owe’ and is a certificate or document that evidences debt of long-term nature whereby the person named therein will be given the issuing company the amount usually less than the total par value of the debenture.
These debentures have maturity period of between 10 and 15 years but may be endorsed, negotiated, discounted or given as securities for loans. In this case, they are liquidated before maturity date.
The current interest rate is payable twice a year and it is a legal obligation (Gowthorpe 2005, p. 127).
A proposal for source of finance
Based on the company’s financial analysis, it would be appropriate if the required additional finance (10%) were sourced through issuance of initial public offerings (IPO).
The company’s leverage level is already high, thus, an additional financing from any other source that legally obligates the company to meet fixed charges would be a cause of financial strain to the company. The company’s cash flows are high enough to facilitate payment of loan within the right time.
However, to avoid any financial risk associated with borrowing more debt, IPO is the safest direction. Retained earnings are also a good source of finance but the only problem with the method is that it would negatively affect dividend decisions of the company.
That is, instead of paying dividends to the shareholders, the earnings would be reinvested. Unstable dividend decisions send a message of poor performance to the potential investors. As a result, sends off potential investors (Gowthorpe 2005, p. 125).
Debt finance is another source. Though it is not advisable because Aviva Life Insurance Company already has high gearing levels and therefore, additional debt is riskier. During tough financial conditions, the company could be forced into liquidation if lenders file a bankruptcy case.
Debt financing is said to render a company inflexible, that is, a company becomes unable to meet short-term obligations. This method of finance also lowers the value of shares of a company if used in excess (Gowthorpe 2005, p. 123).
Conclusion
Ratio analyses are investor-tools used to assess the performance of a company. They provide the investors with a company’s overview from different financial perspectives. Financial information provides a basis for decision making, for instance, decision on appropriate sources of finance to a company.
Potential lenders heavily rely on these analyses to make informed decision concerning loan applications. The company (Aviva Insurance) is suggested to raise its funds through IPO because the method facilitates long-term operation of projects and enhances the company’s flexibility.
Other sources of finance present the company with constraints that are advantageous. Therefore, in regards to factors revolving around the company’s operation, issuing of shares is the safest way to raise the required amount of capital.
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