Overview and Critical Evaluation of Key Influence Factors
The importance of the housing sector of the market can be understood through the fact that, for homeowners, real estate constitutes a major part of what they have or a major part of their current or planned spending. Moreover, housing as an industry bears particular symbolic significance for all working individuals because having one’s own place to live and improving one’s living conditions are among the main goals pursued by individuals in their lives and work. Major housing companies in the UK have a long history, large turnovers, vast resource bases, and wide networks of operation—all these factors make them complicated entities, and profound analysis is needed to identify and understand the developments that occur for those companies and influence them, both externally, i.e. in terms of market forces and influences, and internally, i.e. in terms of operation and initiatives that are likely to influence in certain ways the industry as a whole. A way to identify and understand these developments is to compare two major housing companies in the UK, and the companies chosen for the comparison are Redrow plc and Crest Nicholson. Both are listed on the London Stock Exchange, and both are constituents of the FTSE 250 Index (codes RDW and CRST respectively) (FTSE 250 2017).
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The first issue to be addressed in this context is the consideration of influence factors, i.e. what the processes that affect the UK housing sector are. This consideration will also constitute a point of comparing Redrow plc and Crest Nicholson, as both companies have made statements on perceived influences, and their statements can be compared and contrasted from this perspective. First of all, to build houses, a company primarily needs things to build from—materials remain one of the main influences in the industry, and any changes experienced or initiated by suppliers are likely to have an effect on a housing company that buys from them. Even this one influence factor is already complicated because large housing companies purchase materials from many different suppliers who can be influenced by different forces, which makes measuring the influence challenging and increases the number of risks and the potential effect of negative changes.
What a company can do to address this influence factor and reduce risks is, first, to establish and develop long-term relationships with suppliers, which can facilitate the collaboration because the companies involved will have an experience of working together effectively; therefore, negotiating and trading will be easier and with a higher level of mutual understanding. Redrow plc recognises the importance of building such relationships, as it states, “Our longstanding relationships with a number of key suppliers helped us mitigate the impact of supply issues across a range of materials” (A better way to live: Redrow annual report 2016, p. 34). What is meant by the “impact of supply issues” is a possible downward trend of operation and sales due to decreasing availability of resources or their increasing price. The second aspect of addressing the influence factor associated with the supply of materials is building wide and flexible networks of cooperation with suppliers. Rigid operation is a threat because a failure of one element leads to the failure of the entire system: therefore, large companies should try to diversify their supplier relations to reduce the dependence on certain suppliers or certain elements of the supply network.
Another major influence factor is demand because building houses, even when one has made sure by taking into consideration what is outlined in the previous paragraph that there are appropriate resources to build them, makes little sense if there is no-one to buy these houses. Demand itself is a complex notion, and it should not be regarded as mere subjective desires of people to suddenly buy more houses or suddenly buy less of them. Crest Nicholson stresses “the cyclical nature of the housing industry, with periodic downturns in customer demand” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 98). There are various ways to approach the influences on demand, and major ones are the availability of loans (or other financial instruments that buyers may employ to purchase a house) and possible deteriorations in the market. All these factors are inevitably connected to the expected sales prices. Sales prices and build costs are the two main considerations in the housing business, and, through the factors outlined above, the two are interconnected.
Policies and Regulations
Another influence factor is comprised of government policies and regulations imposed on the housing industry. It is important to understand that regulations are constantly changing. Redrow plc dedicates a particular section of its annual report to pieces of legislation that have been adopted within a given year and are relevant to the company’s operation. Today, the importance of regulation changes is growing due to the recent decision of the UK to withdraw from the European Union. A particular consideration is the legislation associated with environment protection and sustainable development. Currently, UK housing companies are required to comply with a number of standards concerning not only the amounts of carbon dioxide emissions that they produce but also the amounts of such emissions that the houses they build will be producing.
Both Redrow plc and Crest Nicholson express in their annual reports certain concerns about the upcoming changes in these regulations, as it can “change the way [they] plan and build homes” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 7). Redrow plc also emphasises the fact that not only standards may change but also the interpretations of standards, which can be manifested in various legal and regulatory measures, and the company, along with other housing companies, will need to follow them. For large companies, it is especially difficult because their operations are vast systems, and vast systems are harder to modify. Crest Nicholson further explores possible consequences of Brexit, and one of the potential influence factors that the company recognises is the change of labour relations. In case the new government introduces additional restrictions to the UK labour market, housing companies, as they employ a lot of workforce, will need to reconsider their existing human resources policies and budgets to a significant extent due to the lowered access to European labour.
Internal Influence Factors
Finally, there may be internal influence factors and factors that are associated with the operation of particular companies but extend to influence other companies as well. These factors are mainly attributed to the strategic planning of the industry’s major players. When an influential company in a particular sector of the market employs a new strategy, it may become a driving force for the company’s competitors to change, too, in order not to fall behind and maintain their competitive advantage. Therefore, this influence factor can be described in terms of strategic development, innovation, and technological advancements. The housing industry is evolving, and new technological solutions appear, which makes it necessary for housing companies to constantly monitor the advancements, develop, too, and follow the trends of the sector (Liu et al. 2014). This facilitates competition and ensures that the quality of products, i.e. homes built, is growing in accordance with modern trends, capabilities of house-building, and appropriate standards.
Analysis of Financial Performance
Ratio Analysis as a Method
There are multiple approaches to analysing the financial performance of companies because there is a vast array of financial indicators, and a good understanding of operating in the market is needed to assess what those indicators say about a company’s successes and failures. One of the approaches is reviewing key financial indicators associated with revenues, costs, profits, sales, debts, and other aspects of financial activities and comparing these indicators to the results of previous years. This may show how a company is doing, where it is succeeding, and where its main challenges are focused. However, this approach may overlook important developments because of its fundamental flaw: it tends to examine the results of financial activities separately, while in reality, operations carried out by a company are interconnected and affect one another. The acknowledgement of this interconnection justifies the use of a different approach: ratio analysis.
Ratio analysis allows regarding the financial performance of a company from the point of view of trends of financial operation and processes of change, as opposed to evaluating different aspects of this operation in terms of increasing or decreasing only. This is why ratio analysis is a common method used for examining financial statements of companies. Pulling data from financial documentation, analysts calculate accounting ratios, thus establishing correlations among different indicators. This analysis is particularly helpful for comparing the performance of a company in a given accounting period to the performance in previous periods (which is known as trend analysis), for comparing the performance of a company to the performance of other companies (which is a part of competitor analysis), and for comparing the performance of a company to the industry average in order to find out where the company is on the normal distribution curve of financial performance in a given sector of the market.
Financial ratios can be divided into several groups. Major ones are profitability, liquidity, efficiency, and investment. Some analysts also list certain ratios under such categories as “growth” and “financial health” (Delen, Kuzey & Uyar 2013). Out of the variety of available ratios, ten were selected for examination with the purpose to compare the financial performance of the two companies. In their annual reports in 2016, the companies mostly compared the presented data on financial performance to the results of the previous year, providing only a brief overview of key indicators from an extended perspective of five years (A better way to live: Redrow annual report 2016; Sustaining value: Crest Nicholson annual integrated report 2016). However, for the selected ratios, the brief overview was not sufficient because detailed financial data was required, which is why financial reports of Redrow plc and Crest Nicholson from 2014 (40 years and still growing: Redrow plc annual report and accounts 2014; Creating value: Crest Nicholson annual integrated report 2014) and 2012 (A vision that inspires: Crest Nicholson directors’ report and accounts 2012; Redrow: annual report and accounts 2012) were analysed, too. The main reason for the two companies to provide their detailed financial data in an intelligible form of colourful reports is to assure their clients of the transparency of their operation and, most importantly, to attract investors: Redrow plc stores its financial reports in the “investors” section of their website, and Crest Nicholson stores its reports in the “investor relations” section.
Ratio Analysis of the Examined Housing Companies
Table 1: Financial Ratios of Redrow plc and Crest Nicholson.
|ROCE, %||Redrow plc||8.7||12.2||18.0||22.8||24.2|
|ROE, %||Redrow plc||8.4||12.3||20.5||26.4||26.8|
|ROA, %||Redrow plc||3.7||5.6||8.7||11.0||10.8|
|GPM, %||Redrow plc||17.3||18.8||21.8||23.8||24.2|
|NIG, %||Redrow plc||123.7||77.8||91.3||57.7||23.5|
|PP, days||Redrow plc||91.1||89.0||77.2||78.5||88.3|
Table 1 presents the results of calculating ten important financial indications of the compared companies. The first ratio is return on capital employed (ROCE), which is a major profitability ratio. It is calculated by dividing profit before interest and tax (PBIT) by the sum of share capital, reserves, and non-current liabilities and multiplying by 100 per cent. Put simply, the ratio represents the profit of a company in the form of a percentage of capital employed in this company. Seen as an indicator of the effectiveness of funds deployment, ROCE is often used as the main tool for assessing the profitability of a company. Redrow plc claims to use ROCE as a measurement for one of their major goals, which is to “ensure that we grow our business responsibly [by focusing] on managing all our resources efficiently and effectively” (A better way to live: Redrow annual report 2016, p. 8). The company had the goal of achieving ROCE of 21 per cent by 2018, although within the last two years this point was exceeded: 22.8 in 2015 and 24.2 in 2016 (see Table 1). The growth of ROCE is considered by the company as a major success. However, the ROCE of Crest Nicholson is significantly higher (31.3 per cent), and it has been higher than Redrow plc’s for the last five years (in fact, Redrow plc’s current ROCE is approximately equal to the Crest Nicholson’s in 2013, when the former’s ROCE was two times less than now). From this perspective, Crest Nicholson can be regarded as a company that deploys its funds with higher effectiveness.
The second ratio is return on equity (ROE), which is calculated by subtracting preference dividends from the net profit, dividing the remainder by the ordinary share capital and reserves, and multiplying by 100 per cent. The ratio is used to compare the capital of ordinary shareholders to the profits that have been earned on their behalf. ROE may be used in combination with other financial ratios as a major indicator of investment attractiveness. However, a complication is that ROE can be hardly used to predict whether a company’s shares will be a good investment in the future because ROE reflects recent performance and is not a forecasting ratio. Redrow plc’s ROE has been constantly growing, outrunning the ROE of Crest Nicholson in 2014 and remaining around 26.6 per cent for the last two years, indicating a rather high level of attractiveness for investors.
The third ratio is return on assets (ROA), which is calculated by dividing net income by total assets. It shows the relation of how much a company earn to what it has, i.e. its overall resources; therefore, the ratio is regarded as an indication of management effectiveness. The higher it is, the more effective a business can be considered by investors. However, the meaning of ROA can be different for companies of different scales of operation, which is why it is only helpful in most cases to compare ROAs of companies whose levels of capitalisation are comparable. Within the last five years, Crest Nicholson has always demonstrated a higher ROA than Redrow plc, except for 2015 when Redrow plc’s ROA was one percentage point higher than Crest Nicholson’s, but since then, the former’s ROA has decreased in 2016, while the latter’s ROA continued to grow.
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The fourth ratio is gross profit margin (GPM), which is calculated by dividing gross profit by sales revenue and multiplying by 100 per cent. This is one of the important financial indicators because it assesses the profitability of producing goods and selling them before any other expenses are taken into account. Again, the meaning of the ratio for different industries will be different, e.g. supermarkets operating on low prices should not be compared to housing companies by the criterion of GPM. Also, comparing GMP to operating profit margin allows evaluating the company’s control over its operating expenses. Within the last five years, Crest Nicholson has had a rather stable GPM of 26.7 to 28.6 per cent, while Redrow plc’s GPM has been constantly growing, remaining, however, lower than the Crest Nicholson’s in 2016.
The fifth ratio is trading on equity (TOE), which is also known as financial leverage ratio and calculated by dividing debt on equity by total assets (Bodie, Kane & Marcus 2014). The ratio can be used to assess whether a company is able to properly meet its financial obligations. From this perspective, Redrow plc and Crest Nicholson have been close within the last five years, and their TOEs were reported as practically equal in 2016.
The sixth ratio is current ratio (CR), which is calculated by dividing current assets by current liabilities. The ratio is widely used to assess whether the company is able to meet its short-term financial obligations with the use if its current assets. The ratio is expected to be above one, although a ratio of 1:1 would not be considered sufficiently high for manufacturing companies that hold stock for longer periods than companies with low numbers of receivables and sell it on credit. CRs of the two examined companies have been going up and down within the last five years; Redrow plc’s CR grew in 2016 to 3.1 from 2.9 in 2015, and in the case of Crest Nicholson, it decreased from 3.9 in 2015 to 3.6 in 2016, which is not a dramatic fall and still signifies that the company is able to meet its short-term obligations with what it currently holds.
The seventh ratio is quick ratio (QR), which is often used in combination with CR and calculated by subtracting stock from current assets and dividing the remainder by current liabilities. The necessity of calculating the quick ratio is justified by the fact that some companies may not be able to convert their stock into cash quickly, which is why their CR may look misleadingly high. By subtracting stock from the numerator, QR examination presents a tougher test of liquidity. Unlike CR, QR of less than one can be acceptable because it should be also considered that not only stock is subtracted from current assets, but also those liabilities are counted in the denominator that may not be payable immediately. The difference between Redrow plc and Crest Nicholson becomes obvious when one looks at QR instead of CR. Neither company has demonstrated a QR above one, but Crest Nicholson’s has been significantly higher within the last five years, and it is currently reported to be 0.98, while Redrow plc’s is only 0.26.
The eighth ratio is net income growth (NIG), which is not as widespread as the ratios above, but it can be used to assess how companies grow in terms of their profits. The ratio represents an annual rate calculated by subtracting net income of the previous year from the net income of the current year, dividing the remainder by the previous year’s net income, and multiplying by 100 per cent, i.e. the ratio shows how much more a company earned in a given period than in another one (Chugh et al. 2013). In 2012, Redrow plc had an impressive NIG of 123.7 per cent, and the rate kept decreasing. Not to be misled, one should note that slower growth does not indicate a deterioration of financial performance because, as the profit of a company grows, a given sum is becoming a smaller and smaller portion of it. However, under the assumption that all other rates are equal, an increasing NIG rate is preferable and attractive for investors, and Crest Nicholson showed a slightly higher NIG in 2016 compared to 2015, while Redrow plc’s NIG decreased by almost 25 percentage points.
The ninth ratio is payables period (PP), which is calculated by dividing average payable accounts for a given year by average cost of sold products per day. As a result, the ratio indicates how long it takes a company to pay those who provided products and services to it. Shorter periods are preferable; however, it should not be overlooked that the ratio can be distorted if some suppliers provide significantly larger amounts of products and services than the majority of them. If a company’s PP is increasing over the years, it is an indication of the company’s problems with paying its suppliers, which does not contribute to perceived reliability or investor trust (Atanasova 2012). Redrow plc’s PP was decreasing from 2012 to 2014, but it has been growing since then and has increased by almost ten days since 2015. Crest Nicholson’s PP, on the contrary, has been remarkably decreasing since 2014, which indicates a growing level of efficiency and speed of operation in dealing with suppliers.
The tenth ratio is interest coverage (IC), which is calculated by dividing the company’s profit before interest and tax (PBIT) by interest expense. “Coverage” means that the rate reflects how much times the company’s PBIT can cover its interest expense. Higher numbers are preferable (Fevurly 2013). Both Redrow plc’s and Crest Nicholson’s IC ratios have been decreasing within recent years, but the former’s IC has been mostly higher, and in 2016 it was 18.9 compared to Crest Nicholson’s 16.5.
Further Comparison of the Two Companies
As it was noticed above, the examined housing companies consider their current and potential investors to be the primary audience of their financial reports (see Ratio Analysis as a Method). Therefore, the reports are not presented in the form of plain balance sheets and calculations but designed into colourful files with graphs, pictures, and supporting explanatory texts. Moreover, they feature slogans that are meant to be appealing to target audiences, such as “A better way to live” (A better way to live: Redrow annual report 2016, p. 1) or “Sustaining value” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 1). Therefore, it is proposed to further analyse the companies’ financial reports for highlight, i.e. for information that the companies themselves emphasise for the reports’ readers, find important, and try to draw attention to it. An experienced investor does not need to be explained what is important in financial reports, is capable of finding relevant information on his and her own, and is not only looking at those numbers that are written in larger fonts. However, exploring what the companies themselves may try to present as their successes and strengths can provide a valuable perspective on their perceived attractiveness for investors as well as potential clients.
At the very beginning of its report, Redrow plc presents three financial performance indicators that are meant to demonstrate the company’s growth: profit before tax, earnings per share, and return on equity; all three have been growing within the last three years. The first representation of financial information that one faces in the Crest Nicholson’s report is a statement of growing revenue, operating profit, and basic earnings per share. Therefore, both companies highlight that their operation has been beneficial for shareholders. However, right after this, Crest Nicholson goes to “meeting housing needs” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 2), while Redrow plc presents operational highlights, such as outlets, private legal completions, and private order book.
One of the things that one is likely to turn to in a financial report is risk management (Lam 2014), and the two companies can be compared in terms of their risk management achievements over the last five years. In 2012, Redrow plc listed ten risks in its report: none was reported to have increased, one was reported to have decreased (liquidity and funding), and the rest were reported to not have changed since the previous year (Redrow: annual report and accounts 2012). Five years later, the company listed twelve risks: three were increasing (failures of customer service, employee attraction and retention, and health and safety), two were decreasing (availability of mortgage finance and cyber security), and the rest had not changed since the previous year (A better way to live: Redrow annual report 2016).
Concerning Crest Nicholson, the company listed six risks in 2012 and did not report any assessed changes in the risk areas since the previous year (A vision that inspires: Crest Nicholson directors’ report and accounts 2012). Five years later, the company provided a broader consideration of risks and listed sixteen risks in five areas, with two risks reportedly increasing (adverse macro-economic climate and reputation damage from poor quality of products), three risks reportedly decreasing (build cost inflation, changes in planning systems and political situation, and labour and materials), and the rest reportedly unchanged (Sustaining value: Crest Nicholson annual integrated report 2016). Also, some risks were listed as “new,” including cyber security, which was reported as a decreasing risk by Redrow plc. Most risks are similar because the two companies operate in the same industry. However, what this overview allows concluding is that both companies have been paying increasingly more attention to risk management within the last five years, which indicates the recognition that addressing risks properly is a major consideration in company’s attractiveness and investor trust.
Compliance with the UK Corporate Governance Code
In its statement, Crest Nicholson claims that it “complied with the provisions and applied the main principles of the UK Corporate Governance Code…throughout the year” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 49). However, it should be recognised that the Code used by the company was published in September 2014. In April 2016, the UK Corporate Governance Code was updated by the Financial Reporting Counsel (FRC), although it was ensured that the Code “remained consistent and changes [had] only been made when necessary” (The UK corporate governance code 2016, p. 2). The changes were associated with three areas: “the FRC’s own review of ethical matters, changes to legislation which, after Parliamentary Scrutiny, are intended to take effect on 17 June 2016, and developments in international standards” (Revised UK Corporate Governance Code, Guidance on Audit Committees, and Auditing and Ethical Standards 2016, para. 2). Key provisions, however, were preserved.
In the new edition, the FRC continued its work toward ensuring the independence of auditors. New provisions prohibit certain engagements that could cause a conflict of interest for an auditor. In terms of conflicts of interests, Crest Nicholson acknowledges that its non-executive directors “could be involved in other businesses from which we buy products and services or may have interests in areas of the country where we operate” (Sustaining value: Crest Nicholson annual integrated report 2016, p. 60). However, where material contracts are involved, the company properly discloses all related information in its financial report. Stephen Stone, the company’s CEO since 2005, joined the board of NHBC in 2016 as a non-executive director, which Crest Nicholson presents as role modelling for improving the standards of the UK housing sector. The Nomination Committee is the organ that monitors all the related issues and ensures the effectiveness, competence, and independence of the Board.
Overall, according to the presented report, it can be assessed that Crest Nicholson has complied with the UK Corporate Governance Code, has followed its rules of structuring the report, and has ensured, by means of creating proper committees and reviewing the corporate governance statement, that corporate governance of the company is performed according to the Code.
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