Financial Analysis of Rolls Royce Holdings Plc

Financial statements and corporate reports are the main media through which a corporation communicates with its stakeholders. Financial provides information which helps the decision maker to make a proper economic decision. Business organization summarizes all the financial aspects of financial statements which show financial performance and financial position of a firm. The purpose of this paper is to show how financial statements are interpreted so that investor can evaluate the performance of a particular business. Financial statements of Rolls Royce Holding plc will be evaluated through financial ratio analysis to find major strengths and weakness of the firm. In financial ratios, information of income statement and the balance sheet is used.

Background of Rolls Royse Holdings Plc

Rolls Royse Holdings is a British multinational public limited company that owns the Rolls Royce which was established in 1904. The company is the manufacturer, designer, and distributor of engines and power system for the aviation industry. Rolls Royce is the second largest manufacturer of aircraft engines. The company now manufactures 35 types of commercial aircraft and has 13000 running engines around the world. FH Royce and CS Rolls had a separate business they both formed and incorporated Rolls Royce in 1905 with the name Rolls-Royce Limited (Blue 2016, p.240). The company was liquidated in 1971 due to the incapability to meet the financial obligations. The government of Margaret Thatcher brought the company back in share market in 1987. The name was changed to Rolls Royce Holdings plc with the change of the ownership. Rolls Royce belongs to defense, aerospace and energy industry.

Financial aspects of Rolls Royce

The company has earned £16,307 million revenue and £4208 million net profit in 2017. The company has £30006 million total assets and £6,167 million equity in its balance sheet. Currently, The Company is running operations with 9 subsidiaries and 22,300 employees. The annual growth of revenue, net profit, and capital spending is 1.02%, 41.55 and 9.8% respectively. Rolls Royce is a cash-rich company cash inflow of last year was £219 million. The company has joint venture subsidiary with northern engineering, Allison Engine Company, and BMW. The company has once divested its energy gas turbine and compressor business for £785 to Siemens (Thomas, 2014, p.32).

Operations, strategy and value proposition

Rolls Royce creates value in three major sectors: Customers, corporate and shareholders. The major inputs are people and expertise, research and development, collaboration in the supply chain, advanced manufacturing, customer relationship and financial investments. According to Blue (2016) there are mainly three key drivers of value creation: Operational excellence, engineering excellence and capturing aftermarket value. Values propositions are aligning the differentiated products with operational requirements, creating market position through the world-class development and production facilities and long-term cash flow generation. The company has some emerging markets in East European countries and some Asian countries.

Market overview

Rolls Royce has a strong market position as one of the world’s leading civil aero-engine manufacturers. Airbus and Boeing two major types of aircraft show annual traffic growth of 5% over 20 years. General Electric is the main competitor in wide-body engine supply sector. The market shares of the companies in this industry are Rolls Royce 38%, GE 54%, Pratt Whitney 2% and Engine Alliance 6%. GE competes with Rolls Royce in its well-positioned wide-body airline programs and Boeing 787 family (Thomas, 2014, p.46). There are many business risks which can cost significant financial and reputational consequences. The economic downturn causes a significant reduction in air travel and demand for aircraft. The pricing pressure from the competitors challenges the key financial performance. If the supply chain is suffered delivery schedule might be delayed which damages the reputation and market holdings.

Figure 1: Market shares of companies in Aviation Industry

Financial Ratio Analysis

A ratio is the arithmetic relationship between two variables. Ratio analysis is a very basic and useful tool to analyze the financial statements of an organization. Britton and Waterston (2013) state only the ratios do not provide any meaningful information unless it is compared to other similar organization or industry benchmark. Industry average ratio is the benchmark against which every organization evaluates their financial performance. Ratio analysis gives the investor the foundation of fundamental analysis and qualitative analysis of a firm’s financial affairs. The purpose of the financial statements is to provide information to its various stakeholders. Ratio analysis becomes a very useful way to gain information when a user is concerned about its limitations.

Ratio analysis does not consider the differences in use of accounting policies in different companies. For instance, one company uses FIFO method and the other company uses LIFO method. The company uses LIFO method would have the higher cost of goods sold so that less net income than that of the company which uses FIFO method. Price level index is not considered in it. Ratio analysis can be used at a single point in time. Growth prospect of a firm is ignored in it. Error in a statement can be misleading as well as personal judgment is necessary so that the interpretation can be different for different investors (Gibson, 2013). The business cycle is not considered so that in recession time a company becomes unprofitable if only ratios are considered. There are four types of ratios

Liquidity Ratios

Profitability Ratios

Gearing or Leverage ratios

Efficiency or Activity Ratios

Liquidity ratio analyzes the capability of a firm to pay its financial obligations. Liquidity means how quick a firm can liquidate its current assets and fixed assets into cash or cash equivalents and how much current assets a firm holds against its current liabilities. The investors and creditors use this ratio to assess the capability and credibility of a firm. Current ratio, quick ratio, debt-equity ratio and debt ratios are the major liquidity ratios.

Profitability ratios measure the profitability of a firm. How much profit it generates from its sales and operations is measured through profitability ratios. According to Palmer (2000) it is also called margin ratios as it is represented in percentage which means how much (%) profit it earns from every sales unit. There are some useful profitability ratios such as Gross profit margin, net profit margin, return on equity, and return on asset.

Leverage or Gearing ratio measures the dependency of a firm on external debt financing. It is measured by assets and equity. When a firm has higher debt than its equity the firm is highly leveraged. The risk tolerance of a firm depends on industry type and market. Leverage or gearing ratio shows that to what extent a firm can increase its return from sales and operations (Porter and Norton, 2017). It also gives the firm a signal whether it needs to borrow more or repay previous debt. Interest coverage ratio, debt-equity ratio, and debt ratio are the major leverage ratios.

Efficiency refers to the operational efficiency of a firm. The efficiency indicator measures the firm’s capability to run its day to day business such as turning inventory into sales, recovering money from the debtor, getting favorable trade credit etc. Total asset turnover, inventory turnover, and receivable cycle, payable cycles are the major efficiency ratios.

Ratio analysis of Rolls and Royce

Operating profit margin measures how much operating profit a firm earns from its one unit of sales. It is expressed in percentage. From operating profit margin we can also gain an understanding of the cost structure and expenditures on operations. The operating profit margin of Rolls Royce Holdings plc is given here,

Operating profit margin

2015

2016

2017

Operating profit ÷ Sales

10.92%

.2%

7.89%

In last three years, the company has maintained 6.03% operating profit margin on average. The gross profit of in these years is 23.87%, 20.38%, and 19.45% respectively. It is clear that the gross profit of 2015 is the highest figure but the operating profit is telling that in 2016 the company did not earn enough profit. The reason is Rolls Royce increased its research and development cost more than double in 2016 from £1070 to £2028 million.

Return on capital employed: It is a profitability ratio which measures the earning capacity of the firm from its invested capital. Operating profit is divided by the total invested capital to measure the ROCE. ROCE directly measures the profitability or return of the shareholders (Stickney, 2012). ROCE is measured on equity of a firm by dividing net profit before interest and tax.

Return on capital employed

2015

2016

2017

EBIT ÷ Capital Employed

30%

2.2%

33.79%

Investment in research and development has the impact on current ROCE ratio. In 2016 the retained earnings level had been reduced from £4457 million to 445 million. In 2016 the company incurred £4032 million. But except 2016 the performance of the company is outstanding it had in average 31.8% ROCE in 2015 and 2017. The ratio shows that Rolls Royce earns £30 from each £100 invested capital.

Gearing Ratio: The aviation industry is highly leverage based so that it is natural that the firm has larger portion of external financing or debt in its capital structure. The degree of leverage enhances the earning capacity by borrowing at a lower cost. Financing from internal sources is costly and it is not possible to bear all the cost such as research and development cost from its retained earnings or general reserve.

Gearing Ratio

2015

2016

2017

Debt to Equity Ratio

Debt ÷ Equity

3.45:1

12.7:1

3.86:1

Debt to Asset Ratio

Debt ÷ Asset

.77:1

.92:1

.79:1

Interest rate coverage Ratio

EBIT ÷ Interest Expense

1.03 times

.8 times

12.95 times

Gearing ratios of Rolls Royce shows us this company has £3.45 debt against £1 equity in 2015 it increases to £12.7 debt against £1equity and £3.86 against £1 equity. Aviation industry is a highly leverage based it requires the company to earn. The company has £.77 debt against £1 asset in 2015 it increases to .92:1 as the company borrowed from external financing sources. In 2017 the company has most favorable interest coverage ratio which is 12.95 times. It means the firm can pay its interest expenses almost 13 times by its earnings before tax and interest.

Earnings per share (EPS): Earning per share measures the return a firm earns against its each share. Total net income is divided by the number of shares to measure EPS. EPS is used to measure price earnings ratio which is a very popular ratio among the investors (Rees, 2010).

Earnings Per Share

2015

2016

2017

Net income ÷ Total shares outstanding

4.51

(220.08)

229.4

EPS of Rolls Royce shows that the firm provides £229.4 per share outstanding. The firm has negative EPS in 2016 due to the incurred loss in that year. In 2015 the company provided £4.51 per share.

Findings of analysis recommendation and conclusion

Rolls Royce has a long glorious history of success and growth in Aerospace and energy industry. The company has the leading position in making aircraft and engines for aircraft. Financial statements of Rolls Royce reflect the current financial performance. If all the ratios are measured it is seen that 2016 was not a good year for the company. Except for that year the company is successful, profitable in all the aspects. The company has a solid business model and value creation process which makes the company dominant against its competitors. The performance of 2017 shows Rolls Royce has regained its strength. The company’s retained earnings increased from £445 to £4882.

The investment in research and development has brought a positive result for the company. But considering the market shares, GE is still far ahead of Rolls Royce. Now the company has to focus on the new market of Asia and East Europe. It would be better is the company reap all the benefits from investment in research and development and proceed to develop the operation to the Far East. Rolls Royce has financed its retained earnings in R&D. The rule of finance is to use both internal and external financing for any new risk project. R&D can bring profitable output for the organization but it can be ensured. Moreover, Rolls Royce should solicit for a new industry to diversify its business so that in the recession it can insulate its profitability.

References

Blue, E. (2016). It could prove a hit with the aircraft industry. Aircraft Engineering and Aerospace Technology, 76(2), pp.235-290.

Britton, A. and Waterston, C. (2013). Financial accounting. Harlow: Financial Times Prentice Hall.

Gibson, C. (2013). Financial statement analysis. Mason, Ohio: South-Western.

Palmer, J. (2000). Financial ratio analysis. 10th ed. New York, N.Y.: American Institute of Certified Public Accountants.

Porter, G. and Norton, C. (2017). Financial accounting. Boston, MA: Cengage Learning.

Rees, B. (2010). Financial analysis. 4th ed. London: Prentice Hall.

Stickney, C. (2012). Financial statement analysis. 11th ed. Fort Worth: Harcourt Brace Jovanovich Publishers.

Thomas, C. (2014). Aircraft industry demands more from material suppliers. Aircraft Engineering and Aerospace Technology, 67(5), pp.18-49.

Appendix- A

Calculation of Ratio Analysis

Operating profit margin

2015

2016

2017

Operating profit ÷ Sales

1499 ÷ 13725

44 ÷ 14955

1287 ÷ 16307

Return on capital employed

2015

2016

2017

EBIT ÷ Capital Employed

1501 ÷ 5014

41 ÷ 1864

2085 ÷ 6170

Gearing Ratio

2015

2016

2017

Debt to Equity Ratio

17308 ÷ 5016

23674 ÷ 1864

23832 ÷ 6170

Debt to Asset Ratio

17308 ÷ 22324

23674 ÷ 25538

23832 ÷ 30002

Interest rate coverage Ratio

1501 ÷ 1456

41 ÷ 4773

2085 ÷ 161

Earnings Per Share

2015

2016

2017

Net income ÷ Total shares outstanding

1499m÷332.3m

------

1287m ÷ 5.61m

Financial Statements: