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Before investing in any organization, it is imperative to look at the company’s finances as well as its overall performance (Brigham & Ehrhardt, 2013). This paper looks at the different financial metric for two companies in the aerospace and defense industry; BAE Systems and Rolls-Royce. Some of the key financial ratios addressed include profitability ratios, efficiency ratios, liquidity ratios, and capital gearing ratio. On the same note, the paper performs horizontal and vertical analysis of the two companies. The paper uses secondary analysis of the firm’s annual reports and other financial sources to collect and analyze data. The paper found out that the profitability of BAE System has significantly increased because of decreased demand for its products. On the other hand, Rolls-Royce has been enjoying tremendous growth over the years and this is evident from the increasing price of its Rolls-Royce Shares.
Table of Contents
Executive Summary. 2
Introduction. 5
BAE Systems. 5
Rolls-Royce Holdings PLC.. 6
Financial Ratio Analysis of BAE Systems and Rolls-Royce. 7
Profitability Ratios. 7
Gross Profit 7
Return on Shareholders’ Investment Ratio. 7
Return on Capital Employed. 8
Return on assets. 8
Efficiency Ratio. 8
Account Receivable turnover ratio. 9
Inventory Holding Period. 9
Accounts Payables Periods. 9
Fixed Asset Turnover Ratio. 9
Rolls-Royce Vertical Analysis. 13
Evaluation of Business Performance using Non-financial Measures. 14
How business success is measured in Rolls-Royce. 14
Responsibility Centers and performance evaluation. 17
Rolls-Royce Profitability Ratios. 23
Rolls-Royce Efficiency Ratios. 23
BAE Systems Profitability Ratios. 24
Evaluation of Business Performance Financial Measures Introduction
The Aerospace and defense industry is divided into aerospace and defense segment. The aerospace segment primary activities are the designing, producing and selling of commercial aircraft (Müller, 2014). On the other hand, the defense industry produces military weapons and systems for states. These systems are designed to function in the air, on land, or in the sea. This industry is also responsible for the manufacturing of space vehicles such as satellites used for both military and commercial use. BAE Systems and Rolls-Royce Holdings plc are the main players in the United Kingdom market. The two companies have also been selected to explore the future benefits and opportunities of drone technology.
The purpose of this paper is to do a comparative analysis of the two main companies in the Aerospace and Defense in the United Kingdom BAE Systems and Rolls-Royce Holdings. To achieve this, the paper looks at the different financial ratios compare for the two British corporations.
BAE Systems is a British multinational public limited company in the defense security and aerospace industry. The Corporation headquarters is located in London, United Kingdom. The corporation traces his roots to the year 1999 where it was formed through a merger of General Electric Company (GEC) and Marconi Electronic Systems. BAE Systems is among the best defense contractors in the world. The company’s main operations are done in the United Kingdom and the United States of America (Baesystems.com, 2016). Other main markets for BAE System products are India, Australia, and Saudi Arabia.
The company employs more than 88,200 employees across the world. The key businesses of BAE Systems include Military and technical services, defense, security, cyber and intelligence, IT and information systems, electronics and systems integration as well as consultancy services (Gopalakrishnan et al., 2012). BAE system finances its business operations using equity funding and debt financing. The organization raises its finance through the capital market and bank borrowing. As at the end of the year 2012, the company had a capital of 13,312 million pounds (total equity of 3,774 million pounds, and a debt of 9,538 million pounds) (BAE Systems: Annual Report, 2014).
Rolls-Royce Holdings is a British multinational public limited holding corporation. The firm’s headquarters is located in Westminster, London. The company was created through a partnership between by Henry Royce and Charles Rolls in the year 1906. Rolls-Royce designs, assembles and sales power systems used in aviation and automobile industries, marine propulsion and energy sectors (Rolls-royce.com, 2016). Rolls Royce is the second largest corporation producing aircraft engines.
The company employs about 40,000 workers in the whole world (Rolls-Royce Holdings plc Annual Report, 2014). Some of the key products and services offered by Rolls-Royce Holdings include Defense Aerospace, Civil Aerospace, Marine, and Energy. Rolls-Royce also finances its business activities through equity funding and debt financing (Bank and Capital Market borrowing). By the end of the year 2012, the organization had a total capital of £10,921 million (equity of £6,105 million and debt of £4,816) (Müller, 2014).
Financial Ratio Analysis of BAE Systems and Rolls-Royce
Profitability ratios are financial metrics used to evaluate the performance of a company. A company that has a higher value compared to that of its competitor or the ratio calculated in the previous financial period indicates that the organization is performing well.
Gross profit margin is one of the profitability analyzes metric that shows a company’s financial health by calculating the proportion of money that remains after considering the cost of goods sold. In our case, the BAE Systems Gross profit margin is as at 31st Dec 2014, is 60.4% while the Gross profit margin for Rolls-Royce is 23.3% (Financials.morningstar.com, 2016). This indicates that BAE Systems earns more revenue as compared to Rolls-Royce thus, more profitable.
Return on Shareholders’ Investment Ratio
This metric is used to compute the overall profitability of a firm. Return on Shareholder’s Equity can also be termed as Return on Equity. To compute Return on Equity (ROE), we divide net revenue after interest and tax by average stockholders’ equity.
As at 31st Dec 2014, the Return on equity for BAE Systems is 28.34%. On the other hand, the Return on Equity for Rolls-Royce is 1.15%. The two values indicate that BAE Systems is also performing better as compared to Rolls-Royce because the ability to generate profit is higher for BAE Systems as compared to Rolls-Royce (Financials.morningstar.com, 2016).
Return on Capital Employed (ROCE) is also a financial metric used to compute the efficiency of a company in generating profits for its capital employed (Brigham, E., & Ehrhardt, 2013). To arrive at ROCE, we compare net operating profit with capital employed.
Return on Capital Employed = (Net operating profit)/(Capital Employed)
For BAE Systems; Net operating profits is 740, total assets 19,788, and current liabilities 8,045. Therefore, ROCE will be [740/ (19,788-8,045)] which equal to 0.0630. On the other hand, for Rolls-Royce; Net operating profits is 69, Total Assets 22,224, and current liabilities 7,685. Therefore, the ROCE will be [69/(22,224-7,685)] which equal to 0.00475. Therefore, BAE Systems is more profitable as compared to Rolls-Royce. This is because every dollar invested by BAE Systems earns $0.0630 while every dollar invested on Rolls-Royce earns $0.00475.
Return on asset is also a profitability measure that computes the net income produced by total assets during a specific period (Schmeisser et al., 2014). To get ROA, we divide net income by average total assets. For BAE Systems, the Return on assets is 3.75%. On the other hand, the return on assets for Rolls-Royce is 0.30%. This indicates that BAE is more efficient in managing assets to generate profit during an accounting year.
Efficiency ratios are financial metrics used to evaluate how efficient a firm utilizes its assets to generate revenues. Efficiency ratios also evaluate how companies effectively manage their resources (Collier, 2015).
Account Receivable turnover ratio
This ratio among the efficiency ratios that compute the number of times a firm can convert its account receivables into cash in a given period (Fernández, 2013). The ratio is arrived at by dividing Net Credit Sales by Average Account Receivable. In our case, the account receivable ratio for BAE Systems is 14.89 while the account receivable for Rolls-Royce is 8.77. This indicates that BAE Systems is more efficient in collecting credit sales from customers compared to Rolls-Royce.
It is also referred to as Days Sales of Inventory (DSI) which is a financial metric used to determine the time taken for a firm to turn its inventory into sales. The Days Inventory for BAE Systems is 40.89 while the Days inventory for Rolls-Royce is 105.7 (Financials.morningstar.com, 2016). This indicates that BAE Systems turns its inventory into sales faster as compared to Rolls-Royce.
This metric evaluates a firm’s obligation to settle short-term debts to its creditors. The account payable for BAE Systems in the year 2014 was valued at 21.79 while the Accounts Payables for Rolls-Royce is 6.07. BAE Systems has a higher Accounts payable period indicating that BAE Systems gets a maximum advantage of using credit purchase.
This ratio is an efficiency metric that compares net sales to net fixed asset. The fixed asset turnover for BAE Systems is 8.75 while the fixed asset turnover for Rolls-Royce is 4.02. This implies that BAE Systems is doing an effective job of generating sales with few fixed assets as compared to Rolls-Royce.
This financial metric measures the efficiency of a company by looking at how effectively inventory is managed (Chen & Wang, 2012). The inventory turnover ratio for BAE Systems is 8.93 while the inventory turnover ratio for Rolls-Royce is 3.46. This shows that BAE Systems is more efficient for controlling the firm’s merchandise.
Liquidity ratios are financial ratios that are utilized by investors, management, and other investors to determine a firm’s ability to settle its short-term debts. Examples of liquidity ratios include current ratio, operating cash flow statement, and the Acid-test Ratio.
The current ratio is utilized by financial users such as investors to find out if a company can be able to settle its liabilities such as debts using its current assets (Brealey et al., 2012). In our case, BAE Systems current ratio for the year 2014 is 0.74. On the other hand, the current ratio for Rolls-Royce Holdings is 1.46. Therefore, Rolls-Royce is more liquid as compared to BAE Systems and thus, the ability of Rolls-Roy’s to meet its short-term debts is higher as compared to BAE Systems.
Acid test ratio is a liquidity metric that evaluates a firm’s ability to settle current liabilities by means of assets that can be converted into cash within a period of 90 days. As at 31st, Dec 2014, BAE systems had a quick ratio of 0.62. On the other hand, the quick ratio for Rolls-Royce is 1.07. Therefore, Rolls-Royce has a higher acid test ratio indicating that the company is in a position to settle off any reduction in its business as compared to BAE Systems.
Cash flow analysis is also important when determining the financial strength of business. Cash flow budget is important when it comes to projecting sources and application of funds in upcoming projects. It is important to identify cash deficit earlier and take corrective actions. The free cash flow for BAE Systems is $347 while the free cash flow for rolls-Royce is 176. This indicates that BAE Systems have a higher amount of free cash flow available for use in business operations.
Gearing ratio is an important financial metric used to evaluate the proportion of a firm’s borrowed funds to equity. The main gearing ratio is the debt to equity ratio which is used to calculate the relative proportion of shareholders equity and debts used to finance a firm’s business operations. In our case, the debt to equity ratio for BAE Systems is 1.56 while that for Rolls-Royce is 0.34 (Financials.morningstar.com, 2016). Therefore, BAE Systems has a higher gearing ratio and thus vulnerable to ups and downs in the business cycles as compared to Roll-Royce.
This financial ratio is used calculate the value of equity in a firm by examining the overall debt picture. In our case, the financial leverage ratio for BAE Systems is 10.74 while that for Rolls-Royce is 3.48. Therefore, BAE Systems have higher debts as compared to Rolls-Royce.
The horizontal financial analysis addresses the financial changes that have occurred in an organization over the years. For BAE Systems, most notable changes are seen in the revenues. The firm’s revenue has been decreasing over the years from a value of 17,770 million in the year 2011 to a value of 15,430 million in the year 2014. Rolls-Royce Revenue has also been increasing over the years from sales of 11,124 million in the year 2011 to sales of 13, 736 million in the year 2014. This indicates that the industry has been growing over the years, and business activities are booming.
Operating profits have been decreasing in the industry also over the years. BAE Systems recorded a decreasing operating profit from 1,377 million in the year 2011 up to 1,223 million in the year 2014 (Financials.morningstar.com, 2016). On the other hand, Rolls-Royce operating profits have also been increasing from a value of 1,091 million in the year 2011 to a value of 1,470 million in the year 2013. However, the firm recorded a drop in sales in the year 2014. The sales dropped to a value of 1,286 million dollars.
Similarly, the net profits have been decreasing in the industry over the years. BAE Systems recorded decreasing net profits from a value of 1,240 million in the year 2011 to a value of 752 million in the year 2014. On the other hand, Rolls-Royce operating income increased from a value of 850 million in 2011 to 2,281 million in 2012. However, the value decreased in 2014 to 1,379 million.
BAE Systems Vertical Analysis for the last three years
| 2012 | 2013 | 2014 | ||||
| Total Assets | 22,274 | 100% | 19,681 | 100% | 19,788 | 100% |
| Total Non-current assets | 15, 296 | 68.67% | 13,512 | 68.66% | 13,811 | 69.79% |
| Total current Assets | 6,978 | 31.33% | 6,169 | 31.34% | 5,977 | 30.21% |
| Total Current Liabilities | 8,917 | 40% | 8,445 | 42.91% | 8,045 | 40.66% |
| Total long term liabilities | 18,554 | 83.3% | 16,300 | 82.82% | 17,946 | 90.69% |
| Total shareholders’ equity | 3,720 | 16.7% | 3,381 | 17.18% | 1,842 | 9.31% |
From the vertical analysis of BAE Systems, it is evident that there is a significant increase in the proportion of non-current assets to the total assets over the three years. There is also a significant decrease in the proportion of total shareholders’ equity to the total assets.
| 2012 | 2013 | 2014 | ||||
| Total Assets | 18,115 | 100% | 23,063 | 100% | 22,224 | 100% |
| Total Non-current assets | 8,522 | 47.04% | 10,245 | 44.44% | 11,036 | 49.66% |
| Total current Assets | 9,593 | 52.95% | 12,818 | 55.57% | 11,188 | 50.34% |
| Total Current Liabilities | 7,194 | 39.71% | 9,780 | 37.52% | 7,685 | 34.58% |
| Total long term liabilities | 4,833 | 26.68% | 7,678 | 33.29% | 8,157 | 36.7% |
| Total shareholders’ equity | 6,088 | 33.60% | 5,605 | 24.30% | 6,382 | 28.72% |
From Rolls-Royce analysis, there is a significant decrease in the proportion of total current liabilities to the total assets. However, the rest of the attributes are generally balanced.
It is evident from profitability ratios that BAE systems are earning more revenue as compared to Rolls-Royce. BAE Systems is more efficient also in managing assets as compared to Rolls-Royce. However, BAE Systems profits have been decreasing over the years. On the other hand, Rolls-Royce profits have been increasing over the years. Rolls-Royce is also more lucrative for investors as compared to BAE systems because the company has higher Earnings per Share. Despite the fact that Rolls-Royce has higher Earnings per Share BAE systems seemed to be more lucrative because of a higher dividend yield and strong financial fundamentals. BAE systems have stronger fundamentals, but its sales are declining over the years when compared to Rolls-Roice. As a result, the firm’s debt capital has been increasing over the years. On the other hand, Rolls-Royce revenues have been increasing over the years. This indicates that the profitability of the company is increasing. The level of income has increased by 9% since the over the last three years.
Evaluation of Business Performance using Non-financial Measures
How business success is measured in Rolls-Royce
Rolls-Royce is a multinational company. Therefore, success cannot be quantified regarding money only. Instead, other factors such as customer satisfaction, increased customer loyalty, employee satisfaction among others should be considered when determining if the firm is creating value (Fernández, 2013). In Rolls-Royce, the key performance indicators include financial metrics such as earning per Share (EPS) and sales growth. On the same note, non-financial metrics such as loyalty, product quality, employee satisfaction and business longevity is considered (Van Dooren et al., 2015).
Roll-Royce Plc has a hierarchical organization structure. The company uses this structure because of the fact that the method is effective to supervise and develop the firm. The company is developing in a series of layers from the bottom to the top. The top layer of the organization encompasses of the management and makes decisions concerning the organization operations and policy making.
The internal operation is managed based on different structures and departments. Decisions are made on top and disseminated from the top downwards. There is a Customer Facing Business Units (CFBU) on the top followed by different manufacturing and purchasing Operating Business Units (OBUs). There are different Operating Business Units such as civil and Aerospace, defense unit, the marine unit and the energy unit.
The main role of the CFBUs is to identify new opportunities for the organization and dealing with customers in the markets. On the other hand, the OBUs are responsible for manufacturing the different products by designing, developing and manufacturing the components of the different machines.
Performance evaluation is important as it helps management and employment to work as a team in an effort to increase the performance of employees through mentorship, training, and goal setting for each employee. In Rolls-Royce performance management and evaluation is done based on five areas. The areas include;
Productivity: Rolls-Royce always set goals for each employee and performance is evaluated by assessing the way employees have performed to ensure that each employee maintains consistency in quality. The processed data are often reviewed by a panel of senior associates in Rolls-Royce from time to time (De Waal, 2013). Employees who perform well are motivated to perform even better while those employees who are not performing exceptionally are encouraged through a reward punishment system.
Communication skills: employees are also evaluated based on communication skills. The management of Roll-Royce believes that communication skills are important for communicating with each other and the management. In so doing, employees will be able to share their views, provide suggestion and perform their roles better. The management, therefore, concentrates on enhancing communication skills for their employees.
Innovation and initiative: The management always believes that innovation is the core concept that drives the aviation and defense industry. Therefore, they always encourage employees to share their ideas concerning how they production and work process improve. Therefore, employees are also evaluated on their innovativeness and creativity that help achieve business sustainability.
Rolls-Royce uses balanced scorecard as a key strategic communication mechanism. The management uses the Balance-scorecard as a control system for improving employee performance. Management uses the balanced scorecard to improve communications, evaluate performance in relation to organization goals, and finally align business practices with the vision and strategy of Rolls-Royce (Kaplan & Atkinson, 2015). Rolls-Royce also uses balanced scorecard as a non-financial performance metric to give the management a better view of organization performance. Roll-Royce uses the balanced scorecard as a performance evaluation metric in the following areas;
Internal business process performance: Roll-Royce uses the balanced scorecard to evaluate internal business to ensure that goods are produced at a high productivity rates, timeliness, and quality measurement.
Customer value performance: Rolls-Royce uses the balanced scorecard to evaluate customer perception about the firm. Some of the key metrics evaluated include customer satisfaction, customer loyalty, and market share (Northcott & Ma’amora Taulapapa, 2012).
Financial performance: Roll-Royce uses balanced scorecard in conjunction with financial metrics for guiding and evaluating the company on planning the future based on the story of the past events. Some of the key metrics for evaluating financial performance include return on capital, earnings, and cash flow.
Responsibility Centers and performance evaluation
Managers at each responsibility centers within Rolls-Royce are responsible for managing various activities and are also bestowed the authority to Prepare a responsibility report requisite for evaluating the performance of their centers. Responsibility reports help in measuring cost, revenue, and profit centers by comparing the center’s budgeted performance with the set performance. On the same note, the responsibility reports measures and interprets individual reports.
When evaluating revenue centers’ performance, managers only consider the revenues in responsibility center and ignore other things. Evaluations on revenue centers focus on sales within the revenue centers. The cost centers are the areas where goods and services are produced and offered to other parts of the firm. These centers have controls over the prices of goods and services. Therefore, managers in the cost centers use total cost to evaluate performance. The cost center is important for monitoring the quality of goods produced by the firm and thus important for improving performance. Finally, in profit centers, managers have the responsibility and accountability for managing both revenues and expenses. The managers in profit centers also have the freedom to select what to purchase or offer for sale. Similarly, managers in these profit centers also have the ability to set their prices for goods and services of the firm. Performance in profit centers is evaluated using controllable margins. Costs and Revenues that are controllable are considered. On the other hand, costs that are beyond the manager’s control are excluded from performance evaluation.
Evaluation of Business Performance Financial Measures Conclusion
The aerospace and defense industry is dominated by two main companies in the United States. That is BAE Systems and Roll-Royce Holdings. These firms produce armored vehicles, airplane engines, and marine ships among other machinery used by the military. Similarly, the two companies also produce airplanes, motor vehicles and communication systems for commercial use. This industry has been quite profitable for the last three years. BAE Systems has strong fundamentals in terms of capital structure, and its profitability ratios indicate that the firm has been profitable over the years.
However, BAE Systems profitability has been decreasing. This is because BAE System produces mainly defense equipment and system. The demands for products in the defense sector have reduced because of reduced military spending in the BAE primary markets the United States and Europe. Roll-Royce profitability has been increasing even more as compared to BAE System. This is because the Roll-Royce productivity has been increasing. Similarly, income levels for Roll-Royce have increased by 9% since the year 2012.
BAE System is efficient in managing its resources as compared to Rolls-Royce Holdings. This implies that BAE Systems is more efficient in using resources to produce finished products ready for sale. However, when it comes to liquidity, Roll-Royce is more liquid as compared to BAE Systems.
Due to decreased sales, BAE Systems debt has been increasing. In the year 2014, the debt capital was 90% of the total capital. However, BAE Systems still offer high dividends to its shareholders. However, the profitability of Roll-Royce has been increasing with time. As a result, the price Rolls-Royce shares has been increasing and becoming expensive as compared to BAE System shares.
Rolls-Royce also uses non-financial performance metric to evaluate the performance of the organization. Some of the key sectors of interest include quality, improvement of communication and interpersonal skills, innovation, improvement in customer relations among others. The organization uses balanced scorecard for strategic management and to assist in aligning organization goals. Therefore, the two firms are competitive enough and eligible to work on the drone technology. This is because they possess the requisite resources, and manpower.
Evaluation of Business Performance Financial Measures Recommendations
Investors often make decision whether to invest on a company after doing fundamental analysis and market analysis to determine the profitability and strength of a company. A company that is worth investing in should be profitable, efficient in converting raw materials to finished goods, have enough cash flow to handle day to day operations and finally, have a good future outlook.
Therefore, BAE Systems should find ways to improve its capital structure. The firm is financed more by debt, the firm’s debt amount to about 80% of the total capital. Therefore, BAE Systems should develop strategies to reduce the amount of debt. This can be achieved by reducing debt financing and raise capital through equity financing. The firm should use its shares to finance the business operations and reduce the amount of capital acquired through bonds, and bank loans. Similarly, it is recommended that BAE System should reduce the dividends paid to the shareholders and use a larger amount of profits in investing.
Secondly, BAE Systems should also diversify its product range, the demand for BAE Systems primary products which include military machinery. The demand for these markets has reduced in the primary market for BAE Systems that is; the United States of America and the United Kingdom. Therefore, the firm should diversify its products to minimize risks.
On the other hand, Rolls-Royce seems to be performing well. Its profitability has been improving, and this is evident from the persistent rise in share prices. However, the firm should capitalize on improving its internal efficiency to improve its operations even better. These can be achieved by cutting down costs in the cost center. Using a more flat organization structure, to speed-up business operations and finally improving in the supply chain and logistics.
However, both firms have the requisite resources and technology to be part of the team to explore future benefits of drone technology.
Evaluation of Business Performance Financial Measures References
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Appendix
Rolls-Royce Profitability Ratios
(Data retrieved from Financials.morningstar.com, 2016)
Rolls-Royce Efficiency Ratios
(Data retrieved from Financials.morningstar.com, 2016)
BAE Systems Profitability Ratios
(Data retrieved from Financials.morningstar.com, 2016)
BAE Systems Efficiency Ratios
(Data retrieved from Financials.morningstar.com, 2016)
