Indian Tobacco Corporation Ltd

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Information about Indian Tobacco Corporation Ltd

Published on July 15, 2009

Author: shradha29


Indian Tobacco Corporation Ltd. 1. Working Capital Analysis Vis-à-vis Hindustan Unilever Ltd. 2. Capital Structure Analysis FINANCIAL MANAGEMENT PROJECT - Shradha Diwan, Class of 2010, IBS Kolkata 1

INDEX Serial # CONTENTS Page # 1 EXECUTIVE SUMMARY 3 2 ENVIRONMENTAL ANALYSIS 4 3 COMPANY OVERVIEW : ITC Ltd 6 4 WORKING CAPITAL ANALYSIS 7 (i) Current Ratio Analysis 8 (ii) Quick Ratio Analysis 9 (iii) Inventory Days 10 (iv) Debtor Days 11 (v) Creditor Days (vi) Tracing changes in Working Capital 12 Trend 13 5 CAPITAL STRUCTURE ANALYSIS 14 (i) Capital Gearing 15 (ii) Debt-to-Equity Ratio 16 6 REFERENCES 17 2

EXECUTIVE SUMMARY: The project assigned to us was to assess the financial health of ITC ltd. by the analysis of its Working Capital requirement. Furthermore, the company’s Capital Structure was also analyzed. While studying the intricacies of the financials of the company, it became more meaningful to compare the working capital needs and financial structure of ITC ltd. with that of a corresponding high value company in the same sector. For the purpose, we chose to analyze the financial health of Hindustan Unilever Ltd. which happens to be the largest FMCG company in the country. A face-to-face analysis of the two companies gives a better insight into the financial stature of ITC ltd. in its respective sector. Through a thorough analysis of the business environment, industry, and the company, we aim to understand the external factors influencing the company and its decision making. The financial statements of the last 5 years of ITC ltd are analyzed. As a benchmark, we also analyze the various components of the company vis-à-vis Hindustan Unilever, a competitor operating in the same segment. Every business decision is associated in one way or another with the financial condition of the organization. The results of a working capital analysis will assist in the determination of the organization’s ability to remain in a particular line of business. As in all businesses, including ITC, it must be considered that there is always room for improvement. 3

ENVIRONMENTAL ANALYSIS The Indian FMCG sector is the fourth largest in the economy with a total market size in excess of US$13.1 billion. It has a strong MNC presence and is characterized by a well established distribution network, intense competition between the organized and unorganized segments and low operational cost. Availability of cheap raw materials, cheaper labor costs, and presence across the entire value chain gives India a competitive advantage. The FMCG market is set to treble from US$11.6 billion in 2003 to US$ 33.4 billion in 2015. Penetration level as well as per capita consumption in most product categories like jams, toothpaste, skin care, hair wash etc. in India is low, indicating the untapped market potential. Burgeoning Indian population, particularly the middle class and the rural segments, presents an opportunity to makers of branded products to convert consumers to branded products. Growth is also likely to come from consumer “upgrading” in the mature product categories. With 200 million people expected to shift to processed and packaged food by 2010, India needs around US$ 28 billion of investment in the food processing industry. LEVERAGING THE COST ADVANTAGE Global major, Unilever, sources a major portion of its product requirements from its Indian subsidiary. HLL. In 2003-04, Unilever outsourced around US$ 218 million of home and personal care along with food products to leverage on the cost arbitrage opportunities in the west. To take another case, Proctor and Gamble (P&G) outsourced the manufacture of Vicks Vaporub to contract manufacturers in Hyderabad, India. This enables P&G to continue exporting Vicks Vaporub to Australia, Japan, and other Asian countries, but at more competitive rates, whilst maintaining its high quality and cost efficiency. The following factors make India a competitive player in the FMCG sector: 1. Availability of raw materials 2. Low cost labor 3. Presence across value chain 4

THE TOP 10 COMPANIES IN THE INDIAN FMCG SECTOR 1. Hindustan Unilever Ltd. 2. ITC (Indian Tobacco Company) 3. Nestle India 4. GCMMF (AMUL) 5. Dabur India 6. Asian Paints (India) 7. Cadbury India 8. Britannia Industries 9. Procter & Gamble Hygiene and Health Care 10. Marico Industries ANALYSIS OF THE INDIAN FMCG SECTOR STRENGTHS WEAKNESSES 1. Low operational costs 1. Lower scope of investing in technology 2. Presence of established distribution and achieving economies of scale, networks in both urban and rural areas especially in small sectors 3. Presence of well-known brands in 2. Low exports levels FMCG sector 3. "Me-too" products, which illegally mimic the labels of the established brands. These products narrow the scope of FMCG products in rural and semi-urban market. OPPORTUNITIES THREATS 1. Untapped rural market 1. Removal of import restrictions resulting in 2. Rising income levels, i.e. increase in replacing of domestic brands purchasing power of consumers 2. Slowdown in rural demand 3. Large domestic market- a population of 3. Tax and regulatory structure over one billion. 4. Export potential 5. High consumer goods spending 5

COMPANY OVERVIEW: INDIAN TOBACCO CORPORATION (ITC) Ltd. ITC is one of India's foremost private sector companies with a market capitalization of nearly US $ 19 billion and a turnover of over US $ 5.1 Billion. ITC is rated among the World's Best Big Companies, Asia's 'Fab 50' and the World's Most Reputable Companies by Forbes magazine, among India's Most Respected Companies by BusinessWorld and among India's Most Valuable Companies by Business Today. ITC ranks among India's `10 Most Valuable (Company) Brands', in a study conducted by Brand Finance and published by the Economic Times. ITC also ranks among Asia's 50 best performing companies compiled by Business Week. Presence in diversified areas such as • Cigarettes • Hotels • Paperboards and specialty papers FMCG PRODUCTS • Packaging • Agri – business • Packaged foods and confectionary • Information technology • Branded apparel • Greeting cards • Safety matches 6

WORKING CAPITAL ANALYSIS Working capital management is concerned with making sure we have exactly the right amount of money and lines of credit available to the business at all times. Cash is the life-blood of any business, no matter how large or small. If a business has no cash and no way of getting any cash, it will have to close down. It’s that simple! Following on from this we can see that if a business has no idea of its liquidity and working capital position, it could be in serious trouble. Higher the current assets of a company and lower the current liabilities, greater is the working capital. A larger chunk of working capital can be used to fund the long term liabilities of the company and therefore, the larger the working capital, the better it is for the company. Why Working Capital analysis? Working Capital analysis of a company tells us what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. One of the main advantages of looking at the working capital position is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can’t pay its monthly bills. Working Capital = Current Assets – Current Liabilities Poor Working Capital leads to a poor credit rating of a company which in turn increases the interest charged by the banks on loans given to the company and this leads to greater cost disadvantages. Working Capital Cycle = Operating Cycle + Cash Conversion Cycle The following ratios and components of the working capital cycle of ITC ltd. will be compared vis-à-vis the similar components of Hindustan Unilever Ltd. to get a fair idea about the working capital structure of ITC ltd. 1. Current Ratio or the Working Capital Ratio 2. Quick Ratio 3. Inventory Days 4. Debtor Days 5. Creditor Days 6. Working Capital Days 7. Working Capital Trend 7

CURRENT (WORKING CAPITAL) RATIO ANALYSIS Current Ratio = Current Assets – Current Liabilities The current ratio is a measure of the firm’s short-term solvency. It is normally presented as a real ratio. It is also a measure of the “margin of safety” for the creditors. Current Ratio Trend Analysis 3 current assets / current liabilities 2.5 2 1.5 ITC ltd 1 Hindustan Unilever Ltd 0.5 0 2004 2005 2006 2007 2008 We observe that the current ratio of ITC ltd. is increasing over the 5 year period taken into consideration (2004 - 2008). The reason why the ratio increases mainly is because of a more than proportionate increase of the Current Assets when compared to the Current Liabilities. ITC has been diversifying into many areas over the past few years. Launch of new products and plans call for immediate funding requirements because of which ITC has had to maintain a considerable amount of current assets. A current ratio of 2:1 is generally considered satisfactory. A ratio < 1.5 generally signifies an illiquid state. Here, the short term solvency of ITC is much better over the years as compared to HUL. Even though HUL is a bigger player than ITC in the FMCG sector, its financial strength as depicted by the current ratio trend analysis is not very promising. However, FMCG companies normally do not have a high current ratio because of the ready and fast conversion of inventory into cash. Therefore, the other factors need to be considered before coming to any conclusion about the relative financial strength of the 2 companies. 8

QUICK (ACID TEST) RATIO ANALYSIS The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. That is, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelf that don’t sell as quickly as the supermarket would like. Similarly, there are some items that sell very well. Acid test ratio = (current assets – inventories) / current liabilities Quick Ratio Trend analysis 1.4 (current assets - inventory) / current 1.2 1 0.8 liabilities ITC Ltd 0.6 HUL ltd 0.4 0.2 0 2004 2005 2006 2007 2008 Generally, a quick ratio of 1:1 is considered a satisfactory current financial condition. The quick ratio for ITC ltd. has increased over the period of time where as that of HUL ltd. has declined continuously. This shows that ITC ltd has been stocking fewer inventories as compared to HUL ltd. An increase in quick ratio is normally considered to be a good thing because it implies a stronger liquidity position than before. ITC, with a high value of quick ratio, has to be careful because it may suffer from a shortage of funds if it has slow-paying, doubtful and long-duration outstanding debtors. On the other hand, HUL may be prospering and paying its current obligations in time if it has been turning over its inventories efficiently. This will be analyzed in the coming sections. 9

INVENTORY DAYS Inventory turnover measures how well a company converts stocks into revenues. Inventory Days = (Stocks / Cost of sales) x 365 days It measures how well a company is making use of the working capital that is invested in stock. Inventory Days 70 (stocks / cost of ssales) x 365 days 60 50 40 ITC ltd 30 HUL ltd 20 10 0 2005 2006 2007 2008 Inventory days measure the average number of days goods remain in inventory before being sold. As a measure of short term sales potential, a number above the industry norm indicates problems with sales forecasts. And a number below the norm indicates loss of sales due to the firm’s inability to fulfill demand. Here we see that the inventory days of ITC have increased over the years whereas those of HUL have decreased. The graphs indicate that HUL’s sales forecasts and hence short term sales potential is better than that of ITC. Since HUL has a higher market share compared to ITC, this trend is an expected feature. However, ITC should be careful in its sales forecasts, lest it might idle up a large amount of working capital in holding inventory. 10

DEBTOR DAYS Most businesses make a large proportion of their sales on credit. Debtor days are a measure of the average time payment takes. Increase in debtor days may be a sign that the quality of the company’s debtors is decreasing. This could mean a greater risk of default (so it does not get paid at all). It could also be an indicator that cash flow is likely to weaken or that more working capital will be required. Debtor Days = (Trade Debtors / Sales) x 365 Debtor Days 18 16 (Trade Debtors / Sales) x 365 14 12 10 ITC ltd 8 HUL ltd 6 4 2 0 2005 2006 2007 2008 Generally, lower debtor number days are better. Here we see that the ITC’s debtor quality is good and has remained so over the past years. Increased cash based sales Efficient collection of receivables On the other hand, HUL has succeeded in maintaining its quality of debtors as per the existing standards in the industry (considering that ITC and HUL define the parameters). It should be noted that HUL may be in a stronger position as it specializes in credit selling to its customers which is one of the reasons why it has the largest market share. ITC, though with a considerably strict credit policy, can still work harder to improve on its quality of debtors. Investors should be aware of why changes in debtor days are happening, especially if there is a very large increase or a clear long term increasing trend. It may reflect a change in how the business operates, or its environment. This is not necessarily bad, but it can be an indication of a potentially serious problem. 11

CREDITOR DAYS Creditor days are the average time a company takes to pay to its creditors. Creditor Days = (Trade Creditors / Annual Purchases) x 365 Creditor Days 500 (Trade Creditors / Annual Purchases) x 450 400 350 300 250 ITC ltd 365 200 HUL ltd 150 100 50 0 2005 2006 2007 2008 ITC’s creditor days has decreased significantly over time. This indicates a strong financial position of ITC. It indicates that ITC’s working capital has been utilized efficiently to manage its short term liabilities. However, HUL’s creditor days have been increasing over the years. Lengthening creditor days may mean that the company is heading for financial problems as it is failing to pay creditors. On the other hand, it may also mean that HUL is simply getting better at getting good credit terms out of its suppliers (improving its working capital management), or that its pattern of purchasing has changed. In either of the situations, it may be said that both ITC and HUL have been managing their working capital well. This also explains the increasing trend in the current ratio of ITC and the decreasing trend in case of HUL. It indicates that ITC has been maintaining a good amount of current assets and this has added to its credit rating. HUL is keeping it low so that it can take advantage of its suppliers’ credit and invest its working capital. 12

TRACING CHANGES IN WORKING CAPITAL TREND Working Capital Trend 12000 10000 Current Assets - Current Liabilities 8000 6000 4000 ITC ltd 2000 HUL ltd 0 -2000 2004 2005 2006 2007 2008 -4000 -6000 -8000 From the trend observed above it is clear that ITC ltd. has maintained a continuous growth in its working capital. On the other hand, HUL ltd. has been on a decline with respect to the amount of working capital held by the company. There may be many reasons for this and a decreasing trend in case of HUL may not necessarily indicate a very unstable financial position of the company. ITC has been diversifying into various areas of FMCG goods. Continuous production and launch of new products require ITC to maintain a high net working capital to keep up with its liquidity requirements. ITC has been launching various products of late and continuous advertising and promotional expenditure entails a huge amount of working capital. HUL ltd. has witnessed a continuous decline. This does not mean that HUL is not managing its working capital efficiently. It is noteworthy that HUL is able to meet its creditors’ payment on time and has constantly maintained a declining number of creditor days. Therefore, it might be leveraging the advantages conferred upon it by the creditors, indicating that it enjoys a liberal credit policy of its suppliers. ITC’s financial position is strong and it will continue to be so as long as the working capital needs and availability keep pace with the diversification of the company. 13

CAPITAL STRUCTURE ANALYSIS OF ITC Ltd. Capital Structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm’s capital structure is then the composition or structure of its liabilities. The firm’s ratio of debt to total financing is referred to as the firm’s leverage. FMCG companies are mostly dependent on equity financing. Long term debts form a very insignificant portion of their total financing. As a result, FMCG companies are low geared companies. The capital Structure of ITC ltd can be analyzed using the following 2 important aspects: 1. Capital Gearing 2. Debt-to-Equity Ratio 14

CAPITAL GEARING Capital gearing ratio is mainly used to analyze the capital structure of a company. Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds Low Geared-------High Equity Share Capital (as in the case of FMCG companies) Capital gearing ratio is important to the company and the prospective investors. It must be carefully planned as it affects the company’s capacity to maintain a uniform dividend policy during difficult trading periods. It reveals the sustainability of the company’s capital . The Capital Gearing trend of ITC ltd can be understood with the help of the following graphical illustration: Owners’ fund as a percentage of total source: 8 7 6 5 Owner's Fund 4 Outsiders' Fund 3 2 1 0 2004 2005 2006 2007 2008 Owners’ fund comprises of equity capital as the major portion. Rather, it can be assumed to be the only source of owners’ capital. The outsiders’ fund has been very insignificant over the considered length of time, thereby showing that ITC ltd. is a low geared company. With respect to the current economic and financial scenario, companies which are dependent for expansion on borrowed capital are going to be I some kind of a trouble for the next 1 year or so. Highly geared companies are unattractive for inventors because the company may have difficulty in paying the interest due on its borrowings if their operations fail to generate enough cash. “Low Geared” companies are attractive for the opposite reason. Thus, ITC’s capital structure is attractive and strong both for the company and its owners. 15

DEBT-to-EQUITY RATIO Debt-to-Equity ratio indicates the relationship between the external equities or outsiders’ funds and the internal equities or shareholders’ funds. It is also known as external-internal equity ratio. It is determined to ascertain the long term financial policies of the company. Debt Equity Ratio = Internal Equities / External Equities = Outsiders’ Funds / Shareholders’ Funds = Total Long-term Debts / Total Long-term Funds ITC’s debt-to-equity ratio: Year 2008 2007 2006 2005 2004 Long term .01 .01 .01 .01 .01 debt / equity The ratio indicates the proportionate claims of owners and the outsiders against the firm’s assets. The purpose is to get an idea about the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do business with maximum of outsiders’ funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsiders (creditors) on the other hand, want that shareholders should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be a satisfactory ratio. Theoretically, if the owners’ interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position, it enjoys the same position as the current ratio in the analysis of short-term financing. ITC has maintained a constant debt-to-equity ratio of .01 over the past 5 years. This is a clear indication of ITC’s heavy reliance on equity capital as a source of finance. In the present financial scenario, companies with a high debt-equity ratio are likely to witness a period of high interest costs. Therefore, it makes more sense for investors to look for companies with low debt-equity ratio. ITC ltd is highly solvent and with a very strong capital structure in the present financial situation. Though debt capital financing is preferred by companies since it involves less risk and comes with the bonus of a tax shield, the present scenario dictates that companies with low debt financing are definitely at the summit. 16

REFERENCES WEBPAGES: did=ITC TEXTS: Financial Management (ninth edition) – I. M. Pandey Principles of Corporate Finance – Brealey and Myers 17

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