A report evaluating and reviewing the financial and non-financial Business performance of BAE Systems Plc.

and its competitor Rolls Royce Plc.

NAME STUDENT NUMBER COURSE MODULE TITLE DATE MODULE TUTOR WORD COUNT

: KUTAY OKTAY : 77129140 : MA INTERNATIONAL BUSINESS : MANAGING FINANCIAL RESOURCES : 14th DECEMBER, 2012 : PAUL SMITH : 3,053

Executive summary BAE Systems is one of the biggest defence companies in the world. The company has taken its new name as BAE Systems after merged with GECs Marconi Electronic Systems in November 1999. After these businesses merged, new company became the largest arms dealer in the world. BAE Systems focuses on the three main business areas as defence, aerospace and security. The company continues to their operations all around the globe with approximately 87000 employees worldwide and is managed in London, the UK. It is a global company with operating subsidiaries in the United States, Australia, the United Kingdom, Oman, Singapore, Poland, Sweden, Canada, Germany, South Africa, Puerto Rico, New Zealand, Brazil, Malaysia, Israel, France, Saudi Arabia, Hong Kong, Panama, Venezuela, Nigeria, Brunei Darussalam, Italy, Mexico, Honduras, Barbados, India, the Netherlands, and Colombia (FAME, 2012a). Boeing, Lockheed Martin (US based) and EADS (EU Based) are the biggest rivals for BAE in these industries. Otherwise considering the UK, Rolls Royce can be comparable with BAE Systems in the defence industry. Thus for purpose of this report, Rolls Royce will be used as a second company for the comparison. There are some financial highlights of BAE Systems according to 2011 as follows: - Sales (excluding intra-group sales) down 14% to 19.1bn - Underlying EBITA (excluding HQ) down 8% to 2.02bn - Slightly decrease on operating profit down 1% to 1.580bn - Dividends per share increased by 7.4% to 18.8p - Gained 5.9p per share from an agreement between BAE and UK Tax Government - Earnings per share up 14% to 45.6p including R&D tax benefit (agreement) - 0.8bn debt financing succeeded

Table of Contents

Introduction ............................................................................................................................................ 5 Financial accounting principles and concepts and their importance in considering business performance .......................................................................................................................................... 5 Accounting Policies of BAE Systems ................................................................................................ 6 Critical Accounting Concepts of BAE System effecting to business performance ..................... 6 Ratio Analysis of BAE Systems .......................................................................................................... 7 Profitability Ratios ............................................................................................................................. 7 Return on capital employed ........................................................................................................ 7 Operating profit margin ratio ....................................................................................................... 8 Return on shareholders funds ratio........................................................................................... 8 Efficiency Ratios ............................................................................................................................... 9 Inventories turnover period ......................................................................................................... 9 Receivables turnover period ..................................................................................................... 10 Payables turnover period........................................................................................................... 10 Liquidity Ratios ................................................................................................................................ 11 Current Ratio ............................................................................................................................... 11 Financial Gearing ............................................................................................................................ 11 Gearing Ratio .............................................................................................................................. 11 Global defence market position of BAE Systems .......................................................................... 12 Home Markets of BAE Systems ................................................................................................... 12 Financial Performance Comparison of BAE Systems and Rolls Royce .................................... 13 ROCE ............................................................................................................................................... 13 ROSF ................................................................................................................................................ 14 Current Ratio ................................................................................................................................... 15 Gearing Ratio .................................................................................................................................. 16 Limitations of ratio analysis ............................................................................................................... 17 External factors ............................................................................................................................... 17 Internal factors................................................................................................................................. 17 Issues when using consolidated accounts.................................................................................. 17

The importance of cost and management accounting in terms of business performance ...... 18 Corporate Responsibility Review ..................................................................................................... 18 Conclusion ........................................................................................................................................... 18 Bibliography ......................................................................................................................................... 19

Introduction

The main focus of this report is to explain the financial and non-financial results of BAE Systems. While doing this, second company Rolls Royce will be used for comparative purposes as and when appropriate. The main target of BAE is to be the premier global defence, aerospace and security group. The group delivers through its wholly-owned subsidiaries and equity accounted investments, a full range of systems and services for air, land and naval forces, as well as advanced electronics, security, information technology solutions (FAME, 2012a). The key strategic actions of BAE Systems are; - To deliver sustainable growth in shareholder value - To drive shareholder value by improving financial performance and competitive positions across the business - To increase international business - To improve profit and cash generation - To focus on improving customer satisfaction Financial accounting principles and concepts and their importance in considering business performance

Financial reports provide information about the financial position of a reporting entity, the effects of transactions and other events that change a reporting entitys economic resources and claims. This information is useful in making economic decision about future and about how an entity has managed its resources and the claims on those resources in the past. The International Accounting Standards (IAS) requires from companies to present their financial information comprising of three main financial statements: 1. Balance sheet (A statement of financial situation) 2. Profit and loss account ( The statement of comprehensive income ) 3. Cash flow statement Balance sheet gives us information about companys financial position and shows that how company manages its liquidity and its solvency. The statement of comprehensive income measures the profitability performance of company. Information about changes in financial position of an entity is useful to help assess

the operating, investing and financing activities of the period. It is generally mentioned in a statement of cash-flows (Weetman, 2011). These statements will help us to understand deeply the performance of BAE Systems and will give us a chance to have a comparison with Rolls Royce. In addition, this financial information allows stakeholder to understand general position of the company in stock exchange. Accounting Policies of BAE Systems

Firm procedure wants the managers to settle the group and parent company financial statements for each financial year. Under that law they are required to prepare the group financial statements in according to International Financial Reporting Standards (IFRSs) as accepted by the European Union and applicable law, and have elected to prepare the parent organization financial statements in according to UK accounting standards and convenient law (UK Generally Accepted Accounting Practice). The directors are liable for keeping suitable accounting records that are admissible to show and explain the parent companys transactions, and make public with reasonable accuracy at any time the financial position of the parent company and allow them to guarantee that its financial statements cooperate with the Companies Act 2006 (BAE Systems Plc. 2011, pp. 54 ). Critical Accounting Concepts of BAE System effecting to business performance

The preparation of the financial statements in congruity with IFRS depends upon the use of clear crucial accounting measurements and judgements. The company is immune under the limitations of FRS 1, cash flow statements, from the requirement to publish its own cash flow statement, as its cash flows are included within the consolidated cash flow statement of the group. The critical accounting policies of the group are listed as follows: - Recognition of profit on long-term contracts (IAS 11, Construction Contracts) Revenue on long-term contracts is recognised in the groups income statement when performance stages have been finished. Revenue and cost estimates are considered and updated at least quarterly, and more frequently as determined by events or circumstances. The meaningful proportion revenue of the groups 17.8bn was accounted for under IAS 11 in 2011.

-Valuation of retirement benefit obligations for defined benefit pension schemes (IAS 19, Employee Benefits) The retirement benefit obligation recognised in the groups balance sheet represents the present value of the defined benefit obligations as adjusted for unrecognised past service cost and as reduced by the fair value of scheme assets. The groups share of the IAS 19 pension loss was 4.6bn, excluding numbers distributed to equity accounted investments and other participating employers on 31st of December in 2011. -Valuation of acquired intangible assets (IFRS 3, Business Combinations) and ongoing impairment testing (IAS 36, Impairment of Assets) Earned intangible assets without goodwill are valued in parallel with global used models, which require the use of predictions that may be different from existing outcomes. These intangible assets are depreciated at their guessed beneficial lives. Amortisation periods impact to future results and if there are some differences between predicted and real circumstances related to individual intangible assets. Goodwill is not depreciated, but is tested yearly for impairment and carried at cost less accumulated impairment losses. The impairment review calculations need the use of estimates related to the future profitability and cash-generating capability of the acquired businesses. The group recognised intangible assets totalling 561m in respect of acquisitions made during 2011, including 291m of goodwill. Total intangible assets were 11.5bn, including 10.7bn of goodwill at the end of 2011. Ratio Analysis of BAE Systems Profitability Ratios Return on capital employed The Return on capital employed (ROCE) ratio is generally used by companies for evidence of profitability. This ratio measures the amount of operating profit possible to cover reserves, share capital and non-current liabilities. BAE Systems Plc.s ROCE ratio for last 5 years
2007 11,54% 2008 15,93% 2009 2,15% 2010 11,67% 2011 11,43%

The ROCE ratio for company decreased sharply to 2,15% at the end of 2009.The main reasons of this result are huge amortisation and impairment of intangible assets and regulatory penalties of company. BAE Systems was alleged to have paid bribes to win overseas contracts, including the sale of Tornado jets to Saudi Arabia.

Company has paid 278m for regulatory penalties and spent 1259m for depreciation while group had spent 303m for amortisation in 2008. Operating profit margin ratio The operating profit margin is the most popular way to show the companies operational performance. However, this ratio must not seem as a certain indicator of the operational performance because it changes in different business areas. For example, luxury cars are sold less than cheap cars. Thus they bring huge operating profit and small sales volume. BAE Systems Plc.s Operating Profit Margin for past 5 years
2007 8,23% 2008 10,31% 2009 4,82% 2010 7,13% 2011 8,89%

Operating profit margin increased from 8,23% to 10,31% because rising of other total income and interest received from 1257m in 2007 to 3380m in 2008.Then there was a significant fall in 2009 due to 33% increase in administration expenses and 207% increase in net interest. Another interesting point is that when ROCE ratio was slightly decreasing from 11,67% to 11,43%, operating profit margin increased from 7,13% to 8,89% between 2010 and 2011.It was due to 17% decrease in administration expenses in 2011 despite 16% decrease in sales revenue in the same period. Return on shareholders funds ratio The return on shareholders funds (ROSF) ratio is a measure of the profit for the period that is available to the ordinary shareholders with the ordinary sha reholders stake in a business. This ratio is the indicator for investors who may invest to the company. If company has a high percentage of ROSF, it means that company is more profitable. BAE Systems Plc.s ROSF ratio for last 5 years
2007 20,70% 2008 32,77% 2009 6,05% 2010 27,08% 2011 34,57%

There is a significant increase in ROSF ratio by 60% between 2007 and 2008 because of high amount of interest received in 2008.The reason of sharp fall between 2008 and 2009 is that group had to pay huge numbers of amortisation costs and other interest paid. In addition, BAE was fined 256million by the U.S. department of justice after pleading guilty to conspiring to make false statements to its government (Dailymail, 2010).

By comparing 2010 against 2009, there was less impairment and interest payments while revenues were approximately the same. Thus ratio increased from 6,05% to 27,08% in 2010 compared to 2009.Between 2010 and 2011, ratio increased by 27,66% because of 20,83% reduction in the total reserves. When we have looked the evolution of the stock market prices, outlined below, we can easily recognise that ROSF ratio and prices are going parallel by the years. Especially decreasing of ROSF ratio between 2008 and 2009 affected market prices negatively.

Evolution of Stock Market Prices between 2005 and 2012 (FAME, 2012a) Efficiency Ratios Inventories turnover period Inventories turnover period is an efficiency ratio which shows frequencies of stock changes. And a company prefers short time turnover for inventories because holdings stocks have a cost for companies. BAE Systems Plc.s inventories turnover days
2007 74,50 2008 65,70 2009 83,84 2010 119,57 2011 90,59

There is a negative trend between 2008 and 2010 in inventory turnover periods despite the positive situation from 2007 to 2008 because when cost of sales was increasing, it reflected negatively to turnover period and when cost of sales was decreasing, inventories turnover period was becoming lower and reducing stock costs. Receivables turnover period Receivables turnover period shows that how often company collects money from its customers. So it will be a good benefit for company if customers pay money to company more frequently. BAE Systems Plc.s receivables turnover days
2007 55,91 2008 64,41 2009 54,23 2010 47,35 2011 53,82

Despite the increasing from 2007 to 2008, group was successful on risk and credit management those receivables turnover days had been falling from 64,41 days in 2008 to 47,35 days at the end of 2010.After that there is a slightly increase from 47,35 days in 2010 to 53,82 days in 2011. Payables turnover period Payables turnover period could be analysed by two different ways. Firstly, if the company make payments in short days to suppliers, it will be a good prestige for company. On the other hand, if there is a chance for company to delay its payments and put these payments into long terms, company are not going to face with cash problems. BAE Systems Plc.s payables turnover days
2007 23,29 2008 21,98 2009 19,04 2010 19,27 2011 19,84

BAE Systems Plc. is a global company so directors of company have to protect groups goodwill against competitors and should show this discipline to their suppliers. Between 2007 and 2009, turnover days were deducted by 4 days. After 2009, there were some slight increases from 19,04 days to 19,84 days in 2011.

Liquidity Ratios Current Ratio Most researchers agree that optimum current ratio for business is 2 (2 times or 2:1) but different types of business have current ratios under the 2:1 and it does not mean that their business go for a bankrupt. Manufacturing companies have to keep more raw materials in the stocks and they sell products on credit, because of this increasing possible on trade receivables that causes high ratio. On the other hand, supermarkets do not need to keep all things in stock and most of their sales are made for cash that causes low ratio. BAE Systems Plc.s current ratio for past 5 years
2007 0,74 2008 0,75 2009 0,73 2010 0,65 2011 0,62

Between 2007 and 2009, current ratio hasnt changed so much and stayed stable. However there is a 10% fall from 2009 to 2010 because of decreasing current assets from 8788m to 7616m. When we look for 2010 and 2011, this trend continues from 65% to 62% in terms of declining current assets from 7616m to 6381m while liabilities reduced from 11658m to 10275m. Financial Gearing As Atrill and McLaney so eloquently phrased it, Financial gearing occurs when a business is financed, at least in part, by borrowing instead of by finance provided by the owners as equity (2008, p. 204). Gearing Ratio BAE Systems Plc.s gearing ratio for past 5 years
2007 84,46% 2008 128,56% 2009 197,89% 2010 149,29% 2011 214,71%

The gearing ratio measures the contribution of long-term liabilities to the long-term capital structure of a business. There was a straight increasing on gearing ratio between 2007 and 2012 despite a 24% fall from 197,89% to 149,29% in 2010.High gearing ratio means that company operates its activities by long term borrowings. In addition, highly geared business is risky for shareholders because a small reduction

in operating profit will cause much more negative change in the returns to shareholders. Global defence market position of BAE Systems

In 2010, BAE Systems was second the second largest global defence supplier. This presented sustainability of the groups strong position in its global and domestic markets overall. On the other hand Rolls Royce, competitor of BAE Systems, needs to improve its revenue for challenging its rivals.

45 40 35 30 25 20 15 10 5 0

Defence Revenue in 2010 ($Bn)

Top ten global defence companies (Source:Defence News)

Home Markets of BAE Systems BAE Systems is a major supplier to the US Department of Defence, offering a balanced portfolio of products and services across defence and security domains, including the operational support of equipment used around the world by US forces and their allies. Also the group plays an important role in the UKs defence capabilities across air, maritime and land platforms, including military and technical service contracts. BAE Systems is a leading in-country defence supplier, supporting the operational capability of the Saudi air, land and naval forces, and investing in the development of Saudi indigenous defence capabilities. In addition, India continues to develop as a home market. BAE Systems is investing in its presence through technology sharing and inward investment in this growing defence and security market (BAE Systems Plc. 2011, pp.15).

Financial Performance Comparison of BAE Systems and Rolls Royce

Graph 1 ROCE
40 30 20 ROCE (%) 10 0 2007 -10 -20 -30 -40 Return on Capital Employed between 2007-2011 2008 2009 2010 2011 ROLLS ROYCE BAE

2007 BAE 11,54% ROLLS ROYCE 12,27%

2008 15,93% -28,32%

2009 2,1% 31,45%

2010 11,67% 7,9%

2011 11,43% 11,44%

(FAME, 2012a,b)

Graph 1 clearly indicates that one of the two companies achieved better results in every year. BAE Systems performed more stable than Rolls Royce in five years period. Thus Rolls Royce results has been seemed unexpected during the 5 years. This occurred risk for stakeholders.

Graph 2 ROSF

100 80 60 40 ROSF (%) 20 0 -20 -40 -60 -80 -100 Return on shareholders funds between 2007-2011 2007 2008 2009 2010 2011 ROLLS ROYCE BAE

BAE ROLLS ROYCE

2007 2008 20,7% 32,77% 24,51% -80,21%

2009 6,05% 76,53%

2010 27,08% 18,42%

2011 34,57% 23,65%

(FAME, 2012a,b)

BAE Systems generated considerable return to their shareholders balanced while Rolls Royce had shown changes in every year. Thus investing Rolls Royce is more risky for shareholders than investing BAE Systems. On the other hand, an investor, who can make good future predictions, will have a chance to gain more returns from Rolls Royce.

Graph 3 Current Ratio

1.6 1.4 Current Ratio (%) 1.2 1 0.8 0.6 0.4 0.2 0 2007 2008 2009 Years 2010 2011 BAE ROLLS ROYCE

BAE ROLLS ROYCE

2007 0,74% 1,41%

2008 0,75% 1,10%

2009 0,73% 1,55%

2010 0,65% 1,34%

2011 0,62% 1,22%

(FAME, 2012a,b)

Based on the above, Rolls Royces results were much better than BAE. It means that Rolls Royce managed their current assets and liabilities effectively. The reason why BAE Systems results were going down is increasing long-term liabilities continuously.

Graph 4 Gearing Ratio

250 200 Gearing Ratio (%) 150 BAE 100 50 0 2007 2008 2009 Years 2010 2011 ROLLS ROYCE

BAE ROLLS ROYCE

2007 2008 2009 2010 2011 84,46% 128,56% 197,89% 149,29% 214,71% 122,46% 207,01% 146,58% 163,61% 114,84%

(FAME, 2012a,b)

Both of the companies gearing ratios were seen high but there was reflection difference that sharp changes in Rolls Royce affected their investors as high financial risk. Because when we have looked graph 2, there were significant changes on ROSF in related to gearing ratio of Rolls Royce. Despite the high gearing ratio of BAE, the group showed good performance for its shareholders and investors.

Limitations of ratio analysis

Ratios are necessary indicators but there may be limitations that shareholders and managers have to bear in mind relating to external factors, internal factors and issues specific to consolidated accounts. They are a beginning point for further investigations and should be used together with other analytical techniques. Ratios give information about one company but on the other hand international, national and industrial statistics and projections, trade association reports are necessary resources for giving the true picture of whole companys present position and its future. External factors -Ratios need to be illustrated bearing in mind the political framework within which a company has been operating as, for instance, when governments change the measurements protectively that can affect on the sales of company.(Elliot and Elliot, 2012) -Sudden economic changes such a global crisis could impact on: -non-current assets, e.g. tax incentives to invest; -inflated prices of raw materials that causes increasing costs -costs affecting the profit before tax because of increasing bad debts and interest rate Internal factors -Ratios might be distorted because they are based on period-end figures: -when a business is seasonal, ending year figures are stable and might be an unfair reflection to ratios -On the impairment review of intangible and tangible non-current assets Issues when using consolidated accounts -The consolidated statement of financial situation aggregates the assets and liabilities of the parent company and its subsidiaries. So consolidated accounts are prepared for the stakeholders of the parent company and that they may be irrelevant to the needs of creditors. Because creditors need to seek payment from the individual group company to which it allowed the credit. -Consolidated profit and loss account does not give a clear view of profits available for distribution by the holding company to its shareholders.

The importance of cost and management accounting in terms of business performance

The challenges of the competitive environment should cause companies to reexamine their traditional cost accounting and management control systems. Despite the significant change in the nature of organizations and differentiation of competition, there has been little improvement in the style and implementation of cost accounting and management control systems. Thus it is necessary to understand the sources of todays practices reflect on the new demands for planning and control information and develop a research strategy to meet these demands (Kaplan, 1984). Management accounting is a supporting element for BAE Systems by collecting and processing information that helps planning, controlling and budgeting strategies of company. Corporate Responsibility Review

Creating a successful and sustainable business requires more than financial results. The group places great importance not just on what we do, but how we do it. Responsible business is embedded within the groups strategy. The Corporate Responsibility (CR) objectives support the group in progressing towards recognised leading positions in ethics and safety. The group also has programmes in place to progress diversity and inclusion, and environmental sustainability (BAE Systems Plc. 2011, pp.55) Conclusion Dick Oliver, chief executive of BAE, said that In the current challenging business environment, the group continues to take the actions the board believes are necessary to remain competitive and to deliver value for shareholders. In addition to its well established positions on priority programmes, providing key capabilities to support the needs of defence and security customers, the group has strong positions in electronic systems and cyber security, together with significant international presence. These strengths provide a good base of activity which, with a continued focus on cost, is expected to result in a resilient business performance (BAE Systems Plc. 2011, pp.9).

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