Financial Analysis
FINANCIAL ANALYSIS 2
Executive Summary
Before investing in any organization, it is imperative to look at the company’s financial 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.
FINANCIAL ANALYSIS 3
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
Inventory Turnover 10
Liquidity Ratios 10
Current Ratio 10
Acid Test Ratio 10
Cash Statements 11
Gearing Ratios 11
Financial Leverage 11
Horizontal analysis 11
Vertical Analysis 12
Rolls-Royce Vertical Analysis 13
Comparative Analysis 13
Evaluation of Business Performance using Non-financial Measures 14
How business success is measured in Rolls-Royce 14
Organization Structure 15
FINANCIAL ANALYSIS 4
Performance Evaluation 15
Responsibility Centers and performance evaluation 17
Conclusion 18
Recommendations 19
Appendix 23
Rolls-Royce Profitability Ratios 23
Rolls-Royce Efficiency Ratios 23
BAE Systems Profitability Ratios 24
FINANCIAL ANALYSIS 5
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
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.
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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 PLC
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
FINANCIAL ANALYSIS 7
Profitability Ratios
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
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
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.
FINANCIAL ANALYSIS 8
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 assets
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 Ratio
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.
FINANCIAL ANALYSIS 9
This indicates that BAE Systems is more efficient in collecting credit sales from customers
compared to Rolls-Royce.
Inventory Holding Period
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.
Accounts Payables Periods
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.
Fixed Asset Turnover Ratio
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.
Inventory Turnover
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.
FINANCIAL ANALYSIS 10
Liquidity Ratios
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.
Current 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
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 Statements
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.
FINANCIAL ANALYSIS 11
Gearing Ratios
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.
Financial Leverage
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.
Horizontal analysis
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
FINANCIAL ANALYSIS 12
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.
Vertical Analysis
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.
Rolls-Royce Vertical Analysis
FINANCIAL ANALYSIS 13
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.
Comparative Analysis
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
FINANCIAL ANALYSIS 14
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.
Organization Structure
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.
FINANCIAL ANALYSIS 15
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
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
FINANCIAL ANALYSIS 16
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
FINANCIAL ANALYSIS 17
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.
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
FINANCIAL ANALYSIS 18
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
FINANCIAL ANALYSIS 19
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.
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.
FINANCIAL ANALYSIS 20
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.
FINANCIAL ANALYSIS 21
References
Müller, J. (2014). Rolls-Royce plc. A Company’s Valuation on the Basis of 2013’s and Historic
Financial Reports and Figures.
Schmeisser, W., Mohnkopf, H., Hartmann, M., & Metze, G. (2014).Innovation Performance
Accounting. Springer.
Gopalakrishnan, K., Yusuf, Y. Y., Musa, A., Abubakar, T., & Ambursa, H. M. (2012).
Sustainable supply chain management: A case study of British Aerospace (BAe)
Systems. International Journal of Production Economics,140(1), 193-203.
BAE Systems: Annual Report 2014. (2014).
