A REPORT ON DIAGEO PLC FINANCIAL

STATEMENT

Student Number:
Module Code: UMADFJ-15-M
Module Title: Financial Decision Making (Diageo as a Case Study)
TABLE OF CONTENTS
Section 1…………………………………………………………………………………. 2
Diageo Plc – An Introduction
Long-Term sources of Finance………………………………………………………… 2
Debt finance……………………………………………………………………………… 2
Venture Capital …………………………………………………………………………. 2
Lease ……………………………………………………………………………………. 2
Equity ……………………………………………………………………………………. 2
Weighted Average Cost of Capital ……………………………………………………. 2
Long-Term Capital Structure of Diageo Plc ………………………………………… 3
Section 2 …………………………………………………………………………………. 3
Working Capital Management …………………………………………………………. 3
Conservative Working Capital Policy …………………………………………………. 4

Aggressive Working Capital …………………………………………………………… 4

Section 3 ………………………………………………………………………………… 4
Dividend Policy ………………………………………………………………………….. 4
Section 4 …………………………………………………………………………………. 5
Profitability Ratios ………………………………………………………………………. 5
Gross Profit ratio ……………………………………….………………………………. 5
Operating Profit Ratio ………………….………………………………………………. 5
Net Profit Ratio ………………………………………………………….………………. 5
Return on Investment ……………….…………………………………………………. 6
Capital Assets Pricing Model ………………………………………….………………. 6
Porter’s Five-Forces Model ……………………………………………………………. 6
Summary …………………………………………………………………………………. 6
Appendices ………………………………………………………………………………. 7
References ………………………………………………………………………………. 12

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Section 1
Diageo Plc – An Introduction
Diageo was formed in 1997 through the merger of Grand Metropolitan and Guinness.
Diageo is a global leader in alcoholic beverage with an exceptional collection of brands
across spirits and beer. Diageo produces an outstanding collection of more than 200
brands – old and new, large and small, global and local. They have presence in more
than 180 countries around the world (Diageo Plc 2021).
Long-Term sources of Finance
Long-term sources of finance available to businesses include but are not limited to debt
finance, leasing, venture, and equity finance.
Debt finance
Companies may seek debt finance for a number of reasons such as lesser cost, easier
availability, especially when the company has little or no existing debt finance. Interest
payments are tax free (BPP Learning Media, 2016, p. 231).
If a company considers debt finance, it may want to look at the different types of debt
finance available. Mostly, banks and other facility providers offer short-term, medium-
term and long-term loans. Long-term loans take longer than medium-term and short-
term loans, say 5 years or more. Long-term loans include loan notes and bonds
(Investopedia n.d.).
Venture Capital
Venture capital is simply an investment into a private company by wealthy individuals or
institutions (sometimes called venture capital organisations). When venture capitalists
invest in a company, they usually request equity in the entity. So, venture capital is a
form of equity finance by external investors.
Lease
When a company requires a large asset but currently do not have the financial capacity
to obtain such an asset an agreement could be reached to make periodic payments
until the full amount is reached over a specified period of time, Alternatively, the
company may not want to own the asset for some reason, an agreement is reached for
the company to make payments for the asset as rent for a specified period.
Equity
This is the most popular and riskiest source of finance. Before an ordinary shareholder
is rewarded, all other obligations must be paid. The cost of equity is always higher than
the cost of debt. Unlike other finance costs, the returns on ordinary shares are not tax-
free i.e., the income tax of a company must be paid before ordinary shareholders are
rewarded. Positively, the ordinary shareholders enjoy the highest return on companies
that perform very well. Asides from ordinary shareholding, preference shares are also

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issued to investors which usually do not have as much voting rights as ordinary
shareholders.
Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) is the average of all the costs associated
with using different sources of finance by a company. In many cases, companies use a
mix of two or more of the sources of finance available. When calculating the costs of
new investments, the company may look at the different sources of finance available –
retained earnings, debt, equity – and take their average.
When an entity, which has been operating for quite a number of years, needs carry out
investments that require a lot of funds, the first place to look is internally. By Pecking
Order Theory, companies should first look at raising finance internally – their retained
earnings should preferably be utilised first. After this source has been utilised, debt is
obtained next. When this source has also been explored and utilised, the next source to
consider is equity (BPP Learning Media, 2016, p. 322). A decision made by the
management of a company to use the Pecking Order indicates strength and that the
company has been performing well over the years.
Conversely, Modigliani and Miller believe that the source of finance obtained to carry
out new projects is irrelevant to the value of a firm and that using debt finance helps
reduce the WACC as debt is generally cheaper to finance than equity. This is according
to their postulation – Static Trade-Off Theory.
Long-Term Capital Structure of Diageo Plc
Looking at Diageo’s total liabilities and total equity, one may say that the company is
operating a high level of risk with a gearing ratio of 2.79 with total debt of £23,522m and
total equity of £8,431m.
Although Diageo’s debt is almost three times its equity, showing that the financing
structure is very risky, it may not mean that the company is in poor financial condition.
To further test the level of risk in which the company operates, the number of times
interest is earned is calculated as follows:
From the income statement, the earnings before interests and taxes stand at £3,055m
(Profit before taxation [£3,706m] – Finance charges [£651m]). Diageo’s interest cover
for 2021 therefore stands at 4.69. This means that the company is making good use of
its debt to meet investors’ requirements. Diageo is also saving money by paying less tax
as opposed to if it uses more of equity financing. The risk is high, but it is good. With
these indicators, the management of Diageo Plc leans towards Static Trade-off Theory.
Section 2
Working Capital Management
The operational efficiency of a company is determined by its ability to meet its current
obligations. Financial ratios used to determine this ability are the current ratio and more
precisely, the acid test ratio. The current ratio is derived by dividing the current assets
by the current liabilities. A ratio greater than 1 means that the entity is able to meet its

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current obligations while a ration lower than 1 spells inability to pay short-term debts
(Investopedia n.d.). Conversely, when the ratio is too high, it may mean that the
company has too much loose cash which it is not reinvesting into the business.
Scholars consider the ideal working capital to be between 1.5 and 2.
Diageo’s working capital ratio sits at 1.60. This, and other ratios which have been
derived from the financial statements of Diageo for 2021 show that the management of
Diageo manages their risks and operations optimally.
To further determine the liquidity of companies, some elements of current labilities like
inventory may be removed. This metric is called the acid-test or liquid ratio.
Diageo’s acid test ratio, 0.76, reflects a more realistic view of the company’s ability to
meet its current obligations.
To determine how much time cash is tied up in Diageo’s inventory, the inventory days is
calculated. Diageo’s opening inventory and closing inventory are £5,772m and £6,045m
respectively. The average inventory for 2021 is £5,908.5m. From the annual reports, the
cost of sales is £5,038m. Diageo’s inventory days for 2021 is 428.
Inventory days is a very contextual metric. It shows the average number of days it takes
a company to sell its inventory. It took Diageo a year and a quarter to clear its inventory
in the 2021 financial year. This is a really long time. One must be careful when
interpreting this metric as the industry average should be used for comparison.
The next metric to be calculated in the working capital ratios family is the accounts
receivable days. With average accounts receivable of £2,248m and revenue per day of
£34.9m (£12,733m per year), the number of days it takes Diageo’s debtors to pay is
63.
Next, the account payable days is important in calculating the cash conversion cycle of
a company. With opening and closing accounts payable figures of £3,683m and
£4,648m (average of £4,165.5m) and cost of sales per day of £13.8m (£5,038m per
year), the number of days it takes Diageo to pay its trade creditors is 106.
The cash conversion cycle is the metric that measures the time (in number of days) it
takes a company to turn its inventory and other liquid investments into cash. It shows
how much time it takes for a company to pay its immediate debt. It is calculated as:
Diageo’s cash conversion cycle is 385. This figure is quite extreme. This shows that
Diageo is operating a Conservative Working Capital Policy. Companies might adopt
conservative working capital policies to buffer against risk. There is a lot of long-term
debt tied up in the accounting books.
In contrast, Aggressive Working Capital Policies put a lot of short-term debt to meet
operational cash requirements. A lot of money is put into production in the least possible
time and put the money back into the bank as soon as possible to turn it over for more
production (Chron, 2022).
Section 3
Dividend Policy
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In 2015, the pipeline giant, Kinder Morgan, slashed its dividend pay-out by 75%
following increasing debt load from paying about $2.00 annual dividend per share,
amidst perceived growth in rates of return which would be derived from consistently
issuing equity. The growth became unrealistic and this forced the company to cut its
annual dividend pay-out (The Value Portfolio, 2020). In 2020, Kinder Morgan paid out
$1.05 dividend per year. This confirms Modigliani and Miller’s Irrelevance Theory
which describes the growth of a company as dependent on the earning power of its
assets and investment and not on the amount of dividends paid out of earnings (BPP
Learning Media, 2016, pp. 262-263).
The previous paragraph contrasts with the traditional view of the price of a share being
dependent on both current dividends and expectations of future dividend growth, given
shareholders' expected rate of return on their investment.
Another theory, the Residual Theory supports the payment of dividends only after all
new investment opportunities have been exhausted.
CFI (2022) posits: ‘A company’s dividend policy dictates the amount of dividends paid
out by the company to its shareholders and the frequency with which the dividends are
paid out. When a company makes a profit, they need to make a decision on what to do
with it. They can either retain the profits in the company (retained earnings on the
balance sheet), or they can distribute the money to shareholders in the form of
dividends.’
The different dividend policies are described on their webpage. They outlined the
different policies used by directors of companies. They are: regular dividend policy,
stable dividend policy, irregular dividend policy and no dividend policy.
Diageo pays out regular dividends. From 2017 to 2021, the company paid 62.20 65.30,
68.57, 69.88 and 72.55 respectively.
Section 4
Profitability Ratios
The most important business metrics to investors are arguably the profitability ratios.
Profitability ratios express the actual performance of a business. These metrics are
usually calculated in ratios. For this essay, the ratios calculated are: gross profit ratio,
operating profit ratio, net profit ratio and return on investment.
Gross Profit ratio
This ratio establishes the relationship between gross profit and net revenue of an entity
– this is the metric that shows the profit a company earns from the sales of its goods
Diageo’s gross profit to net sales ratio is 60.4%. Its gross profit is £7,695m and its
Revenue is £12,733m. This performance is may not show enough for investors to make
a decision because there are other metrics that show a better position like the operating
profit ratio and net profit ratio.
Operating Profit Ratio

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Operating profit ratio defines the performance of a company with relation to its
operations before tax and other non-operating expenses and incomes.
For Diageo, the value of this metric is 29.3% Its operating profit is £3,731m. To
determine if this metric is favourable, it is good practice to compare it with the industry
average.
Net Profit Ratio
Net profit ratio compares the profit after interests and taxes of a company with its
revenue. At £2,799m Diageo’s net profit is 21.98% of its net sales. Again, to determine
if this metric is favourable, it is good practice to compare it with the industry average.
Return on Investment
Profit before interest and taxes (operating profit) from the annual reports 2021 is given
as £3,731m. The capital employed figure is computed either by adding long-term debt
and equity or by adding non-current assets and working capital (current assets – current
liabilities). With capital employed of £31,953m, Diageo’s return on investment is
11.68%.
Capital Assets Pricing Model
Investors expect to be compensated for risk and time value of money. The risk-free rate
of return represents the time value of money. The beta of an investment represents the
amount of risk an investment will add to a portfolio of various investments. The risk
premium is the amount of return expected from the market above the risk-free rate.
Generally, CAPM tells the rate to expect when making an investment in relation to the
market forces and time.
Porter’s Five-Forces Model
Porter's Five Forces model examines five forces that determine performance in every
industry and helps determine an industry's weaknesses and strengths. Five Forces
analysis is used by management of firms to identify an industry's structure to make key
decisions pertinent to individual firms in all stages of business growth.
Michael Porter (1980) postulates that:
1. threat of new entrants,
2. intensity of rivalry among existing firms,
3. threat of substitute products or services
4. bargaining power of buyers, and
5. bargaining power of suppliers.
are the forces that act on an industry. The analysis of these forces can be used to guide
business strategy to increase competitive advantage.
Summary
The metrics calculated in this report depict that Diageo Plc’ investors have a high
appetite. The gearing ratio is considered high compared to the belief of scholars that an

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optimal gearing ratio should be between 25% to 50%. Conversely, this risk is being
toned down by the efficient management of working capital which is being managed
conservatively.

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APPENDICES
Total Debt
Gearing ratio=
Total Equity
Earningsbefore Interests ∧Taxes
Interest cover=
Total Interest
Curent Assets
Current Ratio=
Current Liabilities
Total Current Assets−Inventory
Liquid Ratio=
Current Liabilities
Average inventory∗365
Inventory Days=
Cost of Sales
Opening Inventory +Closing Inventory
Average Inventory=
2
Average Accounts Receivables
Account Receivable Days=
Revenue per Day
Average Accounts Payables
Account Payable Days=
Cost of Sales per Day
❑
Cash ConversionCycle=Invento ry Days+ Receivable Days−Payable days
Gross Profit∗100
Gross Profit Ratio=
Revenue
Operating Profit∗100
Operating Profit Ratio=
Revenue
Net Profit∗100
Net Profit Ratio=
Revenue
Profit before Interest ∧Taxes∗100
Returnon Investment =
Capital Employed
Capital Assets Pricing Model (CAPM) is represented by the formula:
E Ri=R rf + βi ( E Rm −Rrf )

Where ERi = Expected Return

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REF
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Diageo Plc 2021, Diageo History, viewed 1 June 2022 <https://www.diageo.com/en/our-
business/our-history/#>
Diageo Plc 2021, Who we are, viewed 1 June 2022 <https://www.diageo.com/en/our-
business/who-we-are>
The Value Portfolio 2020, Kinder Morgan: getting burned in 2015 is 2020's opportunity.
Seeking Alpha, viewed 20 January 2022 <https://seekingalpha.com/article/4389463-
kinder-morgan-getting-burned-in-2015-is-2020s-opportunity>
CFI 2022 dividend policy: the method used by a company to pay out dividends.
Corporate Finance Institute, viewed 20 January 2022.
<https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/dividend-
policy>
Chron 2022 aggressive vs. conservative working capital. Chron, viewed 23 January
2022. <https://smallbusiness.chron.com/aggressive-vs-conservative-working-capital-
65216.html>
Michael E. Porter 1980, ‘competitive strategy: techniques for analyzing industries and
competitors’, University of Illinois at Urbana-Champaign's Academy for Entrepreneurial
Leadership Historical Research Reference in Entrepreneurship, Available at SSRN
https://ssrn.com/abstract=1496175

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