Week 8-Financial Analysis-S2 2015

Seminar 8Financial Analysis

Analysis Implementation

Dr. Chen Chen

Email: [email protected]

Presentation title 1

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Valuation Flow Chart

Presentation title

Accounting analysis ValuationFinancial Analysis

ForecastAccounting analysis

Corporate governance analysis

Economic analysisBusiness strategy analysisIndustry analysis

Financial analysis

Valuation

Business and Industry analysis

3

Financial Analysis

Presentation title

Financial analysis includes:

– Ratio analysis– Cash flow analysis

Value of a firm is determined by (1) profitability and (2) growth.

Financial analysis of past years provides a benchmark for forecasting growth and profitability.

• Hence the importance of historical data (financial statements) and the reliability of these statements for forecasting purposes.

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Financial Analysis

– Ratio analysis – to assess how various line items in financial statements relate to each other and to measure relative performance

– Cash flow analysis – to evaluate liquidity and the management of operating, investing, and financing activities as they relate to cash flow

5Presentation title

Financial Analysis

Profitability and growth are influenced by a firm’s:

1. Product market strategies which are implemented via:

- Competitive strategy

- Operating policies

- Investment decisions

2. Financial market strategies which are implemented via:

- Financing policies

- Dividend policies

6Presentation title

Financial Analysis

Hence, the following decisions can influence profitability and growth of a company:

– Operating management decisions

– Investment management decisions

– Financing strategy decisions

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Drivers of an Organization’s Profitability and Growth

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Ratio Analysis

• Evaluating ratios requires comparison against some benchmark. Such benchmarks include:

– Ratios over time from prior periods (time series)– Ratios of other firms in the industry (cross-sectional)– Some absolute benchmark (e.g., industry norm)– Common size analysis (common size statements)

• Effective ratio analysis must attempt to relate underlying business factors to the financial numbers

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Time-series Analysis

• Time-series analysis refers to the analysis of one ratio (e.g.ROE) for one firm, over time.

– Forecasting future profitability

• The model can take the following form:

ROEi,t+1 = α + βROEi,t + eit

• The estimate of the coefficient β will indicate the persistence of ROE over a time period.

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Limitation of time-series analysis

– The problem with this type of analysis is that it might include the effects of structural or economic changes

– However, the mean reverting property of ROE or the random walk property of earnings are important factors to be considered in forecasting

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Limitation of time-series analysis

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Cross-sectional Analysis

Cross-sectional analysis refers to the analysis of a ratio (e.g.ROE) in one period for all firms, preferably from the same industry

Overcomes some of the problems associated with time-series analysis

Enables comparison of the ratio of the company with the industry average

– For example, in terms of profitability, want company-specific ratio to exceed industry average

If not publicly available, you must calculate the industry norm

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Categories of Financial Ratios (Key Performance Indicators-KPIs)

Profitability ratios

Asset management ratios

Debt and safety ratios

Cash flow ratios

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Profitability Analysis

There are different types of profitability ratios

Important profitability ratios are:

– ROE = NPAT before abnormal / (shareholders equity - outside equity interests).

– ROA = [Net Income + Interest Expense*(1-Corporate Tax Rate)]/[Total Assets - Outside Equity Interests].

– EBITDA margin = EBITDA / operating revenue.

– Net profit margin = NPAT before abnormal / operating revenue

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ROE Characteristics

• ROE indicates how much return you have generated using the equity capital invested by shareholders in your company

• Evidence exists that, on average, long run ROE is between 11-13% (for large Australian firms)

– That is, firms with larger or smaller ROE will overtime tend to revert to the range of 11-13%

• “Mean-reverting”

• What would be the forecast of ROE for the next 5 years of a company that experienced 5 years (historical data) of high (say, 30%) ROE?

– Theoretically, ROE must revert to the mean within the forecast period

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ROE-Mean Reversion

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ROE-Mean Reversion

ASX Code Company Name Industry

EBIT Margin

EBITDA Margin ROE ROA

NOPLAT Margin

Financial Leverage

Price/Book Value

ANZAustralia & New Zealand Banking Group Ltd Bank -- -- 14.74% 0.95% -- -- 1.78

CBACommonwealth Bank of Australia Bank -- -- 16.91% 0.92% -- -- 2.14

NAB National Australia Bank Limited Bank -- -- 11.76% 0.67% -- -- 1.39

WBC Westpac Banking Corporation Bank -- -- 15.42% 0.95% -- -- 1.82

BHP BHP Billiton Limited Iron ore/coal mining 37.44% 46.43% 25.70% 14.70% 24.84% 180.12% 3.64

FMG Fortescue Metals Group Ltd Iron ore mining 34.67% 39.35% 51.57% 19.56% 33.51% 359.16% 7.39

MCC Macarthur Coal Limited Coal Mining 25.98% 26.02% 11.29% 8.68% 18.79% 138.85% 2.73

RIO Rio Tinto Limited Iron ore/coal mining 37.00% 37.52% 24.04% 13.81% 27.75% 172.20% 2.61

CGJ Coles Group Limited Grocery retail 3.25% 4.81% 19.53% 8.83% 2.51% 248.83% 4.45

MTS Metcash Limited Grocery wholesale 3.54% 3.94% 18.58% 8.24% 2.66% 264.16% 2.26

TRS The Reject Shop Limited Discount warehouse 6.95% 8.81% 45.30% 18.14% 5.15% 259.83% 7.91WOW Woolworths Limited Grocery/household retail 5.96% 7.50% 26.69% 11.99% 4.44% 236.48% 4.26

ROE-Comparisons of large Australian Firms

19Presentation title

ROE-BP

Dec 31, 2014 Dec 31, 2013 Dec 31, 2012 Dec 31, 2011 Dec 31, 2010

Selected Financial Data (USD $ in millions)

Profit (loss) for the year attributable to BP shareholders

3,780 23,451 11,582 25,700 (3,719)

Total BP shareholders' equity

111,441 129,302 118,414 111,465 94,987

Ratio

ROE1 3.39% 18.14% 9.78% 23.06% -3.92%

Benchmarks

ROE, Competitors

Chevron Corp. 12.41% 14.37% 19.18% 22.16% 18.10%

ConocoPhillips 13.23% 17.58% 17.56% 19.07% 16.57%

Exxon Mobil Corp. 18.65% 18.72% 27.06% 26.59% 20.74%

Royal Dutch Shell PLC

8.65% 9.09% 14.11% 18.24% 13.60%

ROE, Sector

Integrated Oil & Gas 11.63% 15.04% 17.90% 22.03% 13.71%

ROE, Industry

Oil & Gas 10.17% 14.33% 16.39% 20.05% 12.76%

Decomposing Profitability: Traditional Approach

ROE = ROA x Financial leverage

= Net Income – Preference Divs * Ave. Assets

Ave. Assets Ave. Common shareholders’ Equity

ROA = Profit Margin x Asset Turnover

= Net Income – Preference Divs * Sales

Sales Ave. Assets

ROE= Profit Margin x Asset Turnover x Financial leverage


Decomposing Profitability: DuPont Approach

Profitability Ratio ROE

Profitability Ratio ROA

Debt and Safety Ratio: Financial

LeverageAsset Management Ratio: Asset Turnover

Other Debt and Safety Ratios

Dividend Payout Ratio

Other Asset Management Ratios

Profitability Ratio: Profit Margin

Other Margins


Trade-off between Profit Margin and Asset Turnover

• There is always a trade-off between profit margin and asset turnover.


More Leverage?

ROE= Profit Margin x Asset Turnover x Financial leverage

More Leverage?

Decomposing Profitability: Advanced DuPont Approach

An alternative approach focuses on the effects of leverage

– A. Financial Leverage– B. Operating Liability Leverage



ROE is ultimately being equal to:

– RNOA (Return on Net Operating Assets) = Operating Income (After tax) / Net Operating Assets

– FLEV (Financial Leverage) = Net Financial Obligation (Liability) / Equity – NBC(Net Borrowing Cost) = Net Interest Expenses (after tax) / Net Financial Obligation– SPREAD (Financial Spread)= RNOA – NBC– ROOA = (Operating Income +Implicit Interest (after tax))/Operating Assets – OLLEV (Operating liability leverage)=Operating Liabilities/Operating Assets – OLSPREAD (Operating liability spread)=ROOA-Short-term Borrowing Rate (after tax)

]NBC -RNOA x [FLEVRNOA ROE

Spread

RNOA = ROOA + (OLLEV x OLSPREAD)

When the effective interest rate after tax is larger than operating

ROA, Spread will be negative as will Spread*Net Financial

Leverage

– Results in a reduction in ROE

Spread is the incremental economic effect of introducing debt

into the capital structure

– Spread will be positive provided the effective interest rate

after tax is less than operating ROA


Benchmark for profitability analysis -ROE and Cost of Equity Capital

• To interpret ROE, comparison with firms’ cost of equity capital is most

appropriate

– ROE is the return to equity holders (shareholders) and thus it is best

to be compared against the cost of equity capital

• The advantage is that this measure is determined by the market and can

not be influenced by management

• Calculation of cost of equity capital considered in week 10

28th February 2011

Presentation title 28

Benchmark for profitability analysis - ROA and WACC

• ROA is the return on assets which have been financed by both the equity capital and debt holders

– ROA is best to be compared against the weighted average cost of debt and equity (WACC, weighted average cost of capital)

• Calculation of WACC considered in week 10


ROE vs. ROA

Theoretically, ROE will be higher than ROA

– The benchmark for ROA in Australia is in the range of 8-10%

Recall, ROE tends to revert to a mean in the range of 11-13%:

– As such, firms’ cost of equity capital should be higher than their WACC





3,780 23,451 11,582 25,700 (3,719)

Total assets 284,305 305,690 300,193 293,068 272,262

Ratio

ROA1 1.33% 7.67% 3.86% 8.77% -1.37%

Benchmarks

ROA, Competitors

Chevron Corp. 7.23% 8.44% 11.24% 12.84% 10.30%

ConocoPhillips 5.89% 7.76% 7.19% 8.12% 7.27%

Exxon Mobil Corp. 9.30% 9.39% 13.45% 12.40% 10.07%


4.21% 4.58% 7.38% 8.96% 6.24%

ROA, Sector

Integrated Oil & Gas 5.64% 7.45% 8.75% 10.29% 6.24%

ROA, Industry

Oil & Gas 4.93% 7.02% 7.97% 9.53% 5.98%

ROA-BP


Assessing Operating Management:Income Statement Ratios

• Common-sized income statements facilitate comparisons of key line items across time and different firms

• Additionally, the following ratios are also helpful:– Gross profit margin– EBIT margin– EBITDA margin (EBIT also before depreciation &

amortisation)


Gross Profit Margin

• Measures the profitability of sales, less direct costs of sales:Gross profit margin = Sales – Cost of sales Sales

The gross profit margin is an indicator of:– The price premium that a firm’s product commands in the

market– The efficiency of a firm’s procurement and/or production

process




Gross profit 44,286 53,258 48,427 65,754 16,281

Sales and other operating revenues

353,568 379,136 375,580 375,517 297,107

Ratio

Gross profit margin1 12.53% 14.05% 12.89% 17.51% 5.48%

Benchmarks

Gross Profit Margin, Competitors

Chevron Corp. 23.62% 23.77% 25.69% 26.48% 27.22%

ConocoPhillips 40.96% 45.08% 44.75% 13.98% 15.50%

Exxon Mobil Corp. 24.85% 25.08% 25.83% 27.13% 29.13%


15.15% 15.44% 15.23% 15.67% 16.42%

Gross Profit Margin-BP


EBIT and EBITDA Margins

• The EBIT margin provides a comprehensive measure of operations:

EBIT margin = EBIT Sales

• The EBITDA margin eliminates the significant non-cash expenses of depreciation and amortization along with interest and taxes:

EBITDA =Earnings before interest, taxes, depreciation, and amortization Sales




3,780 23,451 11,582 25,700 (3,719)

Add: Net income attributable to noncontrolling interest

223 307 234 397 395

Add: Income tax expense

947 6,463 6,993 12,737 (1,501)

Earnings before tax (EBT)

4,950 30,221 18,809 38,834 (4,825)

Add: Finance costs 1,148 1,068 1,125 1,246 1,170

Earnings before interest and tax (EBIT)

6,098 31,289 19,934 40,080 (3,655)

Add: Depreciation, depletion and amortization

15,163 13,510 12,481 11,135 11,164

Earnings before interest, tax, depreciation and amortization (EBITDA)

21,261 44,799 32,415 51,215 7,509

EBIT and EBITDA-BP

Oil and Gas Industry: EBITDA margin comparison

Asset management ratios

Asset management is a key indicator of how effective a firm’s management is.

Asset turnover may be broken into two primary components:

1. Working capital management2. Long-term asset management

Working Capital Management

• Working capital is the difference between current assets and current liabilities.

• Operating working capital is defined as (Current assets - cash) - (current liabilities - short term debt).

• Key ratios useful for analyzing the management of working capital include:• Working capital turnover = Operating revenue / operating working capital.• Working capital to revenue = Operating working capital / operating revenue. • Inventory turnover = Operating revenue / current inventory.• Day’s payable = (Creditors / operating revenue) * # days in financial year.• Day’s receivables = (Debtors / operating revenue) * # days in financial year• Day’s inventory = (Current inventory / operating revenue) * # days in financial

year

Inventory Turnover-BP



Cost of operating revenues 309,282 325,878 327,153 309,763 280,826

Inventories 18,373 29,231 27,867 25,661 26,218

Ratio

Inventory turnover1 16.83 11.15 11.74 12.07 10.71

Benchmarks

Inventory Turnover, Competitors

Chevron Corp. 22.28 24.97 26.58 30.95 24.70

ConocoPhillips 23.30 25.03 33.19 42.46 28.17

Exxon Mobil Corp. 16.00 17.64 20.88 20.42 18.01

Royal Dutch Shell PLC 18.14 12.72 12.87 13.68 10.48

Inventory Turnover, Sector

Integrated Oil & Gas 17.73 14.24 15.22 17.30 13.94

Inventory Turnover, Industry

Oil & Gas 16.41 13.95 14.60 16.87 13.67


Receivable Turnover-BP




353,568 379,136 375,580 375,517 297,107

Trade receivables 19,671 28,868 25,977 27,929 24,255

Ratio

Receivables turnover1

17.97 13.13 14.46 13.45 12.25

Benchmarks

Receivables Turnover, Competitors

Chevron Corp. 11.98 10.18 10.98 11.21 9.55

ConocoPhillips 7.87 6.58 6.49 16.71 13.74

Exxon Mobil Corp. 21.26 16.19 15.97 15.54 14.55


14.83 11.54 11.62 9.73 9.83

Receivables Turnover, Sector

Integrated Oil & Gas

15.79 12.32 12.73 12.63 11.69

Receivables Turnover, Industry

Oil & Gas 13.59 11.20 11.56 11.87 10.86

Long-term Assets Management

Invested capital turnover = Operating revenue / operating invested capital before goodwill.

Long term asset turnover = Operating revenue / non current assets

PPE turnover = Operating revenue / (property, plant & equipment - accumulated depreciation).





353,568 379,136 375,580 375,517 297,107

Property, plant and equipment

130,692 133,690 120,448 119,214 110,163

Ratio

Net fixed asset turnover1

2.71 2.84 3.12 3.15 2.70

Benchmarks

Net Fixed Asset Turnover, Competitors

Chevron Corp. 1.09 1.34 1.63 1.99 1.90

ConocoPhillips 0.70 0.75 0.86 2.91 2.29

Exxon Mobil Corp. 1.56 1.73 2.00 2.18 1.85


2.19 2.35 2.71 3.09 2.58

Net Fixed Asset Turnover, Sector


Net Fixed Asset Turnover, Industry

Oil & Gas 1.64 1.77 1.99 2.39 2.04

Fixed Asset Turnover-BP





353,568 379,136 375,580 375,517 297,107

Total BP shareholders' equity

111,441 129,302 118,414 111,465 94,987

Ratio

Equity turnover1 3.17 2.93 3.17 3.37 3.13

Benchmarks

Equity Turnover, Competitors

Chevron Corp. 1.29 1.48 1.69 2.01 1.89

ConocoPhillips 1.01 1.04 1.21 3.75 2.76

Exxon Mobil Corp. 2.26 2.42 2.73 3.02 2.52


2.45 2.51 2.48 2.77 2.49

Equity Turnover, Sector


2.14 2.23 2.41 2.90 2.53

Equity Turnover, Industry

Oil & Gas 1.98 2.07 2.22 2.66 2.28

Equity Turnover-BP

Debt and safety ratios (financial leverage analysis)

• Borrowing allows a firm to access to capital, but increases the risk of ownership for equity holders

• Analysis of leverage can be performed on both short- and long-term debts:

– Liquidity analysis relates to evaluating current liabilities– Solvency analysis relates to longer term liabilities

Liquidity analysis

• There are several ratios useful to evaluate a firm’s liquidity, including:

– Current ratio– Quick ratio– Cash ratio– Operating cash flow ratio

• Each of these ratios attempts to measure the ability of a firm to pay its current obligations

Liquidity analysis

Knowing how the liquidity ratios are calculated allows the user to understand how to interpret them:

Current ratio = Current assets Current liabilities

Quick ratio = Cash + Short-term investments + Accts. receivable Current liabilities

Cash ratio = Cash + Marketable securities Current liabilities

Operating cash flow ratio = Cash flows from operations Current liabilities


Current Ratio-BP



Current assets 87,262 96,840 110,981 97,584 96,853

Current liabilities 63,615 72,812 77,586 84,318 83,879

Ratio

Current ratio1 1.37 1.33 1.43 1.16 1.15

Benchmarks

Current Ratio, Competitors

Chevron Corp. 1.32 1.52 1.63 1.58 1.68

ConocoPhillips 1.31 1.26 1.38 1.08 1.26

Exxon Mobil Corp. 0.82 0.83 1.01 0.94 0.94


1.16 1.11 1.18 1.17 1.12

Current Ratio, Sector


Current Ratio, Industry

Oil & Gas 1.25 1.24 1.34 1.20 1.22


Quick Ratio-BP



Loans 333 216 247 244 247 Trade receivables 19,671 28,868 25,977 27,929 24,255 Other receivables 11,367 10,963 11,687 15,597 12,294 Other investments 329 467 319 288 1,532 Cash and cash equivalents

29,763 22,520 19,548 14,067 18,556

Total quick assets 61,463 63,034 57,778 58,125 56,884


Ratio

Quick ratio1 0.97 0.87 0.74 0.69 0.68

Benchmarks

Quick Ratio, Competitors

Chevron Corp. 0.94 1.16 1.25 1.25 1.30ConocoPhillips 1.03 0.99 0.78 0.82 1.00Exxon Mobil Corp. 0.51 0.53 0.70 0.67 0.65


0.72 0.64 0.74 0.69 0.60

Quick Ratio, Sector


Quick Ratio, Industry

Oil & Gas 0.85 0.83 0.85 0.80 0.78


Cash Ratio-BP



Other investments 329 467 319 288 1,532 Cash and cash equivalents

29,763 22,520 19,548 14,067 18,556

Total cash assets 30,092 22,987 19,867 14,355 20,088


Ratio

Cash ratio1 0.47 0.32 0.26 0.17 0.24

Benchmarks

Cash Ratio, Competitors

Chevron Corp. 0.41 0.50 0.64 0.60 0.59ConocoPhillips 0.44 0.43 0.25 0.23 0.42Exxon Mobil Corp. 0.07 0.07 0.15 0.17 0.13


0.25 0.10 0.19 0.11 0.13

Cash Ratio, Sector


0.29 0.21 0.26 0.20 0.23

Cash Ratio, Industry

Oil & Gas 0.34 0.26 0.27 0.22 0.25

Debt and Safety Ratios

• Beyond short-term survival, solvency measures the ability of a firm to meet long-term obligations

• Several useful ratios are used to analyse solvency. Three using only shareholders’ equity as a denominator are:

• Financial leverage = Total assets / shareholders equity

• Gross gearing = (Short term debt + long term debt) / shareholders equity

• Net gearing = (Short term debt + long term debt - cash) / shareholders equity

Sustainable Growth Ratio

• A comprehensive measure of a firm’s ratios is the sustainable growth rate, which uses ROE:

ROE * (1 - Dividend payout ratio)

Where:Dividend payout ratio = Cash dividends paid

Net income

• Sustainable growth rate measures the ability of a firm to maintain its profitability and financial policies

Sustainable Growth Ratio

Cash Flow Analysis

• Cash flow analysis can provide further insights into operating, investing and financing activities

• The analysis focuses on the financial ability of a company to pay the outgoings according to a priority list

• 1. Interest payments• 2. Repayment of loans• 3. Capital expenditures• 4. Dividend payments

Cash Flow Analysis

– Note that interest expense and dividends paid are related to financing activities.

– Interest income and dividends received are related to investing activities.

– That is, for our purposes, these items should not be included in the operating activities of a company.

Cash Flow Analysis

– So, the first task in cash flow analysis is to rearrange the classifications in the cash flow statement , if required.

– That is, operating cash flow section should include only operating activities.

– Add back interest and dividends paid, to the operating cash flow.

– Deduct interest and dividend received, from operating cash flows.

– Cash flow analysis starts by looking at cash flow from operations and comparing it with NPAT

Cash Flow Analysis

Is there sufficient operating cash flows to meet interest payments?

• If yes, how many times?• If no, the company is in trouble!

Is there sufficient operating cash flows after interest payments to pay cash dividends?

• If yes, how many times?• If no, how does this affect share prices?

• Should the company borrow to pay dividends?

Is there sufficient cash flows to repay loan principal?• Is it feasible to borrow to do so?

• What is the interest rate on the new borrowings?

Is there sufficient cash flows to expand?• Is it a good idea to use our own funds to expand?

Financial Statement Analysis and Public Debt

Debt ratings provide important information to investors (Moody’s

and S&P)

The meaning of debt ratings:

• Standard & Poor’s has a rating system from D to AAA that

grades the relative riskiness of debt

• Debt ratings influence the yield that debt instruments must pay

for investors to buy them.

Table 10.2: Debt Ratings - Example

Table 10.3: Median Financial Ratios by Debt Ratings Category

Financial Analysis and Public Debt

Factors that drive debt ratings:

• Performance measures are used to gauge the expected future health of

the firm and the ability to repay debt.

• Credit analysis (debt and safety ratio)

Factors Used in Quantitative Models of Debt Ratings

Prediction of Distress and Turnaround

Models for distress prediction• Debt of distressed companies present investment opportunities because they trade at steep

discounts. (e.g. Australian Vintage, Photon Group)

• Financials can be analyzed to predict distress (e.g. Allied Brands)

• Several models to predict distress have been developed over the years. One of the more popular and robust models is the Altman’s Z-score model:

Altman z-score

The Altman z-score is a measure of a company financial strength that uses a weighted sum of several factors.

Distress zone will differ across industries and types of companies

Zones of Discrimination:

Z > 2.99 -“Safe” Zones

1.81 < Z < 2.99 -“Grey” Zones

Z < 1.81 -“Distress” Zones

Your Project

Section

F

Financial

Analysis

5 500

Profitability

analysis

Many of the ratios are available in Osiris. Identify the more important ones.

Merely stating the ratios will not fetch marks. A brief discussion on key ratios is

required. Comparison against peer and industry is important (both time series

and cross sectional).

1 100

Asset

management

analysis





1 100

Debt and safety

analysis





1 100

Cash Flow

Analysis

Many of the cash flow ratios are available in database. Identify the more

important ones. A brief discussion on the company’s cash flow position is



1 100

Credit analysis Include credit ratings for your company from credit rating agencies (if any).

Conduct the distress analysis and measure Altman’s Z score across two recent

years.

1 100

65

Next week

Forecasting

Documents

Week 8-Financial Analysis-S2 2015