Financial Statement Analysis

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1 Section 7. Financial Statement Analysis Writing a Financial Analysis Report Hotel Illiquidity risk: short and long-term ratios Fahmi Ben Abdelkader 10/4/ :55 AM 1 Chapter Outline Writing a Financial Analysis Report Illiquidity risk: short and long-term ratios 2

2 Writing a Financial Analysis Report How to conduct a financial analysis? A guiding principle In the long run, a company can survive only if it creates value for its shareholders and meets its commitments towards all its stakeholders To do so, it must: Generate wealth Invest Financial Analysis Growth Analysis Finance its investments Generate a sufficient return Anticipate and manage illiquidity risk Profitability Analysis Risk Analysis 3 Writing a Financial Analysis Report How to conduct a financial analysis? Preliminary analysis (1) Strategic and Economic Assessment 1.1 Understand the characteristics of the sector in which the company operates 1.2 analyse the auditors report and accounting policies 1.3 What do we expect to see? 2.1 Growth measurement The toolkit of the financial analyst Sales, Net Income, EBITDA, Total Assets (2) 2.2 How the firm uses its money? 2.3 Where does the money come from? 2.4 Analysis of the Cash Cycle Fixed Assets, WC, Capital Employed, Cash flow from investment activities Leverage, Equity, Net Debt, Capital Invested, Short-term debt, etc. WC in days worth of sales; Cash flow from operating, FCF Financial Analysis (3) Profitability Analysis 3.1 Margin analysis Profitability ratios, Cost structure 3.2 Return on Invested Capital (ROIC) 3.3 Return on Equity (ROE) ROIC = NOPAT/ Capital Employed ROIC = Oper. Margin * Asset turnover Economic Value Added = ROIC - WACC ROE = Net Income/ Equity ROE = ROIC + Leverage effect Residual Income= ROE - r e (4) Risk Analysis 4.1 Short-term liquidity risk 4.2 Solvency risk Current ratio Quick ratio Interest coverage ratio, leverage, etc. Summary note (5) Recommendations Fahmi Ben Abdelkader 5. Develop and communicate conclusions / recommendations Financial Statement Analysis

3 Writing a Financial Analysis Report Some There is no single indicator of good health A rigorous Financial Analysis requires a combination and a cross-analysis of different indicators covering several aspects to good financial health Ratios are not very helpful by themselves; they need to be compared to something: an appropriate benchmark Time-Trend Analysis Comparison with competitors and industry peers Return ratios should be compared to the required rate of return (Opportunity Cost of Capital) Don t only focus on the numbers, you need to be aware of the organisation s business strategy and objectives Understand the nature of the industry in which the organisation operates Understand that the overall state of the economy may also have an impact on the performance of the organisation There is nothing worse in FSA and valuation than forgetting the overall picture 5 Writing a Financial Analysis Report Don t only focus on numbers, you need to be aware of the organization s business strategy and objectives Business performance and recent decisions in McDonald s Our recent performance has been poor. The numbers don t lie (Steve Easterbrook, CEO, May 2015) McDonald s faces huge challenges Sales and profits have declined substantially over the past years Low morale of franchisees and conflicts due to contract conditions Food quality scandals in Asia which there lead to a decrease of 15% in net income Reputation of unhealthy and low quality food, especially in the US Increasing health conscience of customers and demand for sustainably manufactured products Increasing competition by suppliers who capture the trend for high-end burgers Turnaround shall restore business New CEO Steve Easterbrook announced turnaround plan in May 2015: Strip away management layers and reduce bureaucracy Listen to customers needs and meet them Priority on food quality New services, e.g. mobile ordering Refranchising of stores with target of 95% franchising by 2018 Cost savings and increased financial leverage? Success uncertain: Image change will require a lot of time 6

Writing a Financial Analysis Report Don t only focus on numbers, you need to be aware of the organization s legal form Example: Equinix converted into a Real Estate Investment Trust, or REIT, in 2015.

Equinix implemented the REIT conversion in 2014, and began operating as a REIT for federal income tax purposes effective January 1, 2015.

4 Writing a Financial Analysis Report Don t only focus on numbers, you need to be aware of the organization s legal form Example: Equinix converted into a Real Estate Investment Trust, or REIT, in On December 23, 2014, our Board of Directors formally approved our conversion to a REIT effective on January 1, Equinix implemented the REIT conversion in 2014, and began operating as a REIT for federal income tax purposes effective January 1, Tax Relief Attracting Investors through dividend payments In a REIT, income comes from rent of the properties, and REITs are legally required to distribute 90 percent of their taxable income to investors. It means Equinix will have regular distributions of its earnings. 7 Writing a Financial Analysis Report Don t only focus on numbers, you need to be aware of the regulation rules Example: The soft drink industry and the SSB taxes The soft drink industry is in the middle of a growing policy debate in the United States regarding the taxation of sugar-sweetened beverages. Surveys show mixed feelings about an SSB tax; a poll in New York City indicated more support if the proceeds went toward health-related initiatives. Meanwhile,the soft drink industry has responded strongly to proposed SSB taxes. Internally, the soft drink industry is responding with efforts to influence consumer behavior by introducing smaller-size packaging, encouraging active life styles, and looking into alternative, non caloric sweeteners. Externally, lobbyist and other activist groups have successfully gathered support to defeat many of the proposed SSB taxes. 8

Writing a Financial Analysis Report There is nothing worse in FSA and valuation than forgetting the overall picture Example: Apple posts record profit but iphone growth is slowing: The strong dollar

5 Writing a Financial Analysis Report There is nothing worse in FSA and valuation than forgetting the overall picture Example: Apple posts record profit but iphone growth is slowing: The strong dollar is hurting Apple too Apple had the most profitable quarter in American history ($18.4B Profit), but it has reached the end of its era of unprecedented growth. FT, January 27, 2016 Shareholders took a deep breath when Apple released its quarterly financial report Tuesday. IPhone sales rose last quarter, as did profits and overall sales. Sales in China were also strong. But the iphone's growth has slowed dramatically. The strong dollar is hurting Apple too: the iphone is now too expensive for many potential Chinese customers. Apple said it was a rough time to have two-thirds of its sales come from outside the United States. "The challenging global macroeconomic environment is leading to constrained conditions unlike anything we've seen, everywhere we look," CEO Tim Cook said on a conference call with analysts. And even though Apple managed to beat its record quarter from a year earlier, Apple said it believes sales in the current quarter will fall for the first time in 13 years. 9 Writing a Financial Analysis Report Some Spending money does not necessarily make you poorer and neither does receiving money necessarily make you any richer. A positive cash flow is not always value creating and vice versa (Cash generated by the core business versus cash generated by non-operating activities) Earnings are an opinion, cash is a fact The need to assess earnings quality In assessment of earnings quality, the analyst should consider the materiality and variability of NON-OPEARTING items of income such as non-cash items A lever can become a club The impact of financial leverage cannot be analyzed independently of Risk The value of a business depends primarily on the capacity of its assets to generate cash flows, and less on capital structure choices A lack of liquidity may lead to loss of business opportunities and, in a worst case, bankruptcy 10

6 Writing a Financial Analysis Report «les chiffres sont des êtres fragiles qui, à force d'être torturés, finissent par avouer tout ce qu'on veut leur faire dire» Alfred Sauvy Despite the appealing nature of financial ratios, they should be used with caution: Based on historical accounting information and, thus, backward-looking Many ratios provides a snapshot of the firm s financial position at a given point in time (e.g. Seasonality effects). Accounting practices differ among firms and countries Accounting numbers always subject to window dressing (e.g. ROE). Inflation Effects; mostly on balance sheet and income statement amounts. 11 Chapter Outline Writing a Financial Analysis Report Illiquidity risk: short and long-term ratios 12

7 Strategic and Economic Assessment Hasdrubal is a high-standard hotel (4 stars) with 30 rooms created in 2004 in Monaco. Its customers are mainly business men and women. The construction costs of the hotel have been equal to 4500k financed with 2500k equity and 2000k debt with a 10 year maturity and an interest rate of 5%. The hotel business model relies mainly on the occupancy rate (number of rooms sold/number of rooms available) and the average price per room. The hotel industry is characterized by high selling, general and administrative expenses that increase at the inflation rate each year. To cover these expenses it is necessary to maximize the sales, balancing the price and the occupation rate. Given the success of the hotel California the owner has decided in to build 10 new rooms that will be available at the beginning of in to increase prices in The investment for the new rooms is equal to 400 k financed by long-term debt, and construction works start in Given the low occupancy rate, the manager decides in 2013 to start a huge advertising campaign. He is a bit worried and asks you to do a financial analysis of his Hotel and evaluate his investment policy. 13 Strategic and Economic Assessment Understand the Business well and identify the main characteristics of: the sector in which the company operates the product the production model distribution network markets (local vs foreign) Etc. What are the potential implications of these characteristics on: the operating cycle the Cash cycle the working capital Investment requirements margin Etc. 14

8 Strategic and Economic Assessment Hasdrubal is a high-standard hotel (4 stars) with 30 rooms created in 2004 in Monaco. Its customers are mainly business men and women. The construction costs of the hotel have been equal to 4500k financed with 2500k equity and 2000k debt with a 10 year maturity and an interest rate of 5%. The hotel business model relies mainly on the occupancy rate (number of rooms sold/number of rooms available) and the average price per room. The hotel industry is characterized by high selling, general and administrative expenses that increase at the inflation rate each year. To cover these expenses it is necessary to maximize the sales, balancing the price and the occupation rate. Given the success of the hotel California the owner has decided in to build 10 new rooms that will be available at the beginning of to increase prices in 2011 The investment for the new rooms is equal to 400 k financed by long-term debt, and construction works start in Given the low occupancy rate, the manager decides in 2013 to start a huge advertising campaign. He is a bit worried and asks you to do a financial analysis of his Hotel and evaluate his investment policy. 15 Strategic and Economic Assessment: what do we expect to see? Industry : hotel/services Relatively high fixed costs ; seasonality effect Low or negative working capital (customers pay cash) High-standard hotel and business customers We expect to have high margin rate key events: In 2011, an important new investment to increase the hotel capacity + financed by debt + price increase + construction works Impact on occupancy rate and revenues? Are customers sensitive to the price increase? Does the increase in the hotel capacity increase the ROCE? Debt is expected to increase the financial burden. What is its impact on the ROE? Construction works are likely to cause some inconvenience for clients In 2013, a huge advertising campaign We expect this campaign to boost revenues 16

9 Strategic and Economic Assessment: what do we expect to see? Relevant items that should be closely observed Occupancy rate Pricing policy Margin rate Profitability of the new investments The financial leverage effect 17 Wealth creation at a glance Growth rate Net Sales 0,0% -3,8% 8,6% 31,6% Total Assets -4,1% 1,3% 0,2% -4,1% EBITDA -21,0% -65,4% -173,0% - 18

10 Wealth creation at a glance Number of rooms Average Price ( ) The occupancy rate 80% 80% 70% 57% 75% 19 How the firm uses its money? Fixed Assets / Total Assets 74,5% 75,4% 83,9% 81,0% 81,4% Inventory / Total Assets 12,4% 13,0% 12,8% 17,0% 17,7% Accounts Receivable / Total Assets 0,0% 0,0% 0,0% 0,0% 0,0% Cash & Equivalent / Total Assets 13,1% 11,6% 3,3% 2,0% 0,9% Fixed Assets Operating Working Capital (233) Capital Employed Cash From Investing Activities (II) (225) (736) (273) (287) 20

11 Where does the money come from? Liabilities structure 21 Where does the money come from? Invested Capital trends 22

12 Where does the money come from? Financial Leverage 17,7% 17,3% 52,3% 95,3% 52,1% Long-term debt / Total Liabilities 24,8% 23,3% 33,2% 29,3% 26,6% Short-term debt / Total Liabilities 0,0% 0,0% 0,0% 12,8% 0,0% Accounts payable / Total Liabilities 8,7% 9,3% 9,5% 15,9% 24,0% Shareholders' Equity Net Financial Debt Invested Capital Analysis of the Cash Cycle Working Capital Needs in days worth of sales Inventory days Receivable days Payable Days = Operating Working Capital days worth of sales

13 Analysis of the Cash Cycle Operating Working Capital (233) 25 Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue 100% 100% 100% 100% 100% Cost of sales 62,5% 64,4% 68,9% 76,2% 59,7% Gross Margin 37,5% 35,6% 31,1% 23,8% 40,3% Operating expenses 25,0% 25,8% 27,6% 26,1% 30,3% EBITDA Margin or Operating Margin 12,5% 9,9% 3,6% -2,4% 10,0% Depreciation & amortization 6,3% 6,6% 7,9% 7,6% 6,1% EBIT Margin 6,3% 3,3% -4,3% -10,0% 3,9% Net financial expenses 0,8% 0,7% 1,4% 1,8% 0,7% Pretax Income 5,5% 2,6% -5,7% -11,8% 3,2% - Corporate income tax 1,8% 0,9% 0,0% 0,0% 0,0% Net Profit Margin 3,7% 1,7% -5,7% -11,8% 3,2% NOPAT (Net Operating Profit After Tax) 4,2% 2,2% -4,3% -10,0% 3,9% 26

14 Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue 100% 100% 100% 100% 100% Cost of sales 62,5% 64,4% 68,9% 76,2% 59,7% Gross Margin 37,5% 35,6% 31,1% 23,8% 40,3% Operating expenses 25,0% 25,8% 27,6% 26,1% 30,3% EBITDA Margin or Operating Margin 12,5% 9,9% 3,6% -2,4% 10,0% Depreciation & amortization 6,3% 6,6% 7,9% 7,6% 6,1% EBIT Margin 6,3% 3,3% -4,3% -10,0% 3,9% Net financial expenses 0,8% 0,7% 1,4% 1,8% 0,7% Pretax Income 5,5% 2,6% -5,7% -11,8% 3,2% - Corporate income tax 1,8% 0,9% 0,0% 0,0% 0,0% Net Profit Margin 3,7% 1,7% -5,7% -11,8% 3,2% NOPAT (Net Operating Profit After Tax) 4,2% 2,2% -4,3% -10,0% 3,9% 27 Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue 100% 100% 100% 100% 100% Cost of sales 62,5% 64,4% 68,9% 76,2% 59,7% Gross Margin 37,5% 35,6% 31,1% 23,8% 40,3% Operating expenses 25,0% 25,8% 27,6% 26,1% 30,3% EBITDA Margin or Operating Margin 12,5% 9,9% 3,6% -2,4% 10,0% Depreciation & amortization 6,3% 6,6% 7,9% 7,6% 6,1% EBIT Margin 6,3% 3,3% -4,3% -10,0% 3,9% Net financial expenses 0,8% 0,7% 1,4% 1,8% 0,7% Pretax Income 5,5% 2,6% -5,7% -11,8% 3,2% - Corporate income tax 1,8% 0,9% 0,0% 0,0% 0,0% Net Profit Margin 3,7% 1,7% -5,7% -11,8% 3,2% NOPAT (Net Operating Profit After Tax) 4,2% 2,2% -4,3% -10,0% 3,9% 28

15 Return analysis ROIC (Return On Invested Capital) NOPAT Margin 4,2% 2,2% -4,3% -10,0% 3,9% * Turnover rate of Capital employed 1,52 1,57 1,35 1,56 2,34 = ROIC (Return On Invested Capital) 6,4% 3,5% -5,9% -15,6% 9,2% 29 Return analysis The Financial Leverage Effect ROIC (Return On Invested Capital) 6,4% 3,5% -5,9% -15,6% 9,2% Net cost of debt (after tax) 8,0% 7,8% 5,6% 5,8% 5,1% ROIC - Net cost of debt -1,6% -4,3% -11,4% -21,4% 4,1% * Financial Leverage 17,7% 17,3% 52,3% 95,3% 52,1% = The Financial Leverage Effect -0,3% -0,7% -6,0% -20,4% 2,1% ROE (Return On Equity) 6,6% 3,2% -11,8% -36,0% 11,3% 30

16 Illiquidity and solvency risk: short and long-term ratios Short-term liquidity ratios Current ratio 293,1% 263,4% 169,5% 66,5% 77,7% Cash ratio 150,3% 124,7% 34,8% 7,1% 3,7% 31 Illiquidity risk: short and long-term ratios Long-term liquidity risk Long-term debt / Total Liabilities 24,8% 23,3% 33,2% 42,1% 26,6% Short-term debt / Total Liabilities 0,0% 0,0% 0,0% 30,3% 0,0% Financial Leverage 17,7% 17,3% 52,3% 95,3% 52,1% Solvency ratio 0,0% 0,0% 0,0% 31,8% 0,0% Interest Coverage ratio 7,9 4, ,3 Interest Coverage ratio (Cash) 11,7 1,7-18,2 Debt to EBITDA 0,8 1,0 7,1-1,5 Debt to Cash flow from operations ratio 1,1 10,6-1,1 32

17 s: the strengths and weaknesses The strengths Revenues increased over the three past years The weaknesses Operating costs increased at a higher pace than net sales over the period Substantial investments that have increased the accomodation capacity of the hotel bad management decision: change in the pricing policy without an appropriate communocation policy Capacity of the company to rebound after a very critical situation in 2012 The margin levels are not consistent with the high-end positioning of this business After investments, the level of net margin remained lower that its level in 2009: overcapacity? Opportunities Take advantage of relaized investments and the increase in the number of rooms Threats More attention has to be paid on the management of the working capital, which supposed to be negative given the nature of the business Risk of under-utilisation of the potential of the hotel: must improve occupancy rate 33

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