FINANCIAL ANALYSIS AND MANAGEMENT

BAD 306

CASE 1: THE CASE OF THE UNIDENTIFIED INDUSTRIES

INSTRUCTOR:

DR. ANI TORTIAN

GROUP MEMBERS:

RITA MALIAN

RAZMIG KAPRIELIAN

DIKRAN OHANESIAN

18.10.2010
Introduction

Financial and operating ratios allow one to focus on various areas of business

management, to compare results against industry averages, and to gage the

financial health of an investment prospect. Ratios can be the keys to success in

the many arenas where identification of norms, benchmarks, internal

eccentricities, or long-term trends are critical.

Ratios are intended to show relationships between dollars, numbers, and

percentages taken from balance sheets and/or income statements. An analysis

of the transformed data from these two financial statements makes it possible to

draw inferences, make comparisons, and track long-term results.

The more you know about a company's--or industry's--underlying economics, the

more solid footing you're on when analyzing its prospects. Understanding the

impact of cost structure on a company's or industry's profitability is a big step

toward understanding why some businesses simply have better economics than

others do.

This paper analyzes the case of 5 industries (Electric utility, Japanese trading

company, aerospace manufacturer, automobile manufacturer, and a supermarket

chain) and their corresponding balance sheets and financial ratios (Appendix A)

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Electric utility companies require a large infrastructure in order to produce or

deliver their product, that is, they require a large asset base to generate sales.

Large asset base means a low asset turnover. Electric utilities usually have low

variable costs due to Economies of scale (the increase in efficiency as the

number of goods being produced or services being provided increases). Thus,

high fixed costs and low variable costs lead to high profit margins and an

acceptable ROA. Their cost of goods sold, mostly variable costs that fluctuate

with sales, don’t rise incrementally with sales or rises at a much slower rate, so

any sale beyond the FC leads to pure profits. On the other hand, this kind of

businesses can be risky since they are capital-intensive. If sales don’t go as

expected they cannot cover their fixed costs and get into trouble. Electric utilities

have lots of capital tied up in property, plant and equipment (that is why the

owners’ equity or the capital employed in the firm is high), consequently they

have lots of debt outstanding, and so their interest costs are high.

Unlike cyclical companies (tied to economic or business cycles), electric utilities

have steady inflows of receipts and can safely afford to have high debt/equity

ratios. By receiving periodic payments from customers, Electric utility companies

have a reasonable collection period and employ their proceeds in investments

and thus hold a little cash on their balance sheet.

Being a service company, an electric utility is characterized by the absence or

low levels of inventory and thus a high inventory turnover rate indicating efficient

management of inventory.

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The balance sheet that satisfies this criteria is B (Low cash (2.7%), high Property

and equipment (66.6 %, High owners’ equity (35.2%), Profit margin (0.14), Long-

term liabilities=52.9 % (30 + 22.9%) of, ITR = 10, average collection period = 48

days, asset turnover =0.36).

To further support this conclusion, let us continue by analyzing the two other

capital intensive industries: the automobile and the aerospace manufacturers.

Both industries have high fixed assets (lower asset turnover) and total liabilities.

Aerospace manufacturers, however, would have the highest inventory (due to

low volume demand) and thus lower inventory turnover. Prepayments made by

customers under long-term contracts result in lower receivables and large

customer advances which fall under “Other current liabilities” in the balance

sheet. However, their total assets usually exceed their total liabilities, that is why

they’ve a high owners’ equity (capital employed in the firm). Because these types

of businesses are selling expensive items on a long-term payment basis, they

can't raise cash as quickly. Since the inventory on their balance sheet is normally

ordered months in advance, it can rarely be sold fast enough to raise money for

short-term financial crises (by the time it is sold, it may be too late). It's easy to

see why companies such as this must keep enough cash on hand to get through

any unforeseen difficulties.

All these trends help us conclude that the balance sheet belonging to the

Aerospace manufacture is E (High level of Inventory (48.1%), high property and

equipment (25%)=> high OE (34%), high A/P (21.5%) and current

liabilities(27.4%), low long-term debt (8.1%), low level of inventory turnover (1.1.),

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low receivables (11.5%)). Moreover, the company has a high current ratio

(CA/CL) showing that it is capable of servicing its short-term obligations and that

is due to customer prepayments and has a low Debt to Equity ratio due to the low

level of long-term obligations.

The Automobile manufacturer, on the other hand, would have a lower level of

inventory, a higher inventory turnover, higher long-term debt and thus higher

Debt to Equity ratio. Auto industry is also characterized by the Captive Finance

companies which are finance companies owned by auto manufacturers to

finance dealers’ inventories or to make loans to consumers buying the

company’s products with the purpose of encouraging the sale of the product.

This is why the receivables and notes payable figures of Auto manufacturers are

usually high, so is the collection period.

The analysis helps us conclude that the balance sheet belonging to the

automobile manufacturer is A (Low Inventory (5.3%), High IT(11) , high LTD

(17.4%), High D/E (1.6), High A/R (31.7%), High N/P (38.4%), long collection

period (149), high liabilities (89.3%) and debt ratio (0.89%)).

We are left with two balance sheets and two companies: Supermarket chain and

Japanese Trading Company.

Supermarket chains like most retailers have high variable costs, meaning that

their costs fluctuate with sales levels and high inventory levels. At the same time

and unlike other retailers, supermarkets have relatively more capital tied up in

fixed assets like plant and equipment. When sales go up, this kind of company’s

investment in inventory has to go up too (high inventory turnover due to year-

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round sales). The cost to add new customers is high, which means that profit

margins are usually low. If successful though, high variable-cost firms have high

asset turnover rates (sales/asset), which are just as powerful as profit margins at

influencing overall profitability (NI/OE). Since everyone needs groceries all year

round, sales volume is high and fairly recession-proof. Balances are usually

collected on a daily basis which helps in maintaining a low accounts receivable

and a short collection period. Moreover, such companies that have high inventory

turns and do business on a cash basis need very little working capital (current

assets minus current liabilities). These types of businesses raise money every

time they open their doors, then turn around and plow that money back into

inventory to increase sales (that is why the percentage of cash on their B/S is

low). Since cash is generated so quickly, managements can simply stockpile the

proceeds from their daily sales for a short period of time if a financial crisis

arises. For the same reason, there is no need to have a large amount of working

capital available.

Being a commodity business, supermarket chains are extremely price-sensitive.

Thus, the risk to these types of businesses is their lack of pricing power. They

don’t have a lot of room to raise prices and if they lower prices without

corresponding decreases in their inventory costs or corresponding increases in

their sales volume, they won’t cover their variable costs, which will decimate net

income.

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Between the two balance sheets that we are left with, C matches the

supermarket chain the best (Low cash (1.4%), Low working capital (-8.2%), High

inventory (23%), High fixed assets (49.9%), High Inventory Turnover (10), low

receivables (2.9%), short collection period (3 days), low profit margin (0.02), high

asset turnover (3.2), high ROE (0.41)). It has the lowest current ratio among the

5 industries because the percentage of its current liabilities exceeds the

percentage of its current assets (its assets are mostly fixed).

Finally, the Japanese trading company is only left with Balance Sheet D to be

matched with. Let us see if the figures in this Balance Sheet are representative of

such a kind of company.

A trading company is a firm that connects buyers and sellers within the same or

different countries but foes not get involved in the owning or storing of

merchandise; that is why such companies have minimal inventories and high

inventory turnover. They have low levels of fixed assets and owner’s equity.

Trading companies usually have a high level of debt (High debt and debt-to-

equity ratios) balanced by a high level of receivables with long term collection

periods and a high level of investments (loans and securities). The majority of

their debt is current or short-term, reflecting the short maturities of their loans.

Like other high-variable-cost firms, trading companies have high asset turnover

rates that can almost offset their low profit margins and ROE (due to the very

little investment in assets required).

All these meet the figures in Balance Sheet D (High Receivables (60.3%), low

property & equipment (4.3%), high short-term liabilities (50.8+15.2+5.7=71.7%),

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low OE (4.3%), low profit margin (0.01), low ROE (0.13), high Asset Turnover

(2.1), long collection period (106 days), high inventory turnover (23), high debt

ratio (0.96), high debt-to-equity ratio (5.3)).

The two companies with the lowest quick ratios (CA-Inv/CL) are the supermarket

chain & the Aerospace manufacturer, which is not surprising since these are the

companies with the highest levels of inventories.

Conclusion

This paper was intended to show that industries have balance sheet and financial

characteristics that set them apart from others. These characteristics are often

used to compare firms within an industry. Summarized data should be used with

caution, however. Different firms (even in the same industry) classify identical

items differently. Thus the analyst should examine original financial statements to

achieve better comparability. Differences among firms may be due to operational

or classification differences. When management is available to answer questions,

these differences are often useful starting points for obtaining a better

understanding of the firm.