The shareholders require frequent reports on how their business is performing. To have objective and useful reports regarding the efforts of management and its results, financial reporting was devised.
As businesses grew, there came a divorce between ownership and management of business. Often the owners of a business, that is the shareholders, appointed professionals to handle the day to day running of the business, that is the “management”, give rising to an “Agency” relationship. Theshareholders appoint agents, that is the management team, to run their business.
Understanding the need for Financial Statements
Financial reports are objective statements which show the financial performance and position of a business for a given time period. They are usually for the quarter, half-year and for annual time spans. They are usually made using International Financial Reporting standards, or the accounting standards prescribed by local law.
To put it a nutshell the purpose of financial statements is to provide information which shows:
- Financial Performance
- Financial Position
- Cash flows of the business
The above information is presented, so the various stakeholders of the business, including the management and the shareholders can use the information, and compare it with past information, and that of other businesses. The ultimate goal is to understand and access the performance of the business.
Who are Stakeholders?
Stakeholders in business are those, who can affect or can be affected by the business's actions, objectives and policies.
Stakeholders by their very definition have an interest in a business’s activities, and thus they shall be using the Financial Statements to draw conclusions. Some of the stakeholders which are interested in the information contain in the F/S are:
- Existing and Potential Customers
- Governmental Bodies
Using Financial Analysis to Understand the Business
There is a misconception, that Financial Analysis is the application of a set number of formulas on financial statements and you shall obtain meaningful numbers. However financial analysis is not an exercise that can be performed in isolation. You have to understand the whole context. Doing financial analysis is only one part of understanding the business’s current position.
So what is the whole context? First, you have to understand the business itself. What business is the business in that is what products or services does the business produce? Then you have to understand other businesses that operate in the same place, i.e understanding the industry the business is in. Once you gain this overview, you will need to delve into more specifics things, such as understanding the profiles of the management team of the business you are focusing on etc.
The financial analysis gives you “numbers” which on their own are meaningless. To gain some knowledge out of the exercise, you will have to compare them with the businesses own past results and established industry benchmarks.
As we progress in this article, we will take the example of specific indicators like the Gross Profit Margin and show how they are employed to gain insights.
Starting Point for Financial Analysis - Reliable Source of Data
Financial Analysis, as the very name suggests is analysing Financials to draw out more information. For that information to be credible, one has to consider carefully the possible sources of information available about the business in question. One of the most reliable sources of information is the annual report, audited by an external auditor. These not only contain financial information, but often also other important disclosures, for example expansion plans or the operation’s environmental impact and even ratio analysis.
Calculating and Interpreting Ratios
While financial statements usually do show ratios, it is important to understand how they are calculated, so you can better understand what are the pros and cons of ratios.
There is a variety of rations that can be used. To better understand their use, we shall divide them into four broad categories:
Probability Ratios can be divided into two sets. The first set of ratios sheds lights on the margins of the business. That is how good the business is in turning each dollar earned into profit at various stages of measurement. In simpler words we can say, how much of Sales revenue is actually translated into Profit after all expenses necessary to achieves those sales levels have been deducted.
The margin ratios we shall discuss are: Gross profit margin,operating profit margin and Net profit margin.
The second set of profitability ratios is concerned with the Return the shareholders are earning on the money invested in the business, e.g. ROCE (Return on Capital Employed).
Liquidity Ratios compare a company most liquid assets (that is assets most easily converted into cash), with the businesses short-term liabilities. This comparison helps to show the company’s ability to pay off its short-term debts. Relevant ratios are: Current and Quick (Acid test) ratios.
Efficiency & Activity Ratios
Efficiency Ratios help to analyse how well a company uses its assets to generate income. Such ratios are also known as asset turnover ratios.
Activity ratios help us to gauge the businesses operational efficiency and profitability. They are also known as Working Capital Ratios.
Ratios in Action - Understanding by practical application
As stated previously ratios are tools used for financial analysis, and have to be used within a context. Standalone application of them will not yield actionable information.
To show how they should be employed, we shall choose a public limited company and its competitor. We shall take 3 years of financial information.
I have chosen the cement industry. Our primary company is Lucky Cement (LCL) and its competitor is DG Khan (DGK).
You shall notice that in each of the analysis, we refer to information, which is not seen by glancing just at the financial statements. So where do we obtain this information? As mentioned earlier, that for financial analysis, not only do you refer to the Financial Statements, but also to the notes and other pieces of information, for example message by the chairman. To make your analysis truly effective, you also research the environment in which the business is operating in (a good tool to use here is the PESTEL analysis).
The financial analysis has been performed using horizontal and ratio analysis of LCL and DGK.
Sales revenue of LCL has increased consistently from FY2012-13 to FY2014-15. The sales have increased by 14% and 4% in FY 2013-14 and FY 2014-15, respectively. (Annexure, Ratios)
In the FY 2013-14, LCL showed revenue at PKR 51.41 billion showing an increment of 14% as compared to FY2012-13. (Annexure, Ratios) Both increase in sales volume and average sales price contributed to the increase in overall sales.
As depicted in the chart above, sales volume of both local and export sales showed an increase in the FY2013-14. The growth in local sales volume of 9.6% was in line with the growth in the construction sector of Pakistan, which according to the Economic Survey of Pakistan 2013-14 grew by 11.3%. Cement is the most integral raw material in the construction sector, and therefore a booming construction sector had favorable impact in local cement sales. (Tribune, 2014) The sharp increase in cement demand also had a favourable impact in cement prices resulting in the average sales price to increase to PKR 8,726 per MT from PKR 7,697 per MT. (Annexure, Income Statement) On the contrary, the growth in export sales was due to the fact that there was a 10% depreciation of the rupee which made Pakistani cement more competitive in the global market leading to rising volumes, however the average export sale price fell as a result from PKR 6,431 per MT to PKR 6,126 per MT as there were no major increase in dollar prices. (Khan, 2014)
In the FY 2014-15, the revenue of LCL was PKR 44.761 billion showing an increase of 4% as compared to FY2013-14. The increase was mainly due to the increase in local sales, which was netted off by a fall in export sales. Local sales increased due to both increase in sales volume and average sales price. Whereas, export sales fell due to both fall in sales volume and average sales price.
Overall sales volume rose by 3% in the FY2014-15. Local sales showed an increase of 7% from MT 4,132K to MT 4,421K which was largely due to the improved security situation in Pakistan which raised public confidence and boosted construction activities in major cities. Moreover, the initiation of the China Pakistan Economic Corridor (CPEC) has had significant favorable impact over local cement sales. (Zaheer, 2015) The surge in local demand had favorable impacts on average sales price which increased from PKR 8,756 per MT to PKR 9,034 per MT. (Annexure, Income Statement) On the other hand, export sales showed a fall of 5% from MT 2,487K to MT 2,373K due to weak demand from the Afghan market and anti-dumping duties imposed by South Africa. (Investorguide360, 2015a) As a result in order to counter the decreased export demand, cement prices have been reduced from PKR 6,126 per MT to PKR 5,891 per MT.
In comparison, D.G. Khan Cement Limited (DGK), a competitor of LCL, had a fluctuating trend in revenue over the three year period. LCL’s is the market leader in the cement industry with market share of 18%, followed by DGK with market share of 12%. (Annexure, Industry Statistics)
In the FY2013-14, the sales of DGK showed an increase of 7% as compared to LCL’s increase of 14%. Local sales of DGK improved considering the growth in the construction sector. However, export sales of DGK fell significantly due to the rising competition in the global market.
In the FY2014-15 sales of DGK showed a fall of 2% due to both fall in overall volume and average sales price, when LCL faced an increase in sale of 4%. Local sales showed an increase as a result of rise in demand due to improved security situation and initiation of CPEC as discussed above, and also due to the reduced prices which raised demand. However, export sales showed a significant fall outweighing the rise in local sales leading to fall in overall sales. (Annexure, Income Statement).
GROSS PROFIT MARGIN (GPM):
GPM is the percentage by which gross profits exceed production costs. It reveals how much a company earns taking into consideration the cost of sales.
Both the GPM of LCL and DGK have shown a slight fluctuating trend over the three year period as shown in the chart above.
In the FY2013-14 the GPM of LCL slightly reduced by 0.8% to 43.4% from 44.2%. The fall in GPM was despite the increase in average selling prices. Cost of sales appeared to have increased significantly more than the rise in sales. (Annexure, ratios) Fuel and power expenses lead major increase in cost of sales, which was as a result of 17% increase in gas tariff and PKR 50 per mmbtu increase in Gas Infrastructure Development Surcharge (GIDC). (Tribune, 2014a)
However, in the FY2014-15 the GPM of LCL increased by 1.7% to 45.1% as a result of increase in sales by 4% whereas the cost of sales increased by 1%. The company observed significant savings in fuel and power expenses which fell by 8% due to fall in coal and other fuel prices and as well as the effect of the implementation of Vertical Grinding Mills and Waste Heat Recovery in Karachi Plant. (Thenews, 2015)
In comparison, DGK had lower GPM than LCL in all three years. In the FY2013-14, GPM of DGK reduced by 2.6% to 34.9% which was worse than the fall in GPM of LCL despite higher average sales price (DGK PKR 8,490 per MT vs LCL PKR 7,767), suggesting LCL was better in terms of controlling costs. In the FY2014-15, GPM of DGK increased by 1.3% to 36.2% compared to the LCL increase of 1.7% due to fall in furnace oil and coal cost. (Annexure, Other Information)
NET PROFIT MARGIN (NPM):
The NPM of a business shows how much of the sales are translated into profit. It is calculated as net profit divided by the revenue.
The NPM of LCL increased in each of the year under consideration as shown in the chart above. In FY2014-13 the NPM of LCL increased slightly to 26.3% despite a fall in the GPM. This was due to increase in other income and fall in distribution cost, administrative expenses and finance cost. Other income increased due to interest income on deposits, distribution cost fell due to decrease in logistics cost which was achieved due to better management of logistic activities, administrative expenses decreased due to fall in professional and advisory services fee and decrease in finance cost was due to fall in markup on short term borrowings. (Annexure, Other information)
Similarly, in the FY2014-15 the NPM of LCL increased by 1.4% to 27.8% in line with the increase in GPM. Moreover, reduction in finance cost and higher other income contributed to boosting up the NPM. Finance cost reduced due to repayment of long term finance. (Annexure, Balance Sheet) Other income improved as a result of interest income from bank deposits and earnings from sale of surplus electricity to HESCO.
In comparison, the NPM of DGK has shown a similar increasing trend to LCL in each of three year. However, LCL reported higher NPM in the FY2012-13 and FY2013-14 until the FY2014-15 when DGK’s NPM was 29.2% as compared to LCL’s NPM of 27.8%. (Annexure, ratios) The improvement in DGK’s NPM showed better profitability results in comparison to LCL suggesting strong competition.
RETURN ON CAPITAL EMPLOYED (ROCE):
ROCE measures the profitability of a company by expressing its operating profit as a percentage of its capital employed. (Accounting Explained, 2015c)
The ROCE of LCL has shown a slight fluctuating trend over the three years as shown in the chart above.
In the FY2013-14, the ROCE of LCL was 26.2% as compared with 25.4% in the FY2012-13. The increase was due to increase in operating profit and increase in capital employed (represented by equity and non-current liabilities). The operating profit increased by 23% from PKR 11.789 million to PKR 14.49 million due to increase in sales. Whereas equity and non-current liabilities increased by only 19% resulting in a favorable impact on ROCE. (Annexure, Ratios)
However, ROCE deteriorated to 24.3% in the FY2014-15 as a result of increase in equity and non-current liabilities. Equity increased as a result of increase in reserve which increased due to retained earnings for the year, whereas non-current liabilities increased due to increase in deferred liabilities. On the other hand, operating profit also showed an increase but in lesser proportion.
It is clear from the chart above, that LCL has performed well and has generated better profits for every rupee of capital employed with DGK in all three years. The ROCE of DGK has remained fairly stable during the three year period, except for the down swing in the FY2013-14.
Current ratio shows the extent to which the current liabilities of a business are covered by its current assets.
The current ratio of LCL has remained sufficient to easily meet its current liabilities, as for every Rs.1 of its current liability LCL possessed a minimum Rs.3.38 to cover for it. Moreover, the ratio was also above the ideal current ratio which is considered to be as 2 times.
The current ratio of LCL improved to 4.37 times in the FY2013-14 from 3.38 times showing improvement in liquidity situation. This was primarily due to the large increase in cash and bank balances which grew from PKR 2.8 billion to PKR 8.5 billion, as a result of higher cash generated from operating activities. (LCL Annual Report, 2014)
However, the current ratio reduced to 3.64 times in the FY2014-15 as a result of increase in trade and payable balances. (Annexure, Balance Sheet)
In comparison, the current ratio of DGK was much higher than LCL, except in the FY2012-13. This suggested that DGK had high amount of current assets to cover its current liabilities, which indicated excessive funds tied up in working capital. (Annexure, Balance sheet).
Quick ratio is a measure of how well a company can pay off its short term liabilities using most liquid current assets. (Investing Answer, 2015)
In the three year period under consideration, the quick ratio showed a strong position for LCL as there were enough liquid assets to fulfill the short-term obligations. Moreover, the ratio was also above the ideal ratio of 1 time. The quick ratio of LCL has shown continuous improvement during the three years majorly due to improvement in the cash and bank balance. (Annexure, Balance Sheet)
On the other hand, the quick ratio of DGK was higher than LCL depicting the higher amount of liquid assets to cover its short-term liabilities. This was due to the fact that DGK maintains almost 70% of its current assets as short-term investments. This meant that DGK was better than LCL in terms of liquidity management and was better in managing the liquidity risk. Moreover, LCL had an excess amount of current assets as idle cash whereas DGK has made short-term investments instead of keeping idle cash balance which also provided DGK with an income stream. (Annexure, Balance Sheet)
Inventory turnover shows the frequency by which a company’s inventory is sold and replaced over a period.
Inventory turnover have shown a stable trend over the three year period under consideration. This depicts that LCL is able to sell of its inventories within the range of 23 to 25 days. In the FY2012-13, the inventory turnover was 25 days which remained at the same level in the FY2013-14, and then improved to 23 days in the FY2014-15. The reason for the improvement in the FY2014-15 was due to decrease in stock-in-trade levels at year end. (Annexure, Balance Sheet)
In comparison, the inventory turnover of DGK was higher than LCL depicting longer time taken by DGK to sell of its inventories. LCL is a market leader and faces higher demand for its products which resulted in a better inventory turnover than DGK. However, the inventory turnover of DGK has shown improvement from 39 days to 26 days depicting better stock planning. (Annexure, Balance Sheet)
Receivable turnover determines how quickly a company recovers outstanding receivable balances from its customers. (Ready Ratios, 2015b)
In all three years, the receivable turnover of LCL has been higher than DGK. This depicted that LCL takes longer than its competitor to recover receivable balance and turn them into cash, as in the FY2014-15 the receivables of LCL were converted into cash in 17 days as compared to DGK’s 2 days. This clearly suggested that DGK has high level of cash based sales that kept the receivable turnover as low as 2 days.
The receivable turnover of LCL remained quite stable in the range 16 days - 18 days during the period indicating the efforts made by the company to recover its debts. However, the credit control department of LCL seems to be weaker than DGK due to higher receivable turnover but it is also worth to look at the fact that LCL has higher sales and therefore in order to maintains market leadership higher credit period was offered.
Payable turnover measures the speed with which a company pays its suppliers. An increase is often a sign of poor credit management, lack of long term finance resulting in use of extended credit from suppliers. (BPP ACCA textbook, 2010)
The payable turnover of LCL has shown a fluctuating trend over the three year period as shown in the chart above. However, in comparison to DGK the payable turnover of LCL was much higher indicating that LCL maintains considerable power over its suppliers leading it to enjoy a free source of finance and gets extra liquidity by delaying payments to creditors. However, due to delays in payment LCL may lose out prompt payment discounts, but given the size of the business of LCL this would not be a cause for concern in getting discounts.
The debt to equity ratio compares a company's total debt to total equity. The debt to equity ratio shows the percentage of company financing that comes from creditors and investors.
The chart above depicts that LCL has maintained very low levels of debt/equity ratio, and has been averse in financing growth through debt.
The financial structure of LCL’s balance sheet comprised of long-term finance and deposits, and equity in the form of share capital and reserves. LCL relies heavily on equity, which is the major part of the capital structure of the company as compared to debt. As a result, LCL carries lower financial risk and provides better security to its debt holders.
In comparison, the debt/equity ratio of DGK was much higher than LCL but has shown a falling trend. The debt/equity ratio fell to 7.6% from 20.3% in the FY2013-14, and fell to 5.1% in the FY2014-15, as a result of a fall in long-term finance and short-term borrowings. This appears to be as a result of better liquidity management. (Annexure, Balance Sheet)
Interest cover measures the company’s ability to meet its interest payments on debts. The interest cover is a measure of the number of times a company could make the interest payments on its debt with its PBIT. (Ready Ratios, 2015c)
LCL has shown a strong interest cover due to nominal debt on the financial structure which has shown a rising trend over the three year period as depicted in the graph above. Lower level of financing through debt meant lower interest payments, which resulted in higher interest cover as operating profits have shown a rising trend.
In comparison to LCL, DGK had a much lower interest cover as a result of higher debt/equity ratio. However, the interest cover had shown a rising trend and increased to 34.9 times in the FY2014-15 from 8.13 times in the FY2012-13. The reason for the improvement in interest cover was fall in finance cost and rise in operating profit. (Annexure, Ratios)
EARNINGS PER SHARE (EPS):
Earnings per share (EPS) is the portion of the company’s distributable profit which is allocated to each outstanding equity share (common share). EPS is a very good indicator of the profitability of any organization, and it is one of the most widely used measures of profitability.
As illustrated in the graph above, the EPS of both LCL and DGK have shown an increasing trend over the three year period. Both companies had a constant number of ordinary shares, and the continuous growth in earnings resulted in EPS to increase in each of the three years in consideration. However, LCL posted higher EPS in each of three years than DGK suggesting LCL was better in providing returns to shareholders. Higher EPS of LCL than DGK was as a result of better earnings, and due to the fact that LCL has 305 million shares and DGK has 438 million shares suggesting that each rupee earned by LCL had to be distributed amongst a lower number of shareholders.
PRICE EARNINGS RATIO (PE):
The P/E ratio is a market prospect ratio that calculates the market value of a stock relative to its earnings by comparing the market price per share by the earnings per share. (My Accounting Course, 2015b)
The PE ratio of both LCL and DGK has shown a rising trend over the three year period under consideration. This resulted as stock prices have shown continued growth in the Pakistan Stock Exchange, as shown in the chart below:
The higher PE ratio of LCL shows that investors have a higher confidence in the future performance of the company and its stocks as compared to DGK. Moreover, the rising EPS of LCL had a positive impact on the share price of the company resulting in positive impacts of the PE ratio.
On the other hand, the PE ratio of DGK showed gradual movement over the three year period. However, the ratio was far below that of LCL due to a lower share price of DGK.
The market has remained optimistic about the performance of LCL as a result of the increased earnings of the company. Moreover, LCL’s investment in ICI, along with new investment in Congo, Iraq grinding plant and coal-based power plant raised the earning potential of the company, which further raised the investor confidence in the company.
This article was written by our guest blog writer - Tahir Ashraf
We hope that you found this analysis of 2 Pakistani companies useful and that it shed a light on how you should be analysing financial statements in the future. That is indeed a very useful skill and let me tell you, very useful during your Case Study exams. Bother examiner (for Case Studies) and your co-worker in real life would not want to just read – quick ratio is 3.64 and payable days are 95. What does it mean? What caused that? This is something that is going to make every analysis worth reading, it will distinguish your analysis.
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