Financial Analysis and Management - Assignment€¦ · Financial Analysis and Management 1 | P a g...

12/31/2015

Financial Analysis and Management


1 | P a g e

Executive Summary

The goals of this report are to analyse the recent financial performance of Chemical Company

of XY Berhad (CCM) in order to conclude whether the acquiring CCM is a good investment

or not and to evaluate the main investment appraisal techniques. In the first part of the report

there is an analysis of the CCM in terms of all areas of its recent financial performance. The

analysis has been focused on evaluating and comparing financial risks and financial

performance of CCM over the years 2012 and 2013 utilizing ratio analysis. In the second

section of the report there is an article that deliberates the four main investment appraisal

techniques (NPV, IRR, Payback and ARR) with critical evaluation and recommendation

regarding the best practice of these four methods.


2 | P a g e

Table of Contents

Executive Summary ................................................................................................................... 0

List of Table & Figures .............................................................................................................. 3

Part 1 .......................................................................................................................................... 4

1.1 Current Areas of business of the Chemical Company of XY Berhad .............................. 4

1.2 Critical and Comparative Evaluation of the Financial Risks & Financial Performance .. 5

1.2.1 Critical and Comparative Evaluation of the Financial Performance ......................... 5

1.2.2 Critical and Comparative Evaluation of the Financial Risk .................................... 10

1.3 Conclusion ...................................................................................................................... 13

Part 2 ........................................................................................................................................ 14

2.1 Critical Evaluation of Four Main Investment Appraisal Techniques ............................ 14

1. Net Present Value Method ............................................................................................ 15

2. Internal Rate of Return Method .................................................................................... 17

3. Payback Period Method ................................................................................................ 18

4. Accounting Rate of Return Method .............................................................................. 19

2.2 Recommendation ............................................................................................................ 21

References ................................................................................................................................ 23


3 | P a g e

List of Table & Figures

Figure 1 - Net profit margin ....................................................................................................... 6

Figure 2 - The return on investment .......................................................................................... 6

Figure 3 - MPS and EPS .......................................................................................................... 14


4 | P a g e

Part 1

1.1 Present business engagements of the Chemical Company of XY Berthed

(CCM)

Chemical Company of XY is operating in the corporate sector of XY for 50 years. It is a

listed company on the Main Board of Bursa XY. The company is mainly engaging in

producing chemical products, healthcare products and services, pharmaceuticals, fertilizers

and technical advisory services. Providing total solution for water treatment and

manufacturing polymer coating for rubber gloves application are the main functions of

Chemicals division of CCM. The range of products of the division is applied by a broad scale

of industries worldwide. CCM is the only fertilizer manufacturer in XY. (Chemical Company

of XY Berhad, 2015) Therefore the fertilizer division of the company produces a full range of

fertilizers that covers all crop needs. Manufacturing of branded pharmaceutical products and

markets generic drugs is the function of CCM pharmaceuticals division. It produces over 200

generic products and over 20 over the counter (OTC) brands.

Revenue from sales, services, rental income from property and dividends are the main cash

inflows of the CCM. In addition to that proceeds from disposal of assets, proceeds from new

share issues and proceeds from loans and borrowings are also bring cash to the company.

Attributing to the lower revenue from chemicals and pharmaceuticals division, the financial

results of the company has declined in the year 2014. As a result, CCM recorded a loss for

the year (Rm. 35,423 thousands). Distribution expenses and administrative expenses are the

main cash outlays. In addition to that cash are expended for acquisition of assets, paying

dividends and repayment of loans and borrowings. In year 2014, there is a net cash decrease

in CCM (Rm. 47,125 thousands). CCM possesses Rm. 1,639 millions worth assets and Rm.

758 millions worth liabilities. The equity value is Rm. 881 millions.


5 | P a g e

1.2 Financial Performance and Financial Risk Analysis of the CCM Group for

the Years 2012 and 2013

Financial performance and financial risk of CCM group can be assessed using financial

statements of CCM. In order to that financial ratios are very useful. Because financial ratios

measure and provide useful information regarding the relationships that exist among the

elements recorded in financial statements. Therefore, the financial analysis for CCM group

can be done using ratios as follows:

1.2.1 Critical and Comparative Evaluation of the Financial Performance

Profitability Ratios

1. Net Profit Margin = Net Profit after Tax/ Sales

Year 2012 2013

Net Profit Margin 54,019/ 1,511,335 11,537/ 1,288,200

= 3.57% = 0.9%

2. Return on Investment = Net Profit after Tax/ Total Net Assets

Year 2012 2013

Return on Investment 54,019/ 1,543,637 11,537/ 1,327,150

= 3.5% = 0.87%

Net profit margin measures the company’s ability to earn a net income from its sales. Also it

indicates how much of each XYn Ringgit earned by the company is transformed into profits.

According to the calculations, in 2012 the company has transformed 3.57% of sales into

profits and in 2013 it is only 0.9%; which indicate that CCM has a poor ability to convert its

sales into profits. The company has very low net profit with compared to its sales. It shows

that the company should revise its pricing policies in order to increase its profit. If the

company needs to increase its profit margin it has to increase its selling price. As the


6 | P a g e

company is the only fertilizer manufacturer in XY, it can charge a higher price on fertilizer

products. At the same time for its chemical and healthcare products, CCM should pay more

attention on the cost structures. It should use cost reduction strategies in order to increase

profit margin of those products. (Erich, Helfert, 2003)

Figure 1 - Net profit margin

With compared to 2012, CCM’s net profit margin is very low in 2013. It can be clearly

identified that in 2013 the company has lower net income than in 2012. It is due to the lower

sales revenue in 2013. Therefore the company has to take steps to increase its sales using its

marketing function.

Figure 2 - The return on investment

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

2012 2013

Net Profit Margin

3.50%

0.87%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

2012 2013

Return on Investment


7 | P a g e

When considering the return on investment ratio of the company, it is also same as the net

profit margin. This ratio measures how efficient the management of CCM is at using its

assets to generate profits. According to the figures in 2012 and 2013, the company has lower

return on investment. It shows that management of CCM is inefficient in the use of the

company’s assets and the company is earning less money on its assets. Therefore the

company should increase the management efficiency in order to make more money from the

assets. As same as the net profit margin, the return on investment is also lower in 2013 with

compared to the 2012. (Erich, Helfert, 2003)

Investor Ratios

1. Earnings per Share

(EPS) = Earnings for Ordinary Shareholders/ No. of Ordinary Shares

Year 2012 2013

EPS 36,912/ 405335 647/ 457,630

= RM 0.091 = RM 0.0014

Please Contact assignment.lk for more information & 100% Non-

Plagiarized Assignments

2. Price Earnings (P/E) Ratio = Market Price per Share/ Earnings per Share

Year 2012 2013

P/E Ratio 0.99/ 0.091 1.04/ 0.0014

= 10.88 times = 742.86 times

Earnings per share ratio measures how much income the company has earned for each share

of its ordinary shares outstanding. It is the net income that is available for payment to the


8 | P a g e

holders of each ordinary share. Higher the earnings per share, the company can provide

higher dividend for its shareholders and if the company decides to reinvest those earnings it

can achieve more growth. Therefore if this ratio is higher the company can attract more

investors. However earnings per share of CCM are in a very low position due to the lower

earnings available for ordinary shareholders. As a result the ability of attracting the investors

to the company becomes lower. Since there are lower earnings per share, it does not signal

the investors a worthwhile investment. (Lemieux, 2012)

With compared to year 2012, EPS in year 2013 is very low. It is because the earnings

available for ordinary shareholders in year 2013 is very much low. This declining trend in

EPS signals the investors that there is a trouble in the company earnings and it would result in

decreasing of share price. Therefore the company should focus on increasing its earnings by

revising its pricing strategies and reducing the costs. (Lemieux, 2012)

Price Earnings ratio compares the earnings of the company to the market price of a share of

the company. Investors use this ratio as a general guideline in gauging share values because it

reflects fair market value of a share of the company based on its earnings. Higher the P/E

ratio, higher the opportunities the company has for growth. In year 2012, P/E ratio of CCM is

only 10.88 times which gives negative signals regarding the performance of the company to

the investors. In year 2013 P/E ratio is very high. However it is due to the very low EPS

value and not due to the company’s better performance. Somehow the market price per share

of CCM has increased from year 2012 to year 2013.

Working Capital Ratios

1. Stock Turnover Ratio = Cost of Sales/ Average Stock

Year 2012 2013

Stock Turnover 1,237,691/372,068 1,079,831/ 321,463

= 3.33 times = 3.36 times


9 | P a g e

2. Debtors Turnover Ratio = Credit Sales/ Average Debtors

Year 2012 2013

Debtors Turnover *1,511,335/ 336,151 *1,288,200/ 301,692

= 4.5 times = 4.27 times

*Assumed that all the sales are done on credit.

Stock turnover ratio measures the number of times the stock of the company is sold and

replaced during the year. With the purpose of measuring the liquidity of the stock, inventory

turnover measures the efficiency of the company in turning its stock into sales. Inventory

turnover ratio of CCM is low. It signals the inefficiency as stock has a zero rate of return.

This is due to the poor sales of the company and excess stock. (Lemieux, 2012)

This would result in lower liquidity and excess stock. When there is excess stock, the

company has to struggle to turn over the stock and make sales which keep away the company

attention on growth. Also company has to incur costs to manage the stock. At the same time

there are associated risks of outdating and expiring the stock and shifts in customer demand.

Therefore the company should increase its efficiency in making sales. However excess stock

is effective in the cases of material shortages and expected rising of price levels. With

compared to 2012, there is a slight rise in inventory turnover ratio of CCM in 2013.

Debtor’s turnover ratio calculates how frequently the company converts its debtors into cash

during the year. It indicates the efficiency of the company in converting its credit sales into

cash and efficiency of the collection policies. Higher the debtor’s turnover ratio, the efficient

the credit periods and collection of debtors and the company operate on a cash basis. The

ratio is lower in CCM. It implies that the company takes longer period to convert its debtors

into cash. Therefore the risk of bad debts is higher as the company hold longer debtors.

Therefore the company should revise its credit and collection policies in order to ensure

timely converting of debtors into cash. With compared to 2012, 2013 debtors turnover ratio is


10 | P a g e

further low. It implies that collection efforts of the company are getting worse due to

lowering sales of the company. (Lemieux, 2012)

1.2.2 Critical and Comparative Evaluation of the Financial Risk

Gearing Ratios

1. Debt and Equity Ratio = Long Term Liabilities/ Equity Share Capital

Year 2012 2013

Debt and Equity Ratio 575,683/ 967,954 399,897/ 927,253

= 0.595:1 = 0.431:1

2. Interest Cover Ratio = Profit before Interest and Tax/ Interest Payable

Year 2012 2013

Interest Cover Ratio 102,218/ 32,673 44,517/ 26,324

= 3.13:1 = 1.69:1

Debt and equity ratio compares the company’s total long term liabilities and total equity. It

measures the riskiness of the financial structure of the company. Higher the debt to equity

ratio, more debt capital is used to finance the company than the equity capital. Therefore

there is high financial leverage and more risky to creditors and owners. CCM’s long term

liabilities are only 6/10 of equity capital in 2012. Therefore it has lower debt to equity ratio

implying that the company is a financially stable business. The company is financed with

more debt capital. Therefore the obligation of repayment of funds is lower.


11 | P a g e

In 2013 the debt and equity ratio of CCM has further reduced. Debt capital is only 4/10 of

equity capital. Therefore the company has the capacity to take more loans to achieve

organizational growth. The 2 year trend of debt and equity ratio can be calculated as follows.

Trend Percentage = (0.4-0.6)/0.6

= - 33.33%

There is 33.33% of decline in debt and equity ratio of CCM from 2012 to 2013.

Interest cover ratio is a measure of the ability of the company operations to provide

protection to the long term creditors. Because it measures the company's ability to pay the

interest on its long term debt. Even though there is lower interest cover ratio in CCM, it has

sufficient earnings to cover interest payments. However the ability of CCM to provide

protection to its long term creditors is somewhat lower. It signals that the company may

default on its interest payments. It further generalizes by the fact that the ratio is declining

when it comes to 2013. Therefore the company should increase its earnings enabling it to

make interest payments. The 2 year trend of interest cover ratio can be calculated as follows.

Trend Percentage = (1.69-3.13)/3.13

= - 46%

There is 46% of decline in interest cover ratio of CCM from year 2012 to year 2013.

Liquidity Ratios

1. Current Ratio = Current Assets/ Current Liabilities

Year 2012 2013


12 | P a g e

Current Ratio 1,043,086/ 508,545 927,191/ 526,753

= 2.05:1 = 1.76:1

2. Quick Assets Ratio = Quick Assets/ Current Liabilities

Year 2012 2013

Quick Assets Ratio 690,268/ 508,545 637,084/ 526,753

= 1.36:1 = 1.21:1

Current ratio measures the company’s ability to meet its short term liabilities. It measures

whether the company has enough resources to pay short term debts. According to the

calculations, CCM’s current assets are two times as its current liabilities in year 2012.

Therefore the company is capable of paying its short term obligations. At the same time it

implies that the company has safe liquidity and high operating efficiency. On the other hand

there is a higher level of current assets and it consists with higher level of receivables and

higher level of inventories. It indicates that the company is not using its current assets

efficiently.

Another important fact is current ratio has declined from year 2012 to year 2013. A decline in

the ratio signals deterioration of financial condition of the company. However in CCM the

decline in the ratio can be attributed to the reduction in inventory level and level of

receivables in the year 2013. In that case, it cannot be said that lowering of the ratio is

unfavourable. (Erich, Helfert, 2003)

Quick asset ratio is also same as the current ratio but it excludes some current assets such as

inventories that may be difficult to convert into cash quickly. It measures the ability of the

company to meet short term obligations without having to liquidate the inventory or in other


13 | P a g e

words it measures whether the company has sufficient assets that can be quickly converted

into cash to meet its current liabilities. CCM has more than one quick asset to one current

liability in both years. Therefore the company can meet its current liabilities with the

available quick assets.

However in the same way as current ratio, quick asset ratio also has declined from year 2012

to year 2013. The decline can be attributed to the decline of receivables in the year 2013

which is a positive sign of operating efficiency. Even though there is a decline still the

company has sufficient quick assets to pay its current liabilities.

1.3 Conclusion

The company has lower profitability and it is declining. Therefore the ability of CCM to

generate profits in future is lower. CCM has working capital issues as there are higher level

of stocks and debtors. On the other hand, the company has very low earnings per share and it

is declining. As a whole, all these indicate that the financial performance of the company is

poor and the declining trends imply that the financial performance is getting worse in future.

When consider the financial risks of the company, CCM has lower financial risk as there is

lower level of debt relative to the equity. However the ability of CCM to provide protection

to its long term creditors is somewhat lower. The liquidity risk of the company is at a

moderate level as it has been able to reduce its stock and receivables into certain extent.

Future trends in share prices and dividends of CCM can be shown as follows. According to

that MPS and EPS show declining trends.


14 | P a g e

Figure 3 - MPS and EPS

CCM is not a good acquisition to make as such a poor performing company would badly

affect the large company and it is not an attractive company for investors.

Part 2

2.1 Critical Evaluation of Four Main Investment Appraisal Techniques

In order to evaluate the investment appraisal techniques the following information which are

related to CCM are useful.

Investment (Replacement cost of assets): RM 1,639,059,000

Length of the investment: 5 Years

Expected net cash flows for next five years (Forecasted net cash flows):

(RM’000)

1 7,562

2 4,060

3 559

4 -2,943

5 -6,444

Terminal Value

(Forecasted replacement cost of assets after five years): RM 609,012,333

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

2012 2013 2014 2015 2016 2017

MPS DPS


15 | P a g e

Discount Rate (Weighted Average Cost of Capital): 3.87%

1. Net Present Value Method

Net present value of an investment project is the difference between present value of cash

inflows generated by the project and present value of cash outflows of the project. Present

values of cash flows are calculated using cost of capital or expected rate of return. A positive

net present value represents the value addition of the investment project to wealth of the

owners. In contrast, a negative net present value represents the deterioration of the wealth.

Therefore the decision criteria under this method can be shown as follows:

If NPV is positive – accept the investment project

If NPV is negative – reject the project

NPV of the investment in CCM can be calculated as follows:

Year Cash Flow 3.87% PVF PV

0 (1,639,059) 1.0000 (1,639,059)

1 7,562 0.9627 7,280

2 4,060 0.9269 3,763

3 559 0.8923 499

4 (2,943) 0.8591 (2,528)

5 (6,444) 0.8271 (5,330)


16 | P a g e

5 609,012 0.8271 503,714

NPV (1,131,661)

According to the decision criteria the investment should be rejected as there is a negative

NPV.

Advantages of NPV method:

Incorporates the concept of time value of money in the evaluation.

Uses cash flows of the project rather than accounting profit to calculate the net present

value.

Considers all the cash flows of the project over the life of the investment for the

calculation of net present value.

Takes into account the timing and amount of cash flows generated by the investment

project.

Disadvantages of NPV method:

It is impossible to accept all the projects with positive NPV without the presence of

perfect capital market.

Finding of cost of capital of investment projects is difficult.

It considers cost of capital to be constant over the life of the investment. However it

can be changed over the life of the project.

Over a certain point cost of capital is not applicable to use as the discount rate as net

cash inflows cannot be reinvested at cost of capital.


17 | P a g e

2. Internal Rate of Return Method

Internal rate of return of an investment project is the discount factor (cost of capital or

expected rate of return) which can generate zero net present value for the project. Once the

IRR is calculated, it is compared with the cost of capital. If the IRR is greater than the cost of

capital the project generates a positive NPV and if the IRR is lower than the cost of capital

the project generates a negative NPV value. The decision criteria under this method are as

follows: (Erich, Helfert, 2003)

If IRR is greater than cost of capital – accept the project

If IRR is less than cost of capital – reject the project

IRR of the investment in CCM can be calculated as follows:

NPV values taking -19% and -18% as the discount rates:

Rate NPV

1. -19% 98,828

2. -18% (3,983)

IRR = R1 + (NPV1/ (NPV1-NPV2)) * (R2-R1)

= -19 + (98,828/ (98,828+3,983)) *(-18-(-19))

= -18.04%

The IRR of this investment project is negative due to the lower net cash flows. Investor will

have to incur a loss. Therefore the investment should be rejected as IRR is lower than cost of

capital.

Comparing NPV method and IRR Method:


18 | P a g e

Both methods incorporate the concept of time value of money.

When there are non conventional cash flows in an investment project, use of IRR

method may result in taking inaccurate decision as the method does not provide an

exact return.

However in such a case, NPV method provides appropriate solution as the above.

Therefore when there are non conventional cash flows NPV method provides proper

guidance rather than IRR method.

3. Payback Period Method

This method measures how long will it takes the net cash flows generated from a capital

investment project to recover the initial investment of the project. Under this method the

decision regarding the investment project is taken as follows:

If payback period is equal or less than a predetermined payback period – accept the

project

If payback period is greater than a predetermined payback period – reject the project

In the case of investment in CCM, the initial investment cannot be recovered over the life of

the investment project as the expected net cash flows of the project are very low and include

negative cash flows too. Terminal value also not sufficient to recover the investment.

Therefore the project should not be accepted as the project is unable to recover the initial

investment.

Advantages of payback period method:

Simple method and it is easy to use.


19 | P a g e

Provides information on how long funds are likely to be committed to an investment

project.

It uses cash flows rather than accounting profit.

A way of controlling the risk as the method select shorter payback period and it is

considered that short term cash flows are more certain than long term cash flows.

Disadvantages of payback period method:

Does not incorporate the concept of time value of money.

Ignores any net cash flows that occur after the point where the net cash flows

generated by an investment project are equal to the initial investment. Therefore it

would miss the projects with long growth periods and large cash flows in long term.

Does not take into account the size and timing of the cash flows of an n investment

project.

Does not consider the profitability of the project.

04. Accounting Rate of Return Method

Accounting rate of return is the percentage return on investment which is calculated based on

accounting profit without taking the cash flows into consideration. It can be calculated as

follows: (Erich, Helfert, 2003)

ARR = (Average Annual Profit/ Initial Investment) * 100


20 | P a g e

The decision criteria under this method are as follows:

If ARR is positive – accept the project

If ARR is negative – reject the project

ARR of the investment in CCM can be calculated as follows:

Year Forecasted Annual Profit

1 (79,398)

2 (124,119)

3 (168,840)

4 (213,561)

5 (258,282)

Average Profit (168,840)

ARR = (-168,840/ 1,639,059)* 100 = -10.3%

According to the decision criteria the investment should be rejected as there is a negative

ARR.

Advantages of ARR method:

Simple method.

Unlike payback method, it considers all the cash flows of the project over the life of

the investment.

ARR can be compared with the return on the investment (ROI) of the company.


21 | P a g e

Disadvantages of ARR Method:

Based on accounting earnings rather than cash flows.

Does not incorporate the concept of time value of money.

Ignores the timing of the earnings and gives equal weights for earnings in each year of

the life of the project.

2.2 Recommendation

As discussed above all the four main investment appraisal techniques (NPV, IRR, Payback

and ARR) have both advantages and disadvantages. NPV method and IRR method are

discounted cash flow techniques. Those methods incorporate the concept of time value of

money in the evaluation of an investment project. Payback period method and ARR do not

use the concept of time value and they are non discounted cash flow methods.

After considering all the pros and cons of these four methods, the recommendation is to use

multiple techniques: NPV and IRR methods. The reason for recommending these two

methods is that these two methods are consistent with the main objective of any company.

Maximising the wealth of the owners is the objective of any company. The objective is

supported by these two methods. If a company invests in a project which is having positive

net present value, it would be added to the value of the company and hence the wealth of the

owners would increase. On the other hand, if a company invest in a project with negative net

present value, the value of the company and the owners’ wealth would deteriorate.


22 | P a g e

In IRR method, if a company implements a project with IRR which is greater than cost of

capital, it increase the wealth of the owners by the excess percentage and if IRR is lower it

would reduce the wealth.

Even though payback and ARR methods are simple, they use the cash flows of the project as

it is. It is inaccurate to use future cash flows for evaluation without discounting them to the

present as the worth of money is depreciating with time. Also those methods do not show

value addition or deterioration resulting from the project. Therefore they are inconsistent with

the objective of a company.


23 | P a g e

References

Alice C., John C. L, Cheng F., S, (2009), Financial Analysis, Planning & Forecasting:

Theory and Application. 2nd ed. Salisbury: World Scientific Publisher.

Chemical Company of XY Berhad. (2015), Annual Reports - CCM. [ONLINE] Available

at:http://www.ccmberhad.com/annual-reports. [Accessed 23 December 15].

David V., K, (2002), Financial Analysis and Decision Making. 1st ed. Salford: McGraw Hill

Professional

Erich A. Helfert, G, (2003), Techniques of Financial Analysis: A Guide to Value Creation.

2nd ed. London: McGraw-Hill/Irwin.

Frank J. Fabozzi, Pamela P. Peterson, S, (2003) Financial Management and Analysis. 2nd ed.

London: John Wiley & Sons.

Helfert, K.R, (2004), Techniques of Financial Analysis: A Mode. 2nd ed. India: Tata

McGraw-Hill Education.

Higgins, K.R, (2013), Analysis for Financial Management. 2nd ed. India: Tata McGraw-Hill

Education.

Lemieux, V, (2012), Financial Analysis and Risk Management. 3rd ed. Edinburgh: Springer

Science & Business Media.

Mohana, R.P, (2010), Financial Statement Analysis and Reporting. 1st ed. Stirling: PHI

Learning Pvt. Ltd.

Sarngadharan.S Rajitha, K, (2011), Financial Analysis for Management Decisions. 3rd ed.

Ripon: PHI Learning Pvt. Ltd.

Pamela P., D., Frank J. Fabozzi, S, (2012), Analysis of Financial Statements. 2nd ed. London:

John Wiley & Sons,

Prasanna C, P, (2011), Financial Management. 2nd ed. India: Tata McGraw-Hill Education.

http://www.ccmberhad.com/annual-reports

Financial Analysis and Management - Assignment€¦ · Financial Analysis and Management 1 | P a g...

Documents

Transcript of Financial Analysis and Management - Assignment€¦ · Financial Analysis and Management 1 | P a g...