Financial analysis is the “method of recognizing the financial strengths and weaknesses of a company by properly establishing relationships between the items in the balance sheet and the income statement” (Moyer, McGuigan & Kretlow, 2008). Investors who have invested their money in a firm’s shares are most concerned about the company’s earnings and well-being. As such, they concentrate on the analysis of the firm’s current and future profitability. They are also concerned with company’s financial position to the extent it influences the firm’s earning ability. Ratio analysis is a vital element in financial studies.
Ratios are used as indicators for assessing the fiscal situation and performance of an organization. Complete bookkeeping figures entered in the financial records do not give a significant analysis of the economic situation of the company, unless they are compared or related to some other relevant information (Moyer, McGuigan & Kretlow, 2008). Financial ratios therefore assist analysts and investors in making qualitative judgments about a firm’s financial position and performance.
Profitability ratios
Profitability ratios determine the performance of an organization by scrutinizing how earnings were made comparative to sales, total chattels and net value. Profits are the most vital elements of any organizations that values itself as a going concern, hence stakeholders, especially investors should always analyze the profitability index of an organization and its net profit margin. In addition, the gross profit margin should be a sign of the efficiency of how an organization produces each unit of productivity consequently. “The proportion shows the standard increase between the cost of goods sold and the sales revenue” (Ingram & Albright 2006).
A high gross profit margin relative to the industry implies that the company is able to operate at relatively low costs. A low gross profit margin ratio should be carefully investigated; it may reflect a higher cost of goods sold due to the company’s inability to purchase at favorable terms, inefficient utilization of resources or overinvestment in slow moving stock, resulting in high cost of sales Ingram & Albright (2006) notes “the gross profit ratio could also be low due to a fall in the prices in the market, or marked reduction in selling price by the firm in an attempt to obtain large sales volume, whereby the cost of sales remains relatively unchanged.”
Table 1.
Billabong International is a leading retailer in Australia, which deals in clothing, surf wear and other accessories. As per its income statements, the company has been able to gradually increase its gross profit margins from 0.536 (2007) to 0.551 (2008), before declining marginally in 2009. The company has been increasing profits for three consecutive years, from 2007, explaining the relatively stable gross profit margins. The decline in 2009 gross profit margins is related to the rising cost of sales. The costs of sales have risen at a rate higher than the sales growth rate, with sales growing by 23.63 per cent in 2009, as compared with the 28.35 per cent increase in the cost of sales. This illustrates that Billabong is experiencing difficulties in controlling costs.
Net profit is arrived at by subtracting the operating expenditures, interests and “income tax from the gross profit. The net profit margin ratio is obtained by dividing net profit after taxes by sale revenues.” This ratio establishes a relationship between net profit and sales and indicates management’s efficiency in manufacturing, administration and selling products. If the net margin is inadequate, the firm will fail to achieve satisfactory return on owners’ equity and it shows the firm’s capacity to withstand adverse economic conditions.
Table 2.
A company with higher net profit margin would be in a better position to undergo business cycles, for instance fall in product price, rise production cost or decline in consumer demand of the product (McMenamin 1999). Billabong International’s profitability can be analyzed more meaningfully if both profitability ratios are evaluated jointly. Billabong International’s net profits margins remained relatively unchanged between 2007 and 2008, before declining sharply in 2009. This could be explained by subsequent drop in the gross profit margin in the same period, as well as rising operating expenses. The implication is that both the gross profit margin and the net profit margin should be jointly analyzed, and each item of expenses should be thoroughly investigated to find out the causes of decline in any or both of the profitability ratios.
Efficiency ratios
The funds of creditors and owners are invested in various kinds of assets to generate sales and profits; the better the management of assets by a company, the larger the amount of sales. Efficiency, or activity, ratios are employed to the effectiveness with which the company manages and utilizes its assets. “Efficiency ratios therefore involve a relationship between sales and the various assets, and presume that there exist an appropriate balance between sales and the various assets” (McMenamin 1999).The return on assets (ROA) is a useful measure of the profitability of all financial resources invested in the firm’s assets (Shim & Siegel 2008). It evaluates the use of total funds without any regard to the sources of funds. The rate of return on assets is calculated by dividing net profits by total assets of a firm. This ratio is particularly useful to evaluate the performance of divisions in a multi-divisional firm. The ROA for Billabong International has declined sharply in 2009 (0.1168), from the 2007, 2008 levels. Increase in investments in assets, coupled with tough economic times, increased competition and rising costs. The decline in net profits in 2009 indicates that Billabong is not efficient in its operations, and cannot manage its operating costs effectively.
Table 3.
The ROA is conceptually unsound as it excludes interest charges from the net profit figure. The total assets have been financed by the pool of funds supplied by creditors and owners. In measuring the return on assets, the intention is to judge the effectiveness in using the “pool” of funds. To know how well the “pool” of funds has been used, the return can be compared with the cost of using the pool of funds. However, the net profit after taxes in the numerator of the ratio excludes the interest charges, which is the cost of debt, resulting in an understatement of the earnings generated by the pool of funds. Therefore, to arrive at real earnings, the interest charges should e included in the net profit after taxes.
The rate of return on shareholders’ equity measures an entity’s ability to use and finance assets to generate earnings. The rate of return on the shareholders’ capital is measured to ascertain the productivity of the shareholders’ investments. The total shareholders’ equity is sometimes also called net worth, and can be calculated by subtracting total liabilities form total assets of a company. The return on equity (ROE) is the net profit after taxes divided by the shareholders’ equity. The ROE shows how efficient an organization has used the capital of the stakeholders.
The income of a suitable investment is the most sought-after aim of a company. The ratio of net profit to owners’ equity reflects the extent to which this objective has been accomplished. This ratio is therefore of great interest to present to the prospective shareholders, and also of great concern to management, which has the responsibility of maximizing the shareholders’ wealth. In the table below, the ROE increased in 2008, but again dropped sharply in 2009. This is explained by the drop in decline in net profits for the 2009 financial year, meaning that shareholders are earning lesser returns for their investments in the company.
Table 4.
The earnings per share (EPS) ratio measure the return to ordinary shareholders. The earnings per share are calculated by dividing the net profit after taxes less preferences dividend by the total number of common shares outstanding. The earnings per share show the profitability of the firm on a per share basis. The EPS for the company was 77 cents in 2007, rising to 81 cents in 81 cents in 2008 (Reuters 2011), and declining to 69 cents in the following year as a result of decreased profitability.
The earnings per share calculations made over years indicate whether or not the firm’s earning power on per-share basis has changed over that period (Shim & Siegel, 2008). The earnings per share of a company should be compared with the industry average and the earnings per share of other firms. “The EPS does not reflect how much is paid per dividend and how much is retained in the business, but as a profitability index, it is a valuable and widely used ratio.” (Shim & Siegel, 2008).
Solvency ratios
To judge the long-term financial position of the firm, leverage, capital structure or solvency ratios are calculated. These ratios indicate the funds provided by creditors and owners of the firm. As a common regulation, there should be a suitable mix of liability and shareholders’ equity when investing in a company’s assets (Gill & Chatton, 2000). Employment if debt is advantageous to shareholders in two ways. First, shareholders retain control of the firm with limited stake and second, their earnings will be magnified when the firm earns a rate higher than the interest rate on the invested funds. Employment of debt is advantageous to shareholders in two ways. First, shareholders retain control of the firm with limited stake and second, their earnings will be magnified when the firm earns a rate higher than the interest rate on the invested funds. “Leverage ratios may be calculated from the balance sheet items to determine the proportion of debt in total financing, or can also be computed from the income statement items in determining the extent to which operating profits are sufficient to cover fixed charges.” (Shim & Siegel, 2008).
Solvency quotient analyzes the volume of an organization “after-tax cash income”, compared with the firm’s total debt obligations. It gives a dimension of how probable it is for an organization to carry on to meeting its liabilities. Shim & Siegel (2008) notes “the solvency ratio is measured by dividing the sum of after tax net profits and depreciation by the company’s total liabilities.”
Depreciation is added back to after tax income since it is a non cash expense. As a rule of thumb, a company should have a solvency ratio of more than 20 percent for it to be considered financially healthy. Billabong International’s solvency ratio is only falls marginally below the 20 per cent threshold in 2009, as illustrated by the table below, indicating that despite the fall in profits, the company is still financially healthy.
Table 4
Market based ratios
Market-based ratios illustrate investor attitudes towards the attractiveness and cost of a company’s stock. The price earnings ratio is the most widely used market based ratio and it’s calculated by dividing the market value per share by the EPS (earnings per share). The price earnings ratio or the P/E ratio measures investors’ expectation about a particular stock. A high P/E ratio in comparison with other companies in the same industry may reveal that investors have high expectations about the company (Ingram & Albright, 2006). Billabong International has a P/E ratio of 9.2 by the end of the 2008 financial year, which is lower both the sector and market averages. This indicates that investors expect the company’s performance to decline further in the near future.
Recommendation
In financial statement analysis the direction of change over a period of years is of crucial importance, whereby trend analysis of ratios indicates the direction of change. The ratio analysis will reveal the financial condition of the firm more reliably when trends in ratios over time are analysed. Ratios at a point in time can be misleading to analysts because they can be high or low for some exponential circumstances at that pint in time. An impressive present financial position may be eroding over time, while a weak position may be improving at a rapid rate over time. Therefore, the trend analysis of the ratios adds considerable significance to the financial analysis because it studies ratios of several years and isolates the exceptional instances occurring in one or two periods
Comparison of the company’s ratios with trends in the industry indicates how well the company has been operating over the time relative to its competitors, and may also help to explain the trends in the company’s ratios. The major limitation of ratios is that they only have meaning when they are compared with some other standards. Usually, it is recommended that the ratios be compared with industry averages, which are not always readily available. The factors influencing the performance of a company in one year may change in another, for example the unexpected global recession.
Billabong International continues to earn increasing revenues which could be as a result of the company’s aggressive marketing and other factors such as its wide distribution, including company’s own stores as well as department stores. Rising costs and declining revenues endanger the profitability of the company, while the gloomy economic climate in 2009 may risk further drops in revenues. 2010 may experience a growth in the global economy, and Billabong will be in a better position to exploit its wide geographic distribution network, its main competitive advantage, to increase sales of its products, and also gain market share. An investor could therefore take advantage of the low share prices in 2009 and purchase Billabong shares and hold them for a mid term period of six months.
Reference list
Gill, J. O., & Chatton, M. (2000). Financial analysis: the next step, 2nd ed. New York: Crisp Publications.
Ingram, R. W., & Albright, T. L. (2006). Financial accounting: information for decisions, 6th ed. New York: Cengage Learning.
McMenamin, J. (1999). Financial management: an introduction. New York: Routledge.
Moyer, R. C., McGuigan, J. R., & Kretlow, W. J. (2008). Contemporary Financial Management, 11th ed. New York: Cengage Learning.
Reuters, (2011). Financial stocks overview. Billabong International Ltd (BLLAF.PK). Web.
Shim, J. K., & Siegel, J. G. (2008). Financial Management, 3rd ed. New York: Barron’s Educational Series.