Measuring Performance
In this scenario, and the state of the consumer markets in the UAE along with the prevailing economic outlook, it is recommended that no facilities be granted to Synthasia Electronics for this credit, analyst does not foresee how lending to this institution can bring about any concrete change in its operating position. In effect, major strategy changes at the companys end might be enough to restructure it into a financially viable enterprise, that is, following a more sustained growth policy as far asset acquisition is concerned along with concentration to bring about changes in key operating variables. When this is done, the fundamentals of the company, it is believed, will make a better case for debt investment.
Background
Ms. Synthasia Electronics (the company) has approached the Bank for a credit line of AED 20 Million as part of its capital restructuring program. Formed in the year 2007 through private equity finance, the company is engaged in the electronic goods retail segment with impressive growth in revenue being reported despite the global recession as a result of the subprime mortgage crisis in the United States and the ensuing credit crunch.
However, with falling resilience of the UAE economy to the bleak global outlook, the company feels that new growth opportunities will become restricted as equity investors look towards more liquid investments (stocks and commodities). Hence, adding debt to the company balance sheet might allow it to effectively capitalize on any growth opportunities available.
Key Deliverables
In light of this, we have undertaken a financial analysis of the performance of the company over the past two years with an aim to quantify the financial health of the company in terms of
Sales Analysis
Profitability Analysis
Liquidity Analysis
Return on Equity Analysis (Dupont Method)
Cash Flow Statement For The Year Ended 31st December 2009
It is expected that at the end of this report, the reader will be able to make a clear decision regarding the credit line proposal of the company with respect to its financial health and past financial performance.
Sales Analysis
With the resilience of the UAE economy to the global recession holding strong, the company was able to report impressive sales growth of 35.82 as the same grew from AED 536 Million (2008) to 728 Million (2009). Segmental information is not available at the moment to further dissect this sales growth.
Profitability Analysis
While sales growth has been impressive, it seems that this has not culminated into higher profitability as many expenses to revenue relationships have been disturbed in pursuit of the companys high sales growth strategies to the detriment of ensuring sustained profitability.
The gross profit of the company fell from 70.52 (2008) to 64.97 (2009) as a result of a cost of sales now accounting for 35 of the sales figure as opposed to the previous 29.4 representing higher costs related to stock and its procurement.
Similarly, the net profit margin of the company also suffered as a 53.44 increase in administrative costs led to these rising from AED 174 Million (2008) to AED 267 Million (2009). This failure to curtail costs in an environment of economic uncertainty speaks poorly of the companys cost control measures as the same led to operating margins falling from 14.74 (2008) to 9.34 (2009) as the company reported net profits of AED 68 Million as opposed to AED 79 Million in the corresponding period last year, a decline of 13.92 despite sales growth of 35.82.A major reason for this is the increased depreciation charge of AED 250 M in the current year as opposed to AED 145 M in the previous year due to rapid fixed asset growth by the company. Whereas segmentation of this increase has not been shown, we have assumed it as a separate reason.
Liquidity Analysis
As a base measure of liquidity, we see that the current ratio of the company has fallen from 4.56x (2008) to 0.97x (2009) meaning that whereby an year ago, the company had AED 4.56 in current assets to cover for each 1 AED of current liability, the same has dropped by a wide margin with the company now able to cover only AED 0.97 for every 1 AED of current liability. Probing further, we find that the company exhibits a huge inventory buildup (increased by 1.18x), a buildup of receivables (increase by 94), complete wipe out of the cash position of AED 151 Million (2008) into an overdraft amount of AED 10 Million and an increase in trade payables by 1.27 times.
To synthesize all of this, a look at the cash conversion cycle shows us that the same has increased by 23.5 days from -39 (2008) to -62.5 (2009). Inventory days and receivables days have increased alarmingly by 13 and 10 days respectively while generous supplier credit has allowed the company to stay afloat with payables days increasing from 92 to 130.
Return on Equity Analysis Dupont Method
Using the Dupont equation (see below), we will look at three core attributes of any firm with regard to its operating performance, management effectiveness and financial leverage and how these factors effect the return to equity holders.
ROE Net Profit Margin Asset Turnover Financial Leverage
YearNet Profit MarginAsset TurnoverFinancial LeverageROE200813.9911.0815.1020098.931.131.1912
As can be inferred from the above, the company has shown a dismal operating performance (due to falling profitability margins as a result of high cost of sales, rapid fixed asset acquisition leading to high depreciation charges and poor cost control) with management effectiveness at the utilization of assets and a slightly higher financial leverage allowing a respectable increase in the return to equity holders.
Cash Flow Statement
A cash flow statement for the year ended 31st December 2009 is annexed herewith as Appendix A. This shows that despite reporting positive cash flow from operations, the companys strategy of rapid fixed asset acquisition have resulted in the company to report a negative cash flow position and end the year with a small overdraft. While CFO was positive by a large margin and CFF represented only fractional amounts of CFO, the companys rapid fixed asset growth was responsible for the CFI to be negative by AED 460M.
Interpretation, Conclusions Recommendations
In light of the above, the following interpretations conclusions are witnessed made
Sales have been increased primarily as a result of higher credit sales which increase risk of default by customers as proper credit control procedures may not have been adhered to.
Inventory buildup represents obsolete inventory and a future charge to the profit and loss statement can be expected coupled with a slowdown in sales growth.
The supplier credit is the mainstay of the business and any reduction of support will lead to a massive operating collapse.
The company has poor cost control methods as represented by the rise in administrative costs.
The cash flow position at the company is in continuous stress which implies higher credit risk as there is a high chance that operating cash flows will not be enough to meet all counterparty obligations while also catering to the rapid fixed asset growth strategy that the firm is pursuing.
Taking on debt only implies signs of pressure from creditors and equity holders as the former press for payment of outstanding dues in return for continued supply of products while the latter demand improved performance. The improvement in performance, it seems, is being targeted through increasing financial leverage and not tackling key operating issues as a way to inflate the ROE figure.
Hence, it is recommended that the Bank refrains from any lending to this institution as the risks of default are too high given the poor performance depicted in the financial statements and poor financial health that the company is in at the moment. It is reasonable to believe that while the underlying business premise is a strong one, the company has to change its strategy of over capitalization and focus more on operating growth through sales volume and cost controls then on fixed asset growth as there is an increasing mismatch between profitability and fixed asset growth rates. Unless this is achieved, the continuing mismatch will pull down profitability further and put further pressure on cash flows.
Budgets Performance Measures Advantages
Budgets, while never achieving a final state and continuously staying in the formative process, have been known to be immensely advantageous in terms of meeting key objectives of a firm through the different roles that they play.
Speaking in the context of profit oriented organizations, shareholder wealth maximization is seen as a the overall aim of the firm but the achievement of such a broad task or objective has to be broken down into many smaller objectives like increasing sales and cutting costs to improve profitability. However, these broad objectives still do not tell us how to achieve any of these and by how much. Neither do we see any assignment of targets and responsibilities, any allocation of resources, coordination amongst the various actors in a firm and any control mechanisms. In the end, what we have is a firm which knows what it has to do but is not equipped with the tools to actually do so leading to immense loss of control and communication as activities go uncoordinated and a breakdown as authority, responsibility and accountability do not flow together leading to the firm actually falling short of meeting any of its objectives.
Hence, budgets are important for they help meet objectives by compelling firms to plan and allocate resources appropriately. This helps in communication of plans and hence coordinates firm activities, communicates plans, enables control as responsibility and targets flow hand in hand while at the same time motivate employees as they feel part of the wide spectrum of things while at the same time stay on their toes for now they know that performance evaluation is set to follow.
The same can be said true of performance measures. Firms that intend to grow and meet investor expectations have to continuously assess themselves in terms of what they planned, what they did, were expectations met and what is needed to be done differently. These performance measures can take the form of anything and help in the achievement of the firms objectives as they provide a direction to the firm as to what is to be achieved.
For example, a firm may set increasing profits by 10 per annum. This is a plan and hence activities geared at meeting this objective (as defined in the budget) will be carried out. At the end of the reporting period, any deviations and reasons for them will be noted and corrective action taken. Hence the firm will stay in an act of continuous self assessment while being able to coordinate activities, motivate employees, assigning responsibilities and consequent rewards penalties for results.
Implications For Lenders
According to BPP (2008), It is absolutely necessary for any investor to ensure that the objectives of the firm and his own are in complete compliance for any deviations can be fatal to the investor in terms of risk return profiling (P. 56). Simply put, as investors of debt capital with a shorter term horizon and a risk return profile geared at income generation with safety of principal invested, budgets and key performance measures help lending officers understand the objectives of the firm going forward and our own.
As an example, the Synthasia Electronics company, unless it stops its fixed asset growth program and concentrates on improving its liquidity position, cannot obtain a loan. This is because their objectives and ours are totally different.
However, to qualify for a loan now, it will have to present its desire to improve on performance measures seen critical by the bank through a forecasted budget. Hence, where liquidity is concerned, the bank may demand a current ratio of at least 11. If Synthasia can show that it is targeting a 11 current ratio and appropriate measures to be taken through the budgetary process (cash discounts, new inventory control methods), then a case can be made in front of the lending officer. Similarly, a plan to wipe out is overdraft position (performance measure) may be accompanied by budgetary measures showing lower fixed asset additions and improving the cash conversion cycle further.
To conclude, what draft budgets and performance measures do is that they show how the firm will act differently in the future, thus allowing the lending officer to make informed judgments about the goal congruence between the firm and the Bank coupled with any negative or positive loan covenants that may be set to ensure that performance is improved and the safety of the investors principal and due return is guaranteed.
Thus, lending officers are enabled to avoid historical bias, that is, taking decisions on the future of the firm based on past performance. This means that as a lending officer, the provision of past performance and expected future performance enables me to actively gauge where the firm is, where it intends to go and whether the Bank can earn a handsome return while minimizing risk.
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