Prague University of Economics and Business
Bachelor’s Thesis
2021 Jhanellah Mariz Estillore
Prague University of Economics and Business Faculty of Business Administration
Bachelor’s Field: Corporate Finance and Management
Title of the Bachelor’s Thesis:
Financial Strategy: An Assessment and Proposal for DAMAC Properties
Author: Jhanellah Mariz Estillore
Supervisor: doc. Ing. et Ing. Ondřej Machek, MBA, Ph.D.
Declaration of Authenticity
I hereby declare that the Bachelor’s Thesis presented herein is my own work, or thoroughly and specifically acknowledged wherever adapted from other sources. This work has not been published or submitted elsewhere for the
requirement of a degree program.
Prague, 12 May 2021 Signature
Acknowledgements
I would like to extend my sincere thanks to my supervisor doc. Ing. et Ing. Ondřej Machek MBA Ph.D. for his constructive criticism and
constant guidance, without which this work would not have been
possible.
Title of the Bachelor’s Thesis:
Financial Strategy: An Assessment and Proposal for DAMAC Properties
Abstract:
This bachelor’s thesis pursues the topic of creating a financial strategy for DAMAC Properties.
The main goal of this work is to study and evaluate the financial position of the company in the business period of 2015 to 2019. Based on those findings, viable recommendations are proposed in order to facilitate the improvement and optimisation of its financial situation. The theoretical and methodological background section focuses on the understanding of the concept of financial analysis, which includes various financial performance evaluation methods, users, sources of information, and analytical tools. The results and discussion section focuses on incorporating these methods by using the company’s actual figures. To obtain this data, the company’s major financial statements are extracted from the company’s annual reports. In this study, the author determined that DAMAC Properties has not been financially healthy as its performance indicates that it has been putting only the efforts necessary to survive.
Macroeconomic conditions have certainly made significant impacts on its financial position that several aspects of the business need to be improved to accommodate its resurgence.
Keywords:
Financial strategy, financial analysis, real estate industry, property development
TABLE OF CONTENTS
INTRODUCTION 1
1 THEORETICAL AND METHODOLOGICAL BACKGROUND 3
1.1 FINANCIAL STRATEGY 3
1.2 FINANCIAL ANALYSIS 3
1.2.1 SCOPE OF FINANCIAL ANALYSIS 4
1.2.2 USERS OF FINANCIAL ANALYSIS 5
1.2.3 SOURCES USED IN FINANCIAL ANALYSIS 7
1.2.4 FINANCIAL STATEMENTS AND SUPPLEMENTARY INFORMATION 8
1.2.5 TYPES OF FINANCIAL STATEMENT ANALYSIS 13
1.2.6 FINANCIAL ANALYSIS TECHNIQUES 14
2 RESULTS AND DISCUSSION 27
2.1 ABOUT THE ORGANISATION 27
2.1.1 CORE INFORMATION 27
2.1.2 OWNERSHIP STRUCTURE 28
2.1.3 ORGANISATIONAL ARCHITECTURE 29
2.1.4 MACROECONOMIC FACTORS 31
2.2 FINANCIAL ANALYSIS 33
2.2.1 COMMON-SIZE ANALYSIS 33
2.2.2 RATIO ANALYSIS 43
2.2.3 INDUSTRY ANALYSIS 46
2.2.4 DUPONT ANALYSIS 47
2.2.5 WORKING CAPITAL ANALYSIS 47
2.2.6 BANKRUPTCY PREDICTION MODELS 48
2.2.7 SWOTANALYSIS 50
2.3 RECOMMENDATIONS 52
CONCLUSION 54
BIBLIOGRAPHY 56
ANNEX 61
Acronyms
AED – United Arab Emirates Dirham CO – Company
DFM – Dubai Financial Market GCC – Gulf Cooperation Council GDR – Global depository receipts IPO – Initial public offering LLC – Limited liability company LSE – London Stock Exchange PJSC – Public joint-stock company ROA – Return on assets
ROE – Return on equity UAE – United Arab Emirates
Introduction
In this millennium, to say that “globalisation is ever-changing” is an understatement. Over the recent decades, the world economy has immensely strengthened its interdependence and has now become an indissoluble connection between economies and an indispensable element in today’s modern society. One of the most remarkable attributes of globalisation is international trade which features trade liberalisation, allowing countries to freely trade goods and services between each other with less barriers to trade. Thus, enabling them to optimise the balance between supply and demand which results to a rise in economic development.
But in spite of that, among the many advantages of globalisation provides, there are also disadvantages. As global interdependence continues to grow, the probability of a global recession occurring increases as well. This may lead to a worldwide financial crisis coming off from a chain reaction affecting all nation’s participating in the global economy simultaneously.
Similarly, due to globalisation promoting free trade, businesses are able to diversify their risks and have access to new customers; however, this increases competition not only domestically but foreign as well. These are only a few of the numerous factors that may hinder a business from becoming successful.
To put it simply, it is crucial for businesses to construct a business model which can not only allow them to maximize their profits but, at the same time enables them to get equipped for certain unpleasant circumstances for its survival. In order to facilitate such situations, a business may undertake several analytical tools as this will help them to achieve these goals.
And one of these analytical tools is financial analysis, it is a useful tool which utilises a company’s financial information for the purpose of assessing its performance and position by examining its financial health. The result of this analysis will be beneficial for both internal and external stakeholders.
This bachelor thesis aims to study and evaluate DAMAC Properties Dubai Co. PJSC’s financial position by conducting a financial analysis for a consecutive period of five years from 2015 to 2019. The acquired findings will be mainly obtained from the company’s website and its annual reports. Consequently, these findings will be utilised to formulate feasible ways to improve and optimise its financial situation.
The author chose this specific company mainly due to her interest in the property development industry and the company being the first property developer from the Middle East to be listed on London Stock Exchange. In addition to that, real estate is one of the most lucrative market in the United Arab Emirates, where the population is predominantly made up of expatriates rather than locals, which slightly makes it an interesting choice of topic. The period and length of the analysis is particularly chosen as the property market in the year 2015 started to decline in the UAE.
The structure of this bachelor thesis is divided into two parts. The first part is the theoretical and methodological background which focuses on the understanding of the concept of financial analysis. This includes gaining knowledge of various financial performance evaluation methods, understand who users of various financial analysis are, sources of information financial data are derived from and use of various analytical tools incorporated in analysis. The second part is the results and discussion which focuses on actual calculation of financial indicators according to the structure. In the last segment, the author will draw a conclusion on the basis of financial analysis performed in regard to the financial health of company. To conclude the conducted research work, the author will attempt to to propose own suggestions on how the company performance could be improved based on the results calculated in the practical part. Nonetheless, limitations to an extent will definitely appear in this work, as the author cannot acquire all the financial information imperative to produce a fully developed analysis. Hence, the author will try to avoid irrational assumptions that could impede the financial analysis from being accurate.
1 Theoretical and Methodological Background
1.1 Financial Strategy
The financial strategy is crucial to an organisation’s strategic plan. It is used as a financing roadmap to achieve the organisation’s overarching goals. As a means of attaining these goals, assessing the company’s current financing needs and significant resources needed must be conducted through a financial analysis. Into the bargain, this strategy also allows the company to establish how it should proceed with planning to finance its overall operations in order to permit its growth, success and sustainability (CGMA, n.d.). The essential constituents of strategic financial management are the mobilisation of the financial resources needed by the organisation executed in an orderly fashion, whilst taking into account its overall strategy and the combined weighted requirements of its key stakeholders and administering exertion of these resources within the organisation. For instance, these exertions could be distribution of any profits from money-making activities or decision on reinvesting. This, principally, means that composing a financial strategy is used to recognize and making the most of value-creating opportunities (Bender & Ward, 2009). These are all executed with the main purpose of creating value for the company’s shareholders and creating a competitive advantage against the market it operates in, with the objective of creating a sustainable shareholder value and exploitation of market inconsistency (Bender & Ward, 2009). Although business students are taught that all stakeholders hold great importance to an organisation and are not to be neglected, in this case, shareholders’ interests hold much greater importance and are mostly, directly affected by any fluctuations that may occur. Nevertheless, a sound financial strategy should be specific and customised to the needs of the company and must take into consideration both external and internal stakeholders (Bender & Ward, 2009).
1.2 Financial Analysis
One of the most important steps in creating a financial strategy is conducting a financial analysis. Financial analysis is utilised to evaluate a company’s performance in relation to its industry and economic environment by examining historical financial data to gain insights on its current and future financial health in order to reach a decision or make a recommendation.
These decisions and recommendations are typically concerned with pooling financial resources for the company such as investing in the company’s debt or equity securities (Henry &
Robinson, 2015). Financial analysis serves as a backbone for a company in terms of its financial health as it can be used to attract prospects to invest into the company. Furthermore, it is also useful in evaluating the company’s profitability with factors such as lucratively growing its operations, generating enough cash to meet obligations and pursue opportunities, and most importantly, earning a return on its capital equalling to the cost of the aforementioned capital at the very least. All of the information needed to create a fundamental financial analysis is contained in the company's financial reports, which include audited financial statements, additional disclosures required by regulatory authorities, and any accompanying unaudited
commentary by management (Henry & Robinson, 2015). Overall, a basic financial analysis provides a solid foundation for its users by granting them a deeper, clearer understanding, and comprehensive knowledge of the company's reports and the information gathered beyond it, allowing users - such as potential investors - to pinpoint and plan on how they can leverage capitalising on a company's venture (Henry & Robinson, 2015).
1.2.1 Scope of Financial Analysis
As mentioned earlier, financial reports contain the information necessary to gain an understanding of a company's performance, financial position, and changes in financial position. The purpose of this information is to provide guidance in economic decision-making to a broad array of users. Nonetheless, the users of the financial reports prepared by a company to run a financial analysis typically have certain economic decisions to be reached, and these decisions could be one or more of the following (Henry & Robinson, 2015):
Potential merger or acquisition candidate evaluation Investment options selection
Equity investment evaluation for portfolio inclusion Future net income and cash flow forecasting
A parent company’s subsidiary or operating division for evaluation Credit extension to a customer
Examination of debt covenants or other contractual arrangements for compliance Determining the worth of a security in order to make an investment recommendation to others
Assignment of debt rating to a company or bond issue
A company’s creditworthiness is determined in order to decide whether or not to extend its loan
In financial analysis, these decisions address distinct matters. For instance, its users like financial analysts are subjected to matters relating to risks factors that may affect a company’s performance and financial position; therefore, forming expectations about its future performance and financial position should be applied appropriately by examining its past and current performance as well as its financial position (Henry & Robinson, 2015).
The ability of a company in producing a positive cash flow and in generating a profit from its business operations are a part of examining its performance. To elaborate more into the scope of performance examination, it is wise to know that cash flow and profit are two different things and are not interchangeable. A company’s cash flow needs to be examined mainly due to its financial obligations such as paying to employees and suppliers as well as paying returns in the forms of dividends and/or interests to debt and equity capital providers, and to fulfil the concept of going concern principle. If the company generates a positive cash flow, it shows that it has the capacity to be flexible in investment funding and has the opportunity to exploit appealing, lucrative business prospects. Hence, the result of this examination is rendered significant with
regards to valuing corporate securities and meeting financial obligations, including both liquidity and solvency. On the contrary, substantial information concerning cash flows can be obtained from profits such as earnings used for valuation of a company for discounted cash flow models of valuation by using forecasted future earnings and/or carrying out a comparison of price-to-earnings ratio against competitors’ price-to-earnings ratios as direct or indirect inputs (Henry & Robinson, 2015).
With regards to the current financial position, it is important to be aware of a company’s financial position for the reason that relevant organisations, like rating agencies whose function is to assess a company’s ability to meet its financial obligations swiftly (accelerated debt repayment) such as principal and interest payments on their debts, by performing a credit analysis. Consequently, if the agency concludes that the company has this ability, it will receive an improved corporate credit rating and issue-level rating. This will make it easier for the company to financing resources when needed. Lastly, financial statements, financial notes, and supplementary schedules and a variety of information sources are records that must be consulted as a matter of standard practice when conducting a financial analysis (Henry &
Robinson, 2015).
To conclude, with the expansion of business in various directions, the scope and complexity of financial management has grown. As business competition has increased at a faster rate, more innovative financial management is required to keep the company ahead of the competition (Gopal, 2008).
1.2.2 Users of Financial Analysis
There are several users of financial analysis and the nature of it being undertaken is based on their purpose (Gopal, 2008). They can be classified into two groups relating to the kind of linkage they have towards the company. These categories are identified as internal and external users (Accountingverse, n.d.).
Internal Users
As the name suggests, the first type of users is those who are involved in the operations of the company and utilises the accounting information derived from the financial statements analysis in making informed decisions for the operations of the company (Accountingverse, n.d.). These users are the following:
Shareholders: Shareholders hold direct financial interests to the company’s financial health as their wealth not only fluctuates depending on the company’s competence on making good financing decisions, but also due to the detached relationship between ownership and management which encourages them to dig up and verify the company’s strength and profitability by inspecting financial statements (Gopal, 2008).
Debenture Holders: Debenture holders are paid with interest payments periodically then the principal amount at the end of the term. Therefore, as a long-term creditor of a company, they
like to know and are attentive towards the company’s future outlook, specifically its solvency in the long-run and its survival using financial analysis to determine how its management sets its financial standing in the future built upon on their grounding. This is to meet the need of their assurance that the company or debtor they are lending to are able to generate adequate cash to pay their duly instalments for the loans (Gopal, 2008).
Managers: Primarily, managers perform financial analysis due to their large interest on every aspect of it. They are engrossed on learning about the company’s current and future position to revise its progress, such as the effectivity and efficiency of the utilisation of its resources. In addition to that, they also build informed decisions relating with operations, investments and finance (Gopal, 2008).
Employees: Stability and profitability of the company are what’s important to employees. To elaborate, the relationship between the management and employees relies on trust. On that account, employees carry out financial analysis to discern if they can feel confident working for the company. Furthermore, they tend to be more loyal to the company, when they feel secure about its growth and the quality of employee benefits like career advancement it offers (Gopal, 2008). Nonetheless, this also allows them to understand more about the company and raises the sense of involvement in it (Bragg S. , 2020).
External Users
The second type of users are categorised as external. These users possess no connection with the operations of the company; however, they do have substantial interests in its financial position. Additionally, they can be segregated even further into two groups: direct and indirect.
Direct external users are those who hold direct interest towards a company’s financial health;
whereas indirect external users are those who hold relative interest towards a company’s financial health such as customers and employees (Accountingverse, n.d.).
Creditors: Creditors, characteristically, trade creditors who supply or render service are interested in the company’s liquidity, which can be assessed by using financial analysis, to ensure that they are able to settle their short-term debts on time, before granting them the privilege to extend credit (Gopal, 2008).
Financial Institutions: Financial institutions typically aid companies raise their capitals, which could range in the form of loans and other monetary transactions; therefore, they are definitely interested in the results of its financial analysis in terms of its profitability to find out about its long-term position and solvency for its short-term (Agarwal, n.d.).
Prospective Investors: Prospective investors are certainly interested with the company’s financial strength and its future outlook because of simple reasons (Accountingverse, n.d.).
First, is their concern of its earning ability to afford compensating dividends to its shareholders.
Second, is if their bought shares are to appreciate value over time. These inquiries are to be solved using financial analysis and if it indicates a steady growth in earnings, the company will be in a favourable position among others in the eyes of prospects (Gopal, 2008).
Customers: Customers making use of financial analysis may seem unusual. However, sometimes there are important customers who are interested in the company’s financial health as they are keen on drawing long-established relationship with the company to provide them goods or services mandated in the contract (Accountingverse, n.d.).
Competitors: The knowledge that could be gained by having access to a company’s financial statements could help its competitors to enhance their competitive strategies by evaluating its financial condition (Bragg S. , 2020).
Government: Tax authorities conduct a financial analysis because they are interested how well the company gain profits and imposed appropriate tax on it (Accountingverse, n.d.). Moreover, they also use it to measure the accuracy of the taxes and other duties declared and paid by the company to ensure that they are not paying more or less than they should (Gopal, 2008). At the same time, they may also utilise it for compiling business statistics purpose (Coucom, 2012).
Investment Analysts: Investment analysts perform financial analysis of a specific company which their clients are interested in. After the analyses, these clients or investors will then receive a recommendation from the analysts whether if the company is reasonable enough to put their money in (Bragg S. , 2020).
Credit Rating Agencies: Credit rating agencies use financial analysis to measure the company’s liquidity and solvency in order to rate their level of creditworthiness (Bragg S. , 2020).
Stock Exchanges: To protect the interests of investors, stock exchanges conduct a financial analysis to learn more about the listed companies’ prospects and performance (Agarwal, n.d.).
Unions: The ability of a company to pay compensation and benefits are of special interest of unions; therefore, they evaluate its financial statements, with the intention of protecting their members’ interests or well-being (Bragg S. , 2020).
1.2.3 Sources Used in Financial Analysis
The analyst or user must first collect an immense amount of information in order to execute a financial analysis. Hinging on the specific purpose of the analysis, the nature of the information needed to be extracted will most likely vary. To simplify its nature, the information can be divided into two categories (Henry & Robinson, 2015):
Internal Accounting Information
This type of information is collected from inside the company, which includes major financial statements such as (Henry & Robinson, 2015):
Income Statement Balance Sheet
Cash Flow Statement External Accounting Information
This type of information is collected from outside the company (Henry & Robinson, 2015):
Economic Statistics Industry Reports Trade Publications
Analysis Information Databases - Financial Reports - Press Releases
- Investor Conference Calls & Webcasts
Although the information can be separated into two categories, customarily it regards to the company, its competitors, industry as well as the economy (Henry & Robinson, 2015).
1.2.4 Financial Statements and Supplementary Information
To evaluate the performance and financial position of a company, financial statements accompanied by supplemental disclosures must be prepared. These financial statements are the records of its economic activities resulting from the process of accounting bookkeeping throughout the period and kept in accordance with the applicable set of accounting standards and principles. Furthermore, they are required to be produced at regular intervals - ranging from annually, semi-annually to quarterly. The company decides on its interval based on the applicable regulatory requirements (Henry & Robinson, 2015).
A set of the financial statement includes (Henry & Robinson, 2015):
Statement of Financial Position Statement of Profit & Loss Statement of Cash Flows Statement of Changes in Equity
Financial statements contain notes which can be seen either as footnotes in the financial statements or separately written accompanying it. These notes are compulsory because it is considered as an integral part of financial reporting. Moreover, companies sometimes include additional information with their financial statements depending on the guidelines mandated by regulators or accounting standard boards (Henry & Robinson, 2015). Examples of additional information are (Henry & Robinson, 2015):
Management Discussion & Analysis (Management Commentary) External Auditor’s Report
Governance Report
Corporate Responsibility Report
All this additional information is to be assessed and evaluated along with the financial statements (Henry & Robinson, 2015).
Statement of Financial Position
The statement of financial position, also referred to as the balance sheet, unveils the correlation between the company’s owned and controlled resources and its obligations to those resources from lenders and other creditors at a specific period of time (Bettner, 2015). Nevertheless, the excess of its equilibrium is signified as the owners’ residual claim on the company’s resources.
The relationship between these elements – assets, liabilities and owners’ equity, can be simply expressed in the form of equation known as the accounting equation (Henry & Robinson, 2015):
𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑂𝑤𝑛𝑒𝑟𝑠′𝐸𝑞𝑢𝑖𝑡𝑦
This formulation explicitly displays that the total amount of assets must equalised the total amount of liabilities and owners’ equity combined (Henry & Robinson, 2015).
Correspondingly, the company’s accounting systems failure can be detected from any deviation from this equation. Assets represent the economic resources reported in the balance sheet and are usually arranged in increasing order of liquidity, that are expected to bring benefit for the company in the future. Likewise, liabilities represent the economic obligations reported in the balance sheet and its settlement is expected from the company’s future outflow of economic benefits. Lastly, owners’ equity represents the claim rights of owners to the assets of the company and is also known as shareholders’ equity (Bettner, 2015).
The benefit of preparing a balance sheet is that it is a simple source of information; therefore, it allows the company to compare its current balance sheet to its previous ones, developing trends which can be used for improving its (financial) situation. Aside from the fact that it is compact, it is also important in obtaining credit and capital as well as calculating and analysing ratios, which will be discussed in the later part of this section. On the other hand, there is some limitations like non-current assets being misstated. For instance, depreciation does not reflect the non-current assets actual wear and tear; thus, disregarding its real current value (Karimi, 2017). Applying the use of balance sheet into the financial analysis answers issues like (Henry & Robinson, 2015):
Is the company’s liquidity better than before?
Is the company solvent?
What is the financial position of the company in relation to the industry?
The preparation of balance sheet can be done in two ways: horizontal and vertical. The horizontal format is arranged in two-sided layout with assets typically listed on the left and liabilities on the other; however, it is also acceptable to be arranged in vice versa. On the contrary, vertical format is arranged by listing assets first and liabilities underneath them, but it can also be listed the other way round (Coucom, 2012). Additionally, the statement of financial position is normally presented from the most recent year to most distant year (left column to right column) yet can still be presented in reverse order depending on the company’s practice. Ultimately, regardless of format and order, it must be prepared in accordance with International Financial Reporting Standards (Henry & Robinson, 2015).
To sum up, the purpose of the statement of financial position is to inform the owners of the company its financial standing and allowing users to understand its financial health. Its users can find out about its business performance and liquidity position through studying the balance sheet (Dhand, 2020).
Statement of Profit & Loss
The statement of profit & loss, also referred to as income statement and sometimes statement of operations, summarises the financial performance of a company’s operations for a specific time span. It shows how much the company earned from operating and non-operating activities, as well as the expenses incurred to generate these earnings (Henry & Robinson, 2015). For the exact purpose of expressing income statement, the following is a simple equation to show its components (Bettner, 2015):
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 + 𝑂𝑡ℎ𝑒𝑟 𝐼𝑛𝑐𝑜𝑚𝑒𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Net income is the outcome after deducting all expenses from all incomes made by the company;
sometimes it can also be called as net profit, net earnings or profit for the year. However, in some cases, it is called net loss when expenses happen to exceed all incomes (Henry &
Robinson, 2015). Elaborating on its components, revenues are those that increase the value of assets as a result of the company’s operating activities from selling goods and services.
Conversely, other incomes reflect those that do not arise from operating activities or transaction with owners, but influence owners’ equity. Lastly, expenses are those that decrease the company’s profit from the cost of consuming resources such as cost of sales, depletion of assets and administration expenses in order to generate revenue (Bettner, 2015).
The advantage of drawing up an income statement is that it can be used as a forecasting tool to generate budgets and response plan for anticipated future problems. Moreover, it helps to identify the company’s potential competitive advantages by revising comparable peer companies’ income statements as it could pinpoint where they are outperforming the company, which acts as a signal when and where to shift resources. On the flip side, preparing an income statement can also be used against the company because competitors may use it for the same reason. Besides that, it doesn’t show non-revenue factors that could influence the company’s success (Gaille, 2018).
Nevertheless, income statements are used to track the performance of the company. It is examined by lenders to decide whether to finance them or not due to the sufficient information it provides to acquire deeper understanding of the profitability of the company. In addition to this, when it’s examined over a long period of time, the management can formulate questions regarding its profitability such as (Henry & Robinson, 2015):
Is the fluctuation in revenue due to an increase in units sold, an increase in prices, or a combination of the two?
How are the company's revenue and profits changing if it has multiple business segments?
How does the company compare to others in the industry?
However, they need further information from a number of sources to analyse and interpret, and not only from the income statement in order to answer these questions (Henry & Robinson, 2015).
Statement of Cash Flows
A company’s cash reserves at the beginning of a fiscal year are reconciled with the cash reported in its balance sheet at the end of the same period in the statement of cash flows.
Understanding the cash flow activities of a company is important because it heavily impacts its survival. There are 3 categories to identify all the sources and uses of cash for the specific fiscal period: operating activities, investing activities, and financing activities (Bettner, 2015).
Cash flows from operating activities are those cash flows involving the company’s day-to-day profit-related activities which is used to determine net income. Relatively, cash flows from investing activities are those cash effects connected with the non-current assets’ acquisition and disposal activities (Henry & Robinson, 2015). Similarly, cash flows from financing activities refers to the transactions of debt and equity financing of the company (Bettner, 2015).
The cash flow statement determines a different aspect of the company’s performance dissimilar to what the income statement can detect, and that is the company’s ability to generate cash flow from its operations. Also, it is used in evaluating the financial flexibility, solvency, and liquidity of the company when conducting a financial analysis. Nonetheless, cash flow statement contributes to the success of the company in the long run allowing them to respond and adjust to financial adversities and opportunities (Henry & Robinson, 2015).
Statement of Changes in Equity
A company’s equity opening and closing balances in a fiscal year is reconciled in the statement of changes in equity, which is also referred to as statement of changes in shareholders’ equity, statement of changes in owners’ equity, or statement of retained earnings. It’s structure of calculation is generally done in this way (Bragg S. , Statement of Changes in Equity, 2021):
𝐸𝑛𝑑𝑖𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 ± 𝑂𝑡ℎ𝑒𝑟 𝐶ℎ𝑎𝑛𝑔𝑒𝑠
Although it is not a vital part of the financial analysis, it is produced along with the other financial statements annually (Bragg S. , 2021). This financial statement is composed of equity share capital, retained earnings, minority interests and reserves (Henry & Robinson, 2015). It displays and presents more details on how the total comprehensive income is allocated as well as the distribution of dividends to owners (Henry & Robinson, 2015).
Financial Notes and Supplementary Schedules
The notes are compulsory and are utilised as an auxiliary to the financial statements in order to have a better understanding of the information provided by these major financial statements.
In addition to this, these notes are also denoted as footnotes. As it lays the groundwork in drawing up financial statements, it relays substantial information to the users, such as these (Henry & Robinson, 2015):
Whether the company’s fiscal year matches with calendar year
Whether the preparation of the company’s financial statements is in accordance with IFRS
Whether the financial statements of a company are complying with its respective national law
The figures have been rounded in financial statements denominated in millions of dollars unless otherwise stated, which can result in slight discrepancies when figures are added.
Whether the company's financial statements are on a consolidated basis, which includes the main company as well as all of its subsidiary businesses.
Information on the accounting policies, methods, and estimates used in the financial statement preparation
Accounting decisions that are important
- Summary of significant accounting policies note
The methods the company uses in recognising revenues and depreciating non-current tangible assets
Each line item on the balance sheet and income statement has an explanation. In addition, the note contains information about the following non-exhaustive list (Henry
& Robinson, 2015):
- Financial instruments, as well as the risks that come with them - Commitments and contingencies
- Legal proceedings
- Related-party transactions
- Subsequent events – events that occur after the balance sheet date - Business acquisitions and disposals
- Operating segments’ performance
In connection with the analysis, it is at the users’ discretion how they’ll integrate the information derived from the note disclosures. Case in point, they can notify them about the company’s future financial position and performance by looking over its financial instruments,
legal proceedings and contingencies over time to find out what factors may potentially threaten its success. Likewise, it’s also beneficial to the users when they try to find out what an organisation does and how and where it makes money. To conclude, although financial notes and supplementary schedules, using these notes allow the users to have better insights which enables them to make sound judgments (Henry & Robinson, 2015).
1.2.5 Types of Financial Statement Analysis
There are many ways to execute a financial statement analysis and it can be catalogued into two major categories, which could be centred either by material used and by modus operandi (Gopal, 2008).
Material Used Basis
In this category, there are two financial statement analysis sub-categories: external and internal (Paramasivan & Subramanian, 2009).
External Analysis
At the end of each fiscal year, a set of audited financial statements are to be published due to the public companies’ obligations to provide information (Corporate Finance Institute, n.d.).
On a periodic basis, these are distributed for those who cannot gain access to the exhaustive internal records, but are indirectly involved towards the company, namely the potential investors, creditors, government, competitors, credit rating agencies, and the general public.
They use it to conduct an analysis of their own to acquire knowledge and evaluate the company’s financial health and/or use it to compare with its peer companies depending on their business concern (Gopal, 2008). As it typically does not contain confidential information, the information it provides about the company are limited, unless it is disclosed for a specific reason (Paramasivan & Subramanian, 2009).
Internal Analysis
In contrast with external analysis, companies hold no obligations to distribute internal records to the public; therefore, the Generally Accepted Accounting Principles does not need to be taken into consideration when preparing these reports. This analysis compiles the information needed for managerial purposes within the company, including confidential information such as business and performance indicators, and financial information (Gopal, 2008). It serves as a business practice done on a frequent basis to learn and interpret the operational performance of the company devised to help internal users make informed decisions on their specific business concern (Paramasivan & Subramanian, 2009). These concerns may regard to employee performance or customers’ behaviour and their credit information (Corporate Finance Institute, n.d.).
Modus Operandi Basis
In this category, there is also two financial statement analysis sub-categories: horizontal and vertical (Paramasivan & Subramanian, 2009). When these two analyses are combined and used concurrently, the results make more sense and are more effective (Gopal, 2008).
Horizontal Analysis
Horizontal analysis, also known as dynamic analysis, is when a user studies historical fiscal years of a company’s financial statements with the purpose of comparing and reviewing its financial variables to one another. This analysis is conducted in order to identify significant changes that may have occurred over the years; hence, developing a trend when the change detected appears to be going in a single direction (Paramasivan & Subramanian, 2009). The formula for horizontal analysis is written as follows:
𝐻𝑜𝑟𝑖𝑧𝑜𝑛𝑡𝑎𝑙 𝐴𝑛𝑎𝑙𝑦𝑠𝑖𝑠 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐶𝑜𝑚𝑝𝑎𝑟𝑖𝑠𝑜𝑛 𝑌𝑒𝑎𝑟 − 𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟 × 100 The result of this analysis actively demonstrates that it allows the user to get insight of the company’s strengths and/or weaknesses. Thus, with this knowledge, the user is able to make an informed decision or take necessary action timely (Gopal, 2008). Similarly, it also helps in determining the company’s growth and financial position in comparison to its competitors (Corporate Finance Institute, n.d.).
Vertical Analysis
Vertical analysis, also known as static analysis, is when various items in the financial statements, from a single accounting period, are analysed by figuring out the correlation between them (Gopal, 2008). Contrary to horizontal analysis, the figures used in this analysis are from the same fiscal year and financial statement. This analysis identifies corresponding changes in the accounts of a company over a specific time period (Paramasivan &
Subramanian, 2009). The formula for vertical analysis is written as follows:
𝐹𝑟𝑎𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝐵𝑎𝑠𝑒 = 𝐼𝑛𝑑𝑖𝑣𝑖𝑑𝑢𝑎𝑙 𝐼𝑡𝑒𝑚′𝑠 𝑉𝑎𝑙𝑢𝑒
𝐵𝑎𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 × 100
The result of this analysis is extremely helpful when performing a comparison with different sizes of competing entities in a single industry as well as in industry comparison. This is possible to do so, due to common-size percentages being highly effective. The management of a company can utilised the result to set new goals for the company and create threshold limits for accounts in order to let go of unprofitable activities (Corporate Finance Institute, n.d.).
1.2.6 Financial Analysis Techniques
Financial statement analysis is complex, but its framework can be simplified into 6 steps as illustrated in figure 1 (Henry & Robinson, 2015):
Figure 1: Financial Analysis Framework
Source: (Henry & Robinson, 2015)
In the first step, the analyst must define the reason why an analysis must be executed. Secondly, he/she must gather the data needed for the analysis, which could range from financial statements, industry/economic metrics to other financial data. However, it is advisable to omit data that does not fit or support the purpose in order to keep the information ‘lean’ and be time- efficient in the next step, which is the data processing. In the fourth step, analytical results are then produced from the analyst’s efforts from the previous step. Consequently, these analytical results are used to answer the queries and make recommendations in the first step. Lastly, follow-up, in order to facilitate the modification necessary in recommendations, the steps prior to this are repeated cyclically (Henry & Robinson, 2015). By following these simple steps, the analyst would be able to conduct the financial analysis efficiently, which helps in producing an effective financial strategy.
There are several tools and techniques that can be utilised to assess a company’s financial health. To begin with, here is the list of the tools and techniques that will be used for the financial analysis (Henry & Robinson, 2015):
Common-Size Analysis Ratio Analysis
Industry Benchmarking DuPont Analysis
Working Capital Analysis Bankruptcy Models
1
• Explain the analysis's purpose and context
2
• Gather input data
3
• Process the collected data
4
• Analyse the processed data
5
• Develop and communicate conclusions and recommendations
6
• Follow-up
Common-Size Analysis
Common-size analysis is connected with modus operandi basis type of financial statement analysis, which is previously discussed in 1.2.6, it is a tool that evaluates and expresses financial data by finding out the correlation between the entire financial statement and a specific single financial statement item. Basically, it generates a ratio between each financial statement item and the base item, with total assets or revenue being the most commonly used as bases (Henry, Robinson, & Greuning, 2015). Also, it applies both horizontal and vertical analysis to the three major financial statements: income statement, balance sheet and, cash flow statement.
Ratio Analysis
The arithmetical relationship between two figures can be expressed by ratios. It is a financial statement analysis tool normally used by the analyst, as it articulates and assess various aspects of the company’s performance, such as the effectiveness of its management, financial stability, and its investment attractiveness. The result of these assessments accentuates the progress of the company during the period that is being revised. It shows whether it has strengthened, stabilised, or weakened. Similarly, it is also quite useful in benchmarking when results are compared to appropriate competitors; however, due to difference in financial structure, product mix, and so on, it may be difficult to find a suitable benchmark (Fitzgerald, 2002).
Depending on the area of interest, there are various types of ratios in which the analyst can cherry-pick from in order to gain insight on the concerned aspect of the business. It can be classified as follows (Fitzgerald, 2002):
Liquidity Ratio Activity Ratio Solvency Ratio Profitability Ratio Valuation Ratio
As ratio is an index used for evaluating the company’s financial performance, comparing its results from previous periods and with its comparable peer companies must be undertaken in context of trend and cross-sectional analysis. Nonetheless, underlying inconsistencies may occur due to difference in implemented accounting policies of the relevant companies, causing divergence between the results of their ratios. Therefore, it is worth noting that the objective is to understand the reasons for this. The analyst should also bear in mind the company’s goals and strategies, industry norms and the economic conditions when evaluating financial ratios (Henry, Robinson, & Greuning, 2015).
Liquidity Ratios
As liquidity refers to the company’s ease and speed with converting assets into cash, the company’s ability to meet its short-term obligations is measured using liquidity ratios. A
company can manage its liquidity by utilising its assets efficiently and addressing the structure of its liabilities. Furthermore, depending on the industry, the amount of liquidity required varies such that the company’s liquidity position will be based on the expected need for finance at any given point in time. Thus, analysing the company’s historical financing requirements, current liquidity position, anticipated future financing needs, and opportunities for minimising financing needs or acquiring additional funds is essential to determine if it has sufficient liquidity (Henry, Robinson, & Greuning, 2015). Although several liquidity ratios exist, for this bachelor thesis the author would only discuss further the relevant ratios needed.
Current Ratio
Current ratio is a liquidity ratio which contrasts the assets of the company that are in the form of cash or that can be converted into cash relatively quickly within one year to liabilities that are due for repayment within that time frame (Coucom, 2012). Its formula is as follows:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The result of this ratio indicates the company’s ability to meet its existing obligations when they become due. If the result is in the range between 1.5 to 2, it implies that its liquidity is adequate; however, if it is over 2, it may imply that the liquid assets are being managed poorly.
Nonetheless, the size and type of business still needs to be taken into consideration (Coucom, 2012).
Quick Ratio
Quick ratio, also referred to as acid test ratio, is a liquidity ratio which contrasts the assets of the company that are in the form of money or that will convert into money in the near future with liabilities that are due for repayment soon. The quick ratio is similar to the ratio, but it excludes inventory because it is not considered as a liquid asset. The goods must be sold before the debtors’ money can be collected; therefore, inventory is a few steps away from turning into money (Coucom, 2012). Its formula is as follows:
𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
In contrast with current ratio, a result over 1 implies that the liquid assets are being managed poorly. Inversely, a result of 1 implies that the company has the ability to meet immediate obligations from its liquid assets without having to worry about selling its inventories;
however, similar to the current ratio, the size and type of business still needs to be taken into consideration (Coucom, 2012).
Activity Ratios
Activity ratios, also referred to as asset utilisation or operating efficiency ratio, assess the company’s efficiency to perform daily operations. It’s a financial metric used to determine how effectively the company is in employing its capital or assets (Henry, Robinson, & Greuning,
2015). Similar to liquidity ratios, there is a number of activity ratios available, only those ones that are relevant for the purpose of this bachelor thesis will be discussed further.
Total Asset Turnover Ratio
Total asset turnover is an activity ratio which assesses the company’s efficiency to generate sales by comparing its sales to its assets. Moreover, it is also commonly utilised by external analysts to evaluate its operations (Bragg S. , 2020). Its formula is as follows:
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
In theory, a company with a high total asset turnover ratio can operate with fewer assets, necessitating less debt and equity than its less efficient competitor. Hence, benefitting its shareholders of a higher rate of return. (Bragg S. , 2020).
Receivables Turnover Ratio
Accounts receivable turnover is an activity ratio which counts how many times a company collects its average accounts receivable within one fiscal year. It is used to assess a company’s efficiency in extending credit to its customers and collecting funds in a reasonable time frame;
thus, it is especially convenient in evaluating a prospective acquiree. For instance, an acquirer might apply an aggressive credit and collection practices when they conclude that the acquiree’s ratio is extremely low. Hence, the acquiree’s needed working capital investment to operate is lowered (Bragg S. , 2020). Its formula is as follows:
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑟𝑎𝑑𝑒 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
If the result of the ratio is low, this may indicate that there is a problem with the company’s credit policy either by being lenient or simply non-existent, collections’ function is ineffective, and/or a sizable proportion of customers are having financial difficulties. Similarly, this also indicates that there is an excessive amount of bad debt and a suitable time to collect excessively old accounts receivables that are binding the working capital needlessly (Bragg S. , 2020).
Solvency Ratios
Solvency ratios, also referred to as leverage or long-term debt ratios, are used to determine a company’s ability to meet long-term obligations. The adequacy of earnings and cash flow of a company are disclosed using this ratio as well as its amount of debt in its structure in order to pay for interest and other fixed charges as they become due (Henry, Robinson, & Greuning, 2015).
Equity Ratio
A company’s use of leverage is measured by a solvency ratio called equity ratio. This ratio assesses a company’s ability in managing its debts and funds as well as its assets requirements
by examining asset investments and the amount of equity (Corporate Finance Institute, n.d.).
Its formula is as follows:
𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
If the result of this ratio is low, it may indicate that the company’s financial risk is at a high level, as it is shown that it has acquired assets primarily through debts. On the other hand, if the result of this ratio is high, it simply indicates that the company has managed to acquire assets with a minimal amount of debt. Likewise, in terms of value, the greater the value, the lower the company's leverage. To elaborate, if the result is at .50 or less, the company is considered to be a leveraged one. Conversely, if the result is at .50 or higher, it means they acquire more funding from equity than debt, so it is considered as a conservative company (Corporate Finance Institute, n.d.).
Debt-to-Equity Ratio
The amount of debt is compared to the amount of equity capital when calculating debt-to-equity ratio (Henry, Robinson, & Greuning, 2015). It measures how much of a company's operations are funded by debt against funds that are completely owned. In the case of an economic downturn, it expresses the ability of shareholder equity to meet all outstanding debts (Fernando, 2021). Its formula is as follows:
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦
If the result of this ratio shows a value of 1.0, it means that the amounts of debt and equity are equal. Hence, indicating that the ratio of debt-to-capital is equal to 50 per cent (Henry, Robinson, & Greuning, 2015).
Debt-to-Assets Ratio
Debt-to-assets ratio assesses a company’s leverage by comparing the amount of total debt to the amount of total assets. It is defined as the percentage of a company's debt-funded assets (Hayes, Debt Rate Definition, 2021). Its formula is as follows:
𝐷𝑒𝑏𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
If the result is less than 1, it means that the assets of a company are financed by equity at a higher percentage than by debt. Unlike equity ratio, the greater the value, the higher the company’s leverage. Therefore, if the value is high, at the event of sudden rise in interest rate, the company may be at risk of loan default. Nonetheless, across industries debt ratios still vary (Hayes, 2021).
Profitability Ratios
Typically, analysts are much inclined to concentrate on the company’s profitability during their analysis. This is due to the fact that a company’s overall value as well as its issued securities are determined by the profitability on the capital invested. Moreover, it also reflects a company’s competitiveness in the market and the quality of its management. Sources of earnings are disclosed in the income statement, and these earnings can either be reinvested back to the company or paid in the form of dividends to shareholders. On that account, if the company chose to reinvest its earnings back, it would help to buffer against short-term problems and improve solvency. All in all, it assesses its ability of utilising its resources in order to generate profits (Henry, Robinson, & Greuning, 2015).
Return on Assets
Return on assets measures a company's profitability in relation to its total assets. The company’s efficiency at generating earnings from its assets can be disclosed by this ratio, which information is most likely to be valuable to the management, investors, and other analysts (Hargrave, 2021). Its formula is as follows:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
As it measures the return a company earned using its assets, a higher result means a large portion of profits is derived from its assets than from investment (Henry, Robinson, &
Greuning, 2015). In addition to this, the ratio is convenient to use as a measure of comparison of either a company’s previous results or to other peer companies’ results, since it varies considerably and is densely influenced by the industry for public companies (Hargrave, 2021).
Return on Equity
Return on equity is a financial performance metric which is defined as the return on net assets.
This is because a company’s debt is deducted from its assets in order to get the value of shareholder’s equity. Nonetheless, a company’s profitability is measured in connection with its shareholders’ equity (Fernando, 2021). Its formula is as follows:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦
The result of this ratio can identify unprecedented issues. For instance, an extremely high result may indicate that the company is at risk as it holds less equity in comparison to its income.
However, it may also indicate that the company is performing fairly well. For this reason, it is a good idea to find out about the other companies’ ROEs in the same industry in order to recognise what is considered the normal range. On that note, it is wise to aim for approximately a bit higher or equal ratio to the peer group’s average (Fernando, 2021).
Return on Capital Employed
Return on capital employed is a financial metric which evaluates the efficiency of a company to generate profits from utilising its capital. When evaluating a company for investment, managers and prospective investors may use this ratio as one of various ratios used to discern its profitability (Hayes, 2021). Its formula is as follows:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑇𝑎𝑥 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑
If the result is high, it may indicate that the company is highly efficient; however, it may also mean that the company just holds a high level of cash on hand which momentarily increases the value of its total assets. As this ratio considers both debt and equity financing, unlike ROE and ROA, most analysts prefer this ratio in measuring the company’s performance and profitability in the long run because it is more reliable. Likewise, it is useful for companies with substantial debt since it can neutralise financial performance analysis (Hayes, 2021).
Valuation Ratios
As a means of evaluating a company for investment decision making, several valuation ratios are put to use. It is utilised to measure the relative attractiveness of the company as an investment by assessing its assets or flow associated with a specific claim’s ownership (Henry, Robinson, & Greuning, 2015).
Price-to-Earnings Ratio
The price-to-earnings ratio determines how much per share of earnings a common stock investor pays. The correlation between a company’s current share price and the earnings attributable to a single share is displayed in this ratio (Henry, Robinson, & Greuning, 2015).
Its formula is as follows:
𝑃𝑟𝑖𝑐𝑒 𝑡𝑜 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑅𝑎𝑡𝑖𝑜 = 𝑆ℎ𝑎𝑟𝑒 𝑃𝑟𝑖𝑐𝑒 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒
If the result of this ratio is high, it usually indicates that the company’s growth of earnings is anticipated to be at a much higher level in the foreseeable future than those of with lower results. On the contrary, if the result of this ratio is low, it may indicate that the company is either doing an outstanding performance in comparison to its historical trends or being undervalued. Likewise, this ratio can be convenient for investors who are interested in knowing whether a stock is worth purchasing or not by standardising the value of one dollar of earnings across the stock market (Fernando, 2021).
Market-to-Book Ratio
Market-to-book ratio, also referred to as price-to-book ratio, is used to evaluate the relationship between the outstanding shares’ current stock price of a company and its book value. To put it
in another way, this ratio compares a company's available net assets to its stock price (Corporate Finance Institute, n.d.). Its formula is as follows:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑡𝑜 𝐵𝑜𝑜𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑠𝑎𝑡𝑖𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒
If the result of this ratio is low, it may indicate that either there’s an underlying problem with the company or its stock is being undervalued. In addition to this, it is quite ineffective for companies that primarily own intangible assets. Nonetheless, it is used by investors to reveal the value of a specific stock from the market’s perspective, as it expresses how much equity investors pay for each dollar of net assets (Corporate Finance Institute, n.d.).
Industry Analysis
Since the activities of a company varies from industry to industry, there is no standard key financial ratios for all industries. Therefore, it is advisable to use extensively specific ratios relative to the industry which the company operates in. Although the ratios that are previously discussed earlier can put forward insights towards various aspects of the company’s performance, it could not suffice if the analyst intends to learn the overall performance of a company. Having said that, in this bachelor thesis the author would delve deeply into the real estate industry because DAMAC Properties is a property development company.
Free Cash Flow
Free cash flow is one of the financial metrics used in order to evaluate a company’s cash flow.
It is a key indicator which factors in all the influences that cause changes in its cash flow.
Similarly, since it expresses the financial health of the company, shareholders use it in order to determine how much of the cash flow is available for distribution as dividends (Bragg S. M., 2012). Its formula is as follows:
𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
If the result of this is positive, it may indicate that the company is managing their cash flow fairly well; however, it does not imply that the company’s financial health is good in the long run. In some cases, the positive result may be due to the deferred payment of the company’s payables, or sale of non-current assets. Hence, in order to determine whether a certain amount of free cash flow is desirable or not, the analyst must be aware of the company’s operations as well as its management decisions overall trend (Bragg S. M., 2012).
DuPont Analysis
DuPont analysis is a technique developed by a company called DuPont; hence, the name. It decomposes the profitability ratio – ROE into its components as they represent different aspects of the performance of a company, which in turn influences ROE. This enables analysts to measure each of these aspects influence over the profitability of a company that can be
evaluated by calculating ROE (Henry, Robinson, & Greuning, 2015). Its formulas are as follow:
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦
The causes of changes in a company’s ROE over time can be determined using this technique as well as the differences in ROE of multiple peer companies over a given period of time. On that note, analysts like investors can utilise it when they want to know the difference in the operational efficiency of different companies. It actively demonstrates that the overall profitability of a company which is used for taxes, financial leverage, and as an efficiency function is measured by ROE. Furthermore, it expresses the various types of ratios discussed earlier relative to how each of them impacts the owner’s return on investment. Nonetheless, it allows the management to use the information gathered from this technique in order to determine which financial activities make up the changes in ROE; therefore, they would know which aspects should be prioritised to improve the company’s ROE (Henry, Robinson, &
Greuning, 2015).
Working Capital Analysis
A company’s financial performance is evaluated typically by calculating its net working capital. It assesses the efficiency of a company as well as its short-term finances, whether it has adequate short-term assets to settle its short-term debts (Maverick, 2019). Its formula is as follows:
𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
If the result of the ratio is less than 0, it indicates that the company may struggle to repay its creditors as it is unable to meet its financial obligations with its current working capital.
Similarly, if the result is less or close to 1, the company may still face serious financial difficulties. On the other hand, an excessively high result, may also indicate that current assets like cash are being handled inefficiently instead of being put to use for reinvestment which would contribute to the company’s growth. To conclude, this financial performance metric should be compared from the company’s result to its peer companies operating in the same industry as the other ratios (Maverick, 2019).
