Financial Analysis of Wesfarmers Limited - Report Example

Financial analysis of Wesfarmers Company background Wesfarmers is one of the largest companies in Australia. The activities of the company cover areas such as departmental stores, supermarkets, coal manufacturing and export, chemicals, fertilizers, industrial safety products, energy products, home and office supplies. The company is considered to be one of the largest private sector companies of Australia. Wesfarmers employs more than 200,000 workers (Wesfarmers, 2011). The driving motive for Wesfarmers is to provide adequate returns to shareholders. The main activities of Wesfarmers are distribution and retailing and the company has remained dedicated towards providing the best in class services to both the household and the business sectors. Wesfarmers is also considered to be one of the strongest diversified industrial firms. The firm’s activities are limited within Australia. Wesfarmers tries to achieve sustainable long term success through the intelligent combination of different types of businesses. The Wesfarmers team strives to create long term relations with their suppliers so that business activities are not interrupted. The company displayed a strong financial performance in the financial years 2010 and 2011 (Wesfarmers, 2011). Wesfarmers considered its management and skilled employees to be the primary reason behind their massive success. Through the efficient utilization of resources, it has been possible for the company to deliver year on year admirable performance. The current paper aims to reflect upon the financial performance of Wesfarmers. The analysis has been conducted on the basis of financial ratios. Short term solvency or liquidity ratios The short liquidity position of the business has been analyzed through the calculation of current, quick and Cash flow from operations to current liabilities ratio. The current ratio shows the proportion of current assets in respect to current liabilities. A current ratio of 2 is considered to be ideal. Companies expect to maintain at least a current ratio of 1 so that each unit of current liability gets covered by a unit of current asset. The current ratio of Wesfarmers is seen to remain adequately satisfactory. Current ratio is considered by suppliers of materials on credit. Short term creditors can therefore assess the ability of a firm to repay their dues on time. The current ratio position of Wesfarmers had significantly improved from the year 2010 to 2011, signifying that the working capital situation of the firm had significantly improved (Palepu and Healy, 2007). Quick ratio depicts the immediate short term liquidity of a firm. A firm must possess adequate levels of quick ratio so that short term liabilities can be settled at an immediate notice. It is also an indicator of the level of current assets which are illiquid. Quick ratio levels also depend on the characteristics of a business. Firms which have longer operating cycles, tend to posses low quick ratio levels. Wesfarmers are seen to have a low level of quick ratio. A significantly large amount of cash reserves of the company are seen to remain trapped in inventories causing the firm to lose a large portion of its short term liquidity (Palepu and Healy, 2007). The cash flow from operations to current liabilities ratio signifies a firm’s ability to meet the current liabilities through operational profits. This ratio is seen to be low for Wesfarmers. This signifies that the operational profits are not enough for the company to meet all their expenses related to the current liabilities. The current assets would also play an important role in this respect to pay off current liabilities. Usually, most firms find it difficult to meet their current liabilities from only the profits arising out of operations. However, the ratio facilitates in determining the level up to which operating profit facilitates meeting the needs of the current liabilities (Revsine, et al., 2005). Efficiency ratio Debtor’s turnover ratio indicates the relation between debtors and sales revenue. If the ratio is high, it indicates that debtors can be converted into cash more swiftly. It also indicates that the existence of debtors in the balance sheet is low as compared with the sales revenue. A low debtor turnover ratio is not favorable as it would indicate larger proportion of debt in the overall sales revenue. A low debtor’s ratio also indicates high value of debt and less cash received from customers, hampering the firm’s liquidity. On the other hand, a short debtor’s turnover ratio indicates that the firm’s ability of converting debtors into cash is low. In case of Wesfarmers, the level of debtor’s turnover ratio is seen to be high. As a result, it is also seen from the calculated ratios that the average sales uncollected period is low. This indicates that revenue from maximum portion of debtors is recovered early. However, the firm’s inventory conversion period is seen to be low. As a result, the inventory turnover period is also seen to remain high. Such a scenario indicates that the company takes up an adequately longer period of time to convert inventory into sales (Garrison, Noreen and Brewer, 2003). Profitability ratios Net profit is the amount of profit earned after meeting all sales, administrative and other operating expenses. The revenue earned by a company is utilized for meeting a number of different types of costs. The ratio facilitates in measuring a firm’s capability of retaining profits after meeting all operational expenses. The higher the net profits, the more efficient are the firm considered to be. In case of Wesfarmers, it is seen that the net profit margin is considerably low. A major portion of the revenues earned are spent by the firm to meet operational costs (Garrison, Noreen and Brewer, 2003). The interest costs as a percentage of sales reveal the proportion of interest in the net revenues earned. The ratio indicates whether the sales revenue earned by the firm is adequate enough for meeting the interest expense of the organization. The ratio is a suitable indicator of the expenses allocated towards financing costs out of the net revenues earned. The lower the ratio, the more are the profits retained by the business and the less are the expenses incurred for financing. Wesfarmers are seen to be having a low interest cost to sales ratio indicating that the financing expenses incurred by the firm are not very high. Interest expenses are usually low when the debts procured by the firm are not adequately high (Gitman and Zutter, 2011). Asset turnover ratio indicates how effectively an organization is able to convert assets into sales revenue. Hence higher asset turnover ratios are considered to be more favorable. A high ratio indicates that the company is able to generate more revenue through efficient usage of assets. Return on assets ratio measures the ability of a firm to generate income from the efficient utilization of assets. Wesfarmers are seen to incur a low level of asset turnover and return on asset ratio. This indicates that the firm’s ability to reduce operational expenses and incur higher profits is low. It also indicates that Wesfarmers have not been very highly successful at incurring very asset turnovers as compared to the amount of investments made in sales. It is therefore essential that Wesfarmers enhances their asset turnover capacity by increasing sales levels. Similarly, the return on assets ratio can be improved by reducing operational expenses (Gitman and Zutter, 2011). The return on shareholders’ equity facilitates in measuring the capability of a firm to generate income from the investments received from shareholders. Higher return on shareholders’ equity is considered more favorable. Wesfarmers incurs a low level of return on equity ratio. This is likely to create a negative impression upon potential investors of the company (Hung, 2000). Long term solvency ratios The debt equity ratio indicates the relation between total equity with the net total liabilities of a firm. A higher debt equity ratio is an indicator of the strong presence of debt capital which induces risk into the business. It is therefore preferred that an organization maintains a low debt equity ratio. Wesfarmers incur a smaller level of debt equity ratio due to the lower presence of debt capital within the organization. The company is mainly financed through equity share capital (Cornett and Saunders, 2003). Debt to total asset ratio indicates the extent to which debt capital is used by the organization to finance assets. Just like debt equity ratio, it is also preferred that the debt asset ratio remains low. Wesfarmers are seen to finance majority of their long term assets through share capital (Nissim and Penman, 2001). Interest coverage ratio indicates a firm’s ability to pay interests out of their earnings. A high interest coverage ratio shows that the firm has the capability to pay interests several times over. Wesfarmers has a low level of interest coverage ratio. This is due to the aspect that the company’s earnings are low. The interest expenses of the firm are not high as majority of the financing requirement are fulfilled through equity. However, the interest coverage ratios are still low due to lower earnings. Cash flow from operations to total liabilities ratio indicates a firm’s ability to meet their total liabilities related expenses from the earnings. In general, when the earnings are high, the ratio is smaller. Hence it is preferred that the ratio remains low. Wesfarmers are seen to be having a low cash flow from operations to total liabilities ratio (Nissim and Penman, 2001). Market-based investment and other ratios The price earnings ratio reflects the relationship existing between stock prices and the firm’s revenue. This ratio is referred by the investors of equity to understand whether the stocks of a firm are priced adequately in respect of their revenues earned. It indicates the amount the market is prepared to pay for a company’s earnings. It is generally preferred by organizations that the price earnings ratio of a company remains high. Wesfarmers price earnings ratios are seen to be low. The low level of earnings is considered to be the main reason behind its low price earnings. The dividend yield ratio indicates the connection between the price of stock and accordingly the dividends paid per share. Wesfarmers has a low dividend yield ratio indicating lower returns provided to shareholders. Similarly, the dividend cover ratio of the organization is also low. It is usually seen that a firms dividend ratios to be low when a major portion of the earnings are used for reinvesting in the business rather than providing dividends to shareholders. The net tangible asset backing ratio is seen to be extremely low. This indicates that the issued shares are not backed adequately by the available assets (Will, Subramanyam and Robert, 2001). Conclusion The ratio analysis conducted for Wesfarmers indicates that although the revenue position of the company has remained adequately high, the firm was not capable of reducing costs of operations which ultimately led to reduced earnings. The long term ratios and the investments ratios of the company are seen to be primarily dissatisfactory. These ratios can only be improved if the firm reduces their costs of operations. Wesfarmers had undertaken a few expansion projects which had raised the firm’s investments and costs of operations. This is therefore identified to be a potential reason behind their weak investments and long term solvency ratios. On the other hand, the company’s profitability, efficiency and short term solvency ratios are seen to remain satisfactory. This indicates that the company is able to manage its short term operating cycle efficiently. Reference list Cornett, M. M. and Saunders, A., 2003. Financial institutions management: A risk management approach. New York: McGraw-Hill/Irwin. Garrison, R. H., Noreen, E. W. and Brewer, P. C., 2003. Managerial accounting. New York: McGraw-Hill/Irwin. Gitman, L. J. and Zutter, C. J., 2011. Principles of Managerial Finance 13th Edition. New Jersey: Prentice Hall. Hung, M., 2000. Accounting standards and value relevance of financial statements: An international analysis. Journal of accounting and economics, 30(3), pp. 401-420. Nissim, D. and Penman, S. H., 2001. Ratio analysis and equity valuation: From research to practice. Review of accounting studies, 6(1), pp. 109-154. Palepu, K. and Healy, P., 2007. Business analysis and valuation: Using financial statements. Connecticut: Cengage Learning. Revsine, L., Collins, D. W., Johnson, W. B., Collins, D. W. and Johnson, W. B., 2005. Financial reporting & analysis. New York: Pearson/Prentice Hall. Wesfarmers, 2011. Wesfarmers Annual Report 2011. [pdf] Wesfarmers. Available at: [Accessed 28 January 2015]. Will, I., Subramanyam, K. R. and Robert, F. H., 2001. Financial statement analysis. New York: McGraw-Hill International. Read More