Accounting and Finance for Managers - Case Study Example

Accounting and Finance for Managers

One of the primary reasons why shareholders need financial statements is to enable them to evaluate their equity investments in public corporations. The three most important documents include the balance sheet, income statement, as well as the cash flow statement. The income statement shows the investors the amount of revenue that the company produced in a particular period, the expenditures that were incurred to attain that level of revenue and the resulting gross and net profits. The balance sheet presents the information about the company’s financial position at a specific date. It informs the shareholder about the company’s assets and the liabilities and the total shareholders’ equity. The cash flow statement details the movement of money in cash as one that get in and then out of the business.

The cash flow statement covers three major elements; the cash flows from the firms working accomplishments, from investing undertakings and from financing actions. The statements provide the source of information on which they can rely to make informed decisions and determine whether to dispose of their investments or to continue holding on (Tugas & Rosario, 2012). The statements reveal the profitability of the company during the ending year as well as providing an indication of the direction that the firm is likely to take in future. Thus, this enables them to make informed decisions on how to vote on corporate matters. There are different ways that shareholders can use to glean useful financial data from the published reports from the company. The available metrics for evaluation include profitability ratios, debt ratios, price ratios, liquidity ratios and efficiency ratios. The use of ratios is simple and gives the investor instant results which they can then evaluate against the industry average or their ideal expected rates and make their future investment decisions.

Profitability ratios refer to a collection of metrics that are usable in evaluating company’s capability to continually produce earnings. The ratio reveals the returns on equity which reflect the percentage of the company’s net income that goes to its shareholders. Shareholders are interested in investing in those companies where their money or investments can increase in value and generate dividends. As for liquidity ratios, they enable the shareholder to analyze critically how the company handles its cash flow as well as the short-term debts. The current ratio, which is the most common liquidity ratio and is the simplest to compute measures the firm’s current assets against current liabilities and gives the shareholder a glimpse of how the company is using current assets to cover current liabilities. For a company to meet its short-term obligations, it must have enough liquid reserves that can easily be converted into cash and used to pursue new business opportunities (Oberoi, 2014). Investors are interested in companies that are continually able to stay afloat and with healthy cash flow.

Other avenues available to shareholders to conduct a quick analysis of their target company are through the use of debt ratios and efficiency ratios. The efficiency ratios enable the shareholder to determine how efficient the company is run and how it has managed its assets and liabilities. This ratio is used together with the debt ratio, which helps the shareholder analyze the debt situation. Shareholders would not want to invest in businesses that are riddled with debt. For shareholders who wish to do a comparative industry study of firm profitability before buying any stock, the efficiency ratios provide the best way of analyzing a firm’s performance against the industry average. Regardless of the kind of information that the investor is interested in, all these ratios must be computed together and should be analyzed against the industry average (Guides.wsj.com, 2016). A comparative cross-industry analysis will give the investor a broader picture on the direction in which the firm is taking and the opportunities that exist for the business in future.

Wells Fargo & Company History

Since 1852

Establishment of Wells Fargo & Company happened in 1852 by two business associates Henry Wells and his friend William Fargo. The business began operating as a financial services company, mainly buying gold and selling bank drafts. It also focused on the express business through which it carried out the rapid delivery of gold and any other valuable good across the western United States. The 1850s was the period of the gold rush in California, and the state was bustling with different forms of businesses. Many entrepreneurs and businesses sought out to capitalize on the emerging prosperity which meant that Wells Fargo, being a late entrant, faced a very stiff competition from the established players like America Express, Citigroup among others. It adopted an entry strategy that focused on strategic partnerships and acquisitions and concentrated on linking the California state with the rest of America.

Currently, the company operates as a differentiated, community-based financial services business with its headquarters in Palo Alto, San Francisco and branches in nearly all states in America. It is currently the largest bank by customer base and also the world’s most valuable bank, according to the Fortune 500 magazine that ranks financial institutions. Under its current leadership, the bank has shifted its vision from connecting all Americans to satisfying its customers’ needs and helping them succeed financially. The company’s breakthrough came when the transcontinental railway line was completed. It focused on doing coast to coast deliveries and connected the American businesses to overseas territories. Outside the US, the company is still known for its express business more than it is recognized for the banking services despite being the most valuable bank in the world. The company became globally known for its ability to deliver business goods using the fastest means possible mainly through stagecoach, steamship, pony rides, telegram or railroad.

The firm created its brand as an efficient stage coach system that was relied upon during the good and bad economic times. The express business saw the firm survive and achieve greater success during the 20th century. Its attention to customers and the desire to always deliver to their satisfaction helped it grow its financial service business. The two business categories perfectly complemented each other. The firm’s success can be attributed to sound management and successive strategic mergers proved successful and allowed it to venture into its non-traditional markets. The banking business became an independent function, separate from the Wells Fargo express in 1905. During the early 1910s and 20s, Wells Fargo operated as a commercial bank in California with a focused on developing banking products for small and medium enterprises especially in agriculture and the emerging aerospace and film industries. In the 1930s, like with all the other banks in the US, the company suffered the effects of the great depression and the Second World War. Wells Fargo, however, emerged stronger, thanks to the sound management that enabled the bank to position itself strategically to serve the American public during the post-war era which was marked by rapid economic growth. Innovative banking solutions allowed the bank to expand rapidly into a statewide bank. Having already had prior experience doing business in other states, the bank expanded rapidly in the 1980s to become the largest bank in the US.

Wells Fargo Today

Today, Wells Fargo & Company trades at the New York Security Exchange (NYSE) as WFC. It offers diversified financial services with over $1.7 trillion in assets. Wells Fargo has diversified its portfolio to include insurance, investments, mortgages as well as its consumer and commercial financial services. The firm has branches in more than 8,700 locations across the US and has leveraged on technology to improve its services. It has a robust online banking system and mobile banking services available to its customers. The bank structure is such that it is still headquartered in San Francisco, but it has been highly decentralized so that every branch serves as headquarters and customers can find all the services they need from there. Today, the bank boasts of over 70 million customers, which translate to one in every three US households making it the biggest bank by customer base. It is among the top four banks that are classified under the category of too big to fail, meaning that the government will have to bail it out in the case of any recession or the event of a financial crisis. Internationally, Wells Fargo has a presence in over 36 countries and over 90 branches and employs over 266,000 staff. For some time in 2007, Wells Fargo was the only bank to attain a credit rating of AAA; however, it has since been downgraded to AAA-.

Financial Objectives of Wells Fargo

As one the companies in the top list in the U.S as listed by Fortune 500 magazine, Wells Fargo has to regularly set financial objectives and put in place mechanisms that will lead to their achievement within schedule. These goals are usually varied with some ranging in the short-term, medium-term as well as long-term. Wells Fargo, however, is highly diversified, and it may not be easy to point out, with definitive accuracy, its current financial goals. The bank has set goals for its investments function, banking targets as well as corporate social responsibilities. According to a report released by the firm in 2014, the firm outlined the status of its progress towards achieving the 2020 CSR goals. Some of these goals include;

Investing 7.7 billion to assist financially challenged homeowners over a period of 10 years from 2009 to 2019.

To invest 1.2 billion in affordable housing and commercial properties that are targeted at the low and moderate income earners in order to spur consumption and growth of small businesses.

To invest 30 billion in environment that is supportable for doing businesses that include greener structures and projects that use energy that is renewable.

Making donations and contributions to nonprofit initiatives within the localities in which the business operate. The target is to make contributions totaling to at least 1 billion by 2017.

To provide 15 billion in loans and investments to power development of community projects by 2016.

An investor must critically analyze the financial goals of their companies when deciding to dispose or continue holding onto their stock. These goals for Wells Fargo presented above are highly focused on the corporate social responsibility function and reveals very little as far as the profitability of the firm is concerned. They also do not reveal the direction that the business is likely to take and hence cannot inspire enough confidence for one to invest in the company. A more appropriate consideration, therefore, would be to look at the business’ current strategic plan. The strategic plan will be able to tell the investor the business goals as well as the strategies the firm has put in place for achieving them.

Many analysts have sought to determine what differentiates Wells Fargo from the other main competition such as Goldman Sachs and JP Morgan. These analysts all tend to agree that the bank’s strategy of showing off as a glamorous investment bank has caused it to be grossly undervalued by potential investors, yet it provides the most stable stock option for those investors who are seeking to hold their stock for longer periods of time. Short-term investors, however, consider it boring due to its tendency of not seeking out risk. The bank’s stated priority is to look after the interests of its customers; it values inculcating lasting relationships with its customers. By developing deeper relations with their clients, the firm will, therefore, be able to innovate continually and develop products that satisfy their needs without a struggle. The firm’s strategy for growing its revenue is to offer diversified services to the existing customers. For instance, the bank offers free financial education to their retail customers, through which they inform them of their investment brokerage and retirement plans. The goal is to become a one-stop financial service center for their customers. In essence, Wells Fargo’s strategy is focused on increasing its revenue from every household that bank with it through selling. The bank identifies its six key priority areas as follows;

Managing expenses; According to the management, the firm is always looking for ways to simplify its operations and make things easier so that customers do not have to spend more money while seeking to bank with them. Moreover, the bank’s primary objective is to increase shareholder value by investing in projects that will guarantee the highest level of returns at the lowest cost possible. The firm sets expense reduction targets from time to time which helps it to minimize the effect of these expenses on the bottom line.

Managing risks; Wells Fargo has a reputation for stability, which means it does not engage in risky ventures that would sharply affect the prices of its shares in the market. Its stated goal is to set the global standard for risk management among financial institutions. The stability that the organization offers to its investors makes its stock relatively more attractive over the long-term compared to its other more glamorous but high-risk competitors like the JP Morgan. A long-term investor would, therefore, easily find the stock for the company more profitable and would choose to buy it over the other. Part of the source of stability comes from the banks focus on cultivating lasting relationships with its customers, meaning that at any given time, it will always have a reliable business no matter the market situation.

Building better communities; Wells Fargo understands that for its long-term goals to materialize, it must focus on building stronger societies through a robust social responsibility program. The firm’s stated objective is to enable its customer to succeed financially by investing in communities and helping the economy grow stronger. The firm sets annual targets for donations to non-profits that seek to address various challenges within the community such as diseases, education, environmental improvement, affordable housing and poverty.

The Ratios

Financial ratios are the window, through which investors can assess the performance of a company compared to other companies or industry averages. Different ratios show different aspects of the company or industry. Some of the ratio that will be used in the assessment of the Wells Fargo & Company performance over the year 2015 will be computed as follows;

Debt/Equity Ratio

This ratio is also known as gearing, and it measures the company’s financial leverage (Bhandari, 2011). It is calculated as illustrated below;

Debt/Equity Ratio = Total Liabilities divided by Shareholders' Equity

Shareholder’s equity refers to the variance between the total liabilities and assets of the company as at the time of computation of the balance sheet.

According to Wells Fargo’s published financial results for the year 2015, the total liabilities as at December 31, 2015, was $1,594,634,000 and the total shareholders’ equity was $192,998,000 (NASDAQ, 2016).

The D/E ratio is therefore given as

D/E=$1,594,634,000/($1,787,632,000-$1,594,634,000)

=$1,594,634,000/192,998,000

=8.262

The debt ratio measures the firm’s debt comparative to the total value of its stock. The measure is used to gauge the extent to which the firm is using debt to finance its growth. A higher debt ratio means that the firm has greatly leveraged on debt to finance its activities. In the case of Wells Fargo, the company’s debt ratio is over 82%, meaning that it has taken considerably high amounts of debt. When a company uses a lot of debt to finance its operations, the implication is that the firm can potentially generate more earnings than if it concentrates on using internal resources. This would, in turn, benefit the shareholders as more earnings will result in greater dividends. Wells Fargo has steadily used debt to finance its activities with a greater deal of success. There is, however, a greater risk if the cost of servicing the debt exceeds the expected returns from the operations that it is used to finance. A firm’s failure to generate enough profits to cover for debt will negatively affect the shareholders’ value, and the firm runs a greater risk of going bankrupt. However, in the case of Wells Fargo, the firm is currently generating enough profits to enable it cover the debts and even pay dividends to its shareholders.

Profitability Ratios

Such ratios are often usable in assessing the capability of a firm to make earnings based on the expenditures as well as other relevant operating expenses that it has incurred during a given period of time. There are different profitability ratios that can be computed from Wells Fargo’s published financial reports. These include;

Gross Profit Margin

Gross profit margin is usable in determining a firm’s financial health. It measures the fraction of money that remains from the revenue earnings after the charge for the goods sold have been factored in. It guides the firm in paying out additional expenses and planning for future savings. The metric is calculated as

Where: COGS = Cost of Goods Sold

Based on the published income statement for 2015, Wells Fargo’s total revenue was $90,033,000,000 and the total cost of goods sold was also stated as $963,000,000. The GPM, therefore, would be computed as

GPM= ($90,033,000,000-$963,000,000)/ $90,033,000,000

=0.989

A gross margin is an important tool for investors who wish to compare a company with its competitors in the industry. Investors should look for companies whose GPM are stable and do not fluctuate between one period and another. Based on the calculations above, Wells Fargo can be said to have a healthy gross margin and that it is able to pay for its operating and other expenses and build an adequate savings portfolio for the future.

Return on Assets

This is a metric that measures the profitability of a business comparative to its properties. The metric provides an idea of how efficiently the firm board is utilizing its assets to produce revenue. It is computed as follows;

Consider the income statement and the balance sheet of Wells Fargo for 2015; the net income was stated as $22,894,000,000 and the total assets were $1,787,632,000,000. The ROA, therefore, will be computed as follows

ROA= $22,894,000,000/$1,787,632,000,000

ROA= 0.128

The ROA for the company is 12.8%, meaning that the company has more assets relative to the revenue that it generates.

Return on Equity (ROE)

It relates to the amount of net revenue that is spread as to shareholders. It measures the profitability of the company by establishing the amount of profit that the company generates using the money invested by its shareholders. It is computed as;

Return on Equity = Net Income/Shareholder's Equity

The shareholders equity is exclusive of preferred shares.

ROE= $22,894,000,000/$192,998,000,000

ROE=0.1186

The ROE for Wells Fargo based on the 2015 results is 11.86%, meaning that the company is a high growth firm. However, for better decision-making, it is important to compute an average of the company’s ROEs for a period of between five to ten years as this would offer one a better idea of the past progress of the business. According to NASDAQ, the ROE for Wells Fargo in the years 2012, 2013, 2014 and 2015 are 12%, 13%, 13%, 12% respectively. This shows that the company is stable, and hence investors can continue holding their stock (NASDAQ, 2016).

Profit Margin

Profit margin is the ratio of net income and revenue or net profits and sales. Profit margins measure the rate of earnings per every unit of sale. Based on Wells Fargo’s income statement the profits or net income is stated as $22,894,000,000 while net revenues are $90,033,000,000. The company’s profit margin will, therefore, be computed as

PM=Net Income/Net Revenue

PM=$22,894,000,000/$90,033,000,000

PM=0.2543

PM=25.43%

This shows that for every dollar of sales, the company makes $0.25 in earnings (Market Watch, 2016). This indicates that Wells Fargo is a relatively high profitable company, and investors can maintain their stock for a foreseeable future.

Earnings per Share (EPS)

It refers to the fraction of the firm’s net income that is allotted to every unsettled share of mutual stock. The ability to pay a dividend on outstanding shares indicates that the company is able to generate profits. The formula for calculating the EPS is given as;

The EPS is the most important variable that is used in determining the share price and is also usable in the calculation of the price to earnings ratio.

Wells Fargo’s net income in 2015 was $22,894,000,000 and the outstanding common stock as at the said date was 5,077,047,651 shares. The company paid dividends on preferred common stock of $1,976,563,678. The EPS for WFC, therefore, will be given as

EPS= ($22,894,000,000-$1,976,563,678)/5,077,047,651

EPS= 4.12

The EPS is usually a good way to stimulate investor confidence since all shareholders would wish to invest in companies that would increase the value of their investments over time. However, it often ignores the capital component that is required to generate revenues. Two different firms can have the same EPS rate with completely different amounts of capital. One company can use less equity to generate the same level of EPS, indicating that such a company is more efficient at converting capital into income. A shareholder would be more interested in such details before deciding to put their money on any given company. In the case of Wells Fargo, its earnings are generated from operations that are financed heavily by debt. It is important for one to do a comparative analysis of the capital structures of different companies before deciding to invest.

Dividend Ratio

It relates to the percentage of earnings that is paid out to shareholders in dividends. It is computed as follows

The dividend ratio indicates the amount of money that a company is returning to its shareholders after accounting for all expenses and other operating costs against the money that it is keeping as retained earnings for reinvestment in other growth opportunities, debt payments or as addition to cash reserves. The dividend payout ratio is reflective of the company’s level of maturity. Companies venturing into new industries for the first time are expected to retain a larger proportion of their earnings for its long-term growth ambitions. It is understandable when such a company decides not to pay any dividend on its outstanding shares. However, for well-established companies like Wells Fargo, with over 150 years of operation, there is need to pay dividends to shareholders. Failure to pay dividends can lead to investors growing impatient and activists suing the company. It is also not easy to justify failure to pay dividends when a company boasts of a healthy cash flow. However, high payout ratio means that the company’s shares are less likely to appreciate rapidly, which should also make investors wary about buying the shares.

For investors seeking to know whether to hold on to their stock or dispose, they can use the dividend ratio to assess the sustainability of the firm’s dividend policy. Many companies are reluctant to cut down on dividends because of the fear that it can reflect negatively on the management’s capabilities. The best way therefore to address the question of the dividend is to compute forward-looking ratios centered on the expected impending earnings of the company and compare it to the actual historical rates that the company has paid out. A company with a long history of steady payout rates like Wells Fargo is worth holding its stock because it inspires confidence that the stock portfolio will not only deliver returns but also grow continually. The payouts also differ widely depending on the industry in which the firm operates. Technology companies are more likely to experience rapid growth within a very short time and are hence more likely to start paying out higher dividends much faster. Some industries, like investment trusts are under legal obligation to distribute a given percentage of their earnings to shareholders.

Analysis and Recommendations

The ratios computed provide an important insight for any investor considering a decision of whether to dispose or continue holding onto the company stock. Key among the main considerations should be the historical evidence that a company is committed to returning value to its shareholders and the demonstrated ability of the company to follow through on its commitments (Rudegeair & Glazer, 2015). The ratios help an investor to tell the overall financial soundness of a company. Looking at Wells Fargo & Company’s history, the firm has demonstrated financial soundness, ability, and commitment to return value on shareholder investment. From its financial records, it is currently the largest bank in the world measured by market capitalization. The bank has a healthy growth outlook for the coming year and is expected to strengthen and consolidate its position as the top bank, not only by market capitalization but also by value to the customer. The bank is also the largest mortgage financial in the United States and the second largest by credit cards and deposits. This is evidence that the bank has a strong performance outlook and enough cash reserve that it can invest in innovation and technology. It has a great potential to increase its revenues and stay profitable.

Another strength that should give investors enough confidence in Wells Fargo is that it is highly diversified. The diversification means that risks are substantially reduced. The bank derives half of its revenues from non-interest income activities meaning that the fluctuations in the interest rates market do not affect it greatly (Reuters, 2013). The firm’s different operations such as mortgage consultancy fees, financial advisory, and management, securities and investments management among others have all historically performed well over the past five years. The company remained strong and is one of the few that recovered quickly from the 2009 financial crisis, paying back the government funding within a year. The bank paid a higher dividend last year of 37 cents compared to the pre-crisis high of 34 cents. The banking has an average annualized dividend growth rate of 79 percent in the four years beginning January 2012 to December 2015. This is higher than its closest competitors in the industry.

In considering whether to hold onto the firm’s stock based on dividends, it is important to look at the net income that a firm generates its revenues. The profit margin ratio provides an easy way of computing this information. Looking at the profit margin for Wells Fargo computed above, the firm has a return of 25% for every dollar of sales made. The firm has also shown strong performance over the last five years. The firm has also consistently increased its profitability over the years from 16 billion in 2011 to 22 billion in 2015. Such increments in net income are key indicators of a firm’s ability to increase shareholder value and pay better dividends to investors. The performance of Wells Fargo over the past five years indicates that the company is well managed and hence an investor would be highly encouraged to hold their stock.

Conclusion

There are many advantages of investing in Wells Fargo & Company today compared to its closest competitors. Its past and current performance indicate that among all the stocks available in the US banking industry, the WFC may be the best. This is backed by evidence of solid performance and continual growth throughout it’s over 150 years of operating history. Based on its current management strengths, this strong performance is expected to continue hence a stable dividend payout.