Financial Ratio Analysis - Example

Student: Tutor: Subject: Date: A friendly recently visited me with financial statements of General Electric Company hoping that I will give them advice on whether or not they can invest in this company. General Electric Company is a financial services and technology firm which manufactures products for generation, distribution, transmission, utilization and control of electricity (GE, 2014). Its products include consumer and business financing, security technology, aircraft engines, industrial products, media content and medical imaging. Before making that decision, it is very important to understand the financial health of General Electric Company by looking at several financial aspects. In this essay, a brief company profile of GE will be given after which an explanation of how the stock market works and specifically in respect to public limited companies. An analysis of the relationship between financial performance and investor’s value will be given and a discussion of the gearing level of General Electric Company to make the investor understand whether the company has debt funding issues. Finally, there will be a summarized analysis of investing in general Electric which will form a basis for recommendation o whether or not o invest in General Electric Company. A stock market is also known as an equity market and is defined as a structured mechanism through which stocks are traded (Richard et al, 2011). A stock market allows companies to raise new or additional capital by listing and issuing shares while providing an opportunity for investors to buy or sell shares. A share indicates ownership of part of a company and when investors buy shares, they become part of that company. There are different types of shares namely; ordinary shares, preference shares and deferred share (Richard et al, 2011). With ordinary shares, the share holder has a right to dividends, right to vote, receive copies of financial accounts and attend Annual General Meetings. For preference shares, the holder has a fixed rate of dividend and is paid before the ordinary share holder. Preference shares can be cumulative where arrears of dividends will have to be paid in future before ordinary shares are resumed, non cumulative where arrears are lost for good, participating where they are paid a percentage of dividends paid to ordinary shareholders on top of their fixed dividends and redeemable where they may be redeemed for cash at a determinable date (Richard et al, 2011). For deferred shares, they are paid dividends after preference share holders and ordinary shareholders are paid. For companies to trade in the stock market, they must be listed in the stock exchange. Public limited Company is a company whose shares can be bought by the public and traded in the stock market (Richard et al, 2011). All shares in the stock market are quoted with both the bid price which is the price you can sell and the offer rice which is the price you can buy the share. This price is updated through the market opening hours. You can only buy or sell shares during the opening hours. For example, for London Stock Exchange, the opening hours are Monday to Friday 8.00 a.m to 4.30 p.m. in order to buy or sell shares in the stock market as a private investor, you need services of stock brokers (Richard et al, 2011). Stock brokers offer three types of services: Discretionary Services, Advisory services and Execution only. Discretionary services are where the investor gives the broker complete authority to buy and sell shares without obtain approval. For advisory services, the stock broker merely gives course of action to the investor which they may chose to take or chose not to take. For execution only services, the investor simply tells the broker to buy or sell a share (Richard et al, 2011). There is a positive correlation between a company’s financial performance and investor’s value. Investors’ value is delivered from the company’s management ability to grow earning, share price and dividends since investors’ value is the sum of all strategic decisions that affect the company’s ability to efficiently increase the free cash flow. Every investor will first assess the company’s performance before investing his/her money in a company since he/her wants to be certain that his investment value will increase in the future (Richard et al, 2011). To assess the relationship between General Electric financial performance and the company’s investors value we will analyze market capital values, return on capital employed ratio, and net and gross profit ratios from 2010 to 2013. Market capitalization measures the value of a company which is based on the share price and number of shares outstanding. It represents the market views of a company’s stock value and therefore it is a determining factor in stock valuation. Companies with good financial performance have a high market cap. Since their securities are frequently traded in the stock market. Currently, the market capitalization of General Electric is at 263$B which is an increase from 148.9B in 2010. This means the General Electric in the mega-cap group (company’s whose market cap. is over $200B) compared to its major competitors such as Honeywell International, Boeing, and 3M whose market capitalization are $74.13B, $87.26B, and 96.$28B respectively which means that mid-cap group. There General Electric Co. good financial performance has contributes to the high market capitalization as it has enabled the company’s share to be frequently traded in the stock markets. Return on capital employed ratio is can also show the relationship between company’s financial performance and investors’ value. The ratio measures a company’s profitability and the efficiency with which its capital is employed (Steffy et al, 2007). GE return on capital employed ratio has continuously deteriorated over the past 4 years. The ratio was at 24% in 2010, 29% in 2011, 23% in 2012, and 9.25% in 2013 (appendix 1). This decline can be attributed to declining level of the company’s fixed assets and low profitability. Moreover, General Electric Co’s gross profit margin has continuously decreased from 2011 to 2012 and 2012 to 2013. As at 2010 the gross margin ratio was at 52% but has decreases to 47% in 2013 (appendix 1). On the other hand, net profit margin ratio of General Electric has also declined slightly. As a result of deteriorating gross margin profit and net profit, General Electric Co.’s ability to efficiently increase the amount of free cash flow is low hence reducing its investors’ value The gearing level is defined as the proportion of the company’s debt to its equity (Peavler, 2012). It is also known as the leverage ratio and is obtained by dividing all debts by the total shareholder’s equity. High gearing ratio means high levels of external borrowing and hence high risk for the business because repayment of dents and interest accrued has to be paid and so have the dividends (Peavler, 2012). However, gearing can form a solid part of the capital structure especially if it has predictably strong cash flows. A high gearing ratio is also an indicator that the company is continuously using debts to finance its day to day operations. This could be risky meeting all the debt schedules and in extreme cases, this may lead to bankruptcy (Peavler, 2012). This is even more dangerous where a company has loans that have variable interest rates meaning that changes in such interest rates may lead to problems repaying such loans. A gearing of over 50% means the company is highly geared. Those with gearing of 25 to 505 are said to be normally geared while those with below 25% are said to be low geared. The Gearing ratio GE has been reducing significantly from the year 2010 when it was at 76%, reduced to 75% in 2011, then to 72% in 2012 and to70% in2013. Reducing gearing ratio is a good indicator for GE as it means that the gearing level is reducing. It is above 50% and therefore it is still highly geared. However, this is normal for companies like GE that invest heavily in fixed assets. This can also be translated that the company is borrowing more money to finance its capital intensive activities which will later on have a high return on investment for the investors. The industry gearing level is at 95% and GE is below the industry average which is a good indiator. In summary, GE is a good company to invest in. In terms of profitability, profitability ratios of GE including Gross Profit margin, net profit margin and Return on Capital employed have been reducing yearly. However, compared to the industry ratios, GE is doing better than the industry. When it comes to the company leverage, the company has demonstrated high gearing ratio of above 50% meaning it is highly geared. This is however not a problem to GE as it works in a capital intensive sector and it has steady cash flow to ensure that they pay off the debts in good timing. GE gearing ratio against the industry’s is also lower and hence the company is not badly off. As far as GE’s liquidity is concerned, the company is going well. It has a current ratio is greater than one which indicates that it can pay off its short term obligations when they fall due. They also rate higher at 2.00as compared to the industry’s current ratio at 1.39. As far as Investment ratios are concerned, GE is doing well compared to the industry. The company’s EPs has been increasing consistently standing at 0.24 in 2013. Price per earnings ratio stood at 17.26 in02013 against the industry ratio of 16.66. the Dividend Yield on the other hand stood at 3.43 in 2013 compared to the industry ratio at 1.85. This is a good indicator for future investors. According to a letter by GE management in 2013 annual report, GE has the interest of the investors at heart. Executing their initiatives will bear good fruits for their investors. They project that by the year 2016, they expect to get 70% of all their earnings from their industrial businesses. They expect to gain industrial profits 17% above their competitors. They expect to generate 90 billion Dollars of cash to be distributed to investors as dividends and buy backs. The annual report indicates that they made progress last year and manage to earn 7% higher segment profit up from 24.5 billion dollars the previous year. Further analysis indicates that GE grew its operating EPS by 9% and distributed 18 billion dollars to its shareholders in form of dividends and share repurchase. In the Annual Report, GE assures its investors that it has been running the company well which have led to increase in the profits by 60 basis points and led to generation of $17 billion in cash (GE Annual Report, 2013). However, it is very important to note that there are various limitation associated with financial information in making investment decision. Financial information only focus on financial measures of health without incorporating information outside the financial statement when assess a company. Organization’s health cannot be just be determined by its economic characteristics and therefore when assessing attractiveness of a company we also needs to collect and present information about environment, social, and economic cost and benefit to make an accurate evaluation. With all this in mind, I would go ahead and advise my friend to invest in GE Company as it has promising future for investors. References GE (2014). Retrieved on 27th October from http://www.ge.com/ GE 2013 Annual Report, Retrieved on 27th October from http://www.ge.com/ar2013/pdf/GE_AR13.pdf GE Annual Report 2012, Retrieved on 27th October from http://www.ge.com/sites/default/files/GE_AR11_EntireReport.pdf Richard J. Teweles, Edward S. Bradley (2011), the stock market. 7th Edition, John Wiley & sons publishers: USA Steffy, W.Zearley, T.,Strunk J.(2007). Financial Ratio Analysis: an effective Management Tool. Industrial Development Division publishers, University of Michigan: USA Peavler, R (2010). Use profitability ratios in Financial Ratio Analysis.Retrieved on 27th October 2014 from http://bizfinance.about.com/od/financialratios/a/Profitability_Ratios.htm Peavler, R (2012) What is the Gearing Ratio, What Does it Mean, and How is it Calculated. Retrieved on 27th October 2014 from http://bizfinance.about.com/od/financialratios/f/what-is-the-gearing-ratio.htm Appendix 1 Read More