Financial Performance of the Two Companies - Essay Example

Introduction This report presents the financial analysis of two companies CLP Ltd and HEH Ltd in terms of the companies' profitability, efficiency,liquidity, leverage and investment attractiveness. The analysis has been done on the basis of various useful financial ratios (See appendix 1 and 2) while evaluating the year on year performance of the two companies, as well as on a cross-section comparison. Finally, the report provides a recommendation with respect to the ordinary shares of the two companies on the basis of the analysis. Financial Analysis- CLP Ltd Profitability 2005 2004 Net Profit Ratio 27.07% 32.23% Return On Capital Employed 3.45% 18.24% Return On Assets 11.15% 10.66% Profitability analysis of a company reveals how successfully a company generates profit for its various stakeholders. Belkaoui (1998, p11) says, "the profitability ratios portray ability of the firm to efficiently use the capital committed by stockholders and lenders to generate revenues in excess of expenses". The net profit ratio shows that CLP Ltd was able to retain about 27% of the total revenue after accounting for various costs and expenses in the year 2005. It also suggest that the company loses about 73% of its sales revenue on account of various production, distribution, selling, administrative, operating, and other expenses. This ratio has decreased as compared to the previous year by about 5% even though the revenue increased in the current years. This suggests that the company is confronting with increasing expenses to carry out its activities. Riahi-Belkaoui says that the return on capital employed ratio "indicates how efficiently the capital supplied by the common stockholders was employed within the firm" (11). CLP Ltd utilized the funds provided by shareholders to generate a profit of about only 3% in 2005, which has tumbled from 18.24% in 2004. The analysis of return on assets ratio shows that in 2005, the company utilized its assets towards the generation of profit in a slightly better manner than the year 2004. Hence, profitability analysis suggests that the company is a fairly profitable company. Liquidity 2005 2004 Current Ratio 0.65:1 0.72:1 Acid Test (Or Quick) Ratio 0.61:1 0.68:1 The liquidity analysis shows the current position of a company in terms of its ability to pay off the short-term liabilities and expenses as and when the need arises. The current ratio for CLP Ltd reveals that the company owns HK$0.65 of current assets to pay off HK$1 of its liabilities in 2005. This indicates a severe shortage of liquid assets in the company to the extent that it cannot discharge its short-term debts out of even all of its current assets. In the current year, this has declined by about 10%, which is not a good sign for its liquidity position. The quick ratio also suggests a falling trend in the company's ability to pay off its short-term liabilities and day-to-day expenses. Efficiency 2005 2004 Receivable Turnover 52 days 42 days Cash Dividend Coverage Ratio 1.75 1.89 The receivable turnover ratio exhibits that in the year 2005, the company's management converted its receivable into cash in 52 days, which has dramatically risen as compared to the previous year. This shows that the company is becoming inefficient in collecting money from its debtors on time. The cash dividend coverage ratio shows how well the company is able to pay off dividends to its shareholders out of available cash funds. An analysis of this ratio for the company suggests that although the company's cash balance is sufficient enough in 2005 to pay the dividends, yet the ratio has declined from that of the year 2004 due to the firm's attempt to pay a higher dividend in the current year out of almost the same operating cash balance. Leverage 2005 2004 Debt Ratio 28.84% 23.23% Gearing Ratio 58.59% 42.47% Riahi-Belkaoui illuminates that the leverage ratios are "used to assess the long-term solvency risk of the firm" (10). The debt ratio reveals that in 2004, about 23% of the company's assets were financed with the borrowed funds, which increased to about 29% in the year 2005. An analysis of the company's financial statements suggests that the company has increased the volume of debt capital to finance its increasing assets. The gearing ratio for CLP Ltd shows the capital structure of the company, i.e., it uses a mixed capital structure comprising funds obtained both from lenders as well as shareholders and investors. However, the most notable point is that the ratio has increased by 38% in 2005 as compared to 2004, which reveals that the company's tendency to rely on more borrowed funds to finance its activities. Investment 2005 2004 Earning Per Share 4.72 3.58 Dividend Per Share 2.27 2.08 Dividend Cover Ratio 0.48 0.58 Meigs & Meigs suggest that, "common shareholders and potential investors in common stock first look at a company's earning record" (934). The earning per share as obtained from the company's financial statements, expose an increasing trend in the company's earnings along with an increasing dividend per share paid to the ordinary shareholders. The EPS has increased by about 32% whereas the dividends have risen by 9%, which is quite attractive for the company's ordinary shareholders. Financial Analysis- HEH Ltd Profitability 2005 2004 Net Profit Ratio 84.12% 65.19% Return On Capital Employed 17.19% 18.68% Return On Assets 14.01% 10.66% The net profit ratio for HEH Ltd shows that the company managed to retain about 84% of its total turnover in the year 2005, dramatically up by almost 29% from that of the year 2004. An analysis of the company's financial statements suggests that the turnover has remained almost stable over the last two years, yet the company has successfully shot up the profit before tax margin in the current year. The return on capital employed ratio exhibits that the company managed to earn a profit margin of about 17% on the funds invested by shareholders in the year 2005, down by about 8% as compared to 2004 owing to rising shareholder funds in the current year. The return on assets ratio demonstrates that the company utilized all its assets to generate a margin of 14% in 2005 also showing an increasing trend from previous year. Hence, this analysis finds the HEH Ltd as a highly profitable company. Liquidity 2005 2004 Current Ratio 4.68:1 1.42:1 Acid Test (Or Quick) Ratio 4.4:1 1.27:1 The current ratio of the company appears to be drastically high in the year 2005 as compared to 2004. This shows that the company keeps HK$4.68 to pay off every dollar of its current liabilities. Although the company is highly liquid being able to discharge all its short- term debts whenever the need arises, but such a high ratio is not desirable as it reveals that most of the company's cash and assets are lying idle without being invested for further expansion. The quick ratio also suggests a high figure even after keeping aside stock from the current assets. An analysis of the company's financial statements shows that most of the current assets happen to be in the form of cash, most of which needs to be invested in the best interest of the company. Efficiency 2005 2004 Receivable Turnover 34 days 34 days Cash Dividend Coverage Ratio 2.31 1.98 The receivable turnover ratio manifests that the company is efficient enough to convert its receivables into cash in about 34 days, which has been stable over the period of two years. The cash dividend coverage ratio shows that the company possesses more than double cash funds from operation to pay dividends to its shareholders. This ratio has improved over the last year showing a rather satisfactory position for the company's shareholders. Leverage 2005 2004 Debt Ratio 31.78% 35.97% Gearing Ratio 46.59% 56.19% An analysis of the debt ratio for the HEH Ltd shows that about 32% of the company's total assets have been financed with the help of external or borrowed funds in the current year. This ratio has fallen down as compared to the previous year showing that the company has slightly reduced its reliance on borrowed funds to finance its increasing number of assets. Similarly, the gearing ratio has also decreased by about 17% showing that the company is tending to reduce the volume of borrowed funds from its capital structure and relying more on equity funds than external money. Investment 2005 2004 Earning Per Share 4.01 2.93 Dividend Per Share 1.59 1.77 Dividend Cover Ratio 0.39 0.60 The earning per share analysis for HEH Ltd also suggests an astoundingly rising trend in profitability. Albeit the increase in EPS, the payment of dividends to the shareholders on the part of the company has declined by 10% in 2005 from the year 2004, as suggested by the dividend per share figure. The dividend cover ratio shows that about 60% of the earnings were paid as dividends to the shareholders in 2004, which decreased to 39% in 2005. Cross Section Analysis Ratios CLP HEH Net Profit Ratio 27.07% 84.12% Return On Capital Employed 3.45% 17.19% Return On Assets 11.15% 14.01% Current Ratio 0.65:1 4.68:1 Acid Test Ratio 0.61:1 4.4:1 Receivable Turnover 52 days 34 days Cash Dividend Coverage Ratio 1.75 2.31 Debt Ratio 28.84% 31.78% Debt to Equity Ratio 58.59% 46.59% Earning Per Share 4.72 4.01 Dividend Per Share 2.27 1.59 Dividend Cover Ratio 0.48 0.39 If these two companies are compared in terms of profitability, on the basis of above analysis, HEH Ltd is certainly much more profitable than the CLP Ltd owing to the increasing trend in its already high net profit margin over the last years. In terms of liquidity, HEH Ltd again tops the list for the reason that although such high investment in the current assets is not feasible for a company, but this also shows the sufficient availability of cash and cash equivalents in it. When compared with respect to efficiency, the company is also above in performance than the CLP Ltd due to the former company's efficiency in quicker collection of accounts receivable than the later one. In terms of leverage, HEH is showing a decreasing trend with regard to its reliance on borrowed funds, whereas with CLP Ltd, there is the opposite trend. However, both the companies are moderately leveraged at this stage. Finally, for investment perspective, HEH Ltd can be attractive for investors looking for high earnings and profitability. On the other hand, CLP Ltd is attractive for investors willing to invest for the sake of rising dividends payments. Recommendation Based on the above detailed analysis and comparison, the following recommendation can be made: CLP Ltd: Sell HEH Ltd: Buy The ordinary shares of CLP Ltd should be sold because of its decreasing profit margins and deteriorating liquidity position, which can lead the company to bankruptcy. On the other hand, shares of HEH Ltd should be purchased considering its rising profitability, efficient management and high liquidity. APPENDIX- 1 CLP Ltd 2005 2004 Net Profit Ratio Profit before tax x 100 = 10,445 9,910 Sales 38,584 30,741 = 27.07% 32.23% Return On Capital Employed (ROCE) Operating profit x100 = 8,695 8,061 Equity shareholders fund 50,159 44,199 = 3.45% 18.24% Return On Assets Net Income x100 = 11,368 8,614 Total Assets 101,905 80,799 11.15% 10.66% Current Ratio Current Assets___ = 9,444 6,383 Current Liabilities 14,405 8,916 = 0.65:1 0.72:1 Acid Test (Or Quick) Ratio Current Assets- Stock = 9,444-596 6,383-299 Current Liabilities 14,405 8,916 = 0.61:1 0.68:1 Receivables Turnover Receivables = 5,505 3,564 Turnover/365 38,584/365 30,741/365 = 52 days 42 days Cash Dividend Coverage Ratio Cash Flow From Operations = 10,046 10,195 Dividends 5,732 5,370 = 1.75 1.89 Debt Ratio Total Debt x 100 = 29,391 18,774 Total Assets (Fixed + Current) 101,905 80,799 = 28.84% 23.23% Gearing Ratio Total Debt x100 = 29,391 18,774 Total Shareholders' equity 50,159 44,199 = 58.59% 42.47% Earning Per Share Provided in Annual Report = 4.72 3.58 Dividend Per Share (Ordinary) Provided in Annual Report = 2.27 2.08 Dividend Cover Ratio Dividends Per Share = 2.27 2.08 Earning Per Share 4.72 3.58 = 0.48 0.58 APPENDIX- 2 HEH Ltd. 2005 2004 Net Profit Ratio Profit before tax x 100 = 9,777 7,436 Sales 11,622 11,407 = 84.12% 65.19% Return On Capital Employed (ROCE) Operating profit x100 = 7,167 7,017 Equity shareholders fund 41,685 37,572 = 17.19% 18.68% Return On Assets Net Income x100 = 8,562 6,256 Total Assets 61,108 58,683 = 14.01% 10.66% Current Ratio Current Assets___ = 7,715 4,158 Current Liabilities 1,650 2,916 = 4.68:1 1.42:1 Acid Test (Or Quick) Ratio Current Assets- Stock = 7,715-445 4,158-466 Current Liabilities 1,650 2,916 = 4.4:1 1.27:1 Receivables Turnover Receivables = 1,090 1,069 Turnover/365 11,622/365 11,407/365 = 34 days 34 days Cash Dividend Coverage Ratio Cash Flow From Operations = 7,853 7,474 Dividends 3,394 3,778 = 2.31 1.98 Debt Ratio Total Debt x 100 = 19,423 21,111 Total Assets (Fixed + Current) 61,108 58,683 = 31.78% 35.97% Gearing Ratio Total Debt x100 = 19,423 21,111 Total Shareholders' equity 41,685 37,572 = 46.59% 56.19% Earning Per Share Provided in Annual Report = 4.01 2.93 Dividend Per Share Provided in Annual Report = 1.59 1.77 Dividend Cover Ratio Dividends Per Share = 1.59 1.77 Earning Per Share 4.01 2.93 = 0.39 0.60 Works Cited Ahmed Riahi-Belkaoui, Financial Analysis and the Predictability of Important Economic Events, Quorum Books, 1998 Meigs & Meigs, Accounting: The Basis For Business Decision Making, Mc Graw Hill: New York, 1993 Read More