Financial Analysis of Emerald Energy Plc - Case Study Example

Financial Analysis Emerald Energy Plc Emerald Energy based in the UK is engaged in the activity of exploration and production of hydrocarbons. The company operates in the regions of South America and the Middle East. The shares of the Company were listed in the London Stock Exchange. Further to a recommended scheme of arrangement which was put to effect from 12th October 2009, the Company’s shares were delisted from the London Stock Exchange and the Company became a wholly owned subsidiary of Sinochem Resources UK Limited, belonging to the Sinochem Group (Emerald Energy Plc, 2009). The financial performance of the Company during the year 2008 which enabled the Company to generate spectacular cash reserves was so impressive that it made a comparison of the performance of the during the previous year’s interesting. The following sections of this paper present a detailed financial analysis of the company based on various key ratios worked out from the information available in the published financial statements. Sales Revenue The revenue earnings of Emerald Energy have shown a sharp increase during the year 2008 as compared to the previous year. The increase is significant to the extent of 94% over the sales revenue for the year 2008. The change in the sales revenue during the year 2007 as compared with 2006 is showing a decline of 3.38% over 2006 figures. This trend is depicted in the following graph. 1 Analysis of Profitability The ability of a firm to generate profits can be assessed by working out the profitability ratios for a historical period and by analyzing the sources of income. The gross profit margin, operating profit margin and net income as a percentage of total turnover presents a realistic view of the firm’s ability to generate profits. “Profitability ratios offer several different measures of the success of the firm at generating profits.” (NetMBA, 2007) The ratios worked out for the Company and the ratio derived for the industry from the published sources are presented below: 2006 2007 2008 Industry Gross Profit Margin 18.00% 30.08% 70.75% 19.38% Operating Margin 2.60% 18.80% 61.69% 7.40% Net Margin -5.94% 14.77% 41.43% 4.10% Return on Equity -3.56% 7.31% 28.45% 17.53% The above table indicates that the profitability of the company has shown a sharp increase in the year as compared to the year 2007, in respect of gross margin, operating margin and net margin. The gross margin has increased mainly because of the increase in the sales revenue due to higher prices of petroleum products during early 2008. The increase in gross margin can be traced to the lower cost of sales. The cost of sales for the year 2008 was 29.25% as against 69.92% for the year 2007. This accounts for the steep increase in the gross margin as well as the increase in the operating and net margins. The increase in the profitability can be observed from the following graph. Return on Shareholder’s Equity (ROE) The return on shareholder’s equity ratio is another important investment valuation ratio used by the investors to evaluate the profitability of the company and its ability to generate earnings by utilizing the capital invested by the equity shareholders. This ratio is considered as more meaningful to the investors. The return on shareholder’s equity has increased significantly over the three year period. Presently as per the latest financial information available on the company, the return on shareholder’s equity ratio is stated as 28.45% while the ratio for the industry stands at 17.53 (Reuters, 2009). Analysis of Operating Efficiency The working Capital ratios indicate how well the company is able to manage its working capital. “The asset management ratios are also known as working capital ratios or the efficiency ratios. The aim is to measure how effectively the firm is managing its assets.” (NetTom, n.d.) The efficiency ratios for Emerald Energy are exhibited below: 2006 2007 2008 Industry Receivables Turnover (Times) 12.06 9.41 5.76 12.26 Total Assets Turnover (Times) 0.49 0.35 0.44 0.60 Inventory Turnover (Times) 8.09 4.97 3.20 4.73 Receivables Turnover Accounts receivable turnover indicates how many times the company has turned over the accounts receivable to achieve the total revenue. This ratio is purely a relative one which needs to be compared with the historical performance of the Company and the ratio for the industry (Accounting Coach, 2008). The performance of Emerald over the three year period is showing a decline in which the ratio is coming down. This indicates that the company has an increased debtor level and has not been efficient in collection of accounts receivable. The ratio for the Company is lower than the industry showing an under performance in this respect. Total Assets Turnover Assets turnover ratio explains the efficiency of the Company in utilizing its assets for generating more sales revenue. The ratio indicates the number of times the Company has used the assets to achieve the sales revenue. The ratio is also an indicator of the pricing strategy of the Company. A higher asset turnover ratio indicates a lower profit margin for the company. On the other hand, companies with lower asset turnover ratio are likely to have higher profit margins. In the case of Emerald Energy the ratio is lower and there is scope for improvement to reach the industry standards. Inventory Turnover Inventory turnover shows how many times the company is able to roll over its inventory. A higher ratio indicates that the Company is able to turning over its inventory quickly. However the ratio by itself does not convey any meaning unless the ratio is compared with industry average (ABREMA, n.d.). This ratio has also shown a declining trend over the three year period. The increase in inventory from the year 2006 level by 68.9% clearly indicates that the Company has not been able to efficiently turn around its inventories. Analysis of Short term Liquidity Liquidity ratio is defined as “A class of financial metrics that is used to determine a companys ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger is the margin of safety that the company possesses to cover short-term debts.” (Investopedia, 2009) Liquidity Ratios are the ones that exhibit the short-term liquidity of the company. The liquidity ratios of the company are appended below: 2006 2007 2008 Industry Current Ratio 2.67 8.24 3.20 0.67 Quick Ratio 1.99 6.64 60.35 0.46 The short term liquidity of the company is high, as in general the ratio of 2:1 between the current assets to current liabilities is considered sound and safe. The industry current ratio however is low implying that Emerald Energy enjoys a comfortable liquidity position. The quick ratio is very high for the year 2008 because of the excessive cash flow generated by the Company during the year. Despite the increase in the current liabilities in the year 2008, current ratio and quick ratio of the Company are at more than satisfactory level, because of the increased sales revenue and cash generation during the year 2008. This indicates a sound short term financial position of the Company. Analysis of Capital Structure and Solvency Gearing ratio explains the relationship between the long-term debts of the company and its equity. The company should be able to maintain a correct balance between the debt and equity so that the company can ensure a good return for the company’s shareholders. 2006 2007 2008 Industry Long-term Debt to Equity 7.84% 25.50% 23.31% 26.25% Cash flow to Debt Ratio 2.78 0.70 10.25 NA The company has increased its long-term borrowings during 2007 due to the addition of debt component of convertible bonds to the extent of $ 24,269 million. This has altered the capital structure of the Company significantly during 2007 (gearing ratio went up from 7.84% in 2006 to 25.50% in 2007). However the excess cash generated from the operations during 2008 has increased the total equity content and resulted in a slight reduction of the gearing ratio in the year 2008. Because of lower cash flow during 2007 the cash flow to debts ratio is low as compared to the year 2008, which witnessed a record increase in the cash flow. Investment Valuation Ratios Investment valuation ratios enable the investors to estimate the attractiveness of a potential investment as to the worthiness of investing in the relevant stocks. While the information like revenue, operating cash flow, and earnings before interest, tax and depreciation obtained from the financial statements of a company can overload the investors’ with information, the investment valuation ratios provide a simplified approach on the evaluation of different investment options b comparing the ratios for different companies. Price earnings ratio and earnings per share are two of the important ‘per share’ investment valuation ratios that could provide vital information for the investor to decide on the potential investment options. Price Earnings Ratio (P/E Ratio) Price earnings ratio is the valuation ratio of a company’s current share price compared to its earnings per share. This ratio is calculated by dividing market value per share by earnings per share. The price to earnings ratio is the best known ratio among the investment valuation ratios. This ratio is widely used by the investment professionals and portfolio managers for judging the investibility in different stocks. It is nothing but usual that estimated earnings per share figures will be mostly optimistic when the stock prices go up and pessimistic with the stock prices going down. Historically a price to earnings ratio at an average of 15 has been considered as a benchmark for broad market. However, this figure is subject to wide fluctuation depending upon the economic and market conditions (Investopedia, 2009). The ratio will be varying among different industries and companies. Therefore a comparison of the P/E ratio of the individual company with that of the industry is necessary for proper evaluation of the investment in stocks. The price to earnings ratio for the three years for Emerald Energy is calculated as below: 2006 2007 2008 Industry Price to Earnings -41.77 17.84 5.70 19.99 Earnings per Share EPS -4.86 11.21 59.77 16.68 It can be noticed from the above table that the P/E ratio for Emerald has been high during 2007 and has declined in the year 2008. With the increase in the earnings per share, there is a decline in the P/E ratio. A comparison of the price earnings as of the current date of Emerald based on the financial information indicates that the Company has a current P/E ratio of 5.70 as against 15.55 for the industry (Reuters, 2009). Earnings per share (EPS) has also increased during the period due to increased net income during 2007 and 2008 as compared to the net loss in 2006 Cash Flow Analysis There has been a significant increase in the net cash flow of the Company over the period of last two years. Especially for the year 2008, despite the economic slowdown the Company could earn higher revenue of $ 86,041 million, as against the total revenue of $ 44,357 million for the year 2007 showing an increase of 94%. This has led to an increase in the cash and cash equivalents at the end of year 2008 of $ 74,447 million, from the net cash and cash equivalents at the end of year 2007 of $ 40,169 million which represents 85.33% increase under this head. The following graph indicates the relative changes in the net cash and cash equivalents for the three years. Cash and Cash Equivalents at the end of the Years The increased sales revenue has contributed to a net operating cash inflow of $ 64,660 million during 2008, as against $ 30,496 million for 2007. Due to net loss in the year 2006, the net operating cash inflow was less at % 18073 million. The net cash inflows and outflows from the operating, investing and financing activities are exhibited in the following graph. The lesser cash flow from the operating activities can be cited as the main reason for this decline during 2008. While the cash flow from the operating activities was $ 4,069 million for the year 2007, the cash flow for the year 2008 from operating activities was lower at $ 3,391 million which accounts for almost 20% reduction in the cash flow (Annual Report, 2008). Cash Flow from Operating, Investing and Financing Activities There has been an increase in the cash outflows in the year 2008 on account of investing activities as compared to the year 2007. The Company has spent an amount of $ 29,764 million during 2008 on additions to property and equipment, while the spending on this head during 2007 was $ 26,327 million indicating no major changes in the comparative figures for the two years. In respect of financing activity, during the year 2008, the company has made payment of interest and banking charges to the extent of $ 1,748 million and no other significant outflows have been made during 2008 on account of financing activities. However the Company has issued convertible bonds to the extent of $ 30,000 million which might have changed the nature of debt instruments and terms of repayment and interest rates (Annual Report, 2007). The share price movement for the last one year is shown by the following graph. Between January 2009 and November 2009 the share price of Emerald has increased by 50.43%. Despite the general economic slowdown the company has registered a growth in the total earnings. Therefore it is recommended that it is wise to invest in the shares of Carnival at the current price. With the revival of the economic conditions, the Company can be expected to do well and provide good returns on the investments. There is no adverse financial situation that prevents investing in the company shares. Overall Performance “The graph below compares the total shareholder returns in terms of the change in the value of an initial investment of £ 100 made for five years prior to the end of December 2008. The performance of this hypothetical investment is benchmarked against that of the FTSE All Share Oil & Gas Producers Index which was selected as it represents the industry to which the Group belongs” (Annual Report, 2008) Conclusion The company has consistently registered a growth with the revenue for the company has been steadily increasing. The net cash flow has increased due to the volatile fuel prices. Despite the general economic slowdown the company has registered a growth in the total earnings. Therefore it is recommended that it is wise to invest in the shares of Emerald at the current price. With the revival of the economic conditions, the Company can be expected to do well and provide higher returns on the investments. There is no adverse financial situation that prevents investing in the company shares. Reference List ABREMA, n.d. Inventory Turnover. [Online] Available at: http://www.abrema.net/abrema/invent_to_g.html [Accessed 03 December 2009]. AccountingCoach, 2008. What is the Accounts Receivable Turnover Ratio. [Online] Available at: http://blog.accountingcoach.com/receivables-turnover-ratio/ [Accessed 03 December 2009]. AnnualReport, 2007. Emearld Energy Plc. [Online] Available at: http://www.emeraldenergy.com/documents/2007AnnualReportandAccounts.pdf [Accessed 03 December 2009]. AnnualReport, 2008. Emerald Energy Plc. [Online] Available at: http://www.emeraldenergy.com/documents/AnnualReportandAccounts2008.pdf [Accessed 03 December 2009]. EmeraldEnerbyPlc, 2009. Home Page. [Online] Available at: http://www.emeraldenergy.com/ [Accessed 03 December 2009]. Investopedia, 2009. Investment Valuation Ratios - Price/Earnings Ratio. [Online] Available at: http://www.investopedia.com/university/ratios/investment-valuation/ratio4.asp [Accessed 30 November 2009]. Investopedia, 2009. Liqudity Ratio. [Online] Available at: http://investopedia.com/terms/l/liquidityratios.asp [Accessed 02 September 2009]. NetMBA, 2007. Financial Ratios. [Online] Available at: http://www.netmba.com/finance/financial/ratios/ [Accessed 02 September 2009]. NetTom, n.d. Session14:Calculation of ratio Analysis. [Online] Available at: http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page25.htm [Accessed 21 Aug 2009]. Reuters, 2009. BP Plc. [Online] Available at: http://www.reuters.com/finance/stocks/ratios?rpc=66&symbol=BP.L [Accessed 03 December 2009]. Appendix EMERALD ENERGY PLC Profitability Ratios 2006 2007 2008 Gross Profit 8,255 13,342 60,873 Total Revenue 45,856 44,357 86,041 Gross Profit to Sales (%) 18.00% 30.08% 70.75% Operating Profit 1,190 8,337 53,082 Total Revenue 45,856 44,357 86,041 Operating Profit to Sales (%) 2.60% 18.80% 61.69% Net Income -2,724 6,551 35,645 Total Revenue 45,856 44,357 86,041 Net Income to Sales -5.94% 14.77% 41.43% Net Income -2,724 6,551 35,645 Total Equity 76,472 89,650 125,285 Return on Equity (ROE) (%) -3.56% 7.31% 28.45% Efficiency Ratios Accounts Receivable 3,801 4,715 14,944 Turnover 45,856 44,357 86,041 Receivables Turnover 12.06 9.41 5.76 Turnover 45,856 44,357 86,041 Total Assets 92,803 127,087 193,962 Assets Turnover 0.49 0.35 0.44 Cost of Sales 37,601 31,015 25,168 Inventory 4,649 6,241 7,853 Inventory Turnover (Times) 8.09 4.97 3.20 Liquidity Ratios 2006 2007 2008 Current Assets 26,279 55,574 97,907 Current Liabilities 9,827 6,748 30,602 Current Ratio 2.67 8.24 3.20 Liquid Current Assets 19,563 44,834 89,331 Current Liabilities 9,827 6,748 1,480 Quick Ratio 1.99 6.64 60.35 Gearing and Capital Structure Long-term Debt 6,504 30,689 38,075 Long-term Debt + Equity 82,976 120,339 163,360 Gearing Ratio (%) 7.84% 25.50% 23.31% Operating Cash flow 18073 21,612 64,660 Total Debt 6,504 30,689 6,310 Cash flow to Debt Ratio 2.78 0.70 10.25 Investment Valuation Ratios Market Price 203 200 340.5 Earnings per Share -4.86 11.21 59.77 Price to Earnings 41.77 17.84 5.70 Earnings per share -4.86 11.21 59.77 Read More