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For both debt ratios, the lower their values are the more conservative the company is, choosing to finance its operations/investments from internal sources. However, such a company may miss out on growth and investment opportunities.
It is recommended for companies not to finance more than 50% of their capital via external debt. The debt-to-equity is superior to the recommended values, indication a much higher proportion of equity financing via external debt. The debt-to-asset is also higher to the recommended values, but much closer indicating that the assets are around 80%financed by external debt.
The two indicators suggest that the group is heavily financing its capital/assets from external debt, which is explained by the group's expansion strategy. However, FFS's values are not as justified because the company didn't expand as fast as the group, yet the debts were proportional to those of the group. At both levels, group and company, the financing from external sources was far too great and burdening for the entity.
The interest coverage ratio is an indicator of a company's ability to cover its fixed interest charges from current earnings.
The margin of safety varies within and across industries. In general, when the value is lower than 1.5 the company's ability to pay outstanding debt is questionable and values lower than 1 indicates a company that doesn't generate sufficient revenues to pay the outstanding debt. In this case, the group is at the limit between questionable and good capacity to cover its fixed interest charges. FFS has a good interest coverage ratio.
The cash flow coverage reflects the extent to which the net cash flow is financed by annual interest expense.
The cash flow is critical when assessing a company. Thus, a company with good profits, but poor cash flow requires further investigation. Specialist prefers a cash flow coverage superior to #2. In this case, the group has poor cash flow coverage due to high annual interest expenses generated by large debts, which needed to be contracted to finance the expansion process. The group needed to focus on improving this indicator as it was vital for its solvency and far below recommended values.
FFS has a good cash flow coverage in the first 2 years analyzed, in the 3rd year there is no interest expense and in the last year analyzed the cash flow coverage is very low, which indicates either a low cash flow or high annual interest expense, both of these situation being negative for investors.
Where the net cash flow is equal to Net income +/- non-cash items (e.g. depreciation; see table3).
TABLE 3 - NET CASH FLOW FILIPPO FOCHI GROUP 1989-1992 (MILLIONS of LIRA)
Net cash flow
Source: Author's own calculations based on Filippo Fochi SpA - case No. 001/04
TABLE 4 - NET CASH FLOW FILIPPO FOCHI SPA 1989-1992 (MILLIONS of LIRA)
Net cash flow
Source: Author's own calculations based on Filippo Fochi SpA - case No. 001/04
Finally, the solvency ratio is an indicator of the company's capacity to meet long-term obligations. Solvency is measured as the ratio of net cash flow to the company's total debts.
Solvency ratios vary from one industry to another. However, a rule of thumb suggests that solvency ratios superior to 20% indicate company health. In this case both the goup and FFS are not even close to the recommended value. Both of them have solvency problems as the total net cash flow is very small when compared to total debt/total liabilities. Conversely, the solvency problems can be seen as generated by large total debt when compared to net cash flow.
The amount of total debt is explained by the group's/company's need of financing its expansion process. The internal sources being very limited, the organization resorted to external sources. However, this endangered its capacity to meet its long-term obligations and therefore pushed away a number of investors that could have provided additional financing sources.
Profitability is a very complex notion as a company's profitability depends on its position in the industry, on the position on its product in their life cycle or on costs of debt.
Whenever analyzing profitability it is useful to know if its performance indicators are falling, stable or rising (e.g. If the sales are falling, stable or rising; if the company's market share is falling, stable or rising; if the profits are falling, stable or rising).
In addition to key performance indicators trends, analysts use a set of ratios including: net profit margin, return on assets (ROA), return on equity (ROE), earning per common share (EPS) and payout ratio.
The net profit margin is very small, suggesting increased risk associated with a decline in sales, which could easily lead to net loss.
ROA is an indicator of how many earnings are generated from controlling a given amount of assets. Companies that require large amounts of initial investments have a low ROA. In this case, the group being in an expansion phase, it is understandable why the indicator has such low values. However, a low proportion of profit after taxes in total assets could also be a sign of inefficient use of assets to generate earnings. The same explanation is available for FFS.
ROE measures the rate of return on shareholder's equity, which is the ownership interest of the common stock owners. The ratio is one of the most important financial ones as it measures the company's capacity to generate profit from net assets (shareholders' equity = assets - total debt).
ROE varies across industries from very small to very high depending on how much asset is required to generate profits. Companies, such as Filippo Fochi with activities in industries requiring high assets are not expected to have high ROE. Also, a high ROE is assumed to be irrelevant if earnings are not reinvested. Reinvested earnings are meant to generate growth.
In this case, the ROE is inconclusive as more information is needed to draw a conclusion, such as additional ratios, such as dividend payout.
FIG. 1 - SALES and PROFITS FILIPPO FOCHI GROUP - 1989-1992 (MILLIONS of LIRA)
Sales and gross profits use the left-hand side scale and net profits the right-hand side scale. All three indicators have registered a positive evolution over the 4-year period analyzed. Their trend is explained by the expansion strategy adopted by the group.
These ratios measure how well the company manages its assets. Some of the most common ratios used to measure efficiency are: total asset turnover, accounts receivable turnover, inventory turnover, average collection period and days in inventory.
The higher the value of total asset turnover the better as the indicator measures the company's efficiency of generating revenues from its assets. In this case, the group managed to generate
1.5 for each
1 of assets in the last 3 years analyzed. FFS had also a positive evolution for this indicator, although not as stable. Thus, the company managed to generate between
1.36 for each
1 of asset.
This ratio shows the number of times the company's inventory is sold and replaced over a given period of time. The indicator can be expressed as the ratio of total sales to average inventory as well. However, the ratio of cost of goods sold to average inventory is considered to be a more consistent expression of the indicator as sales are recorded at market values, whereas inventories are recorded at cost value. A low value suggests high inventories and a high values suggests either high inefficient cost of goods sold or low inventories.
The indicator is measured in days, reflecting the number of days needed to receive payments owed from customers. A low collection period preferable to a high collection period, as this implies that the company needs a short period of time to turn its sales into cash. However, many companies, especially large ones sell their products/services on credit, which increases the uncertainty related to payment date. In this case, both at group and company level, the average collection period is very high, translation in a liquidity reduction for the organizational operations.
Decreasing values of days in inventory suggests that the inventory turnover is increasing and therefore the inventories are reduced. At company level, the inventories are increasing in the last three years, reaching a record value in 1992.
In the early 1990s, the Fochi group has operations in four business areas:
Petrochemical - included the "general construction contractor" activities for chemical and petrochemical plants
Energy - implied the supervision of power stations realizations, which in most cases meant the installation of boilers and furnished small and medium-sized turn-key plants for cogeneration and desalination plants
Manufacturing components for industrial plants (including 3 main product lines: heat exchangers, air-cooling systems and boilers)
Assembly of industrial plants (the group's core business, done mainly for steel sector, cement and lime production plants and various kinds of plants in general)
FIG. 2 - % of the Business AREAS in the GROUP'S TURNOVER 1992
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