Financial analysis of Filippo Fochi SpA, 1989-1992

FINANCIAL ANALYSIS - Filippo Fochi SPA

Financial highlights

Income statement data

Group Revenues

Group Net earnings

FFC Revenues

FFS Net earnings

Balance sheet data

Group Total assets

Group Debt

Group Shareholders' equity

FFS Total assets

FFS Debt

FFS Shareholders' equity

Group Net profit margin (%)

Group EBIT

Group debt-to-equity ratio

FFS Net profit margin (%)

FFS EBIT

FFS debt-to-equity ratio

Filippo Fochi SpA - case No. 001/04 and author's own calculations from the same document

Total assets = Total liabilities; Total liabilities = Total debt + Shareholders' equity

Financial analysis and the results of operations

FILIPPO FOCHI GROUP INCOME STATEMENT 1989-1992 (MILLIONS of LIRA)

Items

Revenues

Cost of sales

Gross profit

Sales and administrative expenses

Depreciation

EBIT (Earnings before interest & taxes)

Interest expense

Interest income

Other extraordinary items

EBT (Earnings before taxes)

Taxes

EAT (Earnings after taxes)

Gains/losses from discontinued operations

Gains/losses on extraordinary items

Income from subsidiaries

Net earnings

Source: Filippo Fochi SpA - case No. 001/04

TABLE 2 - FILIPPO FOCHI SPA INCOME STATEMENT 1989-1992 (MILLIONS of LIRA)

Items

Revenues

Cost of sales

Gross profit

Sales and administrative expenses

Depreciation

EBIT (Earnings before interest & taxes)

Interest expense

Interest income

Other extraordinary items

EBT (Earnings before taxes)

Taxes

EAT (Earnings after taxes)

Gains/losses from discontinued operations

Gains/losses on extraordinary items

Income from subsidiaries

Net earnings

Source: Filippo Fochi SpA - case No. 001/04

Revenues

The group's revenues increased 313% from

352,117 millions to

1,455,840 millions between 1989 and 1992 with an average growth of 78%/year. The growth was primarily attributable to:

The company's policy of integrated production

The acquisition of existing companies, which were added to those already part of the group

The rationalization of the organizational structure meant to transform Filippo Fochi SpA into a pure holding company with the ability to spin off areas within.

Filippo Fochi SpA's (FFS) revenues increased 172% from

263,806 millions to

718,409 between 1989 and 1992 with an average growth of 43%/year. FFS's revenues increased slower than the group's revenues as the market abroad were more dynamic than the domestic one, especially the Middle East.

Cost of sales

The cost of sales increased slower than the revenues with 217% from

84,260 millions to

266,707 millions between 1989 and 1992 with an average growth of 54%/year. This suggests that the company achieved cost efficiency as it increased its size, probably due to economies of scale and scope.

The typical cost of sales related to construction activity includes:

Purchase of raw materials

Operational costs related to the construction of various objectives, such as consumable materials, personnel and third party services

FFS's cost of sales decreased 24% over the period analyzed with an average of 6%/year. The company managed to increased cost of sales efficiency by reducing the costs and still increasing the revenues from one year to another.

Gross Profit

The gross profit grew 350% from 1989 to 1992 with an average of 86%/year. The growth rate was superior to both that of revenues and the cost of sales as during this period the latter reduced its size as % of the former. Thus, in 1989 the cost of sales represented 24% of the revenues and 3 years later in 1992 the percentage was reduced to 18%. One of the reasons behind gross profit evolution is the increased efficiency of the cost of sales.

FFS's gross revenues increased 221% over the 4-year period analyzed with an average of 55%/year. Despite the gross profit increasing faster than the company's revenues, and the company's cost of sales decreasing, FFS's gross profit couldn't increased faster than the group's one due to the slow growth of its revenues.

Sales and administrative expenses

The sales and administrative expenses increased 330% from

226,003 millions to

971,249 millions between 1989 and 1992, faster than many other items in the income statement. The increase is explained by the fact that this item reflect the group's fixed costs, such as permanent personnel costs and given that the group was expanding its operations in this period, the personnel increased proportionally and so did all the components of this income statement item.

FFS's sales and administrative expenses increased 218% over the 4-year period analyzed, with an average of 54%/year. The company's sales and administrative expensed increased slower than those of the group as the company didn't expand its activities in the home market as extensively as the group did abroad.

Depreciation

The depreciation increased faster then the cost of sales and slower than the revenues with 244% from

18,458 millions to

63,644 millions between 1989 and 1992 with an average growth of 61%/year.

The depreciations costs are related to the production assets. The increase was primarily attributable to the increase in production.

FFS's depreciation increased 120% over the 4-year period analyzed, with an average of 30%/year. The company had less investment in the home market than abroad.

EBIT (Earnings before interest & taxes)

The EBIT grew 559% over the 4-year period analyzed with an average growth rate of 140%/year. The growth rate was superior to that of gross profit, sales and administrative expenses and depreciation as the last 2 items reduced their size as % of gross profit, falling from 91% in 1989 to 76% in 1992. This suggests that both sales and administrative expenses and depreciation have increased their efficiency over the analyzed period.

FFS's EBIT increased 321% during 1989-1992 with an average of 80%/year. The sales and administrative expensed and depreciation increased their efficiency for the company as well as they did for the group.

EAT (Earnings after taxes)

The EAT grew 353% over the 4-year period analyzed with an average growth rate of 88% per year. The growth rate was inferior to that of EBIT because the proportion of taxes in this latter item was maintained to roughly 40%.

FFS's EAT increased 219% during 1989-1992 with an average of 55%/year. Again, EAT increased slower than EBIT as the proportion of taxes in this indicator maintained constant to roughly 38%, as it did in the group's case.

Net Earnings

The net earnings increased with 350% from £7,439 millions to

33,493 millions between 1989 and 1992 with an average growth of 88%/year. The evolution of net earnings was similar to that of EAT, as the gains/losses from discontinued operations or on extraordinary items and the income from subsidiaries has an insignificant impact of EAT changes.

The income statement analysis is somewhat limited. Financial analysts tend to focus on "valuation," rather than "historical earnings." The valuation pays respect to expected cash flow, which is different than income. Furthermore, such items as depreciation don't reflect reality as they are calculated based on historical cost of the asset, which is lower to that of a similar product today as a consequence of inflation. Consequently, such items overestimate the actual earnings.

FFS's net earnings had identical evolution with its EAT as the indicators have the same values.

Financial analysis - ratios

Liquidity

This indicator reflects the asset's ability to be converted into cash easily. Short-term liquidity ratios reflect the firm's ability to meet its short-term obligations. Numerically, a ratio higher than #1 would be a positive indicator of liquidity and a lower risk for short-term creditors. The two most common ratios are: current ratio and quick ratio, with ideal values of (2:1) and (1:1)

The current ratio is positive and between 1 and 2 in the 1st year analyzed. In the following 3 years, the ratio has negative values as current liabilities item is negative due to high negative debts to associated companies, which represent loans to associated companies. Based on these values, the group's ability to meet short-term obligations is good.

FFS's ability to meet short-term obligations is good in the first three years and in 1992 the company starts incurring problems in this area.

The quick ratio in the first three years analyzed has values below 1, indicating a reduced ability of the group to meet immediate financial obligations. This ratio shows the group's liquidity by subtracting inventories from current assets. The rationale behind this is that inventories are the least liquid item among current assets and even though they are considered current assets, the group would need a certain period of time to turn them into cash.

FFS's immediate liquidity is within acceptable limits only in 1989, but in the following 3 years, the indicator deteriorated badly to reach 0.11 in the last year.

Profitability

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.

Efficiency

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

0.96 and

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.

Business segments

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

FIG. 3 - % of the Business AREAS in the GROUP'S TURNOVER 1993

Note: The "other" category includes % of the groups profits registered by Asian and Latin American subsidiaries

Petrochemical, energy and manufacturing represented the vast majority of the group's profits.

The group's expansion strategy was focused on vertical integration. This implied the acquisitions of companies that performed different activities in different industries. Basically, the group acquired companies along the value chain. Their expansion strategy was successful for a short period of time. For the same period of time the expansion was made not just nationally, but also abroad and between 1989 and 1993, the Italian market's contribution the groups turnover decreased from 40% to 33%.

FIG. 4 - % of the GEOGRAPHIC AREAS in the GROUP'S TURNOVER 1989-1993

The expansion abroad was very important for the company as it enabled access to a wider variety of resources and to larger markets. In 1992 and 1993 the breakdown for abroad markets was made between Europe, Middle East, Far East and America. The first two markets together were responsible for roughly 60% of the group's turnover abroad, with Middle East being the largest of them. In the Middle East, the group had mainly petrochemical, assembly and energy operations, whereas manufacturing components for industrial plants was more popular in the home market and Latin America.

Some of the international markets were: Kuwait, China, Dubai, Pakistan, Bangladesh, Thailand, Syria, Iran, Romania, Hungary, former Yugoslavia, Latin America, Egypt, Russia, Poland and Malaysia. The geographical diversification was done on four continents.

Competitors

All four large business areas in which the group ran its activities are typically characterized as oligopolies in which a small number of large companies concentrate the vast majority of the market turnover.

In the construction sector, most of the international orders were serviced by an oligopoly made of: Foster Wheeler (U.S.), ABB (Sweden), Siemens (Germany) and Daewoo & Mitsubishi (Asia). In the home energy market, Ansaldo and Sondel/Falck were part of the oligopoly, subcontracting in the international consortia. The Fochi group had a reduced production capacity compared to all these oligopoly members and was carrying out only low cost, small orders. The group's vertical integration increased its international reach and probably had a cost efficiency contribution as some of the group's activities were internalized every time a new acquisition was added. However, this didn't help enhancing the group's production capacity, limiting its turnover to small contracts.

Summary

The Fochi group started and expansion process oversees with the purpose of increasing the scope of operations. The expansion process included the acquisition of existing companies in adjacent sectors to its core business. The vertical integration of activities along the value chain was beneficial for a group the size of Fochi because that allowed it to achieve numerous savings, such as scope economies. The group started from a small size and moved to a medium one for the domestic markets, but it never reached a dimension sufficient to compete with the large players in the international arena such as ABB or Siemens. Therefore, the group was never able to contract large project or to develop the capacity to contract them in a future period of time. Most of the investments made were meant to increase geographical or product scope, rather than production scale. Many analysts saw this integration process as a successful one. However, in 1993 the group filled for bankruptcy.

The financial analysis made in this paper highlights some of the mistakes made at both group and parent company level. Firstly, both the group and FFS had difficulties meeting short-term and long-term obligations. The difficulties related to long-term obligations were from the very beginning as the group chose to heavily finance its expansion process on external debt. The burden of these debts became heavier and heavier over time and started and extended to short-term obligations as well. Meeting short-term obligations was between good and questionable in the first years of expansion, but it became difficult in 1992. The decision to rely on debt to finance operational and strategic activity affected both organizational liquidity and solvency, and implicitly its attractiveness for investors.

Both the group and FFS managed to generate high revenues/sales for each

1 of asset or equity, but the profits were very small due to high sales and administrative expenses and depreciations. Also the annual interest expense was high when compared to the net cash flow, suggesting either a bad cash flow management of high interest expenses related to high debts. In the case analyzed the net cash flow was quite small for both the group and FFS. Cash flow refers to the amount of cash received or expended by the business over a certain period of time. A small cash flow suggests that the cash moves slow within the company over a certain period of time, leading to inefficiencies.

Finally, the inventories had a large proportion in the group's/FFS's current assets. Correlated to high days in inventory figures, this suggests bad inventory management. The collection period was also very high. Given that the group/FFS had cash problems, one way to remedy this situation would have been by reducing inventories and collection period.

Net earnings, net profit, net income are used interchangeably in this paper

FINANCIAL ANALYSIS - FILIPPO FOCHI SPA