Financial Analysis of Basic Industries’ Declining ROE in 1994

First Investments Inc. owned stock of Basic Industries (BI), a diversified multinational corporation with major shares in various electrical related markets · The BI annual report of 1994 shows a decline in the return on owners’ equity (ROE) · Fred Aldrich, a trainee in First Investment, was asked to conduct a financial analysis on BI · Three years financial statements (1994, 1993 and 1985) and reported 10 year financial highlights (1985 to 1994) were available for the analysis assignment · The focus was on the 1993-1994 period and comparison of the quality of the returns on equity of 1985 and 1994, along with the other key financial ratios · The analysis should not focus on the financial information of 1989 and 1990 because of a strike. The company did not change its accounting policies and practices materially over the last decade

Issues:

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1. How Basic Industries had achieved its return on equity over the last 10 years ?
2. Why did the ROE of BI decline in 1994 ?

Discussion: The portfolio people were worried about the decline in owner’s equity. By doing the financial analysis, we hope to find out why the return on shareholders’ equity declined in 1994.

ROE in 1994 dropped by almost 1% and was the main cause of concern. This is primarily because the proportion of Capital Employed has increased more than the proportion of Net Profit After Tax. The level of return on invested capital depends primarily on the skill, resourcefulness, ingenuity and motivation of management. In order to analyze the company’s financial performance, we make use of financial ratios. This is done for the period 1985-1994 where possible, and the total analysis can be found in the attached excel spreadsheet. Leverage Ratios

As the leverage ratio increases within certain extent, the ROE should increase. The Debt to Equity ratio is rising from 1.02(in 1985) to 1.45(in 1993) and 1.51(in 1994). This indicates a high proportion of company’s funds are through equity. The biggest difference is in long-term debt to equity ratio, which almost doubled from 0.17(in 1985) to 0.27(in 1993) and increased to 0.32(in 1994). Times Interest earned 5.56 (in 1994) is almost ?th of its counterpart 25.19 (in 1985), a dramatic decrease. The interest expense in 1985 was only $27.4M compared to $180.1M in 1994. When the financial leverage is increased, the company uses more debt financing instead of equity financing which initially leads to a higher return on equity. However, an increase in debt will only increase return on equity if the return on assets is higher than the interest rate.

Liquidity Ratios Current Ratio is? 1.34 in 1994, 1.28 in 1993 ?and 1.81 in 1985. The major decrease in assets shows that marketable securities turned into long-term investments. The Quick Ratio and Working Capital Ratio have decreased from 1985. This clearly tells us that the net current liabilities of the company have increased.

Profitability Ratios - Operating Performance Net Profit Margin has reduced from 5.05% in 1993 to 4.53% in 1994 (a net decrease of 0.52% ). The main culprit in the decrease of profit margin seems to be the rising interest expense shown by the interest expense to revenue ratio rising from 0.44% to 1.34%. The proportionate increase in Sales (15.87%) is more than Net Income increase (3.78%). Relatively less increase in Net Income can be explained by the increasing Operating Costs.

Among the Operating Costs, the major increases are materials, supplies, services etc. It has increased by 22.42% which is significantly higher than the increase in Sales (15.87%). The Operating Profit Margin shows decrease from 1985 to 1994 thus sales generate less money and result is lower return on equity. The Gross Margin has decreased over the years from 1985. In 1993, it was very high (0.93) as the cost of sales (materials, engineering & production costs) were unbelievably low $855.2M while in 1994, it was 8.4% of the $10,137.6M. The cost of materials were heavily understated in 1993 to increase profit margin.

Return on Asset Return on investments accesses financial rewards to the suppliers of equity and debt financing. The Return on Asset (ROA) decreased from 8.89% in 1985 every year till 1990, the years 1992(8.91%) and 1993(9%) showed some positive increase and it dropped again in 1994(8.86%). The average total assets was not available for 1985 (beginning balance not available). The 1985 total asset figure is used in this calculation.

Asset Utilization and Efficiency The Asset Turnover increased from 1.44 in 1985 to 1.46 in 1992 and 1.51 in 1994. It assesses effectiveness and intensity of assets in generating sales. Various ratios were calculated to access the efficiency and utilization of assets. Limitations were that average figures were not available for all the years. For Account Receivables, Inventory and Accounts Payable, we calculated averages for 1994(using 1993 data as beginning balance). For 1993 and 1985 we did not have the average, thus the ratios are not as representative of reality. The trends of these ratios over the years can be seen on the attached excel spreadsheet. Overall the ratios show that receivables collection period increased and payable collection period decreased. The PP&E turnover declined from 5.99 (in 1985) to 5.39 (in 1994). Again only the 1994 ratio calculation was done using average PP&E. The effective tax rate calculated also changed over the years which has affected profitability.

Retained Earnings In 1985, the Dividend Payout Ratio was 60.91%. It was 46.73% in 1993. This shows that the company had fuelled its growth by partly utilizing the increased retained earnings proportion. However, in 1994, the Dividend Payout Ratio was 47.9% (an increase of 1.17% year-over-year) which does not give any indication of some future growth or expansion plans. The Earnings Per Share (EPS) has increased over the years from $1.97(in 1985) to $3.21(in 1993) and $3.34 (in 1994).

Conclusion

Given the limited information, it appears that BI has issued debts to purchase PP&E in 1994. With the new PP&E, BI should have more production next year which should increase the profit margin and in turn increase ROA and ROE. However, they continue to grow EPS and ROE through higher leverage and are not focusing enough on producing their product more efficiently. If BI faces adversity, the effects will be harder felt with the greater leverage.

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