Australian Industry Report Office of the Chief Economist

Question: Describe about the Australian Industry Report for Office of the Chief Economist? Answer: Introduction Financial Statement Analysis is an important tool in understanding the financial performance and position of a company for a specified period. The analysis comprises of three financial statements i.e. Balance Sheet, Income Statement and the Cash Flow Statement. There are many users of these reports which include management, investors, creditors, debtors and the government. In this report, we have analysed the financial performance of Rio Tinto Group which is into the mining and metals business with its headquarters in London, United Kingdom and management office in Australia. The financial statements of the company for five years starting from 2010 to 2014 have been referred to and analyzed. The financial statements are available in the annual report of the company. However, a consolidated data from a financial website Morningstar have been extracted and the same has been analysed. This analysis is majorly useful to the potential investors as the analysis includes determining the profitability, liquidity and stability of the company. Based on the above analysis, the investor can decide whether to or not invest in the company depending upon the financial performance. Various ratios have been calculated to ascertain the profitability, liquidity and stability of the company. The results have been analysed after reading the annual report and other source o f information to make them meaningful. Rationale for choosing Rio Tinto Mining is one of the most important industries in Australia and contributes a major part of the National Income. Rio Tinto is into the business of finding, mining and processing the Earths mineral resources. These minerals and metals are further used in the infrastructure industry to build the countrys infrastructure. Hence, the nature of the business is core to the growth of an economy and hence, the company has been chosen for analysis. Australia has experienced boom in the mining sector in the last decade which has brought in investment, jobs and wealth to Australia. However, the boom has peaked now and the commodity prices have started falling. The second half of 2014 was challenging for the mining companies due to low commodity prices, changing demand patterns, tougher regulatory environment, increasing costs and a changing competitive landscape, but the real challenge was to continue smooth operations and maintain profitability for the shareholders in such a volatile environment. Only companies with operational excellence, improved productivity and profitability, lower costs, and a strong cash flow can sustain in such changing market conditions. The changing landscape of the mining industry makes it imperative to study and analyse the companies working in this landscape to see whether they are able to cope up with the changing market conditions or not. Rio Tinto appears to be a strong player and has maintained a value driven approach to stay ahead in the competition. The company very well realises the end of boom and hence has framed its policies accordingly. Performance Analysis The performance of the company has been analysed by calculating various ratios which are explained below: Profitability Ratios Gross Profit Ratio The gross profits are highest in 2011 as the year experienced the peak of mining boom, thereafter, the commodity prices started falling and so did the total revenue. However, the gross profits have increased in 2013 and 2014 due to operating cash cost improvements and strengthening of the US dollar against the local currencies. Net profit Ratio The net profits are negative in 2012 mainly due to impairment charges of $5 billion and also the though the gross profits were high in 2011 but net profits are comparatively very low due to impairment charges of $8.5 billion. Even in the era of falling commodity prices, 2014 has recorded a significant net profit due to increased sales volume, improved operational efficiencies and strengthening of dollar against local currencies. Operating Ratio The ratio was highest in 2012 as the year is marked by high costs with respect to impairment charges, similarly year 2011 also has high operating ratio even though the revenue is higher than other years, majorly due to the impairment charges. After 2010, 2014 has the lowest operations ratio as the company has moved towards being cost effective. Return on Assets The ROA has decreased from 2010 to 2012 due to a fall in net income as the total assets have increased in these years. In 2013 and 2014, the total assets have decreased mainly due a fall in receivables, inventories and property, plant and equipment. Even then the ROA has increased as a result of increasing net profits. This means the company has been able to utilize its assets efficiently to generate profits in the later years. Return on Capital Employed The ROCE also has similar pattern as the ROA. The total capital employed has decreased from 2012 to 2014, but the ROCE has increased due to an increase in EBIDTA, where the interest expenses have fallen in 2014 and so has the depreciation expense. In 2014, the company has been able to generate higher returns on lower capital employed. Stability and Liquidity Ratio Current Ratio The current ratio is above 1 in all the years which means that the current assets are sufficient to meet the short term obligations. The current ratio has been the lowest in 2012 as the current assets decreased considerably in the form of cash and cash equivalents and the current liabilities increased due to short term debts. However, the company recovered and the cash balance increased in later years and was at $1.2 billion in 2014 indicating high liquidity of the company. In 2014, the company also got rid of some part of its short term debt and there was a decrease in accounts payables, thus leading to a further increase in liquidity. Quick Ratio The quick ratio is also the lowest in 2012 as the cash balance has decreased and payables and inventory have also increased. Even after removing the inventories, the liquidity still remains low in 2012 due to lower assets as compared to current liabilities. However, in 2013 and 2014, the company has reduced its inventories, thus increasing the liquidity and the payables have also gone down so has the short term debt in 2014. Thus 2014 can be termed as a year in which the company was very liquid with low inventory, debt and more cash balance. Debt to Equity Ratio The company has on an average 50% debt and 50% equity in its capital structure. The total debt has been increasing from 2011 to 2013, whereas, stockholders equity has decreased continuously with equity increasing slightly only in 2014. The company has undertaken both short term and long term debt. The borrowings of the company decreased in 2014, making it less risky and more stable. There is more financial flexibility and low cost of capital. Interest Coverage Ratio The interest coverage ratio has decreased during 2010 to 2012 and after that it has increased. The negative coverage in 2012 is on account of negative EBIT resulting from high impairment charges. 2010 and 2011 were years of high profits and low debt, hence a very impressive interest coverage ratio is there. However, with the mining boom reaching its peak in 2012 and commodity prices after that, the profits have gone down and the company has undertaken debt to finance its growth and expansion. However, in 2014, the interest expense reduced due to repayment of debt and increased profits led to coverage ratio being 15 times. Working Capital Management Ratios Accounts Payables Turnover The company has a very impressive accounts payables turnover with there being no payables in 2012 to 2012. The company mostly paid its suppliers in cash. In 2013 and 2014, the payables have occurred and show an increasing trend. This is a good sign as the company has started making use of credit and the amount saved from there can be used for other business purposes. Inventory Turnover Ratio The inventory turnover ratio has improved from 2012 to 2014. This is because the company has reduced its working capital tied up in inventories. This is a good sign as it signifies that the working capital management is moving towards being efficient. The turnover is the highest in 2014 as the inventory is the lowest in this period and the revenue has also increased as compared to 2012 and 2013. Accounts Receivables Turnover Ratio The accounts receivables turnover also has a similar trend as that of inventory turnover indicating that the company is improving its working capital management and hence its liquidity. The receivables have decreased continuously i.e. the company has been able to collect cash for sales made. The fast turning cash makes more cash balance available to the company to meet its expenditures. From 2012 onwards, the revenue has increased and the receivables have decreased resulting in higher cash balance and efficient working capital management. The days receivable for Rio Tinto is approximately a months time. Stock Market Performance Ratios Earnings per Share The earnings per share has decreased from 2010 to 2012 and increased after that. The weighted average share capital has not undergone any major change except in year 2012 when it was reduced by approx. $1billion. Thereafter, it has remained almost constant. The change in EPS is due to a change in net income available to equity shareholders. The earnings have increased after 2012 even in a challenging market where the commodity prices were falling mainly due to increased volume of sales and lower operations costs. Dividend per Share The dividend per share has continuously increased from 2010 to 2014. This is due to an increase in the dividends paid every year. The number of shares has not undergone any major change. This is a good return from the shareholders point of view as they are getting paid in cash for the investments made in Rio Tinto shares. A company paying higher dividends is always preferred by shareholders as they are directly being benefited. In spite of suffering losses in 2012 due to impairment charges, the company has still paid dividends of $3 billion as the underlying earnings were positive and cash balance was strong since impairment charge is a non cash item. Dividend Payout Ratio The dividend payout ratio is negative in 2012 because the net income is negative. The ratio is highest in 2013 because net income is low as compared to 2014 but the dividends are almost similar. In 2014, the company has generated the highest net income after 2011, whereas cash dividends paid have not increased in the same ratio, resulting in a low dividend payout in 2014. The company has retained its earnings after paying sufficient dividends. Earnings Yield Ratio The earnings yield has improved from 2012 to 2014. This yield is higher in 2014 as compared to 2013 because the earnings per share have increased and the market price of the shares of Rio Tinto has decreased making it an undervalued stock. The market share price of Rio Tinto was the highest in 2010 followed by 2013. However, the yields are higher in 2014. Dividend Yield Ratio The dividend yield shows an increasing trend due to an increase in dividends paid and a less then proportionate increase/decrease in share prices. The share prices increased in 2013, thus lowering the yield. However, a fall in share prices in 2014 and an increase in dividends paid led to an increase in the dividend yield. Summary of the Analysis Profitability Ratios Comments 2010 2011 2012 2013 2014 Gross Profit Ratio 35.20% 40.10% 26.40% 29.40% 27.30% Decrease Net Profit 25.30% 9.60% -5.90% 7.20% 13.70% Increase Return on Assets 12.70% 5.00% -2.50% 3.20% 6.00% Increase Return on capital 24.60% 16.80% 2.10% 9.20% 15.80% Increase Operating ratio 62.30% 77.40% 104.50% 92.20% 78.60% Improved Stability and Liquidity ratio Current Ratio 1.82 1.46 1.39 1.47 1.73 Increase Quick ratio 1.42 1.11 0.95 1.09 1.37 Increase Debt to Equity ratio 0.26 0.42 0.57 0.62 0.54 Improved Interest coverage ratio 27.45 27.59 -8.30 7.91 15.72 Increase Working Capital Management Ratios Accounts Payables Turnover NA NA NA 11.67 13.37 Increase days payables 31.29 27.3 Improved Inventory turnover ratio 7.71 6.83 6.12 6.29 7.97 Increase Days Inventory 47.3 50.6 55.6 31.3 53.1 Decrease Accounts Receivables Turnover 9.08 9.55 8.49 10.9 13.17 Increase Days Receivables 40.2 38.2 43 33.5 27.7 Increase Stock Market Performance Ratios Earnings Per Share 7.3 3.03 -1.62 1.98 3.53 Increase Dividend Per Share 0.89 1.16 1.64 1.8 2.01 Increase Dividend Payout Ratio 0.1 0.4 -1 0.9 0.6 Decrease Dividend Yield 0.015 0.023 0.031 0.032 0.039 Increase Earnings Yield 0.12 0.06 -0.03 0.04 0.07 Increase The increase/decrease in the comments section has been given for the most recent year i.e. 2014 as compared to 2013. Limitations of Ratio Analysis Though the above ratio analysis gives insights to the companys financial performance, however, there are many limitations of the same that are discussed below: Inflation inflations makes it difficult to compare the financial results over a period of time as it can lead to price increases and thus can mislead the investors. Use of different accounting policies inter firm comparison may be difficult as different firms may use different accounting policies. The standards provide firms with the flexibility to use different accounting policies that may make the comparison difficult. Outdated information in financial statements the balance sheet shows a companys financial position at a point of time. A ratio based on the balance sheet figures may be reflective of the financial position for the year as a whole. Like for a seasonal business, the year end debtors and inventories may be low. Use of creative accounting management may use creative accounting to show better financial performance in the form of changing method of depreciation etc... This may mislead the users of financial statements. Interpretation of ratios it is difficult to generalise whether a particular ratio result is good or bad. Like of the current ratio is high, it is considered good from liquidity point of view but this may mean excessive cash which is bad. Hence interpretation of ratios cannot be generalised. Impact of seasonality on trading there are many fluctuations that may occur during a financial period. However, the financial statements are based on the year end results. Hence, a seasonal firm may choose its accounting period according to seasons to show better results. This may mislead the users of financial statements. Summarised information - the financial statements present the summary of the accounts. The financial statements are presented in two pages whereas notes to financial statements which are written in more than 20 pages are not taken into consideration in calculating ratios. Conclusion and Recommendation Looking at the above financial analysis of Rio Tinto, it is clear that years 2011 and 2012 were not good in terms of profitability as there were huge impairment charges which highly impacted the companys financial position. Impairment of assets means the company has made bad investment decisions of the assets and impacts both the balance sheet and the income statement. However, the company has taken a corrective step and has replaced the Chief Executive Officer, Mr. Tom Albanses who was held responsible for such impairments. The new CEO is expected to work towards better investments decisions. Apart from that, the company has increasing profits in 2014 despite of low commodity prices; this has been possible due to high sales volumes and lower costs. The company is committed to maintaining operative and commercial excellence and even in such challenging market conditions where competition is increasing, prices are falling, it has been able to increase its earnings. The company can be easily said to be liquid and stable. This is because the current ratio and quick ratio have increased in the recent years due to reduction in current liabilities like payables and an increase in the cash balance. The inventories have also reduced in 2014 making the company more liquid. Cash comprises the highest component in the current assets thus indicating high level of liquidity. The company has increased its stability by reducing the debt to 50% of the total capital. The gearing ratio is good enough to give tax benefits and maintain stability. Year 2014 was marked by a reduction in total debts. The company has interest coverage ratio if more than 15 times in 2014 which is an impressive figure as the company can comfortably pay for its interest expenses. Hence, it can be concluded that the company is very stable and liquid. The working capital management is also efficient as the company has reduced its receivables and inventories thus increasing the respective turnover ratios. This gives the company free cash that can be utilized for other growth and expansion purposes. The payables have also reduced meaning good rapport with the suppliers but the company has ensured enough payables to make use of available credit facilities. Thus, it can be said that working capital is being managed efficiently. The stock performance ratios also indicate an improving trend where the cash dividends paid has increased over the period thus increasing cash returns for equity shareholders. The company has not increased its shareholder capital by a great extent whereas the earnings available to the equity shareholders has increased, thus increasing the total earnings available to the shareholders. The companys market share price has fallen in 2014 due to a fall in the commodity prices resulting from a fall in demand of these commodities like iron ore, copper and coal by China. In spite of this, the companys earnings have increased. Though the financial position of the company appears to be strong, however, the falling commodity prices pose a danger for the company. The demand for resources from China which was a major profit driver has slowed down; hence the revenue of the company is expected to decrease. For now it would be better to not invest in the company or the mining sector in particular. 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