MBA403 Week 2: Analysing Financial Statements

Case Study: The Decline and Turnaround of Virgin Australia

• Background of Virgin Australia Limited (FY19):

  • The airline employed over $10,000$ people and operated a fleet of $133$ aircraft.

  • Passenger numbers were on an upward trajectory.

  • Financial performance was "challenging" according to the Chairman due to subdued economic conditions, higher fuel prices, and a weaker Australian dollar ($AUD$).

  • The CEO stated that significant changes were required to improve financial performance.

• Financial Crisis and Resolution (2020):

  • The financial advisory firm Deloitte was appointed to take control of the business.

  • The company was removed from the Australian Stock Exchange ($ASX$) and sold to a private equity firm.

  • A Deloitte report in August 2020 identified a debt pile of approximately $6.8 \text{ billion}$.

  • The primary cause of the difficulty was an already highly leveraged balance sheet.

  • Liquidity was severely reduced, and the company may have traded while insolvent during the early stages of the $COVID-19$ pandemic.

• Fundamental Financial Terminology:

  • Leverage: Refers to the specific amount of debt a firm utilizes to finance its assets.

  • Liquidity: Concerns the ability of a business to meet its short-term financial obligations as they fall due.

  • Insolvency: A state reached when the total value of a company’s liabilities exceeds the total value of its assets.

The Mechanics and Benefits of Leverage

• Exercise: Excellence Pty Ltd (No Debt Scenario):

  • Year 0:

    • Sales: $5000$

    • Expenses: $4000$

    • Profit: $1000$

  • Year 1 (Economy growth of $20\%$ in sales and expenses):

    • Sales ($1.2 \times 5000$): $6000$

    • Expenses ($1.2 \times 4000$): $4800$

    • Profit: $1200$

  • Result: A $20\%$ increase in sales leads to exactly a $20\%$ increase in profit.

• Exercise: Excellence Pty Ltd (Leveraged Scenario):

  • Year 0:

    • Sales: $5000$

    • Expenses: $4000$

    • Interest: $500$

    • Profit: $500$

  • Year 1 (Economy growth of $20\%$ in sales and expenses):

    • Sales: $6000$

    • Expenses: $4800$

    • Interest (Fixed cost): $500$

    • Profit: $700$

  • Calculation:

    • $\text{Profit Increase} = \frac{700 - 500}{500} = 40\%$

  • Result: A $20\%$ increase in sales leads to a $40\%$ increase in profit due to the presence of fixed interest costs.

• Key Implications of Leverage:

  • When a business is growing, debt acts as an amplifier for profit growth.

  • Debt serves as a permanent cost with a contractual obligation to service it regardless of performance.

  • Unlike dividends, which have no contractual obligation, failure to meet debt repayments results in serious legal and financial consequences.

Purpose and Categories of Ratio Analysis

• General Purpose:

  • Interpretation of financial statements is essential for internal and external stakeholders.

  • Ratio analysis allows for the combination and comparison of data from different financial statements to gain deeper insights.

  • Accounting is considered the "language of business" (Warren Buffett).

• Ratio Categories:

  1. Financial Stability Ratios: Examine the company’s financial structure and the risks arising from debt obligations.

  2. Efficiency Ratios: Assess whether a business uses its assets efficiently to generate sales, cash, and profit.

  3. Profitability Ratios: Assess profitability relative to sales, assets, and shareholder equity.

  4. Investment Ratios: Used to analyze the investment merit of a business or share opportunity.

• Calculation Tool Recommendation:

  • While calculations can be performed on a manual calculator, the use of Excel or similar spreadsheet software is recommended to simplify work, develop professional skills, and compile a workbook of financial tools.

Financial Stability Ratios

• Debt Ratio:

  • Formula: $\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$

  • Measures how much debt the business owes relative to assets. Can also be calculated specifically as $\frac{\text{Debt}}{\text{Total Assets}}$.

  • Ideal Range: $30\%-50\%$, though this varies by industry and economic environment.

  • Too much debt: Risk of being unable to meet repayments. Banks are typically less forgiving than shareholders.

  • Too little debt: May reflect overly conservative management, lack of opportunities, or failure to secure bank loans.

• Debt to Equity Ratio:

  • Formula: $\text{Debt to Equity Ratio} = \frac{\text{Liabilities}}{\text{Equity}}$

  • Ideal Range: $40\%-100\%$.

• Current Ratio:

  • Formula: $\text{Current Ratio} = \frac{\text{Total Current Assets}}{\text{Total Current Liabilities}}$

  • Measures liquidity and the ability to meet short-term commitments.

  • Ideal Range: Should be comfortably above $1$, up to a maximum of approximately $2$.

  • Too high a ratio: May indicate a "lazy" balance sheet where cash accumulates instead of being invested or returned to shareholders.

  • Below 1: Can be successful for specific industries, such as supermarkets with high-velocity, profitable, cash-generating sales.

• Quick Ratio:

  • Formula: $\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Liabilities}}$

• Interest Cover Ratio:

  • Formula: $\text{Interest Cover Ratio} = \frac{\text{EBIT}}{\text{Interest Expense}}$

  • Measures how many times a business can cover interest expenses using its operating profit ($EBIT$).

  • Acceptable Thresholds:

    • Below 1: Indicates an inability to meet current interest obligations.

    • 2: The minimum acceptable multiple.

    • Above 3: Preferred level, especially in environments with rising interest rates.

Efficiency Ratios

• Asset Turnover:

  • Formula: $\text{Asset Turnover} = \frac{\text{Sales}}{\text{Total Assets}}$

  • Note: Sales may be labeled as "Revenue."

  • Measures the volume of business per unit of assets. Higher turnover generally indicates greater efficiency and higher profitability (assuming a positive profit margin).

  • Varies significantly by industry (e.g., internet businesses vs. toll road or power generation companies).

• Inventory Turnover:

  • Formula: $\text{Inventory Turnover (days)} = \frac{\text{Inventories}}{\text{Cost of Goods Sold}} \times 365$

  • Measures how many days it takes to sell an item of inventory.

  • High number (>90 days): Relatively high; may indicate obsolete or difficult-to-sell stock.

  • Low number: Indicates higher turnover and improved cash flow.

  • Dependent on product type (frequency of new models, perishables vs. non-perishables).

• Age of Accounts Receivable:

  • Formula: $\text{Age of Accounts Receivable (days)} = \frac{\text{Accounts Receivable}}{\text{Sales}} \times 365$

  • Captures effectiveness in receiving cash from debtors.

  • Acceptable range: Around $30 \text{ days}$.

  • Concerning range: An average of $45 \text{ days}$.

  • Default status: Debts reaching $60 \text{ days}$ are reportable as a default.

  • High ratios suggest cash flow issues and potential bad debts, requiring improved credit policies.

Profitability Ratios

• Return on Sales (RoS):

  • Formula: $\text{Return on Sales} = \frac{\text{EBIT}}{\text{Sales}} \times 100$

  • Measures profit margin or profit earned per dollar of sales.

  • Uses $EBIT$ (Earnings Before Interest and Tax) as it relates directly to business operations, avoiding the distortions of interest and tax schedules.

• Return on Equity (RoE):

  • Formula: $\text{Return on Equity} = \frac{\text{Net Profit}}{\text{Equity}} \times 100$

  • Represents the percentage return accruing to shareholders.

  • Important tool for comparing alternative investments.

  • Acceptable levels: $10\%$ might be reasonable for a stable, mature business, but insufficient for a technology startup. Higher risk ventures require higher expected $RoE$.

• Return on Investment (RoI) / Return on Assets (RoA):

  • Formula: $\text{Return on Investment} = \frac{\text{EBIT}}{\text{Total Assets}} \times 100$

  • Focuses on profit generated by assets rather than the return to owners.

  • Decomposition of RoI (DuPont Analysis):

    • $\text{RoI} = \text{Return on Sales} \times \text{Asset Turnover}$

    • $\text{RoI} = \frac{\text{EBIT}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Total Assets}}$

  • This decomposition helps determine strategies: if $RoS$ is low, address pricing/costs; if Asset Turnover is low, increase sales or divest unproductive assets.

Analytical Frameworks: Horizontal and Vertical Analysis

• Horizontal Analysis:

  • Definition: Measuring a company's performance through time.

  • Uses "time series" data to identify trends/changes.

  • Requirement: At least $3$ observations (time periods) are recommended for a genuine trend impression.

  • Example: Tracking Harvey Norman’s $RoE$ from $FY24$ to $FY25$.

• Vertical Analysis:

  • Definition: Comparing a company’s performance against an appropriate benchmark, guideline, or standard.

  • Comparison targets: Related businesses, competitors, industry averages, or alternative investments.

  • Example: Comparing a company's debt ratio to the ideal industry range ($30\%-50\%$) or comparing Harvey Norman’s $RoS$ ($26.5\%$—$FY22$) to JB Hi-Fi ($8.6\%$—$FY22$).

Retaining the 'Big Picture'

• Contextual Analysis:

  • Financial statement and ratio analysis must be balanced with the "big picture."

  • Factors include trends in revenue/profits, underlying business drivers, economic conditions, competition, regulatory factors, strategy, and business risks.

• Information Sources beyond Financials:

  • Valuable information resides in the Chairman and CEO Reports within annual reports.

  • Case Example - Harvey Norman (2025):

    • Total revenue across segments: $4.47 \text{ billion}$ (Increase of $355.35 \text{ million}$ or $+8.6\%$ from $FY24$).

    • Company-operated sales revenue: Increase of $115.79 \text{ million}$ ($+4.1\%$) due to global network expansion.

    • Category Performance: Mobile, Computer Technology, and Electrical categories showed strong results from franchisees.

    • Drivers: Renovation activity, a "post-COVID refresh phase" for household goods, and recovery in residential construction activity despite cost-of-living pressures.

Questions & Discussion

• Activity: Harvey Norman Financial Stability (FY24-FY25):

  • Task: Calculate the Debt ratio, Current ratio, and Interest Cover ratio for Harvey Norman across $FY25$ and $FY24$.

  • Analysis Question: What do these calculations tell you about the changes in financial stability over those two years?

• Activity: Harvey Norman Efficiency (FY25):

  • Task: Calculate Asset turnover, Inventory turnover, and Age of accounts receivable.

  • Analysis Question: What do these ratios reveal about the specific nature of the Harvey Norman business model?

• Activity: Harvey Norman Profitability (FY24-FY25):

  • Task: Calculate $RoE$ for $FY25$. Compare it to $FY24$.

  • Analysis Question: Is this return attractive given the specific industry risks? How did it change year-over-year?

• Activity: Harvey Norman ROI Decomposition:

  • Task: Calculate $RoI$ and its components ($RoS$ and Asset Turnover) for $FY25$.

  • Analysis Question: How exactly does Harvey Norman achieve its profitability (via high margins or high volume)?