Financial Statement Analysis Section 7. Writing a Financial Analysis Report An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Hotel Hasdrubal Case Study Preliminary Analysis Growth Analysis Profitability Analysis Illiquidity risk: short and long-term ratios Summary Note
Fahmi Ben Abdelkader ©
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Chapter Outline Writing a Financial Analysis Report An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Hasdrubal Case Study Preliminary Analysis Growth Analysis Profitability Analysis Illiquidity risk: short and long-term ratios Summary Note
10/4/2017 11:55 AM
Fahmi Ben Abdelkader ©
Financial Statement Analysis
2
Writing a Financial Analysis Report
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
How to conduct a financial analysis? A guiding principle In the long run, a company can survive only if it creates value for its shareholders and meets its commitments towards all its stakeholders To do so, it must:
Financial Analysis
Generate wealth Growth Analysis
Invest Finance its investments Generate a sufficient return Anticipate and manage illiquidity risk
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Writing a Financial Analysis Report
Profitability Analysis Risk Analysis
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
How to conduct a financial analysis? Preliminary analysis
(1) Strategic and Economic Assessment
(2) Growth Analysis
Financial Analysis (3) Profitability Analysis
(4) Risk Analysis
Summary note
(5) Recommendations
3
Financial Statement Analysis
The toolkit of the financial analyst
1.1 Understand the characteristics of the sector in which the company operates… 1.2 … analyse the auditors’ report and accounting policies 1.3 What do we expect to see ?
2.1 Growth measurement
Sales, Net Income, EBITDA, Total Assets
2.2 How the firm uses its money?
Fixed Assets, WC, Capital Employed, Cash flow from investment activities
2.3 Where does the money come from?
Leverage, Equity, Net Debt, Capital Invested, Short-term debt, etc.
2.4 Analysis of the Cash Cycle
WC in days’ worth of sales; Cash flow from operating, FCF
3.1 Margin analysis
Profitability ratios, Cost structure
3.2 Return on Invested Capital (ROIC)
ROIC = NOPAT/ Capital Employed ROIC = Oper. Margin * Asset turnover Economic Value Added = ROIC - WACC
3.3 Return on Equity (ROE)
ROE = Net Income/ Equity ROE = ROIC + Leverage effect Residual Income= ROE - re
4.1 Short-term liquidity risk
Current ratio Quick ratio
4.2 Solvency risk
Interest coverage ratio, leverage, etc.
5. Develop and communicate conclusions / recommendations
Fahmi Ben Abdelkader ©
Financial Statement Analysis
Writing a Financial Analysis Report
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Some Guidance Notes There is no single indicator of good health A rigorous Financial Analysis requires a combination and a cross-analysis of different indicators covering several aspects to “good financial health”
Ratios are not very helpful by themselves; they need to be compared to something: an appropriate benchmark Time-Trend Analysis Comparison with competitors and industry peers Return ratios should be compared to the required rate of return (Opportunity Cost of Capital)
Don’t only focus on the numbers, you need to be aware of the organisation’s business strategy and objectives Understand the nature of the industry in which the organisation operates Understand that the overall state of the economy may also have an impact on the performance of the organisation There is nothing worse in FSA and valuation than forgetting the overall picture 10/4/2017 11:55 AM
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Writing a Financial Analysis Report
5
Financial Statement Analysis
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Don’t only focus on numbers, you need to be aware of the organization’s business strategy and objectives
Business performance and recent decisions in McDonald’s
“Our recent performance has been poor. The numbers don’t lie” (Steve Easterbrook, CEO, May 2015)
McDonald‘s faces huge challenges
Sales and profits have declined substantially over the past years
Turnaround shall restore business
New CEO Steve Easterbrook announced turnaround plan in May 2015:
Low morale of franchisees and conflicts due to contract conditions
Strip away management layers and reduce bureaucracy
Food quality scandals in Asia which there lead to a decrease of 15% in net income
Listen to customers‘ needs and meet them
Reputation of unhealthy and low quality food, especially in the US
Priority on food quality New services, e.g. mobile ordering
Increasing health conscience of customers and demand for sustainably manufactured products
Refranchising of stores with target of 95% franchising by 2018
Increasing competition by suppliers who capture the trend for high-end burgers
Cost savings and increased financial leverage
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Financial Statement Analysis
? Success uncertain: Image change will require a lot of time
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Writing a Financial Analysis Report
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Don’t only focus on numbers, you need to be aware of the organization’s legal form
Example: Equinix converted into a Real Estate Investment Trust, or REIT, in 2015.
On December 23, 2014, our Board of Directors formally approved our conversion to a REIT effective on January 1, 2015. Equinix implemented the REIT conversion in 2014, and began operating as a REIT for federal income tax purposes effective January 1, 2015. ⇒ Tax Relief ⇒ Attracting Investors through dividend payments In a REIT, income comes from rent of the properties, and REITs are legally required to distribute 90 percent of their taxable income to investors. It means Equinix will have regular distributions of its earnings.
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Writing a Financial Analysis Report
Financial Statement Analysis
7
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Don’t only focus on numbers, you need to be aware of the regulation rules Example: The soft drink industry and the SSB taxes
“ The soft drink industry is in the middle of a growing policy debate in the United States regarding the taxation of sugar-sweetened beverages. Surveys show mixed feelings about an SSB tax; a poll in New York City indicated more support if the proceeds went toward health-related initiatives. Meanwhile ,the soft drink industry has responded strongly to proposed SSB taxes. Internally, the soft drink industry is responding with efforts to influence consumer behavior by introducing smaller-size packaging, encouraging active life styles, and looking into alternative, non caloric sweeteners. Externally, lobbyist and other activist groups have successfully gathered support to defeat many of the proposed SSB taxes.”
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Financial Statement Analysis
8
Writing a Financial Analysis Report
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
There is nothing worse in FSA and valuation than forgetting the overall picture Example: Apple posts record profit but iPhone growth is slowing: The strong dollar is hurting Apple too Apple had the most profitable quarter in American history ($18.4B Profit), but it has reached the end of its era of unprecedented growth. Shareholders took a deep breath when Apple released its quarterly financial report Tuesday. IPhone sales rose last quarter, as did profits and overall sales. Sales in China were also strong. But the iPhone's growth has slowed dramatically. The strong dollar is hurting Apple too: the iPhone is now too expensive for many potential Chinese customers. Apple said it was a rough time to have two-thirds of its sales come from outside the United States.
FT, January 27, 2016
"The challenging global macroeconomic environment is leading to constrained conditions unlike anything we've seen, everywhere we look," CEO Tim Cook said on a conference call with analysts. And even though Apple managed to beat its record quarter from a year earlier, Apple said it believes sales in the current quarter will fall for the first time in 13 years.
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Writing a Financial Analysis Report
Financial Statement Analysis
9
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Some Golden Rules Spending money does not necessarily make you poorer and neither does receiving money necessarily make you any richer. A positive cash flow is not always value creating and vice versa (Cash generated by the core business versus cash generated by non-operating activities)
Earnings are an opinion, cash is a fact The need to assess earnings quality In assessment of earnings quality, the analyst should consider the materiality and variability of NON-OPEARTING items of income such as non-cash items
A lever can become a club The impact of financial leverage cannot be analyzed independently of Risk The value of a business depends primarily on the capacity of its assets to generate cash flows, and less on capital structure choices
A lack of liquidity may lead to loss of business opportunities and, in a worst case, bankruptcy
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Financial Statement Analysis
10
Writing a Financial Analysis Report
An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Limitations of Financial Ratios « les chiffres sont des êtres fragiles qui, à force d'être torturés, finissent par avouer tout ce qu'on veut leur faire dire » Alfred Sauvy
Despite the appealing nature of financial ratios, they should be used with caution:
Based on historical accounting information and, thus, backward-looking Many ratios provides a snapshot of the firm’s financial position at a given point in time (e.g. Seasonality effects).
Accounting practices differ among firms and countries Accounting numbers always subject to window dressing (e.g. ROE). Inflation Effects; mostly on balance sheet and income statement amounts.
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Financial Statement Analysis
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Chapter Outline Writing a Financial Analysis Report An example of analysis grid Guidance Notes Golden Rules Limitations of Financial Ratios
Hasdrubal Case Study Preliminary Analysis Growth Analysis Profitability Analysis Illiquidity risk: short and long-term ratios Summary Note
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Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Strategic and Economic Assessment Hasdrubal is a high-standard hotel (4 stars) with 30 rooms created in 2004 in Monaco. Its customers are mainly business men and women. The construction costs of the hotel have been equal to 4500k€ financed with 2500k€ equity and 2000k€ debt with a 10 year maturity and an interest rate of 5%. The hotel business model relies mainly on the “occupancy rate” (number of rooms sold/number of rooms available) and the average price per room. The hotel industry is characterized by high selling, general and administrative expenses that increase at the inflation rate each year. To cover these expenses it is necessary to maximize the sales, balancing the price and the occupation rate. Given the success of the hotel California the owner has decided in 2010 -
to build 10 new rooms that will be available at the beginning of in 2012
-
to increase prices in 2011.
The investment for the new rooms is equal to 400 k€ financed by long-term debt, and construction works start in 2011. Given the low occupancy rate, the manager decides in 2013 to start a huge advertising campaign. He is a bit worried and asks you to do a financial analysis of his Hotel and evaluate his investment policy.
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Hasdrubal Case Study
Financial Statement Analysis
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Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Strategic and Economic Assessment Understand the Business well and identify the main characteristics of: ⇒ the sector in which the company operates… ⇒ the product ⇒ the production model ⇒ distribution network ⇒ markets (local vs foreign) Etc. What are the potential implications of these characteristics on: ⇒ the operating cycle ⇒ the Cash cycle ⇒ the working capital ⇒ Investment requirements ⇒ margin Etc. 10/4/2017 11:55 AM
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Financial Statement Analysis
14
Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Strategic and Economic Assessment Hasdrubal is a high-standard hotel (4 stars) with 30 rooms created in 2004 in Monaco. Its customers are mainly business men and women. The construction costs of the hotel have been equal to 4500k€ financed with 2500k€ equity and 2000k€ debt with a 10 year maturity and an interest rate of 5%. The hotel business model relies mainly on the “occupancy rate” (number of rooms sold/number of rooms available) and the average price per room. The hotel industry is characterized by high selling, general and administrative expenses that increase at the inflation rate each year. To cover these expenses it is necessary to maximize the sales, balancing the price and the occupation rate. Given the success of the hotel California the owner has decided in 2010 -
to build 10 new rooms that will be available at the beginning of 2012
-
to increase prices in 2011
The investment for the new rooms is equal to 400 k€ financed by long-term debt, and construction works start in 2011. Given the low occupancy rate, the manager decides in 2013 to start a huge advertising campaign. He is a bit worried and asks you to do a financial analysis of his Hotel and evaluate his investment policy.
10/4/2017 11:55 AM
Fahmi Ben Abdelkader ©
Hasdrubal Case Study
Financial Statement Analysis
15
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Strategic and Economic Assessment: what do we expect to see? Industry : hotel/services Relatively high fixed costs ; seasonality effect Low or negative working capital (customers pay cash) High-standard hotel and business customers We expect to have high margin rate key events: In 2011, an important new investment to increase the hotel capacity + financed by debt + price increase + construction works Impact on occupancy rate and revenues ? Are customers sensitive to the price increase ? Does the increase in the hotel capacity increase the ROCE? Debt is expected to increase the financial burden. What is its impact on the ROE? Construction works are likely to cause some inconvenience for clients In 2013, a huge advertising campaign We expect this campaign to boost revenues 10/4/2017 11:55 AM
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Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Strategic and Economic Assessment: what do we expect to see?
Relevant items that should be closely observed Occupancy rate Pricing policy Margin rate Profitability of the new investments The financial leverage effect
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Hasdrubal Case Study
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Wealth creation at a glance Growth rate
2009
Net Sales Total Assets EBITDA
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2010
2011
2012
2013
0,0%
-3,8%
8,6%
31,6%
-4,1%
1,3%
0,2%
-4,1%
-21,0%
-65,4%
-173,0%
Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Wealth creation at a glance
2009
2010
2011
2012
2013
Number of rooms
30
30
30
40
40
Average Price (€)
200
200
220
220
220
80%
80%
70%
57%
75%
The occupancy rate
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Hasdrubal Case Study
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
How the firm uses its money?
Fixed Assets / Total Assets Inventory / Total Assets Accounts Receivable / Total Assets Cash & Equivalent / Total Assets Fixed Assets Operating Working Capital Capital Employed
2009 74,5% 12,4% 0,0% 13,1% 3 000 150 3 150
Cash From Investing Activities (II)
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Financial Statement Analysis
2010 75,4% 13,0% 0,0% 11,6% 2 910 140 3 050
2011 83,9% 12,8% 0,0% 3,3% 3 282 129 3 411
2012 81,0% 17,0% 0,0% 2,0% 3 173 45 3 218
2013 81,4% 17,7% 0,0% 0,9% 3 058 (233) 2 825
(225)
(736)
(273)
(287)
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Where does the money come from? Liabilities structure
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Hasdrubal Case Study
Financial Statement Analysis
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Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Where does the money come from? Invested Capital trends
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Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Where does the money come from? 2009
2010
2011
2012
2013
Financial Leverage
17,7%
17,3%
52,3%
95,3%
52,1%
Long-term debt / Total Liabilities
24,8%
23,3%
33,2%
29,3%
26,6%
Short-term debt / Total Liabilities
0,0%
0,0%
0,0%
12,8%
0,0%
Accounts payable / Total Liabilities
8,7%
9,3%
9,5%
15,9%
24,0%
Shareholders' Equity
2 676
2 599
2 240
1 647
1 857
474
450
1 171
1 570
967
3 150
3 049
3 410
3 217
2 824
Net Financial Debt Invested Capital
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Hasdrubal Case Study
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Analysis of the Cash Cycle Working Capital Needs in days’ worth of sales Inventory days + Receivable days - Payable Days = Operating Working Capital days worth of sales
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Financial Statement Analysis
2009 38 0 27
2010 38 0 27
2011 40 0 29
2012 49 0 45
2013 37 0 50
11
11
10
3
-13
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Analysis of the Cash Cycle
2009 Operating Working Capital
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Hasdrubal Case Study
2010 2011 2012 2013
150
140
129
45 (233)
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue Cost of sales Gross Margin Operating expenses EBITDA Margin or Operating Margin Depreciation & amortization EBIT Margin Net financial expenses Pretax Income - Corporate income tax Net Profit Margin NOPAT (Net Operating Profit After Tax)
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2009 100% 62,5% 37,5% 25,0% 12,5% 6,3% 6,3% 0,8% 5,5% 1,8% 3,7%
2010 100% 64,4% 35,6% 25,8% 9,9% 6,6% 3,3% 0,7% 2,6% 0,9% 1,7%
2011 100% 68,9% 31,1% 27,6% 3,6% 7,9% -4,3% 1,4% -5,7% 0,0% -5,7%
2012 100% 76,2% 23,8% 26,1% -2,4% 7,6% -10,0% 1,8% -11,8% 0,0% -11,8%
2013 100% 59,7% 40,3% 30,3% 10,0% 6,1% 3,9% 0,7% 3,2% 0,0% 3,2%
4,2%
2,2%
-4,3%
-10,0%
3,9%
Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue Cost of sales Gross Margin Operating expenses EBITDA Margin or Operating Margin Depreciation & amortization EBIT Margin Net financial expenses Pretax Income - Corporate income tax Net Profit Margin NOPAT (Net Operating Profit After Tax)
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Hasdrubal Case Study
2009 100% 62,5% 37,5% 25,0% 12,5% 6,3% 6,3% 0,8% 5,5% 1,8% 3,7%
2010 100% 64,4% 35,6% 25,8% 9,9% 6,6% 3,3% 0,7% 2,6% 0,9% 1,7%
2011 100% 68,9% 31,1% 27,6% 3,6% 7,9% -4,3% 1,4% -5,7% 0,0% -5,7%
2012 100% 76,2% 23,8% 26,1% -2,4% 7,6% -10,0% 1,8% -11,8% 0,0% -11,8%
2013 100% 59,7% 40,3% 30,3% 10,0% 6,1% 3,9% 0,7% 3,2% 0,0% 3,2%
4,2%
2,2%
-4,3%
-10,0%
3,9%
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Margin analysis (Common-size analysis - income statement) Profit & expenses % of Net Revenue Net Revenue Cost of sales Gross Margin Operating expenses EBITDA Margin or Operating Margin Depreciation & amortization EBIT Margin Net financial expenses Pretax Income - Corporate income tax Net Profit Margin NOPAT (Net Operating Profit After Tax)
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2009 100% 62,5% 37,5% 25,0% 12,5% 6,3% 6,3% 0,8% 5,5% 1,8% 3,7%
2010 100% 64,4% 35,6% 25,8% 9,9% 6,6% 3,3% 0,7% 2,6% 0,9% 1,7%
2011 100% 68,9% 31,1% 27,6% 3,6% 7,9% -4,3% 1,4% -5,7% 0,0% -5,7%
2012 100% 76,2% 23,8% 26,1% -2,4% 7,6% -10,0% 1,8% -11,8% 0,0% -11,8%
2013 100% 59,7% 40,3% 30,3% 10,0% 6,1% 3,9% 0,7% 3,2% 0,0% 3,2%
4,2%
2,2%
-4,3%
-10,0%
3,9%
Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Return analysis ROIC (Return On Invested Capital)
NOPAT Margin * Turnover rate of Capital employed = ROIC (Return On Invested Capital)
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Hasdrubal Case Study
2009
2010
2011
2012
2013
4,2%
2,2%
-4,3%
-10,0%
3,9%
1,52
1,57
1,35
1,56
2,34
6,4%
3,5%
-5,9%
-15,6%
9,2%
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Return analysis The Financial Leverage Effect 2009
2010
2011
2012
2013
ROIC (Return On Invested Capital)
6,4%
3,5%
-5,9%
-15,6%
9,2%
Net cost of debt (after tax)
8,0%
7,8%
5,6%
5,8%
5,1%
ROIC - Net cost of debt
-1,6%
-4,3%
-11,4%
-21,4%
4,1%
* Financial Leverage
17,7%
17,3%
52,3%
95,3%
52,1%
= The Financial Leverage Effect
-0,3%
-0,7%
-6,0%
-20,4%
2,1%
6,6%
3,2%
-11,8%
-36,0%
11,3%
ROE (Return On Equity)
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Financial Statement Analysis
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Illiquidity and solvency risk: short and long-term ratios Short-term liquidity ratios 2009 293,1% 150,3%
Current ratio Cash ratio
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Hasdrubal Case Study
2010 263,4% 124,7%
2011 169,5% 34,8%
2012 66,5% 7,1%
2013 77,7% 3,7%
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Financial Statement Analysis
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Illiquidity risk: short and long-term ratios Long-term liquidity risk
Long-term debt / Total Liabilities Short-term debt / Total Liabilities Financial Leverage Solvency ratio Interest Coverage ratio Interest Coverage ratio (Cash) Debt to EBITDA Debt to Cash flow from operations ratio
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2009 24,8% 0,0% 17,7% 0,0% 7,9 0,8
Financial Statement Analysis
2010 23,3% 0,0% 17,3% 0,0% 4,5 11,7 1,0 1,1
2011 33,2% 0,0% 52,3% 0,0% 1,7 7,1 10,6
2012 42,1% 30,3% 95,3% 31,8% -
2013 26,6% 0,0% 52,1% 0,0% 5,3 18,2 1,5 1,1
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Hasdrubal Case Study
Preliminary Analysis Growth Analysis Profitability Analysis Liquidity risk: short and long-term ratios Summary Note
Summary Notes: the strengths and weaknesses
The strengths
The weaknesses
Revenues increased over the three past years
Operating costs increased at a higher pace than net sales over the period 2010-2012
Substantial investments that have increased the accomodation capacity of the hotel
bad management decision: change in the pricing policy without an appropriate communocation policy
Capacity of the company to rebound after a very critical situation in 2012
The margin levels are not consistent with the high-end positioning of this business After investments, the level of net margin remained lower that its level in 2009: overcapacity ?
Opportunities
Threats
Take advantage of relaized investments and the increase in the number of rooms
More attention has to be paid on the management of the working capital, which supposed to be negative given the nature of the business Risk of under-utilisation of the potential of the hotel: must improve occupancy rate
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Financial Statement Analysis
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