Financial Analysis of I.T Ltd.

Company background I. T contain (0999. HK) is an investiture retentiveness confede proportionn based in Hong Kong. It was listed on the main board of The Hong Kong short letter Exchange on 4-March-2005. The guild offers a wide range of primp products. It sells its products as well as offers a variety of national and world-wide brands through its lollyworkwork of retail stores. As of February 28, 2011, it ope layd 392 stores in Hong Kong and Mainland China. Objective To fall uponk a comprehensive analysis on the financial per manakinance of I. T. Limited. exact financial dimension analysis streakament be performed.An estimation of the watertights exist of rectitude metropolis of the United States and weighted average comprise of capital allow as well be provided. Horizon of analysis We will focal point on its performance in the la render 5 monetary forms. A) Detail financial analysis The financial analysis will be conducted in two slipway. First, the stud y accounts on financial statements will be inspected in distinguish to derive a general picture on the healthiness of the business. Second, PERL (Performance, efficacy, Risk, fluidity) framework will be use to further psychoanalyze the financial performance of the attach to. I.Going through the financial statements We can get a glimpse of the healthiness of the business by looking into the geld of report items in income statement, proportion canvas tent and immediate payment fall down statement respectively. merge income statement (Referring to concomitant A control board 1 and 2) 2008/09 was a picky grade, financial tsunami happened. Therefore there was a huge simoleonsability extend to in that division, resulting in a large decrease in run profit. And since the market recovered in 2009/2010, the profitability suddenly accessiond a lot in that fiscal twelvemonth. Other than these wo special years, the overall appendage drift in sales perturbation, costs, an d profit is intelligent. (Referring to appendix A table 3) Standardizing the income statement can extract extra information. on the whole the accounts be convey as a percentage of employee turnover. The club has done a dependable job in cost controlling, since the cost of sales as a percentage of turnover is in a decreasing trend, hence the piggish profit security deposit is in an add-on trend. On the separate go through operating expenses fluctuates at about 50-51% of turnover, but since cost of sales has a greater decrease, the net effect is operating profit is in an increasing trend.Consolidated balance poll (Referring to appendix A table 4) In general, constitutional assets experience an increasing trend. This is primerable since the business is at a evolution stage. One nonable point is the process of non- present-day(prenominal) assets look greater than trustworthy assets, especially property, furniture and equipment has a very significant increase in 2010/ 11, this is probably collect to the rapid expansion of retails stores in Hong Kong and China. And as a result, there is a significant increase in inventories in 2010/11 too. (Referring to appendix A table 5)Similar conclusions can be drawn by viewing the same accounts in a standardized balance sheet (all items ar standardized by entirety asset value in the fiscal year). Property, furniture and equipment, and inventories make up most of the total assets. (Referring to appendix A table 6) Liabilities in addition grow a lot with total assets as the business puff outs. Notably there is a significant increase in both short-term and long term buzzword borrowings. In addition the succumbable accounts also increase much than 100%, intend that the f driftrnity bought stocks or services from suppliers on credit more(prenominal) than in front.This harvest-time of liabilities is fine as long as the company can leave consistent operating cash streams, as we will see in the next section. (Referring to appendix A table 7) Similar conclusions can be drawn at standardized balance sheet, hope borrowings and payables increase significantly, especially for longer term edge borrowings. (Referring to appendix A table 8) The growth of the business was mainly funded by growing liabilities, as we can see that the growth of equity is not so significant, the company has not issued revolutionary sh ares to get funding. The company has simply retained some of the profit in for each one year into reserves.Consolidated cash flow statement (Referring to appendix A table 9) The company has improved its cash flow generation as its business grew. The profitability of the company change magnitude, and so as the cash generated from operation. And since the company has increased in sizing, it has increased its ability to finance from banks, therefore it also increased its cash generated from financing activities. Although the company has increased investment in quick-fro zen assets and hence the cash outflow from investment, this is offset by the increase in cash flow from operation and financing.II. PERL (Performance, Efficiency, Risk, Liquidity) analysis (Referring to appendix B and C) 1) Performance earn margins ( common, operating, net) Gross profit margin keeps increasing. The la audition externalise is 63. 35%, which is a very broad(prenominal) margin. This is probably due to the increased brand image of the company, hence the company can increase the sell price of the products. Also, the company shifted the focus on selling products of its own brands more than imported brands, this also increased the gross profit margin.Both operating and net profit margin are also in an increasing trend (despite year 2008/09, a special year which financial crisis happened). But it is deserving noting that the reliable margins are 12. 08% and 10. 12% respectively, which show a great fight from gross profit margin. This indicate the operating expenses are very high, feeding up more than 50% of profit margin. The company should think ways to further reduce operating costs. Return on rectitude (hard roe) The company has increased its hard roe along the years despite the special year 2008/09. The latest ROE is actually a high return, 21. 6%. So what are the main drivers of such high return? By utilizing DuPont analysis, the reason for return growth can be found ROE = wampum net income allowance x plus overthrow x pecuniary Leverage The net profit margin is increasing throughout the years. At the same time, since the financing ability of the company has increased, the financial leverage also increased. These two factors drove the ROE up, offsetting the diminishing effect on ROE by asset turnover. The asset turnover actually decreased in last two fiscal years, indicating the dexterity of turning asset to gross decreased.It is a musical composition worry to see the ratio decreased from 1. 6 to 1. 17 in these 2 years. It may i ndicate that the asset surface of the libertine is too large, further expansion may not transmit further increase in revenue. This may be an indicator of the firm has passed its optimum point and management must take extra tutelage in evaluating whether the company should invest in expanding more retail stores or not. elongate DuPont analysis breaks down net profit margin into revenue kernel, interest burden, and EBIT margin. revenue burden of the company is actually increasing, i. e. it has to pay more effective assess hence impacting the net profit margin.But its whitewash fine as the effective tax rate is lighten at about 20%, which should be quite low when compared to effective tax rate outside Hong Kong and China. worry burden also experiences an increasing trend. This is honest since the company has increased financing ability and financed through more bank loans. EBIT margin is increasing, offsetting the negative effect of tax burden and interest burden. 2) Effi ciency Fixed asset Fixed asset turnover is in a decreasing trend (from 16. 08 to 7. 98 in last five years). This indicates the efficiency of generating sales revenue from fixed assets investment is humiliateing.This confirms with the decreasing asset turnover ratio mentioned above. However the ratio is noneffervescent at a high aim, the management should still invest in fixed asset and expand the business, but extra care should be taken to determine the get and scale to be invested. Inventory Inventory turnover is decreasing (from 3. 72 to 2. 48 in last five years). This indicates that in general, the speed of stocks selling has slowed down as the business expands. When this ratio is converted to days of archive on hand, the heart can even be clearer. The days increased from about 98 days to 147 days in these 5 years.Overstocking, trade or producing products which are not popular, or insufficient marketing efforts are all possible reasons to this decreasing efficiency. Receiv ables Receivables turnover is decreasing. To get a clearer meaning, the ratio is converted to days of sales outstanding, and this ratio is increasing (from 1. 97 to 11. 49). This ratio bureau on average how many days the companys customers who buy on credit will pay their shafts. This increasing ratio means that it takes more time to collect the bill from customers, meaning that capital has to be tied up for longer period.However the chassis actually is not large, its about 12 days and therefore an acceptable value. Payables Payables turnover decreased from 11. 14 to 5. 51. The ratio can be converted to number of days of payable. This ratio increased from 32. 76 to 66. 23. This ratio is the average mensuration of time it takes to pay its bills. The time has increased significantly. It showed the proceeds of the growth of the company, i. e. when the company went listed and expanded, the ability to pay on credit increased. This increased time to pay bills increases the flexibilit y to manage working capital and hence benefits the operation of the company.Working capital The effectiveness of the company in employ working capital has increased since the working capital turnover increased from 2. 72 to 4. 46 in last five years. This means that more sales revenue is generated for each dollar of working capital which funded the sales. This is probably due to increased size of the company, so that the company can get more funding by short-term bank loans, and increase its payables to different creditors. These increased funding are employ to purchase inventories to generate sales revenue. 3) Risk Gearing All debt-to-equity, debt-to-asset and financial leverage ratios are in an increasing trend.As the company grows, more funding is needed. Financing by debt proceeds is better than equity issuance since the required return by debt is lower, and there is possible tax advantage on debt payment. These three ratios are still in a healthy range and further increase in the ratio is still possible. Debt-to-common equity ratio is 0. 32 and debt-to-asset ratio is 0. 18, these two numbers are more or less low. This indicates that the company has a considerable capacity in debt financing if needed. coverage Interest coverage ratio maintains at a high level (159. at 2010/11), although the company has increased financing by bank loans. That means the operating profit is more than enough to cover the interest expense and indicate that the business is healthy. capital flow coverage ratio is also at adequate level despite it has fallen a bit (50. 54 at 2010/11). This is also a healthy signal because net cash flow is positive and adequate. 4) Liquidity Cash change circle Cash conversion cycle is the days the company takes to convert its investment in inventories back into cash. The company has an increased cash conversion cycle, due to the increase in days on inventory on hand.This is still an acceptable length (92. 15 days), but the company should try to lower the days in inventory on hand as mentioned above. accepted and acid test ratio Both genuine and acid test ratio are decreasing, but they are still at a healthy level. menses ratio is at 1. 85, meaning the current assets are 1. 85 times of current liabilities, which is sufficient for its short-term obligations. Acid test ratio is 1. 12, meaning the cash-like current assets are 1. 12 times of current liabilities, indicating that it is sufficient to cover its short-term liabilities by short-term cash.operating(a) cash flow to maturing obligations This is also a measure of the companys ability to ensure short term liabilities from cash flow. Although the overall cash flow has improved, the current liabilities has also increased considerably, therefore this ratio is not at a high level (0. 44). The major cash outflow is from purchasing fixed assets and repayment of bank loans. Management should control the cash outflow in these two areas in order to improve the overall liqu idity. III. Summary The company has a healthy business. It has an increasing net profit and positive cash flow.The ROE and profit margin are at good levels. It apply bank loans to further expand its business, while the leverage ratios are still in a healthy range. There is no liquidity caper associated with the company as seen in liquidity ratios. However the management should focus on improving the efficiency of the company while expanding the business. The major match here is reducing days of inventory on hand, in order to reduce the length of cash conversion cycle. To sum up, this is a company with good financial performance, and therefore it is worth to invest in this company.B) approach of equity capital Capital Asset Pricing Model (CAPM) is used to determine the cost of equity capital. There are three major inputs in CAPM equation risk-free rate, beta of the company stock to a benchmark market, and equity risk premium of the benchmark market. Since I. T. Limited is a Hong Kong based company, therefore the input parameters mentioned above should come from Hong Kong. Risk-free rate Hong Kong government do not issue bill or hamper (despite the newly launched ibond, but that is a floating rate bond which its subprogram is for general public to protect inflation).Therefore risk-free rate should be the refund on Exchange Fund Bills issued by Hong Kong Monetary Authority. Risk-free rate should be the yield on short-term bill, therefore the yield on one-month bill is selected, which is 0. 05%. Stock beta Hang Seng Index (HSI) is the benchmark superpower in Hong Kong. 5 years of monthly return stock of I. T. Limited and HSI were obtained. Stock Beta of I. T. to HSI can be calculated by using Slope function of Excel, or regressing both return series. The estimated beta is 1. 399, meaning that the stock of I. T.Limited is more volatile than the index. R2 coefficient is 0. 2261, meaning that about 22. 61% of the variant of the stock returns can be explained by variability in the index. impartiality risk premium According to Zhu & Zhu (2010), the equity risk premium of Hong Kong is 8. 19%. Applying CAPM Cost of equity capital = (0. 05 + 1. 399*8. 19)% = 11. 51%. C) Weighted average cost of capital (WACC) The company has not issued any debt. The debt of the company is in the form of bank borrowings, so the effective interest rate of borrowing will be treated as cost of debt.In the latest annual report, the effective interest rate is 1. 4% (from notes 23 of annual report). complete bank borrowings is HKD594. one hundred forty-fiveM, total equity is HKD1846. 961M, therefore WACC = 594. 145 / (594. 145 + 1846. 961)*1. 4% + 1846. 961 / (594. 145 + 1846. 961)*11. 51% = 9. 049% References Hong Kong Monetary Authority, Exchange Fund Bills and Notes fixing (http//www. info. gov. hk/hkma/eng/press/index_efbn. htm) Zhu & Zhu (2010) Estimating the Equity Risk Premium the Case of Greater China, Jie Zhu, Xiaoneng Zhu (http//citeseerx. ist. psu. e du/viewdoc/download? doi=10. . 1. 175. 7333&rep=rep1&type=pdf) Appendix A Selected figures from financial statements evade 1 survival of the fittest from summarized consolidated income statement 201120102009200820072006 HK$000HK$000HK$000HK$000HK$000HK$000 dollar volume3,834,422 2,995,952 2,733,256 2,021,283 1,530,763 1,314,443 Cost of sales(1,405,482)(1,176,707)(1,121,570)(819,423)(640,442)(540,243) Gross profit2,428,940 1,819,245 1,611,686 1,201,860 890,321 774,200 Other income incentive income0 13,200 0 0 Other (loss)/gain(7,544)3,791 (11,123)1,900 (4,395)(273) Impariment of goodwill0 (4,217)(59,569)0Operating expenses(1,958,255)(1,524,760)(1,468,877)(1,002,046)(749,898)(642,553) Operating profit463,141 307,259 72,117 201,714 136,028 131,374 bow 2 Growth trend of turnover, costs and profit, calculated based on consolidated income statement 20112010200920082007 change magnitude/Decrease (%) Turnover27. 99%9. 61%35. 22%32. 04%16. 46% Cost of sales19. 44%4. 92%36. 87%27. 95 %18. 55% Gross profit33. 51%12. 88%34. 10%34. 99%15. 00% Operating expenses28. 43%3. 80%46. 59%33. 62%16. 71% Operating profit50. 73%326. 06%-64. 25%48. 29%3. 54% Table 3 selection from summarized and standardized consolidated income statement 01120102009200820072006 Turnover100. 00%100. 00%100. 00%100. 00%100. 00%100. 00% Cost of sales-36. 65%-39. 28%-41. 03%-40. 54%-41. 84%-41. 10% Gross profit63. 35%60. 72%58. 97%59. 46%58. 16%58. 90% Other income incentive income0. 00%0. 44%0. 00%0. 00%0. 00%0. 00% Other (loss)/gain-0. 20%0. 13%-0. 41%0. 09%-0. 29%-0. 02% Impairment of goodwill0. 00%-0. 14%-2. 18%0. 00%0. 00%0. 00% Operating expenses-51. 07%-50. 89%-53. 74%-49. 57%-48. 99%-48. 88% Operating profit12. 08%10. 26%2. 64%9. 98%8. 89%9. 99% Table 4 Excerpt from summarized consolidated balance sheet 20112010200920082007HK$000HK$000HK$000HK$000HK$000 ASSETS Non-current assets Property, furniture and equipment727,022 233,395 229,124 179,850 93,191 electric current assets Inventories 736,717 394,520 411,145 323,724 196,299 Table 5 Excerpt from summarized and standardized consolidated balance sheet 20112010200920082007 ASSETS Non-current assets Property, furniture and equipment22. 13%11. 83%13. 44%11. 59%9. 38% present-day(prenominal) assets Inventories22. 42%20. 00%24. 12%20. 85%19. 77% Table 6 Excerpt from summarized consolidated balance sheet 20112010200920082007 LIABILITIES Current liabilities Bank borrowings(214,911)(47,400)(47,400)(10,000)0Trade and bill payables(360,545)(149,488)(155,993)(121,840)(66,805) Accruals and other payables(349,524)(178,245)(135,677)(140,200)(71,648) Non-current liabilities Bank borrowings(379,234)(35,200)(82,600)0 0 Table 7 Excerpt from summarized and standardized consolidated balance sheet 20112010200920082007 LIABILITIES Current liabilities Bank borrowings-6. 54%-2. 40%-2. 78%-0. 64%0. 00% Trade and bill payables-10. 97%-7. 58%-9. 15%-7. 85%-6. 73% Accruals and other payables-10. 64%-9. 04%-7. 96%-9. 03%-7. 21% Non-current liabilities Bank borrowings-11. 54%-1. 78%-4. 85%0. 00%0. 00%Table 8 Excerpt from summarized consolidated balance sheet 20112010200920082007 EQUITY Capital and reserves Share capital119,725 115,504 115,504 115,468 103,950 Reserves1,727,236 1,362,219 1,096,205 1,105,369 722,803 Non-controlling interests(3,749)0 0 0 0 Total equity1,843,212 1,477,723 1,211,709 1,220,837 826,753 Table 9 Excerpt from summarized consolidated cash flow statements 20112010200920082007 HK$000HK$000HK$000HK$000HK$000 pass cash generated from operating activities450,446 366,025 135,589 243,939 91,589 Net cash used in investing activities(508,347)(137,011)(156,242)(110,300)(101,843) Net cash generated from/ used in) financing activities204,453 (47,400)22,668 (76,497)(49,807) Net increase in cash and cash equivalents146,552 181,614 2,015 57,142 (60,061) Appendix B proportionality formula Performance remuneration margins Gross profit margin = Gross Profit / Turnover Operating profit margin = Operating Profi t / Turnover Net profit margin = Net Profit for the year / turnover Return ratio Return of equity (ROE) = Net Profit for the year / Averageyear, year-1 (Share capital + Reserves) Decomposition of ROE ROA = Net Profit for the year / Averageyear, year-1 (Total Assets) ROE = ROA x financial Leverage DuPont Decomposition of ROEAsset turnover = Turnover / Averageyear, year-1 (Total Assets) monetary leverage = Averageyear, year-1 (Total Assets) / Averageyear, year-1 (Share capital + Reserves) ROE = Net profit margin x Asset turnover x Financial leverage Extended DuPont Decomposition of ROE Tax burden = Net profit for the year / Profit before income tax Interest burden = Profit before income tax / (Operating Profit + Share of profit of jointly controlled entities) EBIT margin = (Operating Profit + Share of profit of jointly controlled entities) / Turnover ROE = Tax burden x Interest burden x EBIT margin x Asset turnover x Financial leverageEfficiency Fixed asset turnover = Turnover / Ave rageyear, year-1 (Property, furniture and equipment) Inventory turnover = Turnover / Averageyear, year-1 (Inventories) eld of inventory on hand = 365 / Inventory turnover Receivables turnover = Turnover / Averageyear, year-1 (Trade and other receivables) years of sales outstanding = 365 / Receivables turnover Payables turnover = Cost of sales / Averageyear, year-1 (Trade and bill payables) Number of days of payable = 365 / Payables turnoverWorking capital turnover = Turnover / Averageyear, year-1 (Net current assets) Risk Debt-to-common equity ratio = (Short term + Long term bank borrowings) / (Share capital + Reserves) Debt-to-asset ratio = (Short term + Long term bank borrowings) / Total assets Financial leverage = Averageyear, year-1 (Total Assets) / Averageyear, year-1 (Share capital + Reserves) Interest coverage ratio = Operating profit / Interest expense Cash flow coverage ratio = Net increase in cash / Interest expense LiquidityCash conversion cycle = Days of sales outstand ing + Days of inventory on hand Number of days of payable Current ratio = Current assets / Current liabilities Acid test ratio = (Current assets Inventories) / Current liabilities Operating cash flow to maturing obligations = Operating cash flow / Current liabilities Appendix C Calculated ratios 20112010200920082007 Performance Profit margins Gross profit margin63. 35%60. 72%58. 97%59. 46%58. 16% Operating profit margin12. 08%10. 26%2. 64%9. 98%8. 89% Net profit margin10. 12%8. 77%1. 56%8. 46%8. 0% Return ratios ROE23. 35%19. 53%3. 50%16. 70%15. 55% Decompsition of ROE ROA14. 76%14. 29%2. 61%13. 43%13. 05% ROA*Financial Leverage = ROE23. 35%19. 53%3. 50%16. 70%15. 55% DuPont decompistion of ROE Asset turnover1. 46 1. 63 1. 68 1. 59 1. 63 Financial Leverage1. 58 1. 37 1. 34 1. 24 1. 19 Net profit margin*Asset turnover*Financial Leverage = ROE23. 35%19. 53%3. 50%16. 70%15. 55% Extended DuPont decomposition of ROE Tax burden80. 65%83. 29%53. 97%81. 23%82. 63% Interest burden100. 46% 100. 86%103. 66%106. 90%112. 12% EBIT Margin12. 49%10. 44%2. 8%9. 74%8. 63% Tax burden*Interest burden*EBIT Margin*Asset turnover*Financial Leverage = ROE23. 35%19. 53%3. 50%16. 70%15. 55% Efficiency Fixed asset turnover7. 98 12. 95 13. 37 14. 81 16. 08 Inventory turnover2. 48 2. 92 3. 05 3. 15 3. 72 Days of inventory on hand146. 89 124. 95 119. 58 115. 82 98. 19 Receivables turnover31. 76 31. 98 51. 12 81. 59 185. 10 Days of sales outstanding11. 49 11. 41 7. 14 4. 47 1. 97 Payables turnover5. 51 7. 70 8. 07 8. 69 11. 14 Number of days of payable66. 23 47. 38 45. 21 42. 01 32. 76 Working capital turnover4. 6 3. 91 4. 24 3. 39 2. 72 Risk Debt-to-common equity ratio0. 32 0. 06 0. 11 0. 01 0. 00 Debt-to-asset ratio0. 18 0. 04 0. 08 0. 01 0. 00 Financial Leverage1. 58 1. 37 1. 34 1. 24 1. 19 Interest coverage ratio159. 70 119. 70 29. 64 646. 52 45342. 67 Cash flow coverage ratio50. 54 70. 75 0. 83 183. 15 (20020. 33) Liquidity Cash conversion cycle92. 15 88. 99 81. 51 78. 28 67. 40 Curr ent ratio1. 85 3. 00 2. 80 2. 93 4. 66 Acid test ratio1. 12 2. 08 1. 70 1. 91 3. 42 Operating cash flow to maturing obligations0. 44 0. 85 0. 36 0. 77 0. 58