Basic Industries is a diversified multinational corporation with major shares in various electric related markets. There is stock that has been held since the early 1980s and we have been asked to analyze and evaluate the past 10 years of data to either sell or continue holding the shares. We have also been asked to closely compare years 1993-1994 and not include the strike years 1989-1990.
Through my analysis, I found that Basic Industries should hold on to the stocks. This can be backed up with several ratios and analysis for it, like the following:
Equity turnover is the highest during 1994, following the trend in increase. If this continues then the company will keep producing more and more revenue with the investments.
Asset turnover is also the highest in 1994, and also if this continues (which according the trend it should) there will be a bigger increase in the reflection of the total assets being efficiently used to produce revenues.
Lastly the equity multiplier is showing its highest value in year 1994. Reflecting the increase in how efficiently shareholders’ equity is being used to make assets.
All the ratios above come from the DuPont formula, the formula that is used to find Return on Equity. So in theory ROE should be at its highest during the year of 1994. This is not the case due to the decrease in net income and profit margin. This decrease can be best explained by the increase in the interest expense ratio, causing the yearly interest expense to be higher and higher. From our net income sheet, we can see that when there are more expenses, there is less net income – ultimately leading to a drop in Equity. Return on Equity will take a hit from this higher interest expense each year.
If the company wants to increase ROE again with good quality, they must continue to hold the investments to produce more revenue and ultimately assets as well. However, they must decrease the interest expense rate by either paying off debt or refinancing their short-term and long term debt. These two decisions will surely reflect an increase in ROE again, unless there is another strike or major economy crash.
We have been asked to solve the assignment given to Fred Aldrich, which is analyzing the data of Basic Industries for the past ten years and making investment recommendations. Basic Industries is a global corporation that holds shares in various electrical related markets. The most recent annual report – 1994, shows a decline in the return on owners’ equity. This has some investors worried and they want him to figure out how the return on equity has been achieved in the past ten years.
Fred has been suggested to forget the years 1989-1990 since there were strikes and the data wouldn’t be as comparable to other years. He has also been suggested to focus on the analysis for key financial ratios and direct comparison between years 1993-1994, the most recent years. We have to focus on the quality of the company’s earning since the investors place an emphasis for it. Our end recommendation should be whether or not we hold on to the stocks because they are generating healthy equity.
The first thing to do was calculate some key financial ratios for all eight years to be able to get a grasp on the trends for equity. Second, is to go more in depth analysis between years 1993-1994 to see why there is a drop in equity. After valuation, we should be able to determine whether or not the drop on equity was due to the stock investments or maybe it was due to something else. Lastly, calculating the quality of earnings will be a key factor for deciding whether or not to keep the stocks – but maybe change something else within the company to raise return on equity again.
ANALYSIS AND CALCULATIONS
Below are all the ratios and percentages used to support the analysis:
From the calculations above, we can conclude that Return on Equity has a smooth trend over the eight years. Return on Equity is lower in the year 1994, which is why investors are worried. But this can be explained with some other ratios. The reason why ROE (Return on Equity) is lower in 1994 is because of the operating profit being lower as well, the year 1992 had the highest operating profit margin and then it started slowly dropping.
Equity turnover has slowly being increasing throughout the years; this is a good sign. It means that the company has been producing more and more revenue with the investment – in this case all the shares in the various electrical related markets. Another good sign for the investment is the asset turnover ratio increasing throughout the years.
This reflects that the assets are being efficiently used in the production of revenues. So far, we can conclude that the company is allocating assets in the right manners to produce the maximum revenues possible, and we know that the investment has also being increasing its turnover ratio. Lastly, the equity multiplier is showing an increase through the years; reflecting how efficient shareholders’ equity is being used to create assets.
So, why is ROE lower in 1994 if the ratios above show otherwise? This is because the interest expense has been increasing year by year; this decreases the quality of earnings since there is more interest being paid for long-term and short-term debt. Even though the company is paying more money, they are getting into more debt and paying high interest rates for such that ultimately reduces net income and therefore reduces ROE. After analyzing the decreasing tax rate, we can say that interest expense and its ratio has also being increasing.