Calculating ratios is indeed what most people (including me) thought what Financial Statement Analysis is all about. But after reading the first chapter of TKWAV, my view has changed whereby I realised they are of no good to me in assessing my firm’s value mainly because the figures are historical – they tell us little about the future. However, to my disbelief, as I am doing this write up, my view has changed again. Financial ratios are of much assistance in fact. They tell me what has happened in the business in the past, what’s happening now, and some hints about where the firm is heading in the future. I feel like I can talk about Dexion with greater confidence.
After calculating the come financial ratios, I thought I should compare them to the industry trend, but unfortunately I can’t find a firm similar to Dexion. In New Zealand, Dexion is a monopoly. In the U.S., Panasonic is a ‘partial’ competitor. ‘Partial’ because despite selling some similar products, Panasonic has more product range and operates across all industries including consumer goods, whereas Dexion only sells capital goods and just recently, commercial goods. In China, I am positive there are many firms similar to Dexion but unfortunately they are non-listed firms, so there isn’t a way to assess their financial ratios. Also non-listed firm is Nu-Con, the sole competitor of Dexion in Australia. Thus far, I still can’t find a benchmark to compare Dexion’s financial ratios against.
Even if such industry averages/trends is available, would it be of any help to me in making sense of the financial ratios? To me, industry averages is a pool of different firms whose nature of business is almost similar to each other. It is akin to stacking New World, Pak ‘n’ Save, Woolworth, Foodtown and Countdown together to calculate the food retail industry averages. But to a varying degree, these firms operate on different ‘ideology’. Some focus on becoming the cheapest food retailer in town while others may be more interested in giving customers a satisfying shopping experience. It’s like comparing apples to oranges to determine which is sweeter, rounder, and juicier – I doubt this is making any sense at all.
Despite the above limitation, financial ratios are still good to be used to measure one’s performance or success against the previous years’. This is what I am planning to do with Dexion’s financial ratios. Of course, we need to keep in mind not to rely too heavily on these quantitative figures in interpreting the firm’s success or failure. It has to be accompanied by qualitative information. For example, Dexion’s ROE for the year 2007 has declined tremendously. I know for a fact that in year 2007 Dexion has acquired seven subsidiaries whom have been great tools for Dexion to produce higher quality products that meet the ISO 9001-2000 requirements. Having acquired the ISO 9001-2000 certificate, Dexion is now at par with its competitor in Australia i.e. Nu-Con, another industrial solution company. Putting these two pieces of information together, I am far from concluding that the decline in ROE is a sign of failure because I know in essence, there are long-term value-adding benefits involved.
Contradictory to what I believed before, financial ratios are important in its own right too, where without it we don’t know the magnitude of the success or problem that we sense to be present. Which is a more insightful statement: “a high ROE” or “an ROE of 70%”? It is my firm belief that the latter is more insightful. Also, ratios provide us with better sense of relativity. For example, when someone asks me to give a review on a restaurant, I could either say “The restaurant is good” or, I could say “I would give 9 out of 10”. The former statement gives us little information because we don’t know where the ‘good’ actually stands on the yardstick. On the other hand, the latter statement tells us that on a yardstick of measurement 1 to 10(assuming 1 is worst and 10 is best), the restaurant sits at 9, which could then be translated into ‘almost perfect’. This is more informative for potential customers.
Dexion’s Abnormal Earnings (AE) calculation
Formula: AE = [ROE – (þE – 1)]*BV
Year
ROE
þE
BV
AE
2005
56.72%
12%
11,293,000
5,050,230
2006
52.61%
12%
16,927,000
6,874,055
2007
28.45%
12%
36,192,000
5,953,584
Based on the formula above, I can conclude that AE is influenced by 2 main components i.e. the ROE and BV (I will revisit this statement after learning more about þE in Chapter 6 of TKWAV. As of now, I am taking Martin’s advice in assuming þE is 12%). In 2007, BV increased 114%, but unfortunately ROE dropped 46%. But surprisingly, the impact of ROE is bigger! The drop in ROE outweighed the increase in BV, resulting AE to fall 13%.
Detailed analysis of the drop in ROE
ROE did not decline so much in year 2006 i.e. it fell only 7% from 2005. But in 2007, it significantly fell 46% from 2006. It was due to the decline in:-
a)RNOA, and
b)FLEV*SPREAD
a)Detailed analysis of the decline in RNOA
RNOA = OI/SALES × SALES/NOA
Year
OI
SALES
NOA
=RNOA
2005
6,264,000
130,972,000
11,872,000
53.95%
2006
8,801,000
187,147,000
29,653,000
29.68%
2007
10,560,000
250,967,000
73,050,000
14.46%
It seems that RNOA has been declining a lot from year to year. In year 2006, NOA increased 150%, but sales increased only 43% and OI increased only 41%. The condition became worse in 2007 whereby NOA increased 146% but sales increased only 34% and OI increased only 20%. The sales growth doesn’t look like a good growth to me (I will explore this later). Dexion was generating less revenue from their assets and less profit from their revenue. Obviously they did not utilise their assets well, and their efficiency in converting sales into profit is declining.
b)Detailed analysis of the decline in FLEV*SPREAD
Year
FLEV
SPREAD
FLEV*SPREAD
2005
0.3125
45.82%
14.32%
2006
1.2951
27.51%
35.63%
2007
1.4311
10.06%
14.40%
In year 2005, high SPREAD and low FLEV resulted in low FLEV*SPREAD. In year 2007, low SPREAD and high FLEV also resulted in low FLEV*SPREAD. But surprisingly in 2006, an average-looking SPREAD and a not-so-high FLEV resulted in very high FLEV*SPREAD indeed. This just proves Martin’s words i.e. it is not the individual figure that is important, rather it is how the figures interact with each other. So my query now is: what is the optimum figure for FLEV and SPREAD? To answer this question, I break them into even smaller bits and pieces.
FLEV = NFO/BV. I shall delve into BV later.
Year
NFO
BV
=FLEV
2005
3,529,000
11,293,000
0.3125
2006
21,922,000
16,927,000
1.2951
2007
51,794,000
36,192,000
1.4311
In 2006, Dexion’s borrowings (NFO) increased 521% from 2005. But these staggering increase in borrowings are rendering very high FLEV*SPREAD figure (35.63%) which consequently increases ROE. It shows that despite its sudden nature, the huge borrowings are well managed. On the other hand, in 2007, borrowings increased only 114% but the FLEV*SPREAD figure became very low (14.40%). It seems that high borrowing is not the problem, rather, not utilising the borrowings in a proper manner is the problem which causes ROE to fall. This is evident from my SPREAD analysis below.
SPREAD = RNOA – NBC, where NBC = NFE/NFO
Year
RNOA
NFE
NFO
NBC
=SPREAD
2005
53.95%
287,000
3,529,000
8.13%
45.82%
2006
29.68%
476,000
21,922,000
2.17%
27.51%
2007
14.46%
2,277,100
51,794,000
4.40%
10.06%
To me, 2006 is a good “debt management” year. NFO increased 521%, but NFE increased only 66%. Whereas in 2007, the NFO increased only 114% but NFE increased 378%! Has Dexion exceeded its credit limit, causing interest rate to be higher? Notice that in 2007, RNOA was halved! This shows how Dexion who has borrowed ample amount of money, used those money to acquire new assets, but failed to generate enough profit from those assets – resulting in low RNOA (also proven in my previous RNOA analysis). Well, the profit was enough to cover the borrowing costs, but certainly not enough to maintain their high ROE in 2005 and 2006. It is important that RNOA is kept high all the time because a low RNOA will result in low ROE and also causes FLEV*SPREAD to be doomed as well, which could further aggravate the ROE.
Detailed Analysis on the Increase of BV
Although the significant increase in BV was not successful in saving AE (AE fell by 13% despite BV increased 114%), I think it is still worthwhile looking at what’s causing the huge increase in BV, after all, BV is also a component of ROE through FLEV.
From the surface, I could see that the huge increase in BV was driven by the numerous business acquisitions done. There were also several restructuring projects taking place which costs were being capitalised as assets (NOA). Throughout year 2007, they:-
upgraded their IT system in Australia (the headquarter)
made ongoing investments in sophisticated warehousing and supply chain solutions
built a new facility in New Zealand in East Tamaki
built a new facility in Malaysia in Pelabuhan Klang
acquired a China company Xiou Bao Storage System in Shanghai for AU$3,500,000and rebranded it as Dexion China
acquired a New Zealand company Audeo Limited for AU$7,311,000
acquired a New Zealand company Darroch Consulting Limited for AU$1,543,000
acquired Hamilton Perry Industries Ltd for AU$ $15,788,000
acquired Elite Built Pty Ltd for AU$ $23,379,000
acquired Precision (Audeo Ltd) (cost not disclosed)
acquired Godfrey Office Equipment Pty Ltd (cost not disclosed)
After breaking the BV formula into bits, we can see that Sales, ATO and NFO are the variables involved.
∆BV = ∆ (Sales/ATO) - ∆NFO
Year
Sales
ATO
Sales/ATO or NOA
∆(Sales/ATO)
∆NFO
∆BV
2005
130,972,000
11.0320
11,872,009
n/a
5,918,000
1,207,000
2006
187,147,000
6.3113
29,652,686
17,780,677
18,393,000
5,634,000
2007
250,967,000
3.4356
73,048,958
53,396,272
29,872,000
19,265,000
I could now understand why Dexion is eager to increase their assets (NOA) – increasing assets will render the much needed BV to maintain high AE. Low NOA will put AE at stake. Hence, those endless business acquisitions are pretty much justified.
However, Dexion has to go beyond this – they have to stop acquiring assets and start generating more sales. Increasing sales will not do BV any good (because as Sales increase, ATO increase by the same amount, leaving the Sales/ATO ratio unchanged), but it has to be done to improve RNOA. Again, well utilised assets will secure high RNOA which consequently improves FLEV*SREAD and finally results in high ROE. Increasing borrowings and assets is not the real harm (as seen in year 2006). Rather, the inefficiency in utilising those borrowings and assets is.
My journey in completing this assignment has been very insightful. When I was calculating SPREAD, I noticed there is a negative relationship between NFO and SPREAD i.e. as NFO increased, SPREAD tends to decrease. I can’t help but to conclude that firms should avoid making borrowings and if they need more funds, they should issue equity. But after discussing with my group, I realised that if we issue more equity, then FLEV would decrease and consequently ROE too. So either way, they both have negative impact on ROE. This is consistent with the theory of Modligliani and Miller i.e. a firm’s value is not influenced by its capital structure. Next I asked Martin: how else can we get extra money from? He answered “Through profits”. I agree with this because growth must come from within. If we borrow money from the bank, or issue more shares to the public, the costs involved will impede our growth. We see how in Dexion’s case, the strategy of using debts as leverage backfired. But if we focus on improving cost-efficiency and profitability, growth will naturally follow suit.
A quick discussion with Shazwan about his firm (Qantas) made me realised that abnormal earnings is an interesting concept. Qantas’s AE in 2007 and 2006 were –AUD$108.50m and –AUD182.34m respectively. He mentioned how there are many other friends whose firms are experiencing negative AE as well (some are famous businesses!). I wondered to myself, how can a well-known and successful firm like Qantas have negative AE? While Dexion whom I have never heard before made positive AE instead? Ky wrote in the discussion board about how earnings are distributed normally (normal distribution) and that there will always be 50% of people having negative AE and another 50% having positive AE (the bell-shaped graph). Right now, there is not many people who can tell which firm is making positive AE and which is making negative AE (unless you take ACCY306 course, I think). But once this knowledge is diffused, everyone will invest in firms who are making positive AE! Will the cost of capital then shift upward so that the bell-shaped curve is maintained? This is very likely to be the case. Right now, let’s assume the cost of capital is 12%. If it is shifted rightward, say 13%, then businesses will have to struggle to increase their ROE so that their AE is maintained at a positive level. This is interesting! The smarter investors are, the harder managers will have to toil around to keep ROE higher than the ever increasing cost of capital.
Is Dexion experiencing Bad Growth or Good Growth?
From the analysis above, we can see that RNOA, FLEV, SPREAD, PM and ATO experienced decline, despite the positive growth in sales and OI. Perhaps the growth in sales constitutes bad growth and not good growth?
Dexion has made its products more attractive to customers i.e. they offer lifetime product warranty. Hence, there is a boost in product sales. My query is: are those lifetime warranties form part of the existing huge amount of liability which reduces Dexion’s BV? If yes, then this warranty is reducing the AE. But there is no information in the financial statements regarding how this warranty is being treated. The only information I have is, for the lifetime product warranty to remain valid, Dexion must carry out an inspection of the product during the 12th month of each consecutive 12 month period for the duration of the lifetime warranty. Consider the labour costs and transportation costs involved during the inspection process; not for one year but for the lifetime of the product, and not for one customer but for tens and thousands of customers. This is likely to be the reason why PM declined. Hence, if we follow Martin’s advice closely, then the sales growth shall be deemed as a bad growth because they are value destroying. However, I know for a fact that Dexion invests substantially on technology which consequently improves quality on an ongoing basis. This reduces the risk of selling defective products. And Ning pointed out that usually, lifetime warranties are issued only if the issuer is highly confident that their products will not break down. The warranty is given out with the objective of keeping customers happy which in turn creates brand loyalty and hence achieve good reputation. Good reputation is a long-term investment – it could take decades for the result to show. So, it is still too early to tell whether the lifetime warranty is value destroying.
Sales also grow because Dexion’s NOA has increased, but at the expense of decreasing ATO, RNOA, SPREAD and ROE. Is this a bad growth? Well, the increase in NOA is a must for long-term survival. The ongoing investment on sophisticated warehousing and supply chain solutions as well as the upgrade in IT system will improve Dexion’s long-term performance. And the business acquisitions in China, Malaysia and New Zealand are necessary to strengthen Dexion’s competitive position as a leading regional provider of storage systems. These NOA paves the way for future growth to take place. They are adding value, not destroying value. Hence I disagree if such sales growth is deemed as bad growth.
I also noticed that Dexion has diversified their products. They started off with capital goods, but since year 2004 they have been involved with commercial goods as well. This does not necessarily add value to shareholders. The new commercial products like purpose-built cabinets, drawers, lockers, and library shelving ended up incurring more inventory costs which have pulled down the ATO. Sales for this particular product are low because only customers with a fat budget (like The Australia National Library and The Paramatta Justice Precinct) are willing to buy custom-made storage system from Dexion. The larger percentage of customers would settle for cheap but quality ready-made storage system from say, IKEA who specialises in bulk production of office cabinets, drawers, shelves etc. In this situation, I agree that this is in fact a bad growth. However, is this enough to justify commercial goods should be dropped from Dexion’s product line? Well, I can’t tell this just by calculating financial ratios. I need more information, like what are the real reasons of low ATO for this product range, whether it due to economic slowdown in New Zealand, is the wrong marketing strategy being used, etc. A low ATO now can change into high ATO and good growth in the future.
