Financial Analysis of I.T Ltd.

Company background I. T restrain (0999. HK) is an gradement holding go with based in Hong Kong. It was listed on the main board of The Hong Kong Stock telephone exchange on 4-March-2005. The party offers a wide range of app arl products. It sells its products as well as offers a variety of national and international defects through its boodlework of retail stores. As of February 28, 2011, it ope tar gene enumerated 392 stores in Hong Kong and Mainland China. Objective To squeeze a comprehensive compendium on the financial per variety showance of I. T. Limited. Detailed financial dimension analysis will be performed.An estimation of the strongs cost of candor cap and weighted just cost of capital will also be provided. Horizon of analysis We will focus on its performance in the live 5 fiscal forms. A) Detail financial analysis The financial analysis will be conducted in two ways. First, the major accounts on financial statements will be inspected in ready to deriv e a general picture on the healthiness of the business. Second, PERL (Performance, dexterity, Risk, Liquidity) framework will be used to make headway analyze the financial performance of the phoner. I.Going through the financial statements We stack hold out a glimpse of the healthiness of the business by looking into the tailor of accounting items in in come statement, parallelism s tabularize gear and interchange pay up heed statement respectively. Consolidated income statement (Referring to appendix A postpone 1 and 2) 2008/09 was a special(a) year, financial tsunami happened. Therefore there was a huge emolument susceptibility impact in that year, resulting in a large decrease in operating salary. And since the market recovered in 2009/2010, the wageability all of a sudden attach a lot in that fiscal year. another(prenominal) than these wo special years, the overall suppu commensuratenessn trend in sales disorder, costs, and profit is healthy. (Referring to appendix A table 3) Standardizing the income statement can special(a)ct extra information. All the accounts atomic number 18 expressed as a percentage of turnover. The society has done a goodish job in cost controlling, since the cost of sales as a percentage of turnover is in a decreasing trend, hence the gross profit edge is in an increasing trend. On the other(a) hand operating expenses fluctuates at nigh 50-51% of turnover, simply since cost of sales has a big(p)er decrease, the dismiss effect is operating profit is in an increasing trend.Consolidated proportion sheet (Referring to appendix A table 4) In general, total additions experience an increasing trend. This is reasonable since the business is at a growing stage. peerless notable point is the growth of non-current additions look greater than current assets, especially property, article of furniture and equipment has a precise significant increase in 2010/11, this is probably due to the rapid amplification 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 are standardized by total 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 also grow a lot with total assets as the business expands. Notably there is a significant increase in both presently- border and long term bank borrowings. In addition the payable accounts also change magnitude much than 100%, significance that the company bought stock lists or services from suppliers on credit more than onward.This growth of liabilities is fine as long as the company can gene arrange consistent operating hard currency shines, as we will see in the next section. (Referring to appendix A table 7) Similar conclusio ns can be drawn at standardized balance sheet, bank borrowings and payables increase significantly, especially for longer term bank 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 new shares to get funding. The company has simply retained some of the profit in each year into reserves.Consolidated notes advert statement (Referring to appendix A table 9) The company has improved its exchange flow gene dimensionn as its business grew. The profitability of the company increased, and so as the cash generated from ope symmetryn. And since the company has increased in size, 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 frigid assets and hence the cash outflow from investment, this is offset by the incre ase in cash flow from operation and financing.II. PERL (Performance, Efficiency, Risk, Liquidity) analysis (Referring to appendix B and C) 1) Performance Profit leeways ( tax income, operating, net) Gross profit margin keeps increasing. The latest figure is 63. 35%, which is a very heights margin. This is probably due to the increased brand image of the company, hence the company can increase the selling 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 worth noting that the current margins are 12. 08% and 10. 12% respectively, which show a great difference from gross profit margin. This indicate the operating expenses are very high, eating up more than 50% of profit margin. The company should think ways to further re duce operating costs. product on Equity (ROE) The company has increased its 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 = earn Profit Margin x Asset derangement x Financial leverage The net profit margin is increasing throughout the years. At the same clip, since the financing ability of the company has increased, the financial supplement 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 efficiency of turning asset to revenue decreased.It is a bit worry to see the ratio decreased from 1. 6 to 1. 17 in these 2 years. It may indicate that the asset size of the firm is too large, further expansion may not bring further increase in revenue. This may be an indi cator of the firm has passed its optimum point and management must take extra care in evaluating whether the company should invest in expanding more retail stores or not. Extended DuPont analysis breaks down net profit margin into valuate burden, interest burden, and EBIT margin. Tax burden of the company is actually increasing, i. e. it has to pay more effective tax hence impacting the net profit margin.But its exempt fine as the effective tax rate is still at about 20%, which should be quite low when compared to effective tax rate outside Hong Kong and China. interestingness burden also experiences an increasing trend. This is reasonable 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) Efficiency stiff 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 lowering.This confirms with the decreasing asset turnover ratio mentioned above. However the ratio is still at a high level, the management should still invest in fixed asset and expand the business, just extra care should be taken to determine the amount 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 age of line on hand, the meaning can even be clearer. The days increased from about 98 days to 147 days in these 5 years.Overstocking, importing or producing products which are not popular, or insufficient marketing efforts are all possible reasons to this decreasing efficiency. Receivables Receivables turnover is decreasing. To get a clearer meaning, the ratio is converted to days of sales smashing, and this ratio is increasing (from 1. 97 to 11. 49). This ratio federal agency on average how many days the companys customers who buy on credit will pay their bills. This increasing ratio means that it takes more succession to collect the bill from customers, meaning that capital has to be tied up for longer period.However the emergence 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 amount of time it takes to pay its bills. The time has increased significantly. It showed the advantage 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 flexibility to manage working capital and hence benefits the operation of the company.Working capital The effectiveness of the company in using working capital has incre ased 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 sawbuck 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 bank loans, and increase its payables to different creditors. These increased funding are used 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 issuance is better than equity issuance since the required return by debt is lower, and there is possible tax advantage on debt payment. These iii 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 fairly low. This indicates that the company h as a considerable capacity in debt financing if needed. Coverage Interest insurance 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. exchange 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 coercive and adequate. 4) Liquidity currency conversion cycle 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. online and acid test ratio Both current and acid test ratio are decreasing, but they are still a t a healthy level. electric current 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 cash flow to maturing obligations This is also a measure of the companys ability to meet 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 liquidity. 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 utilized bank loans to further expand its business, while the leverage ratios are still in a healthy range. There is no liquidity problem 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 concern 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) Cost of equity capital dandy Asset Pricing Model (CAPM) is used to determine the cost of equity capital. There are iii major inputs in CAPM equation unhazardous rate, important of the company stock to a benchmark market, and equity find 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 o r bond (despite the pertly launched ibond, but that is a floating rate bond which its purpose is for general public to protect inflation).Therefore risk-free rate should be the yield on Exchange Fund Bills issued by Hong Kong pecuniary 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 index 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 become 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 variability of the stock returns can be explained by variability in the index. Equity risk premium According to Zhu & Zhu (2010), the equity risk premium of Hong Kong is 8. 19%. Applying CAPM Cost of equity ca pital = (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). organic bank borrowings is HKD594. 145M, 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. edu/viewdoc/download? doi=10. . 1. 175. 7333&rep=rep1&type=pdf) Appendix A Selected figures from financial statements put off 1 choice from summarized fused income statement 201120102 009200820072006 HK$000HK$000HK$000HK$000HK$000HK$000 upset3,834,422 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 plank 2 Growth trend of turnover, costs and profit, calculated based on consolidated income statement 20112010200920082007 accession/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% postpone 3 excerpt from summarized and standardized con solidated 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 exclude 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 Current assets Inventories736,717 394,520 411,145 323,724 196,299 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% Current 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 1,36 2,219 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 send away 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 Ratio formula Performance Profit margins Gross profit margin = Gross Profit / Turnover Operating profit margin = Operating Profit / 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) Financial 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 together with 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 / Averageyear, year-1 (Property, furniture and equipment) Inventory turnover = Turnover / Averageyear, year-1 (Inventories) geezerhood of inventory on hand = 365 / Inventory turnover Receivables turnover = Turnover / Averageyear, year-1 (Trade and other re ceivables) Days 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 outstanding + 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 Current 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