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Understanding Fundamental Analysis (Part 6)
Education | 23 October 2008
By: Xavier Lim
Articles (51) Profile

Studying the financial health of a company is never an easy task. Shares Investment (Singapore) hopes that the previous 5 parts of “Understanding Fundamental Analysis” series have helped readers in making good investment decisions. In “Understanding Fundamental Analysis” Part 5, we did mention the importance of reading income statements, cash flow statements and balance sheets. In this issue, we shall go more in detail with regards to this aspect.

Let us take steel-maker FerroChina for this issue’s discussion. FerroChina, once a gem in many analysts’ eyes, shocked investors on 9 October when it announced that it would default on loans worth Rmb706m, making it the first Singapore-listed company that fell victim to the global economic crisis.

FerroChina has been maintaining a very low debt-to-equity ratio (total debts/shareholders’ equity funds) throughout FY05 to 1H08 and as at 30 Jun-08, its debt-to-equity ratio was only 0.7 times. So what has really happened to FerroChina?

Income Statement

1H08

2007

2006

2005

Revenue

6,516,236

5,913,033

3,788,423

2,186,143

Profit before tax

459,840

412,222

299,553

146,128

Net profit

418,886

381,170

269,033

146,128

(Figures in Rmb’000)
Cash Flow Statement

1H08

2007

2006

2005

Profit before tax

459,840

412,222

299,553

146,128

Operating Profit

384,689

157,723

240,519

-608,241

Net Cash from operations

198,850

-21,698

156,993

-642,611

(Figures in Rmb’000)
Balance Sheet

1H08

2007

2006

2005

Cash and cash balance

125,409

142,900

67,984

11,492

Fixed deposits

915,251

441,878

297,802

205,031

Trade and other receivables

2,913,638

2,753,658

486,675

938,326

Inventories

2,364,016

1,809,465

840,012

315,521

Current Assets

6,319,820

5,149,406

1,693,149

1,470,370

Total Assets

15,321,165

12,898,668

2,985,387

1,865,851

Trade and other payables

3,847,435

3,249,596

870,499

517,085

Current Liabilities

6,223,849

5,416,344

1,398,948

785,827

Total Liabilities

8,661,783

6,628,143

2,129,393

1,348,235

Total debts

4,572,922

3,302,151

921,124

831,150

- Short term debts

2,330,613

2,142,706

474,690

268,742

- Long term debts

2,242,309

1,159,445

446,434

562,408

Shareholders’ equity funds

6,659,382

6,270,525

855,994

517,616

(Figures in Rmb’000)

Let us look into FerroChina’s FY05 to 1H08 income statements, cash flow statements and balance sheets. As we see in the income statement table, FerroChina’s revenue and earnings have been soaring since its listing on 19 May-05, but its cash flow statement does not look as fantastic. FerroChina relies heavily on credit to fund its working capital on the back of its inconsistent and weak cash flow, which makes it harder for FerroChina to strengthen its balance sheet during a credit crunch.

FerroChina’s balance sheet looks healthy at one glance, with its total assets to total liabilities at 1.8 times and 1.9 times in 1H08 and FY07 respectively. When we delve deeper into the balance sheet, it shows that over the years, it has been increasing its borrowings at a frantic pace. The critical part that pushed the company into its current financial woes was its huge short-term debts of Rmb2.3b. Although FerroChina maintained huge cash in hands (cash plus fixed deposit), it is still insufficient to meet all the short-term obligations as its fixed deposit was pledged as collateral.

Moreover, FerroChina has to service interest payments on its long-term debt of Rmb2.2b, which may approximate to Rmb100m annually.

In addition, FerroChina’s current ratio (current assets/current liabilities) which is approximately equal to 1 suggests that the company would not be adequate to pay off its short-term obligations if they came due at that point, which is definitely not a good sign.

Let us look into FerroChina’s current assets and liabilities in detail. Its trade and other payables piled up to Rmb3.8b on top of its short-term debts. With a large amount of cash locked in both its receivables and inventories, this further exacerbated FerroChina’s liquidity problems.

Compounded by the fact that the world is already reeling from a global credit crunch, most banks would be unwilling to extend large amounts of loans to any bank, let alone any other corporate entity. Raising capital via issuance of shares will also be tough given the pessimism surrounding investors.

FerroChina has raked up too much debt in a bid for expansion and has forgotten the fundamental importance of managing its cash flow and balance sheet well. No wonder Warren Buffett once said: “It takes 20 years to build a reputation and five minutes to ruin it.”

Armed with an arsenal of investment knowledge, Xavier is the Senior Research Editor at Shares Investment.

Please click here for more information about this author.


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