Financial Statement Analysis of H&M PDF

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Table of contents SUMMARY ............................................................................................................ 2 INTRODUCTION ................................................................................................. 2 PRESENTATION OF H&M GROUP ................................................................ 2 STRATEGIC ANALYSIS .................................................................................... 3 PEST-analysis................................................................................................................. 3 SWOT-analysis............................................................................................................... 5

ACCOUNTING QUALITY .................................................................................. 7 REFORMULATION OF THE ANNUAL REPORTS ....................................... 8 Analytical income statement........................................................................................... 8 Analytical balance sheet ................................................................................................. 9

PROFITABILITY ANALYSIS .......................................................................... 10 Return on invested capital (ROIC) ............................................................................... 10 Weighted average cost of capital (WACC) .................................................................. 10 Return on equity (ROE) ................................................................................................ 11

GROWTH ANALYSIS ....................................................................................... 11 Sustainable growth rate (g) ........................................................................................... 12 Economic value added (EVA) ...................................................................................... 12

LIQUIDITY ANALYSIS .................................................................................... 13 Short-term liquidity risk ............................................................................................... 13 Long-term liquidity risk ................................................................................................ 14

HISTORICAL FIGURES ................................................................................... 15 FUTURE PERSPECTIVES AND FORECAST ............................................... 15 Future perspective......................................................................................................... 15 Forecast of the income statement ................................................................................. 15 Forecast of the balance sheet ........................................................................................ 16 Forecast of future cash flow ......................................................................................... 17

ESTIMATION OF REQUIRED RATE OF RETURN .................................... 17 VALUATION OF THE FIRM ........................................................................... 18 Dividend discount model .............................................................................................. 18 Discount cash flow model ............................................................................................ 19 Economic Value Added model ..................................................................................... 19 Relative valuation ......................................................................................................... 20

RECOMMENDATIONS .................................................................................... 21 REFERENCES .................................................................................................... 22 APPENDICES ...................................................................................................... 23 1

SUMMARY This report is on analyzing and valuating H&M Group through different financial calculations, theories and methods. It consists of strategic analyzes, reformulation of the income statement and balance sheet, along with analyses of the profitability, growth, and liquidity of the firm. It also includes the estimation of future performance and prognosis of future cash flow. The assessments that have been made, show that H&M Group is doing will despite negative figures. It is, after all, a large company that has been around for a long time. In the conclusion, based on different valuation approaches, I recommend buying shares in H&M Group due to the share price of 2018 which gives a higher present value than traded in the market.

INTRODUCTION The main purpose of this report was to analyze the H&M Group to find out whether it is profitable for investors to invest in this company. To draw such a conclusion, several theories and methods have been used to evaluate H&M’s historical performance and expectations for the future. Therefore, data from several years back has been taken into account, specifically from the years 20152018. This data has for the most part been provided by the firm’s annual reports of the respective years. Also, to be able to provide a good overall analysis, it is important to understand the firm in general and the market in which it operates. For this reason, the first part of the report looks at a strategic analysis of both internal and external levels and a short presentation of H&M Group.

PRESENTATION OF H&M GROUP

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H&M Group is a Swedish clothing-retail company that started when founder Erling Persson opened the first store in Sweden in 1947. As of 2020, the firm operates in 74 countries with over 5000 stores, in addition to online shopping in 51 markets. With only Inditex ahead, H&M is the second-largest global clothing retailer with various company brands. According to the annual report, the group includes the brands H&M, COS, Weekday, Cheap Monday, Monki, H&M Home, & Other Stories, ARKET and Afound. The overall business consists mainly of sales of clothing, accessories, footwear, cosmetics, home textiles and homeware to consumers. H&M is the most expanded brand earning most of the total revenue, which offers collections for women, men, teenagers, children and babies (H&M, 2019). To keep up with modern technological advances and the consumer society, the group is continuing to expand online through physical stores and digital marketplaces. The group’s sales are made in leased store premises, online and via external platforms. As stated in the annual report, online sales already make up a significant proportion of total sales in several markets, and for the group, online accounted for 14,5 % of total sales for 2018. Although the numbers in the annual report do not show a strong increase from previous years, the H&M group remains in a strong financial position delivering consistent and positive results. These are good numbers despite the tough competition in the market and rapid changes in consumer behavior that makes up a great challenge for the whole industry.

STRATEGIC ANALYSIS PEST-analysis A PEST-analysis is a strategic tool, that allows you to analyze political, economic, social and technological factors in the external environment of companies. These are four external factors that can affect the company’s activities and performance, and therefore important to have knowledge about for both future and present positions.

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Political factors As a global company, the H&M group operates in many different countries with diverse political governance. While the headquarters are based in Sweden, where the political system and governance is rather stable, the company still has country offices and production offices spread all over the world. This causes the company to be sensitive to changes in local laws and regulations related to taxes, customs, import and export in the many different countries. Furthermore, will geopolitically circumstances and other political factors such as human rights and corruption, also affect the business environment and economy.

Economic factors The most significant currencies for the group’s purchasing are US dollars and euros, as stated in the annual report. Large and rapid exchange rate fluctuations, especially related to dollars, may have a critical effect on purchasing costs. However, to reduce these effects of future exchange rate fluctuation, the group’s purchases of goods are hedged under forwarding contracts on an ongoing basis. Increasing labor costs, rising maintenance costs, inflation rates, interest rates, and taxes are other factors that also affect the accounting figures. Along with these factors, the intense competition in the fashion industry plays a great challenge as well. Zara is the greatest rival, but online retailers such as Zalando and Asos, have made it harder to do compete.

Social factors By being one of the largest and infamous companies in the world, H&M is constantly exposed to great interest and spotlight. Both positive and negative activities carried out by the company will attract the media and consumers. This can thus have a major impact on the company's business, but also the reputation. Following ethical guidelines is therefore very important. To operate in the fashion industry itself is a great risk. There is always something new in fashion, which then leads to changes in consumers' expectations and demand. As a result, changes in consumer behavior is a significant factor. Also, in regards to being a multinational company, shopping patterns and seasons may vary from country to country. 4

Another significant factor is that society is increasingly influenced by growing digitalization. Here the changes in consumer behavior play a great role as well. People now shop more online from their homes, rather than in physical stores. At the same time, businesses are also affected, as these must undergo significant structural changes. There is also an ever-increasing focus on the environment and climate. As H&M operates in one of the most polluting industries, the company shoulders a huge responsibility towards providing sustainable fashion and creating a minimum impact on the environment. H&M group has therefore put in a lot of focus and work into sustainable production. The company releases a sustainability performance report each year, where they highlight their progress towards the company’s vision to lead the change towards circular and climate positive fashion.

Technological factors It is crucial to stay updated with the latest technological advances. New solutions and better production possibilities are always relevant. Investment and adapting to technology which promotes sustainable production is very important for H&M. These technologies are highlighted in the sustainable performance report. Digitalization is also a technological factor, in addition to being a social factor. This results in digital transformation in different parts of the organization's culture. For example, physical stores may incorporate new technology to improve customer satisfaction.

SWOT-analysis A SWOT-analysis is a framework used to evaluate a company’s competitive position and to develop strategic planning. The analysis assesses internal and external factors, by identifying strengths, weaknesses, opportunities and threats related to business. The SWOT-analysis table below includes the most relevant and important factors. Most of the factors are taken from the SWOT-analysis on H&M done by MarketLine in January 2020 (MarketLine, 2020). A detailed explanation of each factor is also provided in the report. 5

The most important conclusions are that H&M Group has a strong market position mostly because of the diverse business operations and sale through multiple channels. It helps the company in meeting the requirements of various customer segments and increases the company’s direct-to-consumer business. Their main weakness is declining profitability, like this, among other things, decreases the company’s ability to provide higher returns for the shareholders. Another significant weakness is that they depend fully on outside suppliers, which can have negative consequences concerning supplier relations and production. The latter results in another important weakness, which is of low quality due to the lack of direct control over the manufacturing process. However, according to MarketLine, a good opportunity is contracting partnerships with strong businesses, because this can improve revenues. The company should also have a constant focus on expansion as an opportunity to affect the declining profitability, as well as focusing on the online retail market. The biggest threats for the company are tough competition from other big brands and online retailers and currency fluctuations. These are threats that H&M themselves acknowledge in the annual report because they affect several aspects of economic growth. Lastly, evolving fashion trends is always a significant threat because of limited shelf-life and that some collections might not be well received from the customers.

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ACCOUNTING QUALITY “There is no universal definition of good accounting quality in the literature or among practitioners” (Petersen et al., 2017). To determine whether a firm’s accounting quality is good or bad, is as stated by this statement very difficult. Nevertheless, it is so that good accounting quality is characterized by financial statements that provide an objective picture of a firm’s financial position and its free of manipulation. In order to reach a conclusion about the quality, it is important to look thoroughly through the notes and attachments in the financial reports. Therefore, it is not satisfactory to just look at the actual figures alone. There is a list of issues presented by Petersen and Plenborg, which accounting users should examine in order to assess accounting quality. These are as following: •

Motives for accounting manipulation

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The quality of applied accounting policies

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Permanent versus transitory accounting items

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The level of information in the financial statements

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Identification or red flags

H&M does not seem to have any motives for accounting manipulation. The major owners are mostly the same over an extended period of time, and it can be argued that there is little to no reason to manipulate the accounting numbers from the actual values. In H&M Group’s annual report of 2018, there is provided a total of 30 notes for the income statement and balance sheet for the company. The information represented in the notes define all the different income and expense-sources, which makes it easier to distinguish between operating and financial items. In the notes about the financial assets and liabilities, they have listed accounts payable and accounts receivables as financing, however these items are always operating. This can be seen as the only “wrong” information found in the annul report. Overall, this qualifies as a high level of information in the financial statements. Further, the company’s financial statements are consistent over time and there are no changes in accounting estimates of accounting policies from 2015-2018. When 7

all the accounting items are recurring, it makes it easier to forecast the financial statements. This is because the forecast was are based the historical numbers. When it comes to red flags in recent times, there is no finding of something that alerts that there is something that is “off”. The quality of H&M Group’s business model is at a rather high level, as the core operations are the main source of earnings through a longer period of time. In the table below, a presentation of total assessments is provided. With a summarizing table, it makes it possible to conclude whether the accounting quality is bad or good.

The table gives us a total score of 1,2, which is considered to be good accounting quality.

REFORMULATION OF THE ANNUAL REPORTS Reformulating the income statement and balance sheet involves classifying the accounting items as either “operating” or “financing”. This is done so that the financial statements reflect the contribution from operating and financing, respectively. Thus, we obtain a better knowledge of the different sources of value creation. As a result, it is then possible to calculate key figures, as well as analyze the company’s profitability, growth, and liquidity.

Analytical income statement There was not much difference between the analytical income statement and the consolidated income statement provided by H&M. A summary of the key numbers is listed in the table below. 8

Adding the tax-shield from net financing expenses (NFE) gives us an important key figure which is NOPAT. This is net operating profit after tax and indicates the profitability of the company’s core activities. The table shows that there is an evident decrease in NOPAT, similar to net income which also decreases for each year.

Analytical balance sheet In the table below, the key figures from the NOA-format are provided. When reformulating the balance sheet to the NOA-format, the net operating assets are moved to the left and the operating assets and liabilities, including the financing posts, are moved to the right. It makes it possible to calculate NOA, which is net operating assets and represent the net amount of a company has invested in its operating activities. NIBD is net interest bearing dept, i.e. financial loans minus financial assets. Of the historical figures we can see that NIBD is negative in 2015 and 2016, but positive in 2017 and 2018. Negative NIBD means that H&M has more financial assets than dept, i.e. their dept is “negative”. Equity is not as stable as it declines and increases slightly over the period of four years. However, there is an increasing in NOA with 20 % from 2015 to 2016, and 10 % from 2017 to 2018.

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PROFITABILITY ANALYSIS Acquiring a satisfactory level of profitability is important for a company’s future survival and return to shareholders. Without generating profit, companies cannot remain in business. Therefore, it is necessary to find out what it is that contributes to profitability and analyze growth in key ratios.

Return on invested capital (ROIC) “Return on invested capital (ROIC) measures the profitability of the operations. The ratio expresses the return on capital invested in a firm’s net operating assets as a percentage.” (Petersen et al., 2017b, s. 142) This ratio is therefore more reasonable for measuring the profitability, rather than ratios as EBIT or NOPAT. However, ROIC is not accurate when used alone, and can therefore be decomposed into profit margin and turnover rate of invested capital.

The table shows that there is an equal decrease in both profit margin and turnover rate, which contributes to ROIC also declining for each passing year.

Weighted average cost of capital (WACC) Weighted average cost of capital is a calculation of a firm’s cost of capital. This is the required rate of return on both lenders and shareholders. One method to evaluate if the level of ROIC is at a satisfactory level, is therefore to compare it with the level of WACC. The graph below shows that ROIC exceeds WACC every year. This means that H&M has been able to meet the required return from their shareholders. The percentages between WACC and ROIC is called super profit.

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Return on equity (ROE) Return on equity measures the profitability taking into account the effect of financial leverage. It tells us at what percentage of return on equity is at. In the graph, were WACC and ROIC is also included, the ROE decreases. This suggests that the owners’ accounting return on their investments in the company has gone down. This may indicate less efficient use of equity capital, but in this case the decrease...