Individual Assignment A - reformulation of FS PDF

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AUSTRALIAN PHARMACEUTICAL INDUSTRIES LIMITED (API) Financial Statement Analysis – Cash flow and Ratio Analysis – Individual Assignment Part A (Word Count: 2005 – Not including: Graphs, Tables, Appendices or References)

─ Devin Rod

(11995293) 1. Introduction: The goal of financial analysis is to assess the performance of a firm in the context of its stated goals and strategy. To do so, one must perform ratio and cash flow analysis, which are tools that enables one to evaluate some of the important information contained in an organisation’s financial statements by providing a benchmark upon which the firm’s performance can be compared against. However, before ratio analysis can be performed, it is necessary to first reformat the balance sheet and income statements into their financing and operating activities (See Appendices A & B).

2. Ratio Analysis: 2.1 Return on Equity (ROE): Return on Equity (ROE) Net Income Avg Share ROE = NPAT/Equity

2013 24,292 575,998 4.22%

2014 -90,771 532,212 -17.06%

2015 43,126 493,070 8.75%

2016 51,670 521,049 9.92%

The Return on Equity (ROE) ratio provides a comprehensive measure of a firm’s overall profitability, highlighting how effective the firm is at converting contributed equity into profits and is therefore a great starting point in analysing a firm’s financial performance. Though it has been stable in the past few years, 2014 saw API’s ROE plummeting from 4.22% to a low of -17.06%, largely as result of API reporting a substantial one-off write down of $111 million (API Annual Report 2014). The impairment resulted in a significant reduction to API’s net income, which consequently impacted upon its ROE. In the following years however, API’s ROE recovered, climbing to 9.92% in 2016. This is largely due to API’s growth in sales revenue derived from its Priceline Pharmacy branding, which has steadily risen over the past five years as a result of its expansion. Though API’s ROE has steadily increased, its important to note that this is

2017 52,371 545,471 9.60%

largely a product of an increase in its Net Operating Liabilities, which has increased from $646,214,000 in 2013 to $856,328,000 in 2017 in order to support API’s expansions.

2.2 Return on Net Operating Assets (RNOA): Return on Net Operating Assets (RNOA): NOPAT Average NOA RNOA = NOPAT/NOA

2013 27,723 705,522 3.93%

2014 -81,924 652,696 -12.55%

2015 49,553 608,648 8.14%

2016 59,440 604,707 9.83%

A company’s Return on Net Operating Assets (RNOA) provides a good indication as to how effectively the firm uses its operating assets in order to generate revenue. As the above ROE ratio does not account for a company’s accumulation and use of debt, it is necessary to also examine the firms RNOA ratio. With the exception of 2014, API’s RNOA in the past 5 years has followed an upward trend, increasing from 3.93% to a height of 9.83% in 2016. This is consistent with the growing sales revenue under the Priceline Pharmacy branding, which has rapidly expanded over the past decade due to the growing demands for pharmacies. The growing demand for pharmacies can be attributed to, amongst other factors, the aging demographic of Australia (Ibisworld Pharmaceutical Industry Report, 2017). Additionally, as the management at API continues to employ cost reduction strategies, its RNOA should continue to improve. However, despite increasing NOPAT, API’s NOA has steadily decreased over the past five years as a result of increasing debts, particularly in its trade payables accounts.

2017 57,191 595,639 9.60%

2.3 Profit Margin (PM): Profit Margin (PM): NOPAT Sales PM = NOPAT/Sales

2013 27,723 3,166,369 0.88%

2014 -81,924 3,345,946 -2.45%

2015 49,553 3,457,400 1.43%

2016 59,440 3,839,987 1.55%

2017 57,191 4,061,200 1.41%

A firm’s Profit Margin (PM) ratio provides a comprehensive measure of the company’s pricing strategy and operating efficiency. Given that the ratio is a product of the company’s operating income after tax and net sales, it provides a greater understanding of how much profit a firm is earning from its sales before interest and tax expenses. Despite increasing sales, API’s Profit Margin has remained relatively stable, seeing only a minimal increase over the past five years as a result of specific expenses in API’s financial statements which have hindered growth in the PM. These expenses shall be examined in detail below:

Significant Expense Accounts: Cost of Sales Warehousing and Distribution Expenses Marketing and Sales Expenses

2013 2,762,118 126,814 166,514

2014 2,914,142 129,594 168,656

2015 3,003,613 128,083 170,258

2016 3,362,053 128,416 178,168

2017 3,567,817 135,152 187,895

2.3.1 Impairment of Assets: Though it was a one-off event, API was subject to a significant asset impairment of $111 million in 2014, which as a result caused API to report a net loss of $88.1 million that year. The impairment was related to bad-debts, fluctuations in foreign exchange which impacted upon API’s New Zealand manufacturing operations as well as stunted store network growth rates that year (API Annual Report, 2014). Despite an almost $200 million increase in sales revenue, the impairment ultimately impacted upon API’s NOPAT, resulting in a PM of -2.45%. However, the following years saw API’s PM recover as it was no longer reeling from the effects of the impairment (API Annual Report, 2015).

2.3.2 Cost of Sales: Due to the increasing competition within the pharmaceutical industry, accompanied by an ageing demographic and depressed consumer spending on discretionary goods, API has had to offer increasingly competitive pricing in order to sustain its market share which has consequently seen its costs of sales increasing (API Financial Report 2017). Thus, despite an increase in sales, the PM has only seen marginal growth. This has been further exacerbated by the industry wide mandatory price reductions under the PBS reforms, which has further increased the costs of sales and hindered the industries ability to sustain rapid growth in the PM ratio (Ibisworld Pharmaceutical Industry Report 2017). However, API has continued to invest in increasing its operating efficiency through improvements to its logistics, IT and warehousing networks across the country, which should lower the cost of sales and therefore see an improved PM ratio in the future (Ibisworld API company report 2017).

2.3.3 Warehouse and Distribution: API’s warehousing and distribution expenses have consistently risen over the past five years as a result of expansions in the retail store networks. Though this assists API in achieving greater economies of scale, it has ultimately forced API to increasingly invest in its warehousing and distribution network. In 2017, API opened a new distribution centre in Western Australia, which aligns with its focus on distribution and supply chain optimisation, and should help reduce future distribution expenses (API Annual Report, 2017). However, it is important to note that the interest rates on API’s operating leases have increased over the past few years, reducing the profitability of opening new distribution centres and further contributing to the increasing warehouse and distribution expenses (API Annual Reports, 2014-2017).

2.3.4 Marketing: In order to support API’s network expansions, marketing expenses have increased by $21 million over the past five years, spiking in 2016 due to initiatives undertaken during that financial period (API Annual Reports, 20152016). Such initiatives included sponsorships of an Adelaide-based Netball team and the Melbourne Fashion Festival. TV and other media advertising campaigns have also significantly increased. These campaigns were crucial to API’s retail division, which operates in a fiercely competitive environment and must therefore commit to achieving high brand awareness and loyalty. Though these expenses ultimately impacted upon API’s NOPAT, the impact is largely mitigated by the increasing sales volume.

2.4 Asset Turnover (ATO): Asset Turnover (ATO) Sales NOA ATO = Sales/NOA

2013 3,166,369 705,522 4.49

2014 3,345,946 652,696 5.13

2015 3,457,400 608,648 5.68

2016 3,839,987 604,707 6.35

2017 4,061,200 595,639 6.82

The Asset Turnover Ration (ATO) is the measure of a company’s sales in relation to the value of its assets. Accordingly, an organisation with a high ATO is generally seen to be utilising its assets more efficiently than a similar company with a lower ATO. API’s ATO has improved over the past five years, consistently outperforming the specific industry averages. This will likely continue to be fairly strong given API’s relatively low asset pool compared to its large volume of sales, a fairly consistent feature of the retail industry. Similarly, in 2017, the average ATO for the pharmaceutical wholesaling industry was 1.8, with API reporting an ATO of 2.8 for this specific industry. In comprehensively analysing a firms ATO ratio, it is generally necessary to disaggregate the ratio into its two primary components: Working Capital Management and Long-Term Asset Management.

2.4.1 Working Capital Management: Working Capital relates to the organisations use of capital through its day to day operations and is therefore primarily concerned with the current assets and current liabilities. The past few years has seen API’s trade receivables increasing, which has coincided with a decrease in its short term borrowings. As a result, API’s working capital is much more efficient as it has decreased its reliance on debt, freeing up extra capital that would have previously been allocated to interest payments. This is further bolstered by the increasing cash and cash equivalents reported by API each year. This however has coincided with an increase in API’s current liabilities over recent years as a result of an increase in its short-term trade payables.

2.4.2 Long-Term Asset Management: Long-term assets, or non current assets, generally consists of items such as Plant, Property & Equipment (PPE) and intangible assets such as goodwill. Given its large retail and wholesale presence, API has a large portfolio of non-current assets such as PPE. However, despite its expansions over the past few years, API’s total non-current assets have been decreasing. This has coincided with a decrease in API’s non-current liabilities. Ultimately, API’s long-term asset management has only had a marginal impact upon the firm’s ATO.

2.5 Net Borrowing Costs (NBC): Net Borrowing Costs (NBC): NFEAT Average NFO NBC = NFEAT/ Average NFO

2013 3,431 129,525 2.65%

2014 8,847 120,484 7.34%

2015 6,427 115,578 5.56%

2016 7,770 83,659 9.29%

2017 4,820 50,168 9.61%

Net Borrowing Costs (NBC) refers to the average interest rates a firm is paying on its financing, or simply, it is the cost of a firm’s debt. Thus, as the NBC increases, the overall financing expenses will too. Though API’s average NFO has consistently improved over the past years, its NBC has increased, thereby increasing the overall proportion of interest paid on its financing expenses. This is largely due to the increased interest rates that API records for its operating leases, which increased by 1-2% in 2017 alone. Thus, even as API reduces its total financing expenses, an increasing proportion of such expenses are attributable to the interest, and thus represents an increase in API’s NBC.

2.6 Financial Leverage (FLEV): Financial Leverage (FLEV): Average NFO Average Equity FLEV = NFO/Equity

2013 259,049 1,151,995 22.49%

2014 240,968 1,064,424 22.64%

2015 231,156 986,139 23.44%

2016 167,317 1,042,097 16.06%

2017 100,336 1,090,941 9.20%

Financial Leverage (FLEV) refers to a company’s use of debt and other fixedincome securities in order to fund the acquisition of additional assets. Accordingly, a firm’s FLEV provides a practical measure of a firm’s capital structure and is strongly related to the ROE and NBC ratios as well as the financial risk associated with the level of debt. Coinciding with a decrease in its NFO as API improves its debt management, the past five years has seen API’s FLEV dropping significantly. This has resulted in a substantial decrease in the firm’s interest expenses over the five-year period, with API reporting a rather significant decrease in interest-bearing debts, which changed from $24,978,000 in 2013 to $2,765,000 in 2017 (Ibisworld API Company Report, 2018). This represents a fairly large decrease in the risk associated with API’s FLEV.

3. Cash Flow Analysis: Liquidity Ratios: Current Ratio: Quick Ratio: Cash Ratio:

2013 1.39 0.88 0.03

2014 1.36 0.86 0.03

2015 1.28 0.81 0.04

2016 1.34 0.85 0.03

3.1 Liquidity - Current Ratio: The Current Ratio is one of the primary measures of liquidity, providing insight into an organization’s ability to meet its short-term liabilities with its current assets. As such, the current ratio is a great indicator of the short-term sustainability of a firm’s operations. API’s current ratio has remained fairly stable over the past years, seeing only a slight decline as a result of an increase in current operating liabilities. Critically, API’s current ratio has consistently remained over 1.0, thereby indicating that it has fairly robust cash flow management systems in place and is sufficiently liquid to meet any short-term debt as it falls due.

3.2 Liquidity - Quick Ratio: The Quick Ratio provides a more conservative measure of short term liquidity compared to the current ratio as its calculation only includes assets that can be rapidly converted into cash if debt was to suddenly fall due. Consequently, inventories are not included in the calculations as it generally will not be able to be quickly converted or sold at its fair value. As can be seen in the table above, API’s quick ratio has been fairly stable. Though it consistently has remained under 1, is largely due to the fact that API’s retail and wholesale operations are entirely dependent upon inventories.

2017 1.32 0.85 0.05

Solvency Ratios: Long Term Liabilities to Equity Ratio: Debt to Equity Ratio: Debt to Capital Ratio

2013 0.22 1.36 0.58

2014 0.25 1.68 0.63

2015 0.12 1.66 0.62

2016 0.12 1.70 0.63

3.3 Solvency – Debt-to-Equity Ratio: The Debt-to-Equity Ratio (DBE) provides a strong measure of a company’s solvency by highlighting how much of a companies financing activities is reliant upon funding through outside debt as opposed to contributed equity. Though API’s DBE ratio has increased in recent years, it consistently remained under 2 indicating that API is generating sufficient cash to meet long-term liabilities. This increase in API’s ratio is largely a result of its recent expansions, which was partially funded by external debt. This further suggests that API is taking advantage of financial leverage in order to increase revenue.

2017 0.08 1.62 0.62

4. Reference List Richardson, A. 2018, Pharmacies in Australia, Industry Report, March 2018, G4271a, viewed September 2018, . Richardson, A. 2018, Pharmaceuticals Wholesaling in Australia, Industry Report, September 2018, F3721, viewed September 2018, . Australian Government Department of Health, Impact of PBS Reform Report, viewed 4 September 2018, Australian Pharmaceuticals Industries Limited 2017, API 2017 Annual Report, viewed 1 September 2018,

Australian Pharmaceuticals Industries Limited 2015, API 2015 Annual Report, viewed 1 September 2018,

Australian Pharmaceuticals Industries Limited 2014, API 2014 Annual Report, viewed 1 September 2018, < http://www.api.net.au/wp-content/uploads/2015/10/2014-Annual-report.pdf> Australian Pharmaceuticals Industries Limited 2013, API 2013 Annual Report, viewed 1 September 2018, < http://www.api.net.au/wp-content/uploads/2015/10/2013-Annual-report.pdf> IBISWorld 2016, IBISWorld Company Premium Report: Australian Pharmaceutical Industries limited’’, IBISWorld, viewed 1 September 2018

Appendix A – API Reformatted Balance Sheet: Net Operating Assets (NOA): Operating Assets: Current Operating Assets: Cash and Cash Equivalents Trade and Other Receivables Inventories Income Tax Receivable Assets Held For Sale Total Current Operating Assets: Non-Current Operating Assets: Trade and Other Receivables Deferred Tax Assets Property, Plant & Equipment Intangible Assets Total Non-Current Operating Assets: Total Operating Assets: Operating Liabilities Current Operating Liabilities: Trade and Other Payables Employee Benefits Provisions Income Tax Payable Total Current Operating Liabilities:

2013 $'M

2014 $'M

2015 $'M

2016 $'M

2017 $'M

22,576 560,451 335,938 918,965

23,526 565,808 342,482 931,816

28,047 592,330 364,206 2,426 6,798 993,807

25,489 689,695 413,782 1,128,966

39,776 681,620 399,344 1,120,740

60,921 39,552 121,901 206,290 428,664

32,035 33,934 116,820 167,232 350,021

30,380 22,722 101,946 193,693 348,741

10,882 19,223 100,129 189,975 320,209

21,187 20,210 95,280 193,659 330,336

1,347,629

1,281,837

1,342,548

1,449,175

1,451,076

607,366 15,637 4,870 8,235 636,108

614,614 19,485 31,261 502 665,862

665,933 23,288 30,245 719,466

799,237 22,402 7,656 13,359 842,654

804,473 18,989 7,907 16,899 848,268

Non-Current Operating Liabilities Trade and Other Payables Deferred Tax Liability Employee Benefits Provisions Total Non-Current Operating Liabilities: Total Operating Liabilities:

5,172 4,934 10,106

5,629 5,936 11,565

5,215 4,982 10,197

5,339 4,653 9,992

364 3,834 3,862 8,060

646,214

677,427

729,663

852,646

856,328

Net Operating Assets (NOA):

701,415

604,410

612,885

596,529

594,748

Net Financial Obligations (NFO): Financial Assets: Current Financing Assets: Total Current Financing Assets:

2013 $'M

2014 $'M

2015 $'M

2016 $'M

2017 $'M

-

-

-

-

-

28,325 28,325 28,325

7,229 7,229 7,229

-

-

-

24,978 24,978

20,966 20,966

58,254 58,254

2,978 2,978

2,765 2,765

5,695 114,947 120,642

8,108 101,828 109,936

8,616 40,613 49,229

8,436 48,420 56,856

7,903 29,834 37,737

145,620

130,902

107,483

59,834

40,502

-117,295 $'M

-123,673 $'M

-107,483 $'M

-59,834 $'M

-40,502 $'M

566,461 30,728 -13,069

566,461 18,940 -104,664

566,461 43,605 -104,664

566,461 74,898 -104,664

566,461 92,449 -104,664

Total Owner's Equity:

584,120

480,737

505,402

536,695

554,246

NOA - NFO

584,120

480,737

505,402

536,695

554,246

Non-Current Financing Assets: investments Total Non-Current Financing Assets: Total Finan...