Discuss about the Financial Analysis for ERM Electricity Limited.
Cash conversion cycle (CCC) is the time taken to convert the investment tied up in inventory into cash. The cash conversion cycle for both the companies is as below:
|
2015 |
2016 |
|
|
EPW |
-7.8 days |
-5.02 days |
|
MCY |
-10.2 days |
-5.43 days |
(Morningstar, ERM Power Limited)
We see that EPW has a negative cash conversion cycle for the years 2015 and 2016. This shows working capital efficiency as a negative cycle is desirable. The company has more days of payables outstanding than the combined days of inventory and receivables outstanding. This means ERM is taking more time to pay its suppliers and it is giving a credit of lesser period and also its inventory is fast converting into sales. However, the cycle has increased from 2015 to 2016. This has been majorly on accounting of an increase in the receivables as the days outstanding receivables increased from 33 days to 43 days. The receivables have increased due to an increase in loan in both Australia and US.
Mercury NZ Limited’s CCC is also negative for both the years because the day’s payables outstanding are more than the day’s inventory and receivables outstanding. However, the CCC has reduced in 2016 due to a higher increased inventory and receivables costs as compared to payables cost. There was an increase in inventory of Consumables stores to $31 million (2015:$22 million) and Meter stock to $14 million (2015: $22 million). The receivables were high due to a decrease in cash flow from sale of electricity and metering services by $20 million as compared to 2015.
Capital Structure is the mix of debt and equity in the company’s invested capital. The ratios used to measure the same are debt to equity ratio and debt ratio.
|
2015 |
2016 |
2015 |
2016 |
|
|
EPW |
MCY |
|||
|
Debt to Equity ratio |
76% |
47% |
35% |
36% |
|
Debt ratio |
65% |
62% |
46% |
46% |
(Morningstar, Mercury NZ Limited)
ERM has more of debt as compared to equity in 2015 and more equity than debt in 2016. The equity has increased in 2016 as a result of the cash flow hedge reserve recognised as part of equity. The company uses cash flow hedges to hedge price exposures in electricity industry in Australia (Limited E. P., 2016) Also there has been a reduction in debt by 8% as the company has repaid part of its long term debt. The debt ratio has remained more or less stable in both the years. A debt ratio of 65% means that the company has more liabilities than assets and hence can be considered as risky. The ratio is high as compared to industry average of 45% which means the company has more liabilities than assets.
Mercury has a lower debt ratio and equity to debt ratio. With regards to the equity to debt ratio, the company has higher equity than debt and the ratio has remained more or less the same in both the years. The debt ratio has also remained stable at 45% in both years and is as per the industry average. The company has more assets as compared to liabilities and the assets have further increased in 2016 by $27 million due to revaluation of the generation assets a capital expenditure of $72 million. This shows the company is less risky as compared to ERM.
DuPont analysis is an analysis of the profitability of a company focusing on the return available to shareholders. The ratio for both companies is as follow:
|
2015 |
2016 |
|
|
EPW |
29% |
11% |
|
MCY |
4% |
5% |
ERM has a high return on equity in both the years but the return has decreased in 2016. This is as a result of the fall in profit margins. The net income has decreased by 54% due to fall in the revenue, increased operating costs in the form of depreciation and finance costs resulting from the operations in the US. Also there was a reduction in the interest income. The total asset turnover increased marginally as the increase in revenue was higher than the increase in total assets. For every dollar invested in assets, the company is able to generate $2 revenue. The company is well leveraged with capital structure comprising more debt than equity.
Mercury has lower return on equity; however, the return has increased by 1% in 2016. This is because of an increase in the profit margin. The profit margin is higher than ERM. The company’s profits increased as a result of very high geothermal generation at 2830 Wh. And benefit of replacement of Turbine at Nga Awa Purua. Also there were high impairment costs in 2015 resulting in lower profits. The total assets turnover is below 1 for both years and the financial leverage has also remained at a constant level of 1.85 for both the years. Even though the electricity sales have increased, the assets have also increased in the same proportion.
As far as return on equity is concerned, ERM has a better profitability with higher returns for equity shareholders. The returns on equity are high for ERM because they have low equity and more debt in their balance sheet and also they are efficiently utilizing their assets in generating sales. ERM has very low profit margin as compared to Mercury and hence would require working on its profitability to further improve its profitability. The company can do so by increasing their sales and also working on reducing their operating costs. On the other hand, Mercury has an impressive profit margin but they have a very poor total assets turnover. The company has large amount of assets at its disposal but it is not using it efficiently to generate sales. Thus, Mercury should work towards better asset utilisation.
The price earnings ratio and market to book ratios are measures of the investment performance of a company. The ratios for both the companies are as below:
|
2015 |
2016 |
2015 |
2016 |
|
|
EPW |
MCY |
|||
|
Price earnings ratio |
0.06 |
0.04 |
0.27 |
0.25 |
|
Market to book ratio |
1.76 |
0.44 |
1.18 |
1.28 |
The price earnings ratio for ERM is very low in both the years because the share price is low as compared to the company’s earnings. The ratio has decreased in 2016 as a result of a decrease in the share price resulting from decreased EPS. The fall in share price is more than the fall in EPS. The market to book ratio has decreased in 2016. This is because the market value has decreased and book value has decreased. The company’s market value has decreased as the price of share has decreased. The share price has fallen due to falling earnings on account of Oakey power station and lower margins as competition increases (Newman, 2016). The company has good future prospects as the price earnings ratio is very low. A decrease in market to book value means that investors do not view the company as profitable
The price earnings ratio of Mercury has remained almost stable for the two years at 0.26 as both the EPS and the share price have increased but EPS has increased at a higher rate. The market to book ratio has increased marginally in 2016 due to an increase in the market value. The market value has increased as a result of an increase in the share price. The book value has also increased but at a lower rate. Even Mercury has a low price earnings ratio which means the future prospects are good. Also an increase in market to book value means the investors view the company with good profitability.
Based on the analysis of the capital structure ratios and the profitability ratios, it is recommended that a potential investor should invest in shares of Mercury NZ Limited and should refrain from buying or sell the shares of ERM Electricity Limited. This is because Mercury has a debt ratio of 45% which is as per industry standards and also shows the stability of the company, whereas ERM has debt ratio of more than 50% which shows high amount of leverage and this may pose threat to the stability of the company. Mercury uses its strong cash balance to fund its capital expenditures whereas ERM relies heavily on debt. Though the return on equity is higher for ERM as per DuPont analysis but that is because of the high amount of leverage. The profitability of ERM is very low at average 3% whereas the profitability of Mercury is good at approx.10%. Mercury is currently performing poorly as far as the utilisation of its assets for revenue generation is concerned, however the company is in the process of selling off non -core land to improve profitability and the capital investments being made by the company currently are to improve operational efficiency and increase the reliability of the key stations under its technological advancement program (Limited M. N., 2016)Moreover the electricity market of New Zealand is relatively healthy with increasing demands whereas the Australian electricity market has is highly competitive leading to lower margins. The future prospects of Mercury look better than ERM and hence it is recommended to invest in Mercury.
Limited, E. P. (2016). ERM Power Limited, Annual Financial Report for the Year Ended 30 June 2016. Australia: ERM Power Limited.
Limited, M. N. (2016). 2016 Annual Report, Mercury. New Zealand: Mercury NZ Limited.
Morningstar. (n.d.). ERM Power Limited. Retrieved September 28, 2017, from Morningstar DatAnalysis Premium: https://datanalysis.morningstar.com.au.ezproxy.uws.edu.au/ftl/company/profitloss?ASXCode=EPW&rt=A&sy=2007-01-01&ey=2017-12-31&xtm-licensee=datpremium
Morningstar. (n.d.). Mercury NZ Limited. Retrieved September 28, 2017, from Morningstar DatAnalysis Premium: https://datanalysis.morningstar.com.au.ezproxy.uws.edu.au/af/company/corpdetails?ASXCode=MCY-NZ&xtm-licensee=datpremium
Newman, R. (2016, June 20). CRASH! Here’s why the ERM Power Ltd share price crashed 22% today. Retrieved September 27, 2017, from The Motley Fool: https://www.fool.com.au/2016/06/20/crash-heres-why-the-erm-power-ltd-share-price-crashed-22-today/
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