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Fundamentals - Financial Analysis



With all the volatility in the market coming from various sources such as the corona-virus (as mentioned in my previous post), government injections of funds, oil price war, global supply/travel disruptions, etc... all these noises in the market results in fear in the market and also undervaluing/overvaluing of stock value.


The current market scenario reminds me of a favorite quote from Warren Buffet:

In other words, in this once a decade market recession lies once a decade of investment opportunities. However, this also means that we have to be more selective in choosing our investment opportunities and re-balancing of the portfolio towards sustainability and survivability of a company - the company will be able to adapt and survive through this recession which will cause severe disruptions to their revenue.


The main topic of this post will be to show you how to conduct financial analysis which is part of the fundamental analysis to determine whether a company has sustainability and survivability to adapt through this recession by analyzing financial reports such as annual reports, financial statements, quarterly reports, etc.


For starters, we should know that a financial statement can tell us the financial performance, financial position and cash flow of a company - the data on the report generally shows a true representation of the company as they are audited by auditors.


The financial analysis consists of a few lists of items to analyze and there are two kinds of analysis namely cross-sectional (comparing performance with its competitors in the same industry) and time series (comparing performance for a period of 10 years) analysis. Normally, I will perform a times series followed by a cross-sectional analysis for financial analysis of a company. The list of items include:


1) Profitability

2) Liquidity

3) Leverage

4) Efficiency

5) Coverage

6) Cash flow


To demonstrate how I perform financial analysis, I will be using Exxon Mobil Corporation (NYSE: XOM) which I recently added into my portfolio this month and Chevron Corporation (NYSE: CVX) as its competitor.


I will be calling Exxon Mobil Corporation as its ticker name XOM and Chevron Corporation as its ticker name CVX from this point onward. Here goes ...


To perform the financial analysis for XOM, I will try to answer two key questions:

1) Can XOM survive through this recession?

2) Is XOM sustainable as a company ten years down the road as compared to its peers?


1) Getting the financial data for XOM and its competitor CVX

- You can get it from the company website under investors (annual report)

https://corporate.exxonmobil.com/Investors/Annual-Report

Pros: More accurate

Cons: More tedious


- Another way is to obtain it through a reliable third-party website (We will be using this)

http://financials.morningstar.com/ratios/r.html?t=XOM&region=usa&culture=en-US

https://financials.morningstar.com/ratios/r.html?t=cvx

Pros: Simple and fast

Cons: Need to double-check the figures with the annual report


2) Computing and analyzing the financial ratios for XOM and CVX (time series and cross-sectional)

As previously mentioned, there are 6 key items to analyze and there are various ratios for each of the items. Therefore, I will only be focusing on a few key ratios that are important to me under each of the items.


1) Profitability (Whether the company is making a profit)

- Gross profit margin

- Net profit margin

- Return on equity

- Return on asset


2) Liquidity (Whether the company is able to pay off its debts)

- Current ratio

- Quick ratio


3) Leverage (Whether the company uses debt to finance its operations)

- Debt ratio


4) Efficiency (Whether the company is efficient in using its assets to generate revenue)

- Asset turnover


5) Coverage (Whether the company is able to meet its interest payments)

- Interest coverage


6) Cash flow (What the company is spending its cash on? Whether the company has free cash flow as a buffer in case of a market downturn/unexpected disruption in its business?

- Operation/Investment/Finance cash inflow/outflow

- Free cash flow


To be able to get all these ratios, you need to know the formula to each of the ratios, however, the good news is that most of the ratios are publicly available on external financial services websites but you need to understand what each of the ratios means to be useful in your analysis. As shown below are the ratios for XOM which are obtained from morningstar.


http://financials.morningstar.com/ratios/r.html?t=XOM&region=usa&culture=en-US)


To break the tabs down:


1) Profitability (Can be found in "Profitability" tab)

2) Liquidity (Can be found in "Financial Health" tab)

3) Leverage (Can be found in "Financial Health" tab)

4) Efficiency (Can be found in "Efficiency Ratios" tab)

5) Coverage (Can be found in "Profitability" tab)


6) For Cash flow, I prefer to see its detailed breakdown of cash flow activities in the cash flow statements as shown below:



In order to perform a time series analysis, we will obtain the ratios (for each of the 6 items) for a period of 3 years for XOM. In this case, it will be for the financial year 2019, 2018 and 2017. On the other hand, to perform a cross-sectional analysis, we will obtain the ratios for CVX for the financial year 2019 as a comparison purpose. I will usually export the data out into excel so that it will be easier for me to perform data manipulation.


XOM:

CVX:



1) Profitability (Whether the company is making a profit)

- Gross profit margin

Based on the gross margin, we can see that XOM profit declined from FY2018 to FY2019 due to the increase in the cost of production.


- Net profit margin

The net profit margin is at a declining trend from FY2017 to FY2019, this shows that the XOM is slowly losing its profitability as a result of increased costs and slow growth in revenue.


- Return on equity and Return on asset

Similarly with the two ratios above, return on equity and return on asset are at a declining trend from FY2017 to FY2019, this shows that the XOM is slowly losing its profitability as a result of increased costs and slow growth in revenue.


2) Coverage (Whether the company is able to meet its interest payments)

- Interest coverage

Despite the decline in interest coverage, it is still at a high number which shows that the company is able to pay off its interest expenses.


Overall, XOM is slowly losing its profitability over the years, which puts the sustainability of the company in the longer term at a risk. However, when we compared it with its competitors CVX, we can see that its profitability is still above average with net profit margin, return on equity and return on asset almost double its competitor. On top of that, its interest coverage is also at a higher level as compared to CVX, which shows that the company will have stronger sustainability and survivability as compared to its competitor in the same industry.



XOM:

CVX:



3) Liquidity (Whether the company is able to pay off its debts)

- Current ratio

- Quick ratio


For both ratios, it declined from 2018 to 2019 and it is below 1, which shows that the company has a lesser current asset as opposed to its current liabilities. This can put the company at risk of not being able to pay off its short term obligations which increase its liquidity risk.


4) Leverage (Whether the company uses debt to finance its operations)

- Debt ratio


At the same time, we can see that the debt ratio increased from 2018 to 2019, which indicates that the company is using more debts in its operations. This further increased the risk of not being able to pay off its obligations when they are due.


5) Efficiency (Whether the company is efficient in using its assets to generate revenue)

- Asset turnover


The ratio declined from 2018 to 2019 and it is also below 1, which shows inefficiency in using assets to generate revenue.


Overall, when compared to CVX, we can see that XOM has a weaker liquidity position (higher liquidity risk), stronger efficiency in using its assets to generate revenue and lesser reliance on leverage. Hence, one thing to note is that the survivability of XOM is reduced due to a higher liquidity risk which is crucial during a market downturn when an operation can be disrupted.


XOM:

CVX:


6) Cashflow (What the company is spending its cash on? Whether the company has free cash flow as a buffer in case of a market downturn/unexpected disruption in its business?


- Operation/Investment/Finance cash inflow/outflow

I can see that XOM is going through an aggressive expansion on its operations and it is relying more on debt for this purpose. (double confirmed through its news report) This can be seen from the increase in net cash used for investing activities which indicates expansion and decrease in net cash used for financing activities on top of the increase in debt ratio (increased leverage) which indicates more reliance on debts due to a reduction of net income over the years. (Note that net income is internal funding and debts are external funding which is generally more expensive)


- Free cash flow

There is a major decline in free cash flow in 2019 and a lesser free cash flow as compared to CVX. This means the company is having lesser buffet/cushion for the recession which puts it at a higher risk of default.


To sum it up, XOM is prioritizing its aggressive expansion and relying more on debt due to a declining flow of internal funding (lower profitability over the years) over its survivability (higher liquidity risk and leverage risk over the years) during this recession (which could be due to the company confidence in surviving this market downturn, after all, it has already survived through many past financial crises but this will be part of another analysis) as seen from our financial analysis.


Lastly, to answer the two key questions above solely based on the financial analysis alone:


1) Can XOM survive through this recession?

If the recession hits really hard, XOM survivability is questionable due to a higher default risk over the years and the fact that it is relying more on debt to fund its expansions. On a side note, its ability for interest payments is still quite strong.


2) Is XOM sustainable as a company ten years down the road as compared to its peers?

As compared to its peers, XOM is aggressively expanding and in terms of profitability and efficiency use of asset to generate revenues, it is performing better than its peers. Hence, XOM is more well-positioned in sustainability as compared to its peers in the same industry.


To conclude, I feel that just solely on financial analysis, XOM is slightly risky in terms of survivability especially when its revenue will be further affected by the oil price and the fact that it is relying more on debts to fund its aggressive expansions with a lesser buffer of free cash flow in case of emergency uses. Nevertheless, I added XOM into my portfolio due to its strong experience in managing its operations during recession periods as the company has gone through numerous market downturns and managed to bounce back each time. In addition, It also has stronger sustainability as compared to its competitor in the same industry as previously mentioned. Therefore, it is important to consider a wide range of factors (not only based on financial analysis), for stock selection purposes.




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