stoichitoiu gabriela adela, graduation paper
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ACADEMY OF ECONOMIC STUDIES
FACULTY OF BUSINESS ADMINISTRATION
(ENGLISH TEACHING)
GRADUATION THESIS
COMPANY’S PERFORMANCE ANALYSIS
CASE STUDY: NATIONAL SOCIETY OF LIGNITE OLTENIA
ROMANIA
Scientific Coordinator: Graduate:
Prof.Univ.Dr. ANA-MARIA CIOBANU GABRIELA STOICHITOU
BUCHAREST
July, 2010
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Table of contents
Introduction
Chapter no.1: Conceptual Component
1.1 Financial Statement Analysis
1.2 Ratio Analysis
1.3 Ratio Classification
1.3.1 Liquidity Ratios
1.3.2 Efficiency Ratios
1.3.3 Financial Leverage Ratios
1.3.4 Profitability Ratios
1.3.5 DuPont Analysis
1.4 Limitations on using Financial Ratios
Chapter no.2: Research Methodology
2.1 Research Approach
2.2 Research Method
2.4 Data Collection
Chapter no.3: Empirical Study
3.1 Company’s presentation
3.2 Empirical Results3.2.1 Liquidity Ratios
3.2.2 Efficiency Ratios
3.2.3 Leverage Ratios
3.2.4 Profitability Ratios
3.2.5 DuPont Analysis
Conclusions and Recommendations
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Introduction
Fundamental analysis or intrinsic value analysis uses financial and other economic
information to determine the firm’s value. The basic fundamentals used by specialists, are based on information which is available to everyone interested and which refers to
financial concepts like accounting earnings, dividends, growth factors or leverage ratios,
to derive the intrinsic value and compare it to the firm’s stock price (Lee, 1987).
This paper explains financial ratios are valuable ways to interpret the numbers found in
financial statements and that these ratios can provide a wealth of information to both
internal and external users. Ratio analysis is undertaken in the mining industry by
comparing the key financial ratios among three mining companies for a certain periods.
The paper aims to determine some financial strengths and weaknesses of the firm and to
suggest some changes to NSLO's future plans to improve the firm's financial
performance. The paper concludes that the financial ratio analysis shows that NSLO has
bad results in many areas and is experiencing financial difficulties.
For the comparable purpose, along with NSLO, were analyzed two other companies, one
of the largest U.S coal producer, Arch Coal Inc. and the UK Coal, Britain’s biggest coal producer. The research is limited to the entities presented in Balance Sheets and Income
Statements from 2007-2009 by NSLO, Arch Coal Inc. and UK Coal.
The reason I chose this topic for my thesis is that the financial analysis is essential in
determining a company’s strengths and weaknesses. Nowadays evaluating the financial
health of a company stands as a difficult and complex task which implies a professional
approach. It has to be reliable and objective and it should necessarily lead to appropriate
and efficient conclusions.
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Chapter no. 1 Conceptual Component
This basic purpose of this chapter is to explain the theoretical framework which is used as
a tool to analyze the research (Analysis of financial statements, ratio analysis) for empirical finding. Prospective users of financial statements have little knowledge about
it; therefore conceptual component helps the readers to understand the purpose of
financial statement analysis
1.1 Financial Statement Analysis
Financial statements provide primary information of economic consequences of thefirm’s business activities. (Palepu, 2000) From economic factors transformed into
accounting numbers, financial statements report data of assets, liabilities, income and
cash flow that are useful to all users. (White, 1998) Despite the fact financial statements’
users are mostly investors that a firm seeks for its capital; the financial statements are
also used for other purposes from analysts inside to outside the firm including
governments that use the financial statements in social and economic policy-making.
(Penman, 2007)
One of the purposes of the analysis of financial statements is to aid the main investors
have a clear imagine of the firm’s activity and make better economic decisions. (White,
1998). Penman (2007) defines financial statement analysis as: ‘Financial statement
analysis is the method by which users extract information to answer their questions about
the firm.”
The four steps that compose fundamental analysis framework refer to: business strategyanalysis, accounting analysis, financial analysis and prospective analysis. (Palepu, 2000)
The main element of fundamental analysis is about creating and developing prediction of
future earnings, as they are one of the most important elements to a firm’s value.
(Penman, 2007)
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Bankers, investors, bondholders, and stockholders or the firm’s managers should possess
knowledge regarding financial statements analysis. A company’s strengths and
weaknesses imply having an objective financial assessment which leads to efficient
investment strategies. (Melicher, 2007)
The role of financial analysis
Financial analysis helps various parties, interested in a company’s activities, to obtain
financial information required to them. The main purpose of financial analysis is to
estimate current financial conditions and define actions necessary to conduct work on
improvement or preserving of these conditions. Financial analysis also summarizes a
firm’s business activities in the past, at present and in the near future. Its main function isto identify financial performance of a company, reveal weaknesses, potential sources of
problem occurrence in its further plans and to find out strengths on which the firm can
rely. Financial performance of a company, being one of the major business
characteristics, defines competitiveness, potential of the business, economic interests of
the company's management and reliability of present or future contractors. Therefore, the
secondary goal of analysis is to reveal financial condition of the company to external
users.
Main types of financial analysis
Financial analysis is about the selection, evaluation, and interpretation of financial data,
with the purpose of assisting in investment and financial decision-making. Internally,
financial analysis is used to assess issues such as employee performance, the efficiency of
operations, and credit policies. Externally, it implies evaluating the potential investments
and the credit-worthiness of borrowers, among other things. (Peterson, 2007)
In „ Finance d’entreprise analyse et gestion”, P. Vernimmen says:" The financial analysis
is more a tool than a theory, a method. Whether performed by internal departments or
external ones, its main objective is conducting a global assessment over the actual and
future situation of the enterprise.”
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Irrespective of type of the analysis, its methods are very similar. They are determination
and interpretation of various financial ratios, studying of changes over time and structural
changes of articles. Correct application of financial analysis allows answering many
questions concerning “financial health” of a business. (Zemitan, 2005)
Objectives of financial analysis
Financial analysis has its specific set of tools along with particular way of their
application that defines methodology of the analysis. Main objectives of financial
analysis specify spheres of finances where its methods suit best.
The main objectives of financial analysis are:
• Making “snapshot” of financial efficiency of a company at a moment of research;
• Revealing tendencies and patterns in a company’s development for a period;• Defining weaknesses that negatively influence financial performance
• Revealing reserves which a company can use for improvement of its financial
situation;
• Make conclusions and suggestions for improving difficult financial situation.
J. Pilverdier-Latreyte believes that "financial analysis aims to establish a diagnosis on the
finances of the company using information contained in the summary calculations
accounting: balance sheet, income statement and annual report.”
There are various techniques that are used in analyzing financial statements, such as
comparative statements, schedule of changes in working capital, common size
percentages, funds analysis, trend analysis, and ratios analysis. Most of these methods
utilize financial statements available for public use as a data source.
To successfully fulfill the objectives of the financial analysis and therefore to reach main
goals of the thesis, a specific method should be used, and this is ratios analysis.
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1.2 Ratio analysis
Ratio analysis studies levels and changes of relative measurements of financial
performance. This method is the most commonly used in the world practices of financial
analysis because of its relative simplicity and availability of data sources. Ratio analysis
is a financial technique that involves dividing various financial statement numbers into
one another. (Melicher, 2007) It expresses a mathematical relation between two
quantities i.e. a ratio of 200 to 100 is expressed as 2:1, or simply 2. Even though the
calculation of a ratio is simple arithmetic operation its analysis is far more complex. A
ratio must refer to an economically important relation to be meaningful. Clues and
symptoms of underlying condition are provided by ratios. It identifies areas requiring
further investigation. It reveals important relations and bases of comparison in
uncovering conditions and trends difficult to detect by inspecting individual components
comprising the ratio. The interpretation of the right factors, which might influence future
ratios, proves the usefulness of ratio analysis.
A financial ratio is meaningful only when it is compared with some standard, a norm,
such as an industry trend, ratio trend, or a planned management objective. This is called
benchmarking and it can be used as a measure. According to David Vance, benchmarking
“involves analyzing the financial statements of the best companies in an industry andusing their financial ratios as a basis for evaluation of a company’s performance”.
(Vance, 2003)
In order to see the profitability and growth of a firm through a certain period of time there
are used three basic categories of ratio analysis:
Trend or time-series analysis- uses ratios to evaluate a firm’s performance over
time;
Cross-section analysis- uses ratios to compare different companies at the same
point in time; it usually concerns two or more companies in similar lines of
business.
Industry-comparative analysis- is used to compare a firm’s ratios against average
ratios for other companies in the same industry. (Melicher, 2007)
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Certainly, the most informative approach to ratio analysis combines both cross-sectional
and trend analyses.
The ratio analysis method is based on a correct interpretation of calculated values.
However, it has some limitations. Because there are so many tools for doing performance
assessment, we must remember that different techniques address measurement in very
specific and often narrowly ways. One can be tempted to “run all the numbers,”
particularly given the speed and ease of computer spreadsheets. Yet normally, only a few
selected relationships will yield information the analyst really needs for useful insights
and decision support. By definition, a ratio can relate any magnitude to any other—the
choices are limited only by the imagination. To be useful, both the meaning and the
limitations of the ratio chosen have to be understood. The problem is to choose a proper ratio that suits best to a goal of analysis. The proper application of a ratio depends on
correct economical and financial meaning of that ratio. To be useful, both the meaning
and limitations of a chosen ratio have to be understood.(Helfert, 2001)
Meaningful ratio analysis must conform to the following elements:
1) the viewpoint of the analysis taken;
2) the objectives of the analysis;
3) the potential standards of comparison.
Any particular ratio or measure is useful only in relation to the viewpoint taken and the
specific objectives of the analysis. When there is such a match, the measure can become a
standard for comparison. (Helfert, 2001)
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1.3.1 Liquidity ratios
The liquidity of a firm is measured by its ability to satisfy its short-term obligations as
they mature or come due. (Gitman, 2004)
This form of liquidity analysis focuses on the relationship between current assets and
current liabilities, and the speed with which receivables and inventory turn into cash
during normal business operations. (Melicher, 2007) Such liquid assets are necessary to
cover any “financial emergencies” and play as a buffer in company’s operations.
Liquidity is important for the firm to avoid defaulting on its financial obligations and,
thus, to avoid experiencing financial distress.
Current ratio
An important ratio whose aim is to evaluate the debt exposure from the balance sheet is
the current ratio. The bond between current assets and current liabilities is a safety
element pointed towards the debts holders, in the unfortunate event of a default.(Helfert,
2001). The current ratio is calculated by dividing current assets by current liabilities.
Formula: Current Ratio = Current Assets / Current Liabilities
A relatively high current ratio indicates that the firm is liquid enough so it can pay its
current obligations in time and when they become due. On the other hand, a relatively
low current ratio means the firm has not a very good liquidity position and the firm shall
not be able to pay its current liabilities in time without facing difficulties. The increase of
the current ratio is responsible for the improvement of the liquidity level of the company.
The decrease of this ratio stands as an indicator of inappropriate liquidity level.
A disadvantage of the current ratio is that it can not be said how liquid the inventories
and accounts receivables are, thus, even if the current ratio has a high value, it does not
mean the company has a high level of liquidity. This ratio is mainly used by the lenders
in order to see if the company is eligible for a loan.
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Acid test ratio (Quick ratio)
The acid test ratio, also denominated quick ratio, is a more convincing element,
calculated on the base of only a part of the current assets-cash, marketable securities, and
accounts receivable, afterwards in connection with the current liabilities. (Helfert, 2001):
Formula:
Acid Test = Cash + Marketable Securities + Receivables / Current Liabilities
Quick assets are those current assets that are quickly convertible into cash. Inventories
are the least liquid current assets. Many financial analysts believe it is important to
determine a firm’s ability to pay off current liabilities without relying on the sale of inventories. (Ross, 2005) A high liquid ratio indicates that the firm is liquid and has the
ability to meet its current or liquid liabilities in time and on the other hand a low liquidity
ratio represents that the liquidity position of the firm is not good. The general convention
considers the 1:1 ratio as appropriate.
However, this 1:1 ratio cannot be imperatively the main reason of a satisfying liquidity
level of the company, unless the debtors are met, therefore cash is necessary to cover the
current obligations. On the other hand, the low level of liquidity ratio doesn’t lead to an
inappropriate liquidity position, the inventories not being entirely non-liquid, this being
considered as a drawback of the ratio. Therefore, a company with a high liquidity ratio
may not reach an appropriate liquidity position if their debts are not being paid in time. In
contrary, a firm with a low liquidity ratio can reach a satisfying liquidity position if the
inventories are rapidly converted to sales. This ratio is also used by lenders in measuring
the liquidity of a firm to see weather it’s able or not to pay the debts.
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1.3.2 Efficiency ratios
These ratios express the proportion in which the assets influence the sales. This kind of
ratios is also known as activity or utilization ratios, each of them relating the financialterms from the income statement with those from the balance sheet. (Melicher, 2007)
The purpose of efficiency ratios is to determine the effectiveness and efficiency of the
controlling process of the assets which have to lead to sales and profit. In addition, they
express the efficiency of the receivable collection process. The company’s health and
efficiency are directly determined by high values of these ratios.
These ratios are used by the company’s manager in order to measure the efficiency of the
firm in using the assets in order to generate sales, the speed with which they collect their
receivables and to see if the inventories have a good management.
Total Asset Turnover Ratio
This ratio indicates how efficiently the firm is utilizing its assets to produce revenues or
sales. It is a measure of the dollars of sales generated by $1 of the firm’s assets. The totalasset turnover ratio is determined by dividing total operating revenues for the accounting
period by total assets.
Formula: Asset Turnover = Sales / Total Assets
This ratio is intended to indicate how effectively a firm is using all of its assets. If the
asset turnover ratio is high, the firm is presumably using its assets effectively in
generating sales. If the ratio is low, the firm is not using its assets to their capacity and
must either increase sales or dispose of some of the assets. One problem in interpreting
this ratio is that it is maximized by using older assets because their accounting value is
lower than newer assets. (Ross, 2005)
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It also indicates pricing strategy: companies with low profit margins tend to have high
asset turnover, while those with high profit margins have low asset turnover . The size of
the ratio is significantly influenced by characteristics of the industry within which the
firm operates. (Melicher, 2007)
A disadvantage of this ratio would be the fact that the investments made in the
company’s assets will increase total assets which will lead to a low ratio, but this does not
represent an inefficient management of the assets.
Average Collection Period
The average collection period measures the speed with which customers pay their bills. It
expresses accounts receivable in terms of daily sales. (Brealey, 2001)
Formula:
Average Collection Period = Average Accounts Receivables/Average sales per day
In order to interpret the average collection period, it is needed comparative data. If the
average collection period is compared to past years and it has an increasing trend that
means the accounts receivables aren't as liquid or aren't being converted to cash as
quickly as possible. If the average collection period is decreasing, the opposite is true. In
addition, the value of this ratio tells if the company has a flexible credit policy and
therefore a higher level of receivables. The optimal period of time is 30 days from the
moment of acquisition. (Ross, 2005)
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Inventory Turnover
The inventory turnover expresses how many times per year the inventories have been
transformed into sales as well as the efficiency of the management of inventories. The
ratio of inventory turnover is calculated by dividing the cost of goods sold by inventory
Formula: Inventory Turnover = Cost of Goods Sold / Inventory
An important objective is to transform the inventories into sales as rapidly as possible.
Efficient firms achieve this task, saving capital otherwise needed to store raw materials or
finished goods. In order to have an efficient inventory management, it is important to
reach an appropriate amount of inventories needed to avoid lack of products, but in the
same time not dealing with huge amounts of them, which would imply extra financing. This kind of ratio also expresses the level of profitability of a company. Thus, high value
of ratio leads to higher profit, while low ratio determines low profit. A drawback would
be the fact that not always the high ratio necessarily leads to high profits, the cause being
low investment rate in inventories.
1.3.3 Financial leverage ratios
When a company borrows money, it agrees to make a series of fixed payments in the
future. Because their shareholders get only what is left after the debt holders have been
paid, the debt is said to create financial leverage. In extreme cases, if crisis times come, a
company may be unable to pay its debts. (Brealey, 2001) Financial leverage enables a
company to have an asset base larger than its equity. A company can finance its assets
with equity or with debt. Usual practice is expanding the equity through borrowings andthe creation of other liabilities like accounts payable, accrued liabilities, and deferred
taxes. Financial leverage increases the company’s ROE as long as the cost of the
liabilities is less than the return from investing these funds. “While a company’s
shareholders can potentially benefit from financial leverage, it can also increase their
risk”. (Palepu, 2000)
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Contrasting with equity, liabilities have predefined payment terms, and the company may
face risk of financial distress if it fails to meet these obligations. There are some ratios to
evaluate the degree of risk coming from a financial leverage. (Palepu, 2000)
There are two types of financial leverage ratios:
• Component percentages
• Coverage ratios.
Component percentages compare the debt of a company with its total capital (liabilities
plus equity) or with its equity capital. Coverage ratios have the ability to satisfy fixed
financial obligations, such as interest, principal repayment, or lease payments. (Fabozzi,
2003)
Financial leverage ratios are used by lenders which fund the needs of a business and theyhave to look for a margin of safety in the assets held by the company. These ratios test
the relative debt exposure in order to weight the position of lenders versus owners.
Total Debt to Assets Ratio
It expresses how much the level of total debts of a company was used to finance its total
assets. It also gives information regarding solvency and ability to meet new financing
opportunities. This ratio determines the proportion of “other people’s money” in
connection with the assets of the company. (Helfert, 2001) The debt ratio is calculated by
dividing total debt by total assets.
Formula: Debt Ratio = Total Liabilities / Total Assets
The higher the ratio, the greater the risk for the lender. This is not necessarily a true test
of the ability of the business to cover its debts, however. The asset amounts recorded on
the balance sheet are generally not indicative of current economic values, or even
liquidation values. Nor does the ratio give any clues as to likely earnings and cash flow
fluctuations that might affect current interest and principal payments. (Helfert, 2001)
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Debt to Equity Ratio
Debt to equity ratio is a measure of a company's financial leverage which is computed by
dividing its total liabilities by stockholders' equity and indicates what proportion of
equity and debt the company is using to finance its assets.
Formula: Debt to Equity Ratio = Total Liabilities / Shareholder’s Equity
If reaching a high level, the debt/equity ratio specifies the aggressiveness of a company
with regard to the financing process of the growth by its debts. This leads to fluctuating
revenues caused by the increased interest expenses.
A great level of debts may lead to increased earnings but also their cost may outrun the
return a company performs. A main result would be the bankruptcy of the company.
Equity Multiplier Ratio
The equity multiplier indicates the amount of total assets per dollar of shareholders’
equity. The Equity Multiplier is calculated by dividing the total assets by shareholder’s
equity.
Formula: Equity Multiplier = Total Assets / Shareholder’s Equity
Even though this ratio determines the simple result of the total assets divide by owner’s
equity, it has a great importance in order to see what percentage of the owner’s equity is
used to acquire assets. The accounting identity must be met: Assets = Liabilities - Equity.
(Melicher, 2007)
High value of the equity multiplier means higher financial leverage. This result indicates
that the firm relies more on debts than on owner’s equity in financing its total assets, thus
increasing the risk of insolvency.
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Interest Coverage Ratio
This ratio is calculated by dividing the firm’s operating income or earnings before
interest and taxes by the annual interest expense. The ratio is developed with the
expectation that annual operating earnings can be considered the basic source of funds for
debt service, and that any significant change in this relationship might signal difficulties.
(Helfert, 2001)
Formula: Interest Coverage = Earnings before interest & taxes / interest expense
The interest coverage ratio indicates how many times interest is covered by the profits
available to pay interest charges. A high interest coverage ratio means that the firm is
able to cover its interest expenses from the earnings before interest and taxes and alsoassures the lenders a regular interest income. A low ratio can cause some problems to the
financial manager in raising funds from debt sources.
1.3.4 Profitability ratios
Generally, profits are the difference between revenues and costs. Profitability is thought
to be the most difficult quality of a firm to conceptualize and to measure. (Ross,
Westerfield, Jaffe, 2005)
The purpose of profitability ratios is to evaluate the ability of the company to make profit
and cover its expenses in a specific period of time. In addition these ratios determine also
the efficiency of transactions, pricing strategies and asset or shareholders profitability.
(Van Horne, 2005)
Assessing the efficiency and the profitability of the operations is a main concern for the
managers of a company, thus the three profit margins as well as return on assets are
computed and analyzed from their point of view.
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Gross profit margin
This ratio measures the percentage of sales money remaining after the company has paid
for the goods it has sold. Gross profit ratio is calculated by dividing the gross profit by
sales.
Formula: Gross Profit Ratio = Gross Profit / Sales
This ratio refers to the efficiency of a firm, regarding the production process. A high ratio
of gross profit implies a healthy company. All operating expenses should be covered by
the gross profit generated by the company and still having a positive value. It should
reach a stable level, assuming that the industry isn’t facing rough changes.
Operating profit margin
This margin expresses the percentage of monetary units generated by sales after dealing
with all the costs. (Gitman, 2004)
Formula: Operating Profit Margin = Operating profit/ Sales
Operating ratio refers to the operational efficiency of the company but on the other hand
it should be used rationally for it may be easily influenced by the many disturbing and
uncontrollable factors outside the firm. A disadvantage would be that total expenses may
include non operating expenses which represent an important part of them, leading to bad
interpretation of the results.
Net Profit Margin
The net profit margin indicates the portion in sales of monetary units which remain after
dealing with the costs, interests and taxes.
Formula: Net Profit Margin = (Net Profit / Sales) x 100
Like the above mentioned profit margins, the net profit margin ratio indicates the
profitability of the company, very expressive to its owners.
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In addition, this ratio refers to the capacity of the company to cope with different
economic scenarios as for example price competition, low demand on the market, etc. A
high ratio means high profitability for the firm. This ratio should be in strong connection
not only with the level of sales but with investments as well.
Return on Assets (ROA)
Return on assets determines the level of profitability of the assets after the costs interests
and taxes have been dealt with. (Van Horne, 2005).Managerial performance is measured
by the ratio of income with regard to the total assets before and after taxes. (Ross, 2005)
Formula: ROA = Net Income / Total Assets
ROA refers to the earnings gained as a result of the invested capital. It depends on the
situation of the industrial environment. Therefore the interpretation of ROA should be
based on comparison with previous ROA levels of the company as well as with those of
similar companies in the branch.
The ROA expresses the efficient usage of the assets which generates profits A higher
level of ROA means a higher earnings level and less expenses as well as management
performance and efficiency in usage of the assets. On the other hand, a low ratio indicates
bad management of the assets. Increasing ROA can be achieved by a high profit margin
or a high asset turnover but separately due to the existing competition on the market.
Return on Equity (ROE)
Return on equity represents the percentage of net income in owner’s equity. It also
indicates the profitability of the company determined by the level of investments
performed by the shareholders.
Formula: Return on Equity = Net Income/Shareholder's Equity
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It is one of the mainly used ratios in order to determine the efficiency of the company,
being important both for the shareholders as well as for the managers. The higher its
level, the better for the health of the firm. This ratio also specifies whether the
investments carried within the company attract other investors or not.
1.3.5 DuPont Analysis
One of the methods used to determine the performance is the Du Pont Analysis, started
by DuPont Corporation in the 1920s. It measures how much the assets are used at their
net book value so that they can generate higher return on ROE. It is also known as
"DuPont identity".
DuPont states that there are 3 elements that affect ROE:
- Operating efficiency, measured by profit margin
- Asset use efficiency, measured by total asset turnover
- Financial leverage, measured by the equity multiplier
Formula:
ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity
Multiplier (Assets/Equity)
Figure 1 shows how Du Pont analysis can break return on equity and return on total
assets into different components (profit margin, total asset turnover, and equity
multiplier) and how these components can then be broken into their constituent parts for
analysis. If the firm’s ROE has increased due to a high turnover, further study will be
conducted on elements which influence the turnover ratio to see weather the increase was
determined by the high volume of sales, improvement of asset management or those two
elements combined. (Melicher, 2007)
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The increase of ROE stands as an advantage of the company, with positive influence on
it, but only if it is determined by the increase of profit margin or asset turnover. In the
case of an increase determined by the equity multiplier, the level of the risk increases as
well, which acts as a negative influence on the company’s profitability.
In the event of an unchanged ROE, the Du Pont analysis proves very useful. It shows that
a possible reason for which the ROE remained positive is a large increase in leverage,
despite the negative values of net profit margin and asset turnover ratios which would
normally, being multiplied, have a positive value. This can only prove the non-
profitability of the company.
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Fig.1 The DuPont system of financial analysis
Source: Melicher (2007)
1.4 Limitations on using financial ratios
Financial ratios have certain limitations in their use and are not meant to be applied as
definitive answers. They are usually used to provide additional details in the
determination of the results of financial and managerial decisions. They can provide cluesto the company’s performance or financial situation. However, on their own, they cannot
explain whether performance is good or bad. As for the external financial analysis, ratios
also play a role of basic indicators, showing just an overview of studying business entity.
Ratios have to be interpreted carefully.
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Lawrence J. Gitman in his “Principles of Managerial Finance” points out some cautions
about using ratios in financial analysis. He defines six of them:
• Ratios with large deviations from the norm only indicate symptoms of a problem. It is
essential always to carry out additional analysis based on internal data to isolate the
causes of the problem. Ratio analysis just directs attention to potential weak spots. It does
not provide conclusive evidence and only shows the existence of a problem;
• A single ratio does not provide enough information sufficient to judge the overall
performance of a firm. Only a group of ratios can practically play key role in it;
• The ratio comparison should be made using ratios calculated with financial statements
dated at the same point in time. Otherwise, the effects of seasonality may produce
incorrect conclusions. (For example, it is especially important while comparing
agricultural companies where seasonality is crucial);• The use of audited financial statements for ratio analysis is preferable. Using an audited
financial statement guarantees a certain level of trust both for analyst and for the end-
user. If the statements have not been audited, the data contained in them may not reflect
true financial situation;
• The financial data being compared should have been developed in the same way. The
use of differing accounting practices is especially relative to inventory and depreciation
and can distort the results of ratio analysis. It is true, that the differences of accounting
policies may distort inter-company comparisons;
• Results can be distorted by inflation, which can cause the book values of inventory and
depreciable assets to differ greatly from their true (replacement) values. Additionally,
inventory costs and depreciation write-offs can differ from their true values, thereby
distorting profits. Without adjustment, inflation tends to cause older firms (older assets)
to appear more efficient and profitable than newer firms (newer assets). (Gitman, 2004)
Ratio analysis is a useful tool, but a person who deals with it has to be always aware of
these limitations and make adjustments as necessary and whenever possible. First, the
ratio analysis is not just a mechanical process, as it seems to be. It involves an accurate
results interpretation.
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Chapter 2 Research Methodology
This chapter describes the methodology using for the study. The chapter organizes as
research philosophy, research approach, research method, and data collection.
The research question is: Based on the ratio analysis, does National Society of Lignite
Oltenia perform better financial results than other companies from the mining industry?
2.1 Research Approach
Research is a systematic method of finding solutions to problems. It is
essentially an investigation, a recording and an analysis of evidence for
the purpose of gaining knowledge. Theoretically speaking, it must be said that
there are two forms of research approach: deductive approach and inductive approach.
The deductive approach descends from the theoretical matters and concepts through
observations in order to obtain results which do or do not align with the hypotheses On
the other hand the inductive approach (or bottom up approach) begins from the particular
situation and observations with the aim of developing and setting new theories. Thedeductive approach is based on scientific principles and quantitative information,
explaining the relationship between variable data. The inductive approach is based on the
matter of human relating within the interpretation of the research context. It is also
qualitative data based.
The thesis is composed of two major parts: theoretical part and the empirical part .The
theoretical section contains descriptive approaches of the various important concepts such
as financial statement analysis, ratio analysis. This part aids setting the foundation and
acts as a point of reference of the empirical study in the last part of the paper.
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Moreover, besides the descriptive approach it will be used explanatory approach, which
helps in creating a general image on the cause and effect relationship among different
features of the financial statements and their consequences.
2.2 Research Method
Depending upon the objective of the research there are two methods between one can
chose for his analysis and those are qualitative and quantitative methods. A difference in
categorizing qualitative and quantitative methods is data. It can be simply stated that
qualitative data contains words while quantitative data contains numbers. Besides data
collection another difference is assumption of the research.
Qualitative methods are usually more flexible. Their objective is to ease the relationship between the researcher and the study subject, as a measure of increasing the spontaneity
and efficiency. In addition, with qualitative methods, the relationship between the
researcher and the participant is often less formal. Participants are allowed to respond
more detailed than in the case of quantitative methods.
Qualitative research contains three elements, according to Strauss and Corbin. The first
one is data, obtained through methods like interviews, observation, and close studies of
documents. The second element refers to procedures performed by the researcher in order
to possess the required data. The third one represents a final report which concludes the
results and findings of the study, as well as its consequences and implications.
Quantitative research refers to counting and measuring of events as well as statistical
analysis of data gathered. This method brings objectivity and reliability to the research.
The researcher is mainly external to the actual research, and results are expected to be
replicable no matter who conducts the research.
Quantitative methods are usually appropriate for carrying evaluations comparing
outcomes with baseline data. This is an excellent way of testing a hypothesis. The
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benefits of using quantitative approach refer to quantifiable and reliable data, usually
applicable to some larger population.
Concerning this study it must be said that the quantitative method suits best because there
are analyzed financial statements from different points of view, such as investors,
lenders, managers and owner. In addition to quantitative method, qualitative method is
complementary being characterized by reciprocal dependence. (Yin, 2006) According to
Yin (1989), the particular strength of a case study is its capability to face different types
of evidence.
2.3 Data Collection
Data collection is an important feature which is part of all research studies. As a result of this process, researcher gathers the needed material on which his research will base on.
(Ibert, 2001)
The main sorts of data collection methods are primary and secondary. The primary
sources represent discussing with employees, collecting data using questionnaire.
Secondary data stands as finished products having been already treated statistically some
way or another.
In conducting this research mainly secondary data collection method were used. The
secondary data source comprises balance sheets and income statements of the studied
companies. Secondary data forms the basis for both the theoretical and empirical part of
the study. It is true that “secondary data is data that was developed for some purpose
other than helping to solve the problem in hand.” (Fay, 1997) There is no doubt that
primary data is important for creating new data and that the secondary data might be
distorted from its value instead of primary data.
The data of chosen company is mainly collected from annual reports between 2007 and
2009. Among different tools and techniques various authors used as performance
measure, financial ratios found to be quite commonly used in the literature. The
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elaboration of study implied using financial ratios to measure and compare NSLO with
two other companies’ performances in the profitability, liquidity, risk & solvency, and
efficiency.
Data for each year have been compiled from the income statements and balance sheets of
NSLO, Arch Coal Inc. and UK Coal. In today’s competitive financial market, one can
better understand the performance of a company by an analysis of inter-company
comparison. In order to see how NSLO has performed in comparison with the other
companies, the study uses 14 financial ratios and the DuPont identity.
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Chapter 3 Empirical Study
This chapter deals with financial analysis of the studied companies. It starts with the
companies’ presentation. It continues by analysis of liquidity ratios, efficiency ratios,
leverage ratios, efficiency ratios and the DuPont analysis.
3.1 Company’s presentation
Industrial experience gained by the National Society of Lignite Oltenia SA Targu Jiu in
coal extraction area extends over a period of 50 years during which extraction was
performed with a quantity of more than 1 billion tones of lignite.
Lignite mining activity of SNL Oltenia is taking place on the territory of three counties:
Gorj, Mehedinti and Valcea, summing twelve mining perimeters out of which nine open
pits and three underground pits grouped in five production units, two technical-material
supply bases, transportation and service , one asset capitalization unit and a recovery and
employment training centre.
The main activity:
Extraction and processing of lignite.
Secondary objects of activity:
Extraction of construction materials, steel construction, general and specialized
transportation, specialized computer products and services, forestry and logging,
construction works, equipments repair and maintenance; water collection, treatment and
distribution; personnel training; environmental protection; scrap metal recovery,
specialized design.
The social capital, meaning 89 million euro is wholly owned by the Romanian state,
represented by the Ministry of Economy and Finance. Production capacity is 19 million
tons / year coal energy of which 92% from open pits and 8% from the underground pits,
as determined by technical equipment, the material and technological conditions.
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Technical features:
43 rotor excavators;
25 machines Dumper;
278 large transport (144 km);
23 deposit machines;
36 trucks Band Track;
19 complex mechanized slaughter;
38 combines for opening and preparation works.
Material base consists of lignite reserves quartered in the leased mining perimeters,
which totals approx. 230 million tones energy lignite, distributed from the territorial and
administrative point of view as follows: Gorj - 78%, Mehedinti - 12%, Valcea - 10%.
Calorific power of lignite, operated by SNL Oltenia S.A., is between 1.7 to 2.2 Gcal / t,
sulfur content of lignite fitting in the range 0.5% and 1.5%, reference humidity W 38.4%,
33.8% ash. The share of Romanian lignite energy balance, solid fossil fuels is an
important primary energy source in Romania's energy structure, representing a 39%
share. Production of SNL Oltenia coal energy production is necessary to provide heat and
electricity 36.3%. Lignite production dynamics achieved by SNL Oltenia bears the
imprint process re-engineering and restructuring transition period covered and crossed by
the energy market in Romania, continuing changes in energy coal applications requiring
very flexible development policies in the mining plan.
Lignite mining activity is conducted on an area of about 100 km2 with 9-to-date mining
technologies to extract the continuous flow rotor excavators, transport belt high capacity
landfill and machines, plus three Underground mining the lignite mining is carried out by
slaughter with long front equipped with mechanized complex.
Market Opportunity
Principal market for coal production conducted by the National Company of Lignite
Oltenia is the fuel market in the production of electricity and heat.
Extract lignite quality, quantity and reliability can be assured that contracts are honored,
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National Society of Lignite Oltenia placed first in the hierarchy of firms operating in
mining area.
The digging for the material is performed with sterile plants with flows between 2500
haldare, ¬ 12 500 m3 / h discharge arm length is between 60 and 170 meters. Excavation
is performed in continuous flow rotor excavators range SRs1300, SRs1400, SRs2000,
working the steps with heights of 25-30m.
Transport excavated material is carried by conveyor belt with a width of 1000-2250 mm,
maximum speed of 6.15 m / s and carrying capacity reaches 12,500 m3 / h. Low oil and
gas reserves available to Romania and the ongoing trend of price increase of these natural
resources worldwide are very strong grounds for solid impetus for recovery in the production of electricity and heat. The process of extraction of lignite mining technology
includes the following: selective excavation, transport, deposit and deposit tailings dumps
lignite deposit.
BENEFICIARIES:
S.c. C.E. ROVINARI S.A.
S.c. C.E. TURCENI S.A.
S.c. C.E. Craiova S.A.
S.c. Oradea ELECTROCENTRALE S.A.
S.c. C.E.T. ARAD S.A.
S.c. Colterm S.A.
R.A.A.N. TERM ROMAG HALÂNGA S.A.
S.c. C.E.T. GOVORA S.A.
The main objectives of S.N.L. Oltenia are:
- Concentration of manufacturing activity in the mining perimeters potential economic
efficiency by reducing and reshaping business activity underground quarries;
- Continuance of rehabilitation, refurbishment and modernization and computerization of
dispatching assimilation components of the business;
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- Technical and technological restructuring in reducing the number of machines in
operation and increase their operating ratios;
- Adapting the organizational structure with fewer hierarchical levels and organization in
accordance with specific mines extraction technology (underground and career) and
resize work under this principle;
- Labor productivity growth to support salary increases and improved living standards for
employees;
-Continuing development and upgrading computer systems;
- Capital raising, given that the company is subject to the privatization process;
- Extended consultation with the local community to achieve environmental measures;
- Promoting community incentives offered morphological reconstruction and landscaping
of land affected by mining so that they become carriers of resources for the future;- Community development activities that use the assets made available to the mining
facilities will close.
Short presentation of Arch Coal Inc.
St. Louis-based Arch Coal is one of the largest U.S. coal producers. In total, it contribute
about 16% of America’s coal supply from its 11 mining complexes in Wyoming, Utah,
Colorado, West Virginia, Kentucky, and Virginia. With 126 million tons of coal sales in
2009, it provided U.S. utilities with the fuel for roughly 8% of the nation’s electricity.
The company controls a vast domestic reserve base summing 4.7 billion tones. Of that
total, 88% is low in sulfur and nearly 83% meets the most stringent requirements of the
Clean Air Act without the application of expensive scrubbing technology.
Short presentation of UK Coal
UK COAL is Britain's biggest producer of coal, supplying around 6% of the country'senergy needs for electricity generation. The Group has four deep mines located in Central
and Northern England with substantial reserves and employs 3,100 people. It had five
active surface mines producing around 1.7 million tones of coal a year in 2008. Total
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surface mining coal reserves, including projects being worked and in planning, are in
excess of 90 million tones.
With substantial land and property interests, UK COAL develops and regenerates brown
field sites, manages business parks on former mine sites and manages a substantial
agricultural portfolio of land and buildings.
3.2 Empirical results
This part of the thesis contains ratios calculated and presented as described above. All
ratios were arranged in tables to make them easier to understand. One summary table,
including the three companies was created for this purpose.
As it was mentioned earlier, ratios itself do not provide enough information withoutcorrect explanation. Therefore, ratio evaluation is the subject of next paragraphs.
Table 1 Financial ratios of the companies.
NSLO Arch Coal Inc. UK Coal2007 2008 2009 2007 2008 2009 2007 2008 2009
Liquidity Ratios
Current ratio 2.75 1.83 1.46 .94 1.07 1.09 .85 .87 1.63Quick ratio 2.008 1.37 1.13 .62 .78 .71 .67 .66 1.26 Efficiency Ratios
Assets turnover 1.27 1.19 .90 .70 .78 .58 .50 .68 .62Average collection period
90.9 112 144.7 37.8 31.6 32.8 184 144.5 233.1
Inventory turnover 10.2 9.6 9.2 10.6 11.4 8.6 8.03 8.33 7.04 Leverage ratios
Debt ratio .20 .32 .38 .57 .56 .56 .33 .45 .29Debt to equityratio
.25 .47 .61 1.35 1.3 1.28 0.5 0.82 0.4
Equity multiplier 1.25 1.47 1.61 2.35 2.30 2.28 1.5 1.82 1.4Interest coverage - (18.1) (21.5) 7.27 12.4 5.14 6.06 (.17) (4.16) Profitability ratios
Gross profitmargin 1.8% (2.2%) (7.4%) 21.7% 27% 20% 3% .7% (24%)
Operating profitmargin
1.3% (2.1%)
(7%) 10% 15% 5% 25% (.5%) (34%)
Net profit margin 1.4% (2.5%)
(7,5%) 7% 12% 1.6% 28% (4%) (40%)
Return on Assets 1.8% (2.9%)
(6.7%) 5% 9% .9% 1.4% (3.1%)
(24%)
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Return on Equity 2.2% (4.2%)
(10,8%) 15% 20% 2% 20% (5.8%)
(35%)
3.2.1 Liquidity ratios
Short term liquidity gained much importance for creditors and investors because“liquidity is a matter of degree, a lack of liquidity may mean that the enterprise in unable
to avail itself of favorable discounts and is unable to take advantages of profitable
business opportunities as they arise” (Bernstein, 1999)
Short term liquidity is of great importance while conducting analysis due to the fact that
until a firm is able to pay its short term debts, it has the prospects of continuing as a going
concern.
Table 2 Liquidity ratios results.
NSLO Arch Coal Inc. UK Coal2007 2008 2009 2007 2008 2009 2007 2008 2009
Liquidity Ratios
Current ratio(CCR) 2.75 1.83 1.46 .94 1.07 1.09 .85 .87 1.63Quick ratio(acid test) 2.008 1.37 1.13 .62 .78 .71 .67 .66 1.26
Current Ratio (CR)
Formula: CR = current assets / current liabilities
The result of the above table presents some important clues of analyzing short term
liquidity over the previous three years of NSLO. The current ratio of NSLO in first year,
according to the rule of thumb, is relatively high, 2.75 but after that, current ratio
decreased every year, reaching its lowest level in 2009, being equal to 1.46. The rule of
thumb of current ratio is 2:1 (or 200 percent), meaning that anything below that norm is
bad while the higher above that figure the current ratio is, the better. (Bernstein, 1999)
High current ratio in 2007 implies a great liquidity meaning that the company is able to pay off its short-term debts as it comes due. The balance sheet from 2007 shows an
increase in both inventories and accounts receivables, with a percentage of 53,5, 33.3
respectively. Meanwhile, the increase in current liabilities is almost insignificant.
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In 2008 and 2009 was a rapid decrease in the current ratio due to increase rate of growth
in current liabilities from year 2007 to 2009 continually, meaning 78% in year 2008 as
compared to previous year leading to the conclusion that the company faces serious
difficulties in paying its bills and 25% in 2009 as compared to 2008 where there can be
observed an improvement comparing to the last year. The decrease of the current ratio in
2009 was also influenced by the decrease in inventories with 12%1. The values of the
ratio for 2008 and 2009 were 1.83, 1.46 respectively. This means that in case of a force-
majeure, current assets were still able to cover all obligations immediately and even leave
around 50 percent of the current assets.
As compared to the other companies, NSLO has a greater level of liquidity being able to
cover up its current liabilities on the basis of its current assets meanwhile the other twocompanies, experienced major issues with liquidity of its assets during the analyzed
period. For instance, in the case of Arch Coal Inc., the year 2007 proves that the company
has the level of liquidity too low to cover up its current liabilities, even though the
currents assets increased, the current liabilities increased with a greater percentage. On
the contrary, in the following two years, 2008 and 2009, a slight increase in the current
ratio can be noticed which leads to the ability of the company to cover up the liabilities,
above mentioned, with a left over of 1% of the current assets. In 2008, the increase of the
ratio was due to a higher growth in all current assets than the growth in current liabilities.
In 2009, the current liabilities decreased, meaning that the company’s difficulties in
paying its bills are diminishing. The current assets decreased, too but with a smaller
percentage. The reason for this decrease was that the company’s cash and receivables
decreased more than the increase in inventory and other current assets. The increase in
the inventory and decrease in cash and receivables is not a very good sign for the
company, signaling bad management practices
In UK Coal case, the current assets proved insufficient to sustain current liabilities both
in 2007 and 2008, the current ratio reaching values of 0.85 in 2007 and 0.87 in 2008.
Surprisingly in 2009 the company managed to cover its liabilities on the basis of its
1 Even though the decrease in inventories lead to a smaller current ratio, this is a good sign for thecompany, meaning that they manage better their inventories.
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assets, with a high ratio value of 1.65. The large increase of the ratio in 2009 was due to
the fact that the company’s liabilities decreased, which is a good sign for the company
and also due to the increase of receivables which lead to the increase of the current assets.
Quick Ratio (Acid Test Ratio) (ATR)
Formula: ATR = (current assets – inventories) / current liabilities
In general, a ratio of 1.0 indicates a reasonably liquid position in that an immediate
liquidation of marketable securities at their current values and the collection of all
accounts receivables, plus cash on hand, would be adequate to cover the firm’s current
liabilities. NSLO acid-test ratio from 2007 to 2009 (2, 1.37 and 1.13 respectively) had
been seen rapidly decreasing position. However, the company has a very good liquid
position. The sharp decrease in from 2007 to 2008 was due to the fact that inventories
went up, same thing happened to the current liabilities. As stated above, the companyfaces difficulties in paying its bills. The positive part is that their current liabilities growth
rate decreased every year.
As compared to the NSLO, neither Arch Coal Inc, nor UK Coal, managed to reach
normal value of this ratio, except UK Coal in 2009 when reached a value of 1.26.
3.2.2 Efficiency ratios
Table 3 Efficiency ratios results.
NSLO Arch Coal Inc. UK Coal2007 2008 2009 2007 2008 2009 2007 2008 2009
Total assets turnover 1.27 1.19 .90 .70 .78 .58 .50 .68 .62Average collection period
90.9 112 144.7
37.8 31.6 32.8 184 144.5
233.1
Inventory turnover 10.2 9.6 9.2 10.6 11.4 8.6 8.03 8.33 7.04
Total Asset Turnover (TAT)
Formula: TAT = sales / average total assets
The total assets turnover measures company’s operating efficiency by estimation of its
assets use in generating sales or revenues - the higher it is the better.
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The NSLO had value of this ratio exceeding "1" in 2007 and 2008. This means that total
assets of these companies completed more than one full business cycle and created
amount of sales listed in their income statements during that year.
Total assets turnover indicate lower performance in year 2009 for NSLO as compared to last
two years. The total assets turnover in year 2007 and 2008 was 1.27, 1.19 respectively while
in year 2009, this ratio had been 0.9. This means that NSLO in 2007, require 0.78 RON of
investment in assets in order to produce 1 RON in revenues. For 2008, NSLO generated 1
RON of sales for 0.83 RON of assets. In 2009, NSLO needed 1.1 RON of assets in order to
generate 1 RON in revenues. Generally, the more efficiently assets are used, the higher a
firm’s profits. The NSLO”s level of profit reveals that the assets are not very efficiently used.
The yearly decrease in the ratio indicates that total assets increased more rapidly than sales in
2008, comparing to the previous year and in 2009 the sales decreased while total assets
increased which lead to a higher decrease in ratio than in 2008. In percentage terms, total
assets increased 13% compared to 1,4% for sales in 2008 and in 2009, sales decreased with
20% compared to previous year and total assets increased with 1,5%. The increase in total
assets, in 2008 was due to the increase in current assets but also in fixed assets, determined
by the purchasing of new equipments, while in 2009, was only because of the increase in
fixed assets, which means investments in equipment. Even though, in 2009 this investmentlead to a low asset turnover ratio, on the long run will bring benefits to the company.
For Arch Coal Inc, low values of the ratio are explained by the increase in total assets,
yearly, caused by the continuous improvement and investments made by the company,
which will lead to higher values in the future. As far as UK Coal is concerned, the
increase of the ratio in 2008 was the result of the increase in sales and the decrease in
total assets, which was caused by the reduction of the amount invested in the
improvements of the fixed assets. In 2009, the ratio decreased, the main cause being the
large decrease in sales. Compared to them, NSLO is using more efficiently its assets.
Average Collection Period (ACP)
Formula: ACP = (account receivables / sales) x 365
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The Average collection period ratio measures average number of days that company’s
customers needed in order to pay their bills, indicating effectiveness of credit and
collection policies of the businesses. The average collection period should not be
exceeding 30 days.
NSLO’s average collection period rose sharply from 2007 to 2009. NSLO has a very high
average collection period which may indicate that the firm has too lax a credit policy and
may be in danger of experiencing a larger number of credit accounts that cannot be
collected as it later on occurred. In 2007, the company’s customers paid their bills in 91
days and in 2008 the period extended with 21 more days, having the average collection
period equal to 112 days, while in 2009 the ratio increased with 33 days, reaching a
period of 145 days needed for having their bills paid. This means that their customers had
difficulties in paying their bills or they were abusing their credit privileges. Still, themain factor affecting the payment is the financial blockage in the economy.
Arch Coal Inc was the only company closest to the normal period of having their bills
paid, with an average of 34 days. In what concerns UK Coal, the company has a higher
period of getting their bills paid, compared to NSLO, this being a bad thing for the
company.
Inventory Turnover (IT)
Formula: IT = cost of good sold / inventories
Inventory turnover is used for estimation of how fast a company's stock is sold and
replaced over the period. Inventory management also requires a delicate balance between
having too low an inventory turnover, which increases the likelihood of holding obsolete
inventory, and too high an inventory turnover, which could lead to stock-outs and lost
sales.
NSLO’s annual inventory turnover decreased slightly from 10.2 in 2007 to 9.6 in 2008 so
that in 2009 reached the value of 9.2. These values are not very satisfactory for the
company. It can be observed that the amount of inventories is increasing in 2008, which
means a bad inventory management which leads to low inventory turnover ratio. Even
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Debt Ratio (DR)
Formula: DR = total liabilities / total assets
The debt ratio shows share of company’s assets that is financed at the expense of loan
proceeds, irrespective of their sources. Some financial experts commend keeping this
indicator at the lowest level.
During the analyzed period, NSLO had good values of this ratio (less than 35-38 %)
increasing annually. This increase was due to the continuous increase of total liabilities,meaning higher interest cost and penalties. In year 2007, the debt ratio of NSLO was
20%. This can be quite costly. Since the interest expenses are deductible for income tax
purposes, the government in effect pays a portion of the debt-financing costs. In year
2008, the NSLO is financed 32% with debt, both long-term and short-term and in 2009
debt-ratio was 38%.
NSLO has the lowest debt-to-assets ratio compared to the Arch Coal Inc. which has a
constant debt ratio of 56% and UK Coal which has an increasing debt ratio in the first
two years, starting from 33% in 2007 and reaching a ratio of 45% in 2008. This might be
due to the fact that NSLO doesn’t rely on debt financing as an investment method. Only
in 2009 the UK Coal company registered a debt ratio smaller than NSLO, because of a
large decrease in total liabilities. Even though they have greater ratios than NSLO, this
does not mean that they do not have debt ratios at a satisfactory level.
Debt to Equity Ratio (DER)
Formula: DER = total liabilities / owner’s equity
The debt to equity ratio shows the company’s dependence on external financing.
Higher value of this ratio means higher risk of insolvency. Importance of this ratio also
reflects potential threat of deficiency of money resources. During the analyzed period,
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NSLO had value of this indicator on a good level with its 25-61 percent of debts in its
total shareholder's equity value. This means for every RON of equity in 2007, the firm
has borrowed about 0.25 LEI. For 2008 and 2009, NSLO has borrowed 0.32, 0.38 LEI,
respectively for every LEU of equity.
Comparing to the other companies, it is obvious that NSLO has greater possibilities in
covering its liabilities with cash coming from equity. For instance, the Arch Coal Inc.’s
debt to equity ratios value is greater than 120% even though they are slightly decreasing.
In case of UK Coal, the debt-to-equity ratio shows significant increases, from 50% in
2007 to 82% in 2008, and drastically decreasing to 40% in 2009, having a positive effect
over the company. While Arch Coal Inc seems to rely mostly on debt financing for their
assets, the NSLO and UK Coal are financing their assets on the basis of their equity, not
relying so much on debt financing.
Equity Multiplier (EM)
Formula: EM = total assets / owner’s equity
The equity multiplier ratio (EM) is in inverse relation to financial leverage ratio and
shows percentage of total assets per 1 RON of shareholders' equity. High equity
multiplier indicates higher financial leverage, which means that company is relying more
on debts in financing its total assets.
During the analyzed period the NSLO reached a satisfactory level of the equity
multiplier, having an increasing trend: 1.25 in 2007, 1.47 in 2008 and 1.61 in 2009. This
shows that company’s administration was able to retain the company secure relative to
any debt obligations during the analyzed period.
Arch Coal Inc. had high (and, hence, negative) results of this ratio registering values
between 2.35 in 2007 and 2.28 in 2009, being the only company with high financial
leverage. In the case of UK Coal, the ratio’s values are closer to the NSLO’s values,
oscillating from year to year, from 1.5 in 2007 to 1.82 in 2008, decreasing in 2009 to 1.4.
Interest Coverage Ratio (ICR)
Formula: ICR = earning before interest and taxes / interest expenses
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The times interest-covered ratio is a measure for estimation a company's abilities to meet
its debt obligations and indicates how many times their interest charges can be covered
on pre-tax basis. Banks prefer to lend to firms whose earnings are far in excess of interest
payments.
Taking a look at the NSLO’s values for this ratio, it is obvious that the company is not
able to cover their interest expenses with their earnings before interest and taxes since
they have registered in 2008 and 2009 only losses. As far as is concerned the year 2007,
there were no interest expenses to cover. Beginning with 2007 the company’s debts
increased every year, as well as the interest leading to a decrease in the interest coverage
ratio. Obviously, this is not the only reason for the decrease in interest coverage ratio.
The high costs of goods and the decrease in the sales lead to a negative EBIT. Even
though UK Coal registered losses in the same years as NSLO, the negative ratios are far smaller then those of NSLO. With an interest coverage ratio of 3.16, 7.17, 1.26 in 2007,
2008, 2009 respectively, Arch Coal Inc. was the only one able to cover its obligations
each year on earnings before interest and taxes basis.
Based on the above leverage ratios, the Arch Coal Inc proved to be the most eligible for a
loan, from lenders’ viewpoint. Its debt ratio recorded constant good values for the whole
analyzed period, as for the interest coverage period, was the only one able to cover its
obligations.
3.2.4 Profitability ratios
Profitability indicators allow giving performance evaluation of a company’s management
by study of how well they use corporate assets. An overall managerial performance is
defined by parity of profit, identified in various ways, with assets used for earning this
profit.
Table 5 Profitability ratios results.
NSLO Arch Coal Inc. UK Coal2007 2008 2009 2007 2008 2009 2007 2008 2009
Gross profitmargin
1.8% (2.2%)
(7.4%) 21.7%
27% 20% 3% 0.7% (24%)
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Operating profitmargin
1.3% (2.1%)
(7%) 10% 15% 5% 25% (0.5%)
(34%)
Net profit margin 1.4% (2.5%)
(7,5%) 7% 12% 1.6% 28% (4%) (40%)
Return on Assets 1.8% (2.9%
)
(6.7%) 5% 9% 0.9% 1.4% (3.1%
)
(24%)
Return on Equity 2.2% (4.2%)
(10,8%)
15% 20% 2% 20% (5.8%)
(35%)
Gross Profit Margin (GPM)
Formula: GPM = gross profit / sales
Gross profit margin shows how much money is left in revenues after accounting for the
cost of goods sold. During the analyzed period, NSLO’ gross profit margin had a
decreasing tendency, same as the other two companies. NSLO was profitable only in year
2007, with a low gross profit margin of 1.8%. Compared to the other two companies, in
the same year, NSLO was the least profitable, Arch Coal Inc. having a margin of 21.7%
and UK Coal with a lower margin and closer to the NSLO’s, equal to 3%. In the next two
years, NSLO was unprofitable, with margins of negative 2.2%, 7.4% respectively,
indicating the absence of any profit for company, while the other two companies
remained profitable except UK Coal, which registered a negative margin at the end of the
analyzed period.
Negative gross profit for NSLO was due to the increased cost of sales compared to their
sales. In 2008, even though the sales increased with 1.4%, the cost of sales had a higher
growth rate equal to 5.6%, leading to a negative gross profit. Even if the cost decreased
from 2008 to 2009, the sales decreased too, and with a higher percentage, having as
consequence a larger decrease in the ratio compared to the previous year.
The Arch Coal Inc’s gross profit margin has very good values. Still, the sharp decrease of the margin in 2009 is not a good sign for the health of the company. This was caused by
the large decrease of the gross profit with 36.2% due to the decrease in the sales with
13.7%. As far as UK Coal is concerned, the gross profit margin is continuously
decreasing, in 2009 reaching negative value. This negative value of the margin was due
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to the inefficient use of assets which lead to an increase in the cost of goods sold even
when the sales are going down.
Operating Profit Margin (OPM)
Formula: OPM = operating profit / sales
Operating profit margin is associated with proportion of the company's revenues that is
left after paying for variable production costs such as wages, raw materials and so on.
This ratio is a rough measure of the operating leverage a company can achieve in the
conduct of the operational part of its business. It indicates how much EBIT is generated
per dollar of sales.
For NSLO, the operational profit margin in decreasing annually, from 1.3% in 2007 tonegative values in 2008 and 2009, negative 2.1% and negative 7.4% respectively. It
illustrates that in 2007, 1 RON of sales generates 0.013 RON of operating profits. For
2008 and 2009, the company is not profitable, and this may be due to the increase of the
costs and the inefficient use of materials. Company's management has not been very
successful in generating income from the operation of the business, getting worse year by
year leading to serious consequences regarding the health of the firm.
The highest value of the margin was recorded by UK Coal, approximately 25% in 2007,
but drastically decreased to negative values in the following years due to the fact that the
operating expenses exceeded operating revenues and the difference between them
continued to increase. The Arch Coal Inc is the only one which remains profitable for the
entire analyzed period, but with a high decrease of the margin registered in 2009. These
results most likely can be connected with high variable production costs.
Net Profit Margin (NPM)
Formula: NPM = net profit / sales
The net profit margin ratio tells how much profit the studied company made for every 1
RON they generated in revenue. As is expected, NSLO’s net profit margin values are
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very low. 2007 was the only year in which the net profit margin is positive, generating
0.014 RON net profits for 1 RON of sales.
Compared to UK Coal whose ratios decreased drastically, NSLO faces a less aggressive
decrease in the net profit margin. As far as Arch Coal Inc. is concerned, their ratios
fluctuate, but with positive values for the analyzed period.
Return On Assets (ROA)
Formula: ROA = profit / total assets
Return on assets is the most important profitability indicator in the thesis. It shows how
effectively has been used each monetary unit involved in the business cycle i.e. how acompany’s assets were allocated for earning its profit.. The ROA ratio is logically
connected with net profit margin and assets turnover.
In 2007, NSLO had maximum ROA equal to 1.8%. However, this is extremely low figure
for company (taking into account decreasing trend of this indicator), which shows that
only 1.8 % of the company's profit were generated from the capital invested. The NSLO's
ROA decreased from 1.8 % to negative 2.9% during the analyzed period. Main cause for
that were financial losses of the company. In 2008 and 2009, NSLO lost 0.029, 0.067
RON respectively, for each 1 RON invested in total assets.
Compared to Arch Coal Inc., NSLO is less profitable, Arch Coal Inc. recording positive
values for ROA during analyzed period. UK Coal is less profitable than NSLO, values of
the ratio in 2007 and 2008 being slightly less than NSLO’s. In the last year had an
aggressive decrease, reaching a negative value of 24%.
Return On Equity (ROE)
Formula : ROE = profit / owner’s equity
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Return on equity defines effectiveness of using a company’s own capital. It shows how
much money per one RON of shareholder’s equity was earned during the analyzed
period. Being the comparative indicator, there is no normal value for this ratio.
NSLO registered a decreasing trend of the ratio, reaching negative values in the last two
years. In 2007, the company earned 0.022 RON per 1 RON of shareholder’s equity. In
2008 and 2009 reached the negative values of 4.2%, 10.8% respectively due to a high
decrease in the profit from 2007 to 2008, when the company began to record losses which
increased in the following year. Again, UK Coal had sharply decreased from 2007 to
2009, reaching high negative values in the last year. Arch Coal Inc. profitability results
were close to critical, with its ROE equal to 5%, 9% and 0.9 % in 2007, 2008 and in 2009
respectively. There is one observation that can be made. For a properly functioningcompany, relation of non-negative ROE to positive ROA will be always higher than 1.
This condition was achieved by NSLO only in 2007, the ratio between them being equal
to 1.22.
3.2.5 The DuPont Analysis
Return on equity is a strong measure of how well the management of a company creates
value for its shareholders. The number can be misleading, however, as it is vulnerable to
measures that increase its value while also making the stock more risky. Without a way
of breaking down the components of ROE investors could be duped into believing a
company is a good investment when it's not.
ROE = profit margin x asset turnover x equity multiplier
= (net income / sales) x (sales / total assets) x (total assets / equity)
National Society of Lignite Oltenia
2007: ROE (0.022) = 0.014 x 1.25 x 1.25
2008: ROE (-0.042) = (-0.025) x 1.13 x 1.47
2009: ROE (-0.108) = (-0.075) x 0.89 x 1.61
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Arch Coal Inc.
2007: ROE (0.15) = 0.07 x 0.67 x 2.35
2008: ROE (0.20) = 0.12 x 0.75 x 2.30
2009: ROE (0.02) = 0.016 x 0.53 x 2.28
UK Coal
2007: ROE (0.2) = 0.28 x 0.49 x 1.5
2008: ROE (-0.058) = (-0.04) x 0.75 x 1.82
2009: ROE (-0.35) = (-0.4) x 0.61 x 1.4
ROE is broken down into net profit margin (how much profit the company gets out of itsrevenues), asset turnover (how effectively the company makes use of its assets), and
equity multiplier (a measure of how much the company is leveraged).
Between 2007 and 2009, the main reason for the decrease in NSLO’s return on equity
was a high decrease in the net profit margin, reaching negative values and a decrease in
asset efficiency, although the equity multiplier increased every year. The lowering of the
ROE is due to the fact that NSLO has higher costs than sales that decrease its profit
margin, the increase in the total assets, due to the acquisitions, and the decrease in sales is
also a factor which leads to the decrease of ROE. Another reason for ROE’s reduction
might be the fact that creditors perceive the company as riskier and charge it higher
interest.
In case of Arch Coal Inc., the values of ROE fluctuate from year to year. From 2007 to
2008, ROE increased with 33.33% due to the increase of profit margin and asset
turnover, which means that the company’s profitability and efficiency is increasing. In
2009, ROE’s value recorded a sharp decrease of 90% due to a drastic decrease of the
profit margin. Also it was influenced by the decrease in asset turnover and a slight
decrease in equity multiplier. Compared to NSLO, Arch Coal Inc. had only positive
values of ROE, meaning that the latter one is more profitable even if it does not use its
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assets more efficiently than NSLO and has a higher financial leverage, meaning that the
company is relying more on debts in financing its assets.
The values of ROE for UK Coal are sharply decreasing from 2007 to 2009, due to high
decreases in profit margin, company registering negative values. Even though in 2008 the
asset turnover and equity multiplier are increasing, negative value of profit margin lead to
a negative ROE. In 2007, the company registered a higher ROE than NSLO, due to high
profit margin, but in 2008 and 2009, due to high decreases in profit margin, registered
lower ROE than NSLO. Neither NSLO, nor UK Coal was profitable in the last two years
of analyzed period, the latter recording larger losses than the first.
Conclusions and Recommendations
Examination of the empirical analysis makes it possible to shed some light on the
findings and draw some conclusions. These specific findings are a direct result of the
financial analysis carried not only upon NSLO but on other global competitors as well,
such as Arch Coal Inc. and UK Coal.
The analysis of liquidity measures, carried upon those three companies indicates that,
regardless National Society of Lignite Oltenia’s highest liquidity level in the first couple
of years from the analyzed period, NSLO registered a lower liquidity level in 2009 than
UK Coal, thus UK Coal being more eligible for obtaining a loan, from a lender’s point of
view. Findings also show that while the liquidity ratios of NSLO are decreasing over
time, those of UK Coal and Arch Coal Inc. are increasing. This decreasing trend is
considered a negative sign for NSLO.
Analysis of the results of all efficiency measures shows that NSLO is more efficient in
terms of utilization of their assets than the other two companies but registers losses. The
reason of these losses, regardless their medium inventory turnover ratio and a satisfactory
asset turnover ratio is that, compared to the other companies, NSLO encounters not only
a higher average collection period but also a continuously increasing average collection
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period. From a manager’s point of view, Arch Coal Company would prove more
efficient, despite the fact that their asset turnover ratio is low. The low average collection
period compensates for their low asset turnover ratio which is the main cause for the fact
that the company still records profit.
After a close study upon the financial leverage ratios, the results indicate that NSLO and
UK Coal have a good financial leverage meanwhile Arch Coal Inc. is more risky and less
solvent. Regarding interest coverage ratio, Arch Coal Inc, is the only company able to
meet their interest expenses with earnings before interest and taxes. From lenders’ point
of view, the issue regarding which company proves to be more eligible, can not be
objectively approached and it depends almost exclusively on each bank’s clients
preferences, past experiences, strategies and individual interest.
The analysis of profitability ratios indicates that NSLO as well as UK Coal Company
have a lower profitability level than Arch Coal Inc. The main reason is that both NSLO
and UK Coal encountered decreases in the level of the profit; starting with year 2008 to
record losses. Therefore, from the manager’s point of view, Arch Coal Inc. is the most
profitable company. As far as the owner’s point of view is concerned the high level of
ROE confirms the findings mentioned above.
As recommendations it must be said that the main problem which threatens NSLO is the
high average collection period. Therefore the company must perform the appropriate
actions in order to decrease this period as much as possible and to stabilize it at an
affordable level that does not endanger the profitability of the company. This issue is
however very delicate to be directly approached since the difficulty in the collection of
their receivables is caused mainly by the financial blockage and the problematic actual
economical conjuncture to which the Romanian economy is exposed.
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References
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Palepu, H. and Bernard, M. (2006) - Business Analysis and Valuation, (2nd edition),
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McGraw-Hill.
Ross, S. A., Westerfield, R. W, Jaffe, J. (2005) - Corporate Finance, (7th Edition),
McGraw-Hill Inc.
Vance, D. I. (2003) - Financial Analysis and Decision Making: Tools and Techniques to
Solve Financial Problems and Make Effective Business Decisions, McGraw‐Hill
Van Horne, James and Wachowicz, John (2005) - Fundamentals of Financial
Management , (12th Edition), Pearson Education Limited
Walsh, C. (2006) - Key management ratios, (4th edition), Prentice Hall Financial Times
White, G.I., Sondhi, A.C. and Fried, D. (1998) - The Analysis and Use of Financial
Statements (2nd edition), Hamilton Printing Company.
Wild, J.J., Subramanyam, K.R., Halsey, R.F., (2007) - Financial Statement Analysis, (9th
edition), McGrow-Hill
Yin. Robert K. (2004). The Case Study Anthology. Sage publications, cop. Thousand
Oaks, CA
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Zemitan, G. 2005. Methods of prognosis of firm's financial performance
Annexes:
Fig.1 The DuPont system of financial analysis, page20
Table 1 financial ratio of the companies, page 30
Table 2 liquidity ratios results, page 32
Table 3 efficiency ratios results, page 34
Table 4 leverage ratios results, page 37
Table 5 profitability ratios results, page 40
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Appendix 1.
Balance Sheet and Income Statement of National Society of Lignite Oltenia, year 2007
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Appendix 2 Balance Sheet and Income Statement for NSLO, year 2008
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Appendix 3 Balance Sheet and Income Statement for NSLO, year 2009
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Appendix 4 Balance Sheet and Income Statement for Arch Coal Inc.
Arch Coal, Inc.
Annual Balance Sheet Period Ended
12/31/20
09
12/31/20
08
12/31/20
07
12/31/20
06Update Update Update Update
5/17/201
05/17/201
05/17/201
0 6/9/2010
In millions of USD
(except for per share items)
Cash & Equivalents 61.14 70.65 5.08 2.52
Short Term Investments 18.81 43.17 7.74 --
Cash and Short Term Investments 79.95 113.82 12.82 2.52
Accounts Receivable - Trade, Gross 190.84 215.25 230.17 215.39
Provision for Doubtful Accounts -0.1 -0.2 -0.2 -3.2
Accounts Receivable - Trade, Net 190.74 215.05 229.97 212.19
Receivables - Other40.63 43.42 19.72 48.59
Total Receivables, Net 231.37 258.47 249.69 260.77
Inventories - Finished Goods 99.16 64.68 61.66 49.61
Inventories - Raw Materials 141.62 126.89 116.13 80.22
Total Inventory 240.78 191.57 177.79 129.83
Prepaid Expenses 21.09 43.78 22.06 6.74
Deferred Income Tax - CurrentAsset
0 52.92 18.79 51.8
Other Current Assets 113.61 45.82 40 35.61
Other Current Assets, Total 113.61 98.74 58.79 87.41
Total Current Assets 686.78 706.38 521.15 487.28
Land / Improvements - Gross 2,417.15 1,818.66 1,690.18 1,587.30
Machinery / Equipment - Gross 2,261.93 2,031.56 1,729.50 1,626.98
Other Property / Plant / Equipment -Gross
832.98 762.75 672.5 550.39
Property / Plant / Equipment, Total -Gross
5,512.06 4,612.96 4,092.17 3,764.67
Accumulated Depreciation, Total -2,145.87 -1,909.88 -1,628.54 -1,521.60
Property / Plant / Equipment, Total -Net
3,366.19 2,703.08 2,463.64 2,243.07
Goodwill, Net 113.7 46.83 40.03 40.03
Intangibles, Net 86.62 66.92 105.11 112.67
LT Investment - Affiliate Companies 87.27 87.76 82.95 80.21
Long Term Investments 87.27 87.76 82.95 80.21
Defered Income Tax - Long TermAsset
354.87 294.68 296.56 263.76
Other Long Term Assets 145.17 73.31 85.17 93.8
Other Long Term Assets, Total 500.04 367.99 381.73 357.56
Total Assets 4,840.60 3,978.96 3,594.60 3,320.81
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Accounts Payable 128.4 186.32 150.03 198.88
Accrued Expenses 227.72 249.2 188.88 190.75
Notes Payable / Short Term Debt 2.24 10.76 0 0
Current Portion of Long Term Debt /Capital Leases
267.46 213.47 217.61 51.19
Deferred Income Tax - Current
Liability
5.9 0 -- --
Other Current liabilities, Total 5.9 0 -- --
Total Current Liabilities 631.73 659.75 556.52 440.81
Long Term Debt 1,540.22 1,098.95 1,085.58 1,122.60
Total Long Term Debt 1,540.22 1,098.95 1,085.58 1,122.60
Total Debt 1,809.93 1,323.17 1,303.19 1,173.78
Minority Interest 8.96 8.89 -- --
Reserves 305.09 255.37 219.99 205.53
Pension Benefits - Underfunded 68.27 73.49 8.53 --
Other Long Term Liabilities 171.22 153.8 192.3 186.29
Other Liabilities, Total 544.58 482.65 420.82 391.82 Total Liabilities 2,725.49 2,250.23 2,062.91 1,955.22
Redeemable Convertible PreferredStock
-- 0 0 0
Redeemable Preferred Stock, Total -- 0 0 0
Common Stock 1.64 1.45 1.44 1.43
Common Stock, Total 1.64 1.45 1.44 1.43
Additional Paid-In Capital 1,721.23 1,381.50 1,358.70 1,345.19
Retained Earnings (AccumulatedDeficit)
465.93 478.73 173.19 38.15
Treasury Stock - Common -53.85 -53.85 0 0Other Comprehensive Income -19.85 -79.1 -1.63 -19.17
Other Equity, Total -19.85 -79.1 -1.63 -19.17
Total Equity 2,115.11 1,728.73 1,531.69 1,365.59
Arch Coal, Inc.
Annual Income Statement
Period Ended 12/31/200912/31/200
8 12/31/2007
UpdateReclassifie
d Reclassified
6/9/2010 6/9/2010 4/19/2010
In millions of USD
(except for per share items)
Net Sales 2,576.08 2,983.81 2,413.64
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Revenue 2,576.08 2,983.81 2,413.64
Total Revenue 2,576.08 2,983.81 2,413.64
Cost of Revenue 2,070.72 2,183.92 1,888.29
Cost of Revenue, Total 2,070.72 2,183.92 1,888.29
Gross Profit 505.37 799.88 525.36
Selling / General / AdministrativeExpense
97.79 107.12 84.45
Selling / General / AdministrativeExpenses, Total
97.79 107.12 84.45
Depreciation 301.61 293.55 243.7
Depreciation / Amortization 301.61 293.55 243.7
Investment Income - Operating -12.06 -55.09 -7.29
Interest / Investment Income -Operating
-12.06 -55.09 -7.29
Interest Expense (Income), Net-Operating, Total -12.06 -55.09 -7.29
Impairment-Assets Held for Use 19.62 -0.71 -1.63
Other Unusual Expense (Income) 13.73 0 1.92
Unusual Expense (Income) 33.35 -0.71 0.29
Other, Net -39.04 -6.26 -24.49
Other Operating Expenses, Total -39.04 -6.26 -24.49
Total Operating Expense 2,452.37 2,522.54 2,184.93
Operating Income 123.71 461.27 228.71
Interest Expense - Non-Operating -105.93 -76.14 -74.87
Interest Expense, Net Non-Operating -105.93 -76.14 -74.87
Interest Income - Non-Operating 7.62 11.85 2.6
Interest / Investment Income, Non-Operating
7.62 11.85 2.6
Interest Income (Expense), Net-Non-Operating, Total
-98.31 -64.29 -72.27
Gain (Loss) on Sale of Assets -- -- --
Other Non-Operating Income(Expense)
0 0 -0.35
Other, Net 0 0 -0.35
Net Income Before Taxes 25.4 396.99 156.09 Provision for Income Taxes -16.78 41.77 -19.85
Net Income After Taxes 42.18 355.21 175.94
Minority Interest -0.01 -0.88 -1.01
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Net Income Before Extraordinary Items 42.17 354.33 174.93
Net Income 42.17 354.33 174.93
Appendix 5 Balance Sheet and Income Statement for UK Coal, year 2007
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Appendix 6 Balance Sheet and Income Statement for UK Coal, year 2008
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Appendix 7 Balance Sheet and Income Statement for UK Coal, year 2009
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