Financial Analysis Assignment: Performance Evaluation of Fortescue Metals Group Ltd

Question

Task: Objective
To evaluate the performance of a firm and its share’s value a financial analyst must be able to analyse the firm’s financial statements. When analysing these statements, the analyst must focus on cash flows of the firm because ultimately it is changes in the cash flows of the firm that determines its value. This is also a market consensus. Hence understanding how and why cash flows change is an indispensable component of valuation of securities.

The objectives of this financial analysis assignmentare:
1. To equip you with a good understanding of the financial statements of the firm;
2. To build up your analytical skills in the area of cash flows analysis;
3. To apply the methods of valuation to value a real-world company.

Write a professional looking report for the management of the selected company with your recommendation. Your recommendation(s) should be succinct and you need to highlight expected outcomes or possible financial consequences of your recommendations. The report should not exceed 2,500 words plus appendices. The body of the report should be self-contained, while the appendices should provide further details for interested readers. It is your decision as to what to be included in your report and the appendices. However, make sure they are relevant to your analysis.

Answer

Executive Summary
The report on financial analysis assignment is based on the financial analysis and evaluation of Fortescue Metals Group Ltd, a strong performer in the field of metal and mining in Australia. The report deals with understanding the financial statement of the firm, cash flow analysis, and application of valuation method to Fortescue Metals Group Ltd. The report initiates with a brief introduction of Fortescue Metals Group Ltd followed by the purpose of financial statements and understanding the current operation of the firm. The report even calculates the rate of return of S&P/ASX 200. Further, using the CAPM model the rate of return of the company stands at 3.16% and the value of shares of FMG’s share comes to $ 90.02 per share.

Introduction
Understanding the worth of the asset and what ascertains the value is a major need when it comes to the decision making process or selection of investments in the portfolio. It helps in deciding an appropriate price for payment or receipt in a takeover or making any investment, financing, and choice of dividend in the course of business activities (Peirson et al 2012). The concept of valuation remains the same for maximum assets and hence the fundamental principles remain the same. Some assets are easier in valuation and the valuation detail differs from one asset to another (Adra and Barbopoulos 2018). Further, the uncertainty with the estimation of valuation remains different for different assets however, the core principles remain unchanged. The report will provide a balanced insight into the process of valuation followed by the CAPM method, identification of cash flow areas, and financial strategies that will enable the firm to enhance the cash flow position. The objective of the report is to assess the performance of Fortescue Metals Group Ltd and its share value through the evaluation of the financial statements. The analysis focuses on the cash flow because the alterations and movements in the cash flow ascertain the value. In the course of the study, the adequate emphasis is provided on the methods of valuation. The report initiates with the introduction of Fortescue Metals Group Ltd followed by the financial statement analysis and evaluation of the current operation by using the financial statements.

1. Fortescue Metals Group Ltd
The Fortescue Metals Group Ltd is an Australian listed company and belongs to the industry of the metals dealing mainly in the iron ore. The company is using and known for its advance and upgraded technological use. The company is the main supplier of seaborne iron ore to China and his expanding its business in other countries like Japan, South Korea, and India. The company is following the principle of sustainable development of the business and pursuing growth by delivering the return to various stakeholders (Fortescue 2019). The company iron ore production or mining will increase as new projects are being started and also the quality of the iron ore will further improve. The iron content of the iron ore will be better than the industrial standards. The company is very cost-effective with advanced technical knowhow which ensures the future viability and growth of the company. The company has a world-class infrastructure facility and the mining assets in Western Australia. The company has also started generating revenue from the shipment of materials (Fortescue 2019). The company is ready for the future with the materials at low cost and with new technologies to face any challenges. The company in collaboration with the CSIRO is doing research and development of the use and potential of the Hydrogen which may become the low emission fuel for the future. The company is expanding rapidly in Australia as well as internationally especially in the South America new projects are being undertaken. The company is also popular for its CSR activities (Fortescue 2019). The company care for the employees, labor is guided by strong policies. The company also works for environmental issues like cleaning up of the oceans and social activities like supporting the treatment and research on Cancer. Thus the company is active socially as well as generating great results for the shareholder.

2. Purpose of financial statement analysis
The financial statements are prepared and reported for various stakeholders. The different stakeholders use financial statements as per their concerns. The financial statement gives us insight into the working of the company and helps us in taking our decisions regarding the company.

The financial statements are prepared to use the common principles to maintain uniformity and comparability of the company with similar companies in the industry (Gowthrope 2017). The financial statement consists of mainly balance sheets, income statements, and cash flow statements, each provides different information which is equally important to the stakeholders. Thus through financial statement analysis, the financial data of the entity is studied to determine the working of the company. It takes into consideration the past trends, current situation as well as prospects into consideration for a better review of the data. The income statement gives us insight into the working of the company and gains or losses incurred as the result of such activities (Leo et al 2011). Thus the analysis of the major sources of income and heads of the expenditures can be done. The income from operational activities and income that generate from nonoperating activity that will not occur regularly should be monitored. The financial position helps us to analyze the overall position of the company on a given date due to the overall period of the company. The capital structure and areas of the utilization of the funds can be monitored. The debt-equity ratio and weighted average cost of debt also pay an important role in the financial analysis and deciding whether the company can cover its cost of capital and generate the required rate of return to the shareholders of the company (Bellandi 2017). The cash flow is a very essential part of the financial analysis as many times the information that is not received from the above statement can be seen from the cash flow. The flow of the fund to and from the organization can be seen. The company's ability to generate sufficient cash and meet its liability when they become due that is the liquidity position of the company should be measured (Melville 2013). The increasing the financial crises in the economy the analysis of the cash flow has gained much importance.

3. Fortescue current operations
The current operations of the company are showing strong improvement from past years and higher returns in the future or coming year. The demand for iron ore is showing an increasing trend in the Chinese market as steel requirements have increased for large scale development activities growth (Fortescue 2019). The cost and quantities available with the company are very competitive which has increased the revenue in the current period and also shows a good future perspective.

The revenue from the sales has increased by around 1/3rd times but the corresponding cost of sales has not increased in the same ratio. The cost of sales is the same as that of the previous year which shows that the cost efficiency has improved and the company can produce more quantities at the given cost. This has increased the profit of the current year from $1957m in 2018 to $4850 in 2019. It can also be seen that the finance expense has also reduced by more than 50%. This is the result of the company reducing its debts with its strong cash flows. This can also be seen from the buyback plan of the company. This increases the equity shareholders return and share in the profit of the company. The basic earnings per share have increased from 28.20 to 103.10 which is a huge difference and thus the confidence of the shareholders has gained and the management policies and programs show that this will continue shortly (Fortescue 2019).

The financial position of the company is also showing a strong position with increased cash and cash equivalents, trade and other receivables, inventories, etc. The trade and other receivables must be controlled as the risk of bad and doubtful debts rise with such a huge amount lying with the debtors.

The company has improved the cash flow from operations in the current which can also be seen from the increased revenue from operations. The company is continuously investing in plant, property, and investment to acquire new and improved technologies and also due to an increase in the work in the two new projects. As compared to the last year the company has not taken borrowings from outside instead the main head of the outflow of cash in the recent year was by payment of dividends. Thus the shareholders have got the benefit of increased revenue in the real term with high dividends for the year. Thus the reduction in the cash flow in the last year has been recovered and the company has retained its cash balances which ensure timely payment of the short term obligations (Fortescue 2019).

Thus the company has presented a strong financial position and increased margin in the sales which will benefit in the long run and thus have a competitive advantage over others.

4. Rate of return
From 2009 to 2019 the average rate of return from the ASX 200 is coming as 0.43% whereas the last year's average return is coming at 0.60%.

5. CAPM
The required rate of return for the company is 3.16%

6. Valuation model
The value of shares of the FMG’s share is coming as $ 90.02 per share.

7. Comparison of the share price
With the monthly share price and return graph, it can be seen the fluctuation in the share price is more than the fluctuation in the return. The expected share price is coming so high as compared to the current price due to more payment of dividends during the period 2018 to 2019.

8. Area of cash flow that needs attention
The firm has shown strong cash flow in recent years. The main outflow of cash was through payment of dividends thus the company should follow a stable dividend policy as such huge fluctuations may hit the confidence of the shareholders when the desired return in any particular year is not achieved. The stable dividend policy builds the shareholder's confidence and brings consistency in the returns of the company (Penman 2010). The financing cash flow the buyback of shares has also been planned and will be executed properly as sufficient fund balance is available with the company. The operating cash flows are in the increasing trend which is a good sign for the stakeholders of the company. The company should maintain and grow operational cash flows. These cash inflows are more vital and beneficial for the company and its stakeholders as it is generated from the main operations of the company and shows the long term profitability of the company (Lieberman 2018).

The cash flow from the investing activity shows a huge investment in the fixed assets every year. The resources of the company should not be wasted and only used prudently as the proper use of the resources enables the company to generate more revenue. This also hints about the future growth of the company (Hanly, Morales and Cassells 2018).

9. Relevant investment and financing strategies to improve the firm’s cash flow
In the year ended 2018, the company had to bear a large sum due to the early payment of debts. This cost should be avoided and terms with the borrowing party should do to reduce such cost in the future as the presence of surplus cash funds. The reduction of the leverage in the company is a very positive view and improves the creditability of the company if required any time in the future (Porter and Norton 2104). We can see that as compared to the previous year the debt-equity ratio has improved. The debt has reduced and equity has increased in the total capital structure. The main debt of the company includes the senior unsecured notes, syndicate term loans, and lease liabilities. The secured notes are maturing in 2022, 2023, and 2024 so the appropriate funds should be kept so that timely payment of the dues can be done. The syndicated loan is on a floating rate which will also mature in April 2022. The lease liabilities are the large investment projects which are done in collaboration with other entities. The company requires huge cash and cash equivalents within 2-4 years thus sufficient provision should be made to meet the liabilities as when they arise. This will improve the shareholder's confidence and lenders will also have faith in the company and due to the goodwill, the company will be able to get the credit at a lower cost as the bargaining power will increase.

Recommendation and conclusion
The shareholder's wealth maximization is the only object with which the company should work. The demand for the primary product that is iron ore is increasing and with the prospect of the vast developmental activities, the sales and revenue will also improve. In recent years the majority of the revenue is earned from China. The global pandemic COVID 19 has also impacted most in China. The situation is improving in China as compared to the rest of the world. The grudge against China is developing and may take any form of post-recovery and thus the company should expand its business with other countries also. The company is already started selling to the other growing economies like India and Japan but the level of revenue is less.

The margin of the company has also increased all because of the improved technology and investment in the cost reduction procedures. The company will become ideal for investment after the debts are reduced and having sufficient cash flow to grab all the opportunities for growth and development.

The stable dividend policy will boost the shareholder's confidence and expectation from the company. The shareholders are sure about some fixed rate of dividends that will also generate to the shareholders.

The payment of such high dividends has increased the expectation from the shareholders of the company. This cannot be continued for a long period to pay such a high amount of dividends. The payment of such a high dividend will also indicate that the company does have alternative investment opportunities from which the company will be able to generate return required by the shareholders or more than that. The distribution of dividends should be monitored properly.

References
Adra, Sarmer., and Barbopoulos, Leonidas.G 2018. “The valuation effects of investor attention in stock-financed acquisitions” Journal of Empirical Finance. 45, 108-125. https://doi.org/10.1016/j.jempfin.2017.10.001 Bellandi, Francesco. 2017. Materiality in financial reporting. Bingley: Emerald Publishing Limited.

Fortescue. 2019. Fortescue 2019 annual report & accounts. Accessed May 5 2020, https://www.fmgl.com.au/docs/default-source/annual-reporting-suite/fy19-annual-report.pdf

Gowthrope, Catherine 2010. Business accounting and finance for non specialists.Financial analysis assignment South Western Hanly, Jim., Morales, Lucia., and Cassells, Damien 2018. “ The efficacy of financial futures as a hedging tool in electricity markets” International journal of finance and economics. 23, no. 10, 29-40. doi: https://doi.org/10.1002/ijfe.1600

Leo, Ken, Hoggett., Sweeting, John ., and Raddford,Jennie. 2011. Company Accounting. Boston:McGraw Hill Lieberman, Diana 2018. Hedge Funds and Impact Investing: Considerations for Institutional Investors. The Journal of Investing Summer 2018. 27, no.2, pp. 47-55. doi: https://doi.org/10.3905/joi.2018.27.2.047

Melville, Alan 2013. International Financial Reporting – A Practical Guide. Pearson, Education Limited, UK
Peirson, Graham, Brown, Rob., Easton, Steve, Howard, Peter., and Pinder, Sea 2012. Business Finance. McGraw-Hill, Australia.
Penman, Hossain. 2010. Financial Statement and Security Valuation. Fourth Edition. McGraw-Hill.
Porter, Gary and Norton, Curtis 2014. Financial Accounting: The Impact on Decision Maker. Texas: Cengage Learning

Appendix
Dividend model

Index Return and Chart