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



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


Conclusions and Recommendations



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.



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)



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.”



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.



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)



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)



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.



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.



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)



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)



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)



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)



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.



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.



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.



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



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.


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)



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.



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.



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.



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.



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



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



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.



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.



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,



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;



- 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



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%)



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.


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.



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.



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.


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.



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



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



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,



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



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.


Gross profitmargin

1.8% (2.2%)

(7.4%) 21.7%

27% 20% 3% 0.7% (24%)



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



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



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



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



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



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



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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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



Appendix 1.

Balance Sheet and Income Statement of National Society of Lignite Oltenia, year 2007



Appendix 2 Balance Sheet and Income Statement for NSLO, year 2008



Appendix 3 Balance Sheet and Income Statement for NSLO, year 2009



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



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



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



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

Stoichitoiu Gabriela Adela, graduation paper

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