Finance

2

Date: June 2, 2019

Ratio Analysis

Background and Industry

Flowserve is an American corporation in industrial and environmental machinery. The company was established in 1997 as a merger between Durco and BW/ IP with it is headquartered in Dallas, Texas. The company is making products include end face mechanical seas, pumps, valves as well as the provision of automation services for the oil and gas, chemical and power industries. The company has an operation on over 50 counties with 18,000 employees[footnoteRef:1]. The company is publicly traded and is registered in the New York stocks exchange. One of Flowserve’s main competitor is Honeywell Inc., which will be compared to the Flowserve’s financial performance [1: About Flowserve (Flowserve)]

Common size analysis

Common size table[footnoteRef:2] [2: The data in the table from (Morningstar, Inc)and (Morningstar, Inc)]

The common size analysis of the income statement shows that both corporations have recorded relatively stable gross profit in the last three years, which are marginally close to each other. Flowserve marginally declined by 1% in 2017 while Honeywell has recorded a similar decline in 2018. However, Flowserve has very high operating expenses, which are 90% more than the excess recorded by its peer. This indicates that Honeywell has higher risks of earning profits compared to its rival, which has lower operating expenses. The high operating expenses have contributed to the low net incomes and the operating incomes reported by Flowserve compared to its peer. Flowserve operating incomes are lower, about half of those reported by its peer in the market while the net incomes are closer to 4 times lower than its peers. This trend indicates that Flowserve has challenges with the operating costs, which have made the company report very low operating and net incomes compared to its peer.

Flowserve has higher current assets and the plant, properties, and equipment than its peer. The larger amount of asset held has a lower contribution to the company profits compared to its rival who have reported higher earnings but lower current and the PPE. Both companies hold large amounts of liabilities compared to the assets as they average above 64% with FLS having a lower amount of liabilities. Honeywell has recorded a lower amount of long-term debts that are declining by more than one percent per year while Flowserve long term debt average above 30% with less than one percent decline in each year. Flowserve’s current liabilities have remained stable at 24% with a marginal increase in 2017 while it has recorded an increasing amount each year for the last three years. All companies have record sound financial performance in their years. The retained earnings majorly finance its equity at an average of 73% for Flowserve and 54% for Honeywell. The year 2017 record a poor performance from both companies

Trend analysis

[footnoteRef:3] [3: Data from (Morningstar, Inc)]

The trend analysis above shows a steady decline in the revenues in the last three years, from $4,500 million in 2014 to $3,803 million in 2018. This decline points to the poor performance of the company in the market. The declining revenues affect other important financial performance, as it will lead to lower gross and net incomes as well as lead to a decline in the company market shares[footnoteRef:4]. The liabilities held by the company have maintained a trend that is directly opposite to the revenues trend. As the revenues were declining, the liabilities were also on the increase up to the first half of 2012 when they recorded a decline as the revenues recorded a recovery. The increase in the liabilities and the decline in revenues indicate that the business acquired more debt to finance the deficits occasioned by the declining revenues. The assets of the company have held a consistent decline since 2014 from 2794 to reach the current level of 2383 while the net revenues have recorded a significant decline almost cutting the net income by 40% in the three years. The net income was $268 million in 2014 while 2018 record a low $162 million, which is more than a $100 million decline. [4: Decline in revenues affect other areas of business (Lee, Lee and Lee 231)]

The overall trend of the assets increasing and decline in net incomes, revenues, and assets indicate a deteriorating financial performance and attractiveness of the company in the market. The company is having trouble operating in the market, as indicated by the declining net incomes and revenues. This decline will have a direct impact on the financial soundness of the business and requires a change in the strategy to change the declining trend

Financial ratio analysis

· Liquidity [footnoteRef:5] [5: From (Morningstar, Inc)]

· Operating performance ratio [footnoteRef:6] [6: ibid]

· Profitability ratios[footnoteRef:7] [7: ibid]

· Return on Investment ratios[footnoteRef:8] [8: ibid ]

The liquidity ratios indicate a company with no liquidity ratios since the current asset held by the company exceeds the current liability needs. The current ratios average above two, which indicates that the current assets double the current liabilities held. However, the current ratio does not take into account the ease with which some of the current assets held by the business can be converted into cash[footnoteRef:9]. The quick ratio cures this problem by eliminating the assets such as inventories that are almost impossible to convert into cash and have no effect on the ability of the business to meet its financial obligations. The quick ratio indicates that the liquid assets such as the cash, cash equivalents, and the marketable securities are more than the overall current liabilities held by the business. This ratio has also been rising in the past three years. The working capital-to-sales ratio indicates that the business working capital has higher earnings from sales generated by the business. Flowserve was able to turn its working capital 3.5 times in 2016 before recording a decline in 2017 and an improvement on 2018 [9: Current ratio = current assets/ current liability. This includes the inventory (Needles, Powers and Crosson 432). ]

The company is earning less on the assets it is holding. The return on assets indicates a return of 2.9 and 2.5 in 2016 and 2018 while 2017 had a low return of 0.05. The earning power means the company has remained above 7% indicating that the company expenses most of its revenues, 6%, 7%, and 6% respectively, to the interests and tax expenses[footnoteRef:10]. The amounts expensed is higher than that amounts the company is retaining as a return on its assets [10: Basic Earning Power ratio - ROA]

There are various recommendations to the company to measure of improving its financial performance. First, the business should look for alternatives to cut down the operating costs it incurs in the source of its business operations. The difference between the gross and the operating margin shows that the operations are eating up to 24% of the gross margin while all the expenses, including the operating expenses, are accounting for more than 27% from the gross revenues generated by the business. An attempt should be made to reduce these costs. Secondly, the business is holding much of its inventories, as they remain outstanding for more than 100 days meaning that they are turned less than three times a year. Holding the inventory for long increases the costs associated with such inventory such as insurance and storage costs, which reduces the profits generated by the business. Reducing the days outstanding by holding less stock and looking for ways to stimulate more sales is highly recommended. Thirdly, the company should seek ways to increase the collection of revenue from the current average of more than 80 days to lower the number of days. Such measures include offering discounts for prompt payments. Having lower days in receivables increase the cash collection of the business, reduces the risk of bad debts and allows the business to reduce the need to acquire current liabilities to finance its working capital

Return on Equity for the company for the last three years using the DuPont analysis

a. FLOWSERVE Corporation[footnoteRef:11] [11: From (Morningstar, Inc)]

b. Honeywell International Inc.[footnoteRef:13] [13: (Morningstar, Inc)]

The ROE has changed over the three years from 8.5 in 2016 to 7 in 2018 with 2017, recording the lowest ratio at 0.2. The major decline in 2017 is occasioned by the poor performance of the company in the year with a major drop in revenues and net incomes. Honeywell also recorded the declining trend in 2018 in 2017 as it also recorded the largest decline from 24 in the previous year to 9.97 in 2017 before recording an impressive improvement to 36.5. Honeywell’s ratio more than triples the Flowserve ROE DuPont analysis

Flowserve management should take several measures in an effort to improve the return on equity. They should seek ways to improve the net margins reported by the business. This increment requires the business to reduce its operating expenses that are reducing the operating profits as well as reduce the other non-operating expenses that have a direct impact on the net margins reported by the business. They also should boost the sales revenues, which will cause an increase in the net incomes.

Recommendation

The improving liquidity and the profitability ratios indicate that the business will have sound financial strength in the market as it will not have working capital issues. It will also continue generating positive incomes. However, there is a risk from the high operating expenses that are reducing the profits generated by the business. The declining liabilities are also favorable, as they will reduce the overall amounts required to pay the costs of debts and increase the incomes available to the shareholders and to finance other business operations. The PPE has also been declining. Currently, the PPE has a lower contribution to the net income. It is expected that the declining will see a reduction in the costs of operating the PPE as well as the reduction in the depreciation costs, all that have a positive impact on the business profitability. The company has recorded an improvement in its revenues in 2018 from the 2017 decline; this trend is expected to continue in the next years, which makes the business have a positive financial outlook.

Reflection

I have learned the importance of conducting a trend and a common size analysis of a business to understand its expected performance. I have also learned the importance of using ratios to gauge the performance of a business in comparison with its peers in the market. This assignment has also allowed me to use analytical skills to understand the current situation of a business, its strength, and the expected performance in the future.

References

Flowserve. About Company . n.d. <https://www.flowserve.com/en/more/about-company/about-flowserve>.

Lee, Alice C., John C. Lee, and Cheng F. Lee. Financial Analysis, Planning & Forecasting: Theory and Application. 2009: World Scientific, 2014.

Morningstar. Honeywell International Inc., 2019. <http://financials.morningstar.com/ratios/r.html?t=HON&region=usa&culture=en-US>.

Morningstar, Inc. Flowserve Corp FLS. 2019. <http://financials.morningstar.com/ratios/r.html?t=FLS&region=usa&culture=en-US>.

Needles, Belverd E., Marian Powers, and Susan V. Crosson. Financial and Managerial Accounting. Cengage, 2010.

FLowserve Trend

net

2014 2017 2018 268 120 162 revenues 2014 2017 2018 4561 3833 3803 assets

2014 2017 2018 2794 2559 2383 liabilities 2014 2017 2018 3036 3256 2974