OMM 622 Week 6 Assignment

The American Electric Power Company

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OMM 622: Financial Decision-Making

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05/21/2018

The analysis of business finance is an important management function in understanding the financial health of their enterprises (Epstein, 2014). The outcome of the financial analysis process usually provides a comprehensive understanding of the business debt and equity status, as well share value, cash flows, profits and dividend payments (Epstein, 2014). Such information is usually important for different organization stakeholders based on their interest in the firm. For example, the investors will use financial analysis information to evaluate dividend payouts, cash flow status, and the business going concern. Likewise, the employees will require financial analysis information to assess the business profit and their anticipated salaries, wages, and commissions. The government will require financial information for tax purposes and policy implementation, whereas the public may need financial analysis information to evaluate the sustainability of the business in its current environment (Epstein, 2014).

Essentially, the financial analysis is a detailed summary of organization financial information as derived from an enterprise different book of accounting, i.e., the balance sheet, and the P&L statement. The P&L/ statement of comprehensive income usually capture information about the business revenues, expenses, and earnings, whereas the balance sheet record about the enterprise liabilities, assets, and equity (Epstein, 2014). Therefore, this assignment will provide a financial analysis report of The American Electric Company. Essentially, the paper will inquire about the enterprise liquidity status, efficiency of operation, as well as the capital structure, trend analysis, and profitability of the venture.

1. Company background

The American Electric Company (AEP Inc.) is a US-based utility firm majoring in the supply of electricity to over five million households in the US (AEP, 2017). AEP was first established in 1906 as the American Gas and Electric Company, before being instituted to AEP in 1958. In 2002 AEP entered a merger with the Central and Southwest Corporation’s that saw it expand its utility services to over eleven states including New York, Ohio, New Jersey, Indian, West Virginia, Illinois, and Michigan among others (AEP, 2017). Currently, the Company has its headquarters at Columbus in Ohio and with several subsidiaries including the Appalachian utility and the West Texas Utility Company. The power plant generates over 26,000 megawatts of electricity, and a capacity of 766 kilovolts of extra-high-power voltage transmission lines, which is by far the largest compared to the total of that produced by the industry (AEP, 2017). Furthermore, the enterprise has above 40,000 miles of power transmission network, which is again high compared to the total of those owned by other firms in the industry (AEP, 2017). The American Electric Power Company is listed in the NYSE stock market using the trade name AEP and is managed by a talented team of staff consisting of Nick Akins as the CEO and Brian Tierney as the CFO (AEP, 2017). The corporate mission upheld by AEP is to establish innovative energy solutions with the aim of powering the society for the betterment of life.

Industry and Economic Analysis

AEP operates in the power and utility sector dominantly controlled by the US Federal Energy Regulatory Commission (Anthony, 2017). AEP operates in an oligopolistic type of market with other of its competing firm comprising of other smaller firms operating within the same States, e.g., Duke Energy, First Energy, Dominion Virginia energy. Other large competitors comprise National Grid PLC, Edison International, and PPL Corp (Anthony, 2017). However, despite enjoying the scale of large operation, the enterprise continues to face several challenges regarding the changing demands in the energy sector. For example, the falling prices of power and demand for renewable clean energy continue to force the business to change its dynamics of operation and the supply of energy (Anthony, 2017).

Future Outlook

The economic analysts predict that the industry will continue to experience growth into the future since the industry is highly regulated, thus guarantee stability in its future earnings (Anthony, 2017). Unlike other industries, the power and utility sector is domestically oriented with little risk of suffering from currency translation. Therefore, it is a lucrative sector for investors into the future (Anthony, 2017).

2. AEP Short-term Liquidity

The liquidity information is primarily used by businesses in assessing their ability to meet short-term obligations when they fall due (Epstein, 2014). The liquidity ratio of a Company is usually helpful in determining the liquidity status of a firm. In this case, it is essential that cash ratios, current ratios, and quick ratios of AEP be analyzed.

I. The Liquidity Ratio

i. The Current Ratio Analysis

The AEP current ratio by March of 2018 was at 0.44 (AEP, 2017). This is a significant decline compared to its end of the year 2017 performance of 0.51, as well as its yearly median of 0.74 and its sustained average of 1.03 over the last decade (AEP, 2017). It means that AEP continues to encounter difficulties in meeting its short-term obligations.

ii. Quick Ratio Analysis

The AEP quick ratio as at March of 2018 was at 0.34 (AEP, 2017). This is a significant decline compared to its end of the year 2017 performance of 0.4, as well as its yearly median of 0.53 and its sustained average of 0.83 over the last decade (AEP, 2017). Nevertheless, the score is marginally above the industry average, which is currently at 0.11 (AEP, 2017). It means that AEP has less fluidity and unable to achieve its short-term obligation from its liquid assets.

iii. The Cash Ratio Analysis

The AEP has a cash ratio of 0.08 (AEP, 2017). This is a significant improvement compared to the previous year at 0.07 (AEP, 2017). The rise in trend depicts that the firm is continuing/ trying to salvage enough cash to meet its short-term debt obligations (Adam, 2015).

3. AEP Operating Efficiencies

The operating efficiencies assess the ability of a firm to manage its revenue and income sources, as well as assets, debt and other overheads incurred by the firm. Information regarding enterprise efficiencies can be derived from the enterprise cash flow information, ratio analysis, as well as the income and balance sheet statement of the business (Epstein, 2014). In the case of AEP, the business can be claimed as being less efficient and is not adequately managing its assets and liabilities. For example, revenue per employee is below the industry and sector revenue per employee by 10.3. Likewise, the net income for each employee at AEP is below the industry total by 3.2 and sector total by 1.9 (AEP, 2017). It means that employee turnover for the Company remains at a manageable level compared to the sector and total industrial employee turnover. In addition, the turnover rate for AEP receivables is relatively high at 10.08 compared to sector turnover at 9.31 (AEP, 2017). Meaning, the business encounters some inconsistency in managing its debt compared to how debt is being managed by the sector (AEP, 2017). Conversely, the inventory turnover and asset turnover for AEP is relatively low (9.74, 0.24) compared to the sector and industrial turnovers (19.46/0.34, 21.68/0.23 respectively). Such statistics imply that AEP is striving to sustain lower inventory levels, and has a potential of influencing its future sales drive (Epstein, 2014). Furthermore, the enterprise asset turnover ratio reveals that it is fairly managing its assets compared to the industry and poorly managing its asset in terms of sector performances.

Also, the analysis of the management effectiveness reveals that the return on asset (2.66) and the average return on assets over the last five years (2.32) have remained low compared to the industry (4.23/ 4.63) and sector (3.33/ 6.19) return on assets. Comparatively, the return on investment for the firm remained below the industry and sector average, further demonstrating the management effectiveness (Adam, 2015). However, there was a substantial increase in the business return-on-equity at 9.66 compared to that of the sector at 8.76 in 2017 (AEP, 2017). However, such deviations do not negate the management effectiveness considering that five years equity average remains below the industry and sector average.

4. AEP Capital Structure

Epstein (2014) defines a business capital structure a permanent form of capital consisting of either debt capital or equity capital, or even a combination of both. However, the most appropriate mix of capital structure in any scenario should consist of a minimal debt level and a high equity level (Epstein, 2014). This is because debt financing increases an enterprise leverage level and lowers its gearing ratio, i.e., influencing its ability to borrow (Adam, 2015). Therefore, the ideal mix of the capital structure should take into consideration the value they have on the enterprise. In the case of AEP, its total debt-to-equity is at 126.37%. However, such a debt-to-equity percentage exceeds the 40% standards set for healthy businesses (AEP, 2017). Hence, AEP can be rendered as not being capital intensive and holds debt at an unacceptable level, i.e., holds the debt over and above its worth. In a practical sense, such businesses are usually perceived as unable to honor their interest payment and debts in the short-run (Epstein, 2014). However, AEP is mentioned as generating 3.74 times its interest payment (AEP, 2017). Hence, AEP can still borrow from the debt market in growing its debt structure.

Conversely, the total debt-to-capital for the firm is at 55.82%, with total debt-to-assets at 33.87% (AEP, 2017). It means that the business is financed more using debt as opposed to equity and that a significant portion of its asset is financed using debt capital (Epstein, 2014). Such outcomes could be dangerous for the business as it will negatively impact its liquidity status. Relatively, the long-term debt-to-equity for AEP is at 107.5% and the long-term debt-to-capital at 47.49%. Again, such values imply that the business holds an unacceptable level of debt capital as they exceed the rule of thumb necessitating 40% for businesses perceived as being financially sound/ healthy (Epstein, 2014). Such figures imply that the business will have to sacrifice a large portion of its income in settling debts, which is not the ideal type of venture for investors.

5. AEP Profitability Status

This section will involve the analysis of different profitability ratios for a Company.

i. Profit Margin

AEP Company profit margin increased to 13% in the 2016/2017 FY down from 4% in 2015/2016. Nevertheless, the profit margin was still below the industry average of 51.82%, implying that the business is achieving some positive performances despite the dismal growth in revenue (AEP, 2017).

ii. ROA

AEP Company return on assets was at 2.66% by the end of 2017, compared 3.02% in 2016 (AEP, 2017). However, the asset turnover changed from 1.98 to 2.03. Meaning, $2.03 as earned by the business asset is contributed to its net income. It implies that the business is striving to improve its inventory turnover (Epstein, 2014). Such change in AEP turnover is indicative that it is meaningfully using its assets to generate sales (Adam, 2015).

iii. ROE

AEP Company return in the FY 2017 was at 10.72, compared to 3.89 in 2016 (AEP, 2017). The high on equity by the Company denotes that it is experiencing a smooth transition in its assets and investment capital. Also, it means that 10.72% of the accrued profits are contributed to the shareholders' equity.

iv. Price to Earnings (P/E) Ratio

Again, the P/E ratio for AEP Company has recorded some inconsistencies over the previous period. Currently, the firm P/E ratio stands at 18.93 compared to 48.28 in 2016 (AEP, 2017). It implies that share price and the cash flow the Company generates on per share basis unstable and somehow not worthy of investors (Epstein, 2014). Besides, the industry has a P/E value of 12.33 which is below that of AEP. Such a value suggests that it is performing relatively well compared to the industry. Nevertheless, with a declining P/E ratio (a shareholder in the Company will pay $18.96 for each share held) renders it less appealing for investors. Thus, AEP is not doing enough to boost its investors’ confidence, and the enterprise future earnings (Epstein, 2014).

6. Recommendations for the AEP Trend Analysis

Bestowing from studies by Epstein (2014), the financial analysis tools provides an important lead of enterprise trend analysis. As such, the trend analysis information is vital to help with monitoring of the enterprise future earnings. In the case of AEP, the trend analysis will capture quarterly and annual financial information provided for the enterprise to help forecasting and recommending investment decision. From the analysis of AEP trend, it has a large market capital rendering it ideal for investors and creditors. Besides, the business earning trend over the last two (0.79 to 0.92) quarters shows that it is rising (AEP, 2017). Furthermore, the EPS value of the enterprise is unstable (-16.35%) and consistently declining compared to the industry EPS at 1.2% (AEP, 2017). Similar declines are also witnessed in the firm P/E, dividend and price-to-cash flow ratios further suggesting of its deteriorated financial health.

However, as a remedial action, the business can work towards minimizing its payout ratio is to grow its retained earnings for investment purposes (Adam, 2015). The business can also encourage insider trading considering that its share price is unstable and continue falling in the market. Again, AEP can pursue free cash flow growth to improve its shareholders' value (Adam, 2015). The book value growth for AEP is also low (4.3), with a further decline recorded in its profit and growth analysis reducing the firm relative strength index to 17.55. Hence, AEP can be rated as a hold investment at the moment or even a buy investment on long-term perspective. AEP may be a buy investment considering that its quarterly revenue and profit trends are projected as growing into the future for the firm.

Conclusion

The AEP financial analysis reveals that the enterprise is significantly achieving sales in the market despite the instability in its finances. Besides, the analysis of the enterprise short-term liquidation status, i.e., quick ratio, Current Ratio, and cash ratios reveals that AEP less liquid (AEP, 2017). Further inquiry into its profitability status discloses that it is less efficient, less profitable, and is ineffectively managing its assets (AEP, 2017). Hence, it is a less appealing venture for investors. Furthermore, AEP has a high working capital despite incapability to lower its leverage levels. Again, the P/E ratio is below the sector ratio further pointing out to its poor stock performance. Therefore, the analysis of AEP concludes that it is currently a hold investment due to its risky nature. However, it also has signs of buy investment since trend analysis project that it will be lucrative in the long-run/ future (Epstein, 2014). As such, financial analysis is an important financial management tool for forecasting business trends and achieving concrete decision about the enterprise going concerns (Adam, 2015).

References

Adam, H. (2015, March 24). Ratio Analysis: Using Financial Ratios Retrieved May 16, 2018, from https://www.investopedia.com/university/ratio-analysis/using-ratios.asp

American Electric Power. (2017, February 3). AEP.com - Investors. Retrieved May 16, 2018, from http://www.bing.com/cr?IG=7022A17E8AB14853BC2F4B9F3B4B7DC6&CID=2EDAA05EE7C769DE30CEAAC3E6C16802&rd=1&h=R0I4MynGl2j_Bt9mihVlJLjQE2P-wESOLdwHyLAIOfk&v=1&r=http%3a%2f%2fwww.aep.com%2finvestors%2f&p=DevEx,5098.1

Anthony, K. (2017, April 19). Could American Electric Power Join the Regulated Utility Club? Retrieved May 16, 2018, from http://finance.yahoo.com/news/could-american-electric-power-join-195403841.html

Epstein, L. (2014). Financial decision making: An introduction to financial reports  [Electronic version]. Retrieved from https://content.ashford.edu/

Appendices

The trend Analysis Graph for AEP Company

AEP Financial Ratios

Valuation Ratios

Company industry sector P/E Ratio (TTM) 18.93 12.33 19.03 P/E High - Last 5 Yrs. 50.46 27.70 25.44 P/E Low - Last 5 Yrs. 15.48 6.86 8.96 Beta 0.16 0.93 1.10 Price to Sales (TTM) 2.13 3.51 2.47 Price to Book (MRQ) 1.79 1.47 1.33 Price to Tangible Book (MRQ) 1.79 4.77 3.00 Price to Cash Flow (TTM) 8.82 9.92 8.50 % Owned Institutions 74.35 1.99 1.25 Dividends

Company industry sector Dividend Yield 3.70 2.95 2.36 Dividend Yield - 5 Year Avg 3.57 2.39 2.66 Dividend 5 Year Growth Rate 4.92 8.12 -9.13 Payout Ratio(TTM) 68.27 24.15 33.21

Financial Strength

Company industry sector Quick Ratio (MRQ) 0.34 1.27 2.08 Current Ratio (MRQ) 0.44 1.35 2.22 LT Debt to Equity (MRQ) 101.86 77.53 73.16 Total Debt to Equity (MRQ) 130.38 108.54 90.53 Interest Coverage (TTM) 4.58 8.88 8.76 Profitability Ratios

Company industry sector Gross Margin (TTM) 40.24 35.44 30.95 Gross Margin - 5 Yr. Avg. -- 3.21 16.80 EBITD Margin (TTM) 34.17 -- -- EBITD - 5 Yr. Avg 32.72 47.23 38.13 Operating Margin (TTM) 20.46 39.84 26.53 Operating Margin - 5 Yr. Avg. 17.70 38.81 28.82 Pre-Tax Margin (TTM) 15.74 31.63 21.04 Pre-Tax Margin - 5 Yr. Avg. 13.10 29.23 24.13 Net Profit Margin (TTM) 10.88 23.18 14.76 Net Profit Margin - 5 Yr. Avg. 8.80 20.79 17.74 Effective Tax Rate (TTM) 30.87 22.16 33.17 Effective Tax Rate - 5 Yr. Avg. 32.88 29.07 26.34 Efficiency

Company industry sector Revenue/Employee (TTM) 879,650 854,441,213 8,510,179,671 Net Income/Employee (TTM) 95,709 295,593,729 498,510,487 Receivable Turnover (TTM) 10.08 10.41 9.31 Inventory Turnover (TTM) 9.74 21.68 19.46 Asset Turnover (TTM) 0.24 0.23 0.34 Management Effectiveness

Company industry sector Return on Assets (TTM) 2.66 4.23 3.33 Return on Assets - 5 Yr. Avg. 2.32 4.63 6.19 Return on Investment (TTM) 3.08 5.65 4.26 Return on Investment - 5 Yr. Avg. 2.66 6.02 7.56 Return on Equity (TTM) 9.66 12.41 8.76 Return on Equity - 5 Yr. Avg. 8.61 11.46 13.35