Financial Analysis

Analysis

Based on the above factual data collected and complied, we now proceed to analysis the financial position of Caterpillar Inc. with respect to its competitors and the industry. The analysis is based on various parameters calculated above and measured based on yardsticks such as Liquidity, Activity, Leverage, Profitability, Market Value and Market-to-book ratio.

Liquidity

The first and foremost parameter to study liquidity is Net working capital. It can be observed that the net working capital has dropped by USD 2.87b when compared to 2014. The operating cash flows have dropped by USD 4.51b. This, prima facie appears to be alarming. However, on a careful evaluation of the other factors and the competitors, the following can be observedFinancial Analysis 11 | P a g e The main competitor as well has witnessed a drop of USD 3.08b in their net working capital numbers. Current ratio is stable and has not fluctuated. (from 1.39 to 1.31) The revenues have dipped by 85% (from USD 55b to USD 47b) It may be noted from the above that the current ratio is stable. It can therefore be concluded that there has not be any inefficiency as far as working capital management is concerned. However, there is an indication that there has been a slump in the industry as a whole in which the company is operating i.e. Manufacture of earth moving and other heavy equipment’s. The revenues have dipped by 15% where the competitor’s revenues have dipped by 20%. One of the broad causes for this can be attributed to an overall fall in the commodity and metal prices worldwide. The competitor has however, maintained very good liquidity position at 2.05 and is one of the best in the industry which is averaging at 1.7. On the whole, the working capital and liquidity levels are not the best in the industry. However, considering the capital intensive nature of business and heavy reliance on metal coupled with a slump in the metal industry, it can be concluded that the company has well managed and maintained its working capital and liquidity position.

Activity

In order to evaluate the Activity and Efficiency of operation, we have computed the Inventory and Receivable number of days. Inventory days have only marginally increased from 112 days to 116 days and receivable days from 123 to 139 days. On a careful analysis of these two parameters, it can be observed that in-spite of the pressure on the revenues, the Inventory days and receivable days have not drastically fluctuated. This is an indicator that the management has been quite sensitive to the developments in the industry and had taken adequate precautions regularly in order to keep the working capital under control. It can also be seen that the competitor could not control the receivable days and have increased by 82 days. With a dip in revenue, there is a high likelihood that the inventories pile up and customer payments get delayed resulting in higher inventory days and receivable days. However, in case of Caterpillar Inc., they have done a commendable job of keeping both these parameters under control.

Leverage

Debt to equity ratio is the best measure to assess how the capital is leveraged. The D/E ratio of Caterpillar Inc. for the current year and previous year has been 2.57 and 2.35 respectively. This simply means that the company relies on debt capital 2.5 times that of the shareholders equity. In short, the company is heavily debt leveraged. This is the reason why the interest costs are very high (almost 2-3% of the revenues). The interest coverage ratio indicates that the EBIT covers the interest expense only by 6 times in 2015 whereas it used to be 11.5 times in the previous year and industry average is 14.12. It however needs to be remembered that this is a heavily capital intensive process industry and requires huge amount of capital investment for its process. On a comparison of the competitor’s numbers, it can be seen that their D/E ratio is enormous. It is clear that the competitor is not safely placed in the industry on capital leverage terms. On the contrary, the industry is maintaining a D/E ratio of only 0.69. This is certainly a matter of concern for both Caterpillar Inc. as well as the competitor. Both the companies are nowhere in competition when it comes to the capital leverage of the industry as a whole. Caterpillar Inc. has to take urgent measures to improve its capital structure either through public offerings or institutional investment and try and reduce its debts and in-turn reduce the interest burden which is almost 50% of its Net Income.

Profitability

The two parameters namely Return on Equity (ROE) and Profit Margin have been calculated to assess the profitability of the business with respect to the competitor and the industry. It can be seen that Caterpillar Inc. is reporting 14.19% of ROE which has however decreased from the last year number of 22.06%. This decrease is mainly due to a decrease in the profit margin from 6.7% to 4.47% YoY. What is also worth noting is that the ROE number of the competitor are very high at 28.775 for the year 2015. The main reason is that the competitor Deere & Co. is able to generate more than 2% higher net income and is continuing to do so even in the current year. Deere & Co. is also able to match the industry average which is not a very positive sign for Caterpillar Inc. What is also worth noting is that the industry average of ROE is only 10.11% whereas the target company and the competitor are able to report a very good number. This however, is misleading. It may be recalled in the previous section where D/E ratio was discussed that both Caterpillar Inc. and Deere & Co are operating with very high debt vis as vis the Sharholders Equity whereas the industry average of D/E ratio was very low. ROE considers the net income with respect to only the shareholders equity. As a result of this, the ROE of Caterpillar Inc. and Deere & Co. is very high compared to the industry average which might mislead the users and public and may lead to wrong decisions if not read along with the D/E ratio Caterpillar Inc. is not well placed in terms of profitability vis a vis the competitor as well as the industry. It is facing heavy pressure on its revenues due to market and industry factors. This coupled with its inability to match the competitor and industry margin by 2% will put more burden on the operations team to stay ahead in the race.

Market Value

The market value of Caterpillar is USD 44.47b whereas that of Deer & Co. is USD 24.62b. The market price of the share of the both the companies are at an average of 76-78 presently. In spite of the same levels of price per share, Caterpillar is enjoying a very high market value when compared to the competitor. This is an indicator of the reliance placed by the shareholders of the company. There can be various reasons to this such as excellent track record, reputation, higher dividend yield, reputation of the key managerial personnel, quality of the products, shareholder sentiments etc. These factors can be both monetary and nonmonetary. There can be even emotional reasons for such high market value. It is also worth noting that the high market value is in-spite of reporting a lower EPS than the competitor. From the investor point of view, such sentiments are positive signs of long term trust and faith on the management. For the same reason, the PE ratio of Caterpillar is very high when compared to the competitor.

Market-to-book ratio

Market-to-book ratio measures the market value vis a vis its book value. This measures whether the stock is overvalued or undervalued in the market. If the stock is undervalued, that will be strong reason to buy the stock as there is a hope that in the long run it will aleast match its book value if not higher. An overvalued stock on the other hand has to be carefully evaluated. There are various factors both monetary and non-monetary as discussed in the previous section. This is where the reported financial numbers play a crucial role to properly evaluate the company’s performance and also predict future prospects. Given the above facts, the M/B of Caterpillar Inc. is 3 whereas Deere & co. is 3.65. This indicates that Caterpillar is 3 times overvalued with respect to its book value.

Conclusion & Recommendation

On a careful examination of the financial position and various ratios such as liquidity, Activity, leverage, profitability & market value, following are the conclusions. Caterpillar Inc. is best placed in the industry and is ahead of its competitors in terms of Management of working capital, Internal controls and Efficiency in managing resources and market value. In terms of profitability, it has to improve by at least 2% in order to match the competitors and industry averages. In terms of capital leverage and interest coverage, there is lot of scope for improvement. At present, Caterpillar Inc. is likely to leverage its market value to improve its capital structure and improve its D/E ratio and Interest coverage which can give long term benefits in terms of profitability. In spite of a strain on the revenues and profits, it has been able to maintain a good dividend yield, P/E ratio and market value. Based on the above strong factors working in favour of Caterpillar and also a potential improvement in the commodities & metals market outlook, we give a BUY recomm