4-5 pages paper

Part I: Introduction-objective and scope of financial analysis

Part II: Country Analysis A. Macroeconomic Analysis and Economic Ties China has undergone a relatively great deal of economic restructuring over the past year  and will likely continue to do so moving forward, due to initiatives put in place by the government.  China has been transitioning from an investment- and export-led growth model to one driven by consumption and innovation, which has led to the emergence of what is being called a two-track economy.  The part of the economy that is focused in basic manufacturing and traditional industries is experiencing difficulty growing, while the part of the economy focused in services, advanced manufacturing and consumer markets shows strong potential growth.  The economy does face some potential risks though.  Due to deterioration of the financial structure and decline of financial efficiency, the economy faces risks of stagflation and risks triggered by rising interest rates, worsening family finances and a real estate bubble.  As a whole, the Chinese economy is predicted to have long-term growth from various dividends including system, labor, science and technology, natural resources, internationalization and ecologicalization that will promote strong and continuous growth and changes in the economic development. B. Political Analysis The political power in China is called the Chinese Communist Party (CCP)and has been in control for 63 years.  Conflicting interests among leaders and institutions is common, but a state of a permanent monopoly on power and intolerance of those who question its right to rule still exists.  There is, however, a collective leadership body of China's most senior leadership body, known as the Communist Party's Politburo Standing Committee (PSC).  In the PSC the leaders are ranked from one to nine, one having the most power, but a majority must be in accordance for the passing of major policies.  The PSC has "absolute leadership" and control over the military, known as the People's Liberation Army (PLA).  The PLA is also allowed to have two uniformed officers serve on the PSC.  Overall, political figures have the power and ability to influence and/or advance particular causes, include an increasingly diverse media, state-owned and private corporations, official and quasi-official research institutes, university academics, officially sponsored associations and societies, and grassroots non-governmental organizations. C. Providers of Financing D. Cultural Analysis As home to more than one billion people, China has a variety of customs and traditions that vary by geography and ethnicity.  Vital components of Chinese culture include religion, food, style, language, marriage, and music.  Currently there are five official religions recognized in China - Buddhism, Taoism, Islam, Catholicism, and Protestantism.  All other religions are illegal.  As far as language is concerned, there are seven major groups of dialects of the Chinese language.  The majority of the country, about 72%, speak Mandarin dialect.  The cuisine in China is greatly influenced depending on geographic location and ethnic group.  Regardless, rice and tofu are of major food sources.  Chinese history has impacted various aspects of the culture including the arts and customs and celebrations.   E. Legal Analysis The structure of the legal system in China includes the executive branch, legislative branch, and judicial branch.  The executive branch consists of the President, Vice President, and The State Council.  The National People's Congress (NPC) elects individuals to serve as President and Vice President.  The State Council is the highest organ of state power, and of state administration.  It consists of the Premiers, Vice-Premiers, State Councillors, Ministers in charge of ministries, Ministers in charge of commissions, Auditor-General, and the Secretary-General, whom perform a number of functions and have powers, including but not limited to:  the adoption of administrative measures, rules and orders, submission of proposals to the NPC, creation and execution of a plan for national economic and social development, conducting foreign affairs and concluding treaties and agreements with foreign nations; protection of the rights of Chinese nationals abroad, and exercising any other functions that the NPC may delegate.  Each of these individuals serve a five year term, with a maximum of two consecutive terms. The legislative branch consists of the National People's Congress (NPC), which is deemed to be the "highest organ of state power."  Some powers of the NCP are to amend the Constitution, enact laws, elect the President and Vice President of the PRC, elect the President of the Supreme People’s Court, deciding questions of war and peace, and various removal powers  Legislation is also created at more local levels by the people’s congresses of provinces, municipalities, autonomous areas and cities.  The stages of a typical bill in the NCP are presentation, examination, passing the bill and publication of the enacted law. The judicial system consists of the people’s courts, the Supreme People’s Court, the people’s procuratorates, the Supreme People’s Procuratorate, military procuratorates and other special people’s procuratorates.  There is a hierarchy within the court structure from the top down: The Supreme People’s Courts, the Higher People’s Courts, the Intermediate People’s Courts, and the  Basic People’s Courts, as noted in the diagram below.  The specialized courts are also displayed.

Despite the different branches, China’s legislation structure is not one of checks and balances, where the legislation, administration and court stand independently to restrain one another.    F. Tax Analysis China's tax system has gone through various reforms over the past 30 years.  The most recent reform, in 2003, focused on the goals of the establishment of China's socialist market economy system.  China's value added tax and business tax are actually still in a transition period, in an effort to eliminate double taxation issues arising under the prevailing indirect tax system. Currently, according to Chinese tax code, taxable income includes profits, capital gains and passive income, such as interest royalties and rents, and dividends received from a foreign entity.  Generally, all documented costs related to the generation of taxable income are deductible unless the law specifically states otherwise.  The normal corporate income tax rate for this income is 25%.  However, special rates apply in the following situations: for small-scale enterprises if certain requirements are met (20% or 10%), enterprises with high and new technology enterprise (HNTE) status (15%), and enterprises incorporated in certain regions of China and engaged in encouraged business (15%).  Some other tax regulations are outlined in the charts below:

Part III. Industry analysis

A. Looking at the computer industry, trends, competitive environment, the major players

Part IV: Company Specific Analysis

A. Specific U.S. GAAP Adjustments

Lenovo prepares its financial statements according to the Hong Kong Financial Reporting Standards (HKFRS).  As such, there will numerous differences in the amounts reported under the HKFRS and U.S. GAAP.  The significant differences are highlighted below:

1. Intangible Assets - Both HKFRS and U.S. GAAP amortize intangible assets on a straight-line basis over the useful life of the intangible asset.  However, HKFRS records ‘Customer Relationships’ with their intangible assets.  Customer relationships are recognized at fair value and amortized on a straight line basis over its useful life.  U.S. GAAP does not permit the recording of Customer Relationships on the Balance Sheet.  Thus, total assets for Lenovo are higher than they would be had they been recorded with U.S. GAAP.  

2. Provisions/Contingent Liabilities- HKFRS records provisions on its financial statements; with its U.S. GAAP counterpart being contingent liabilities.  According to HKFRS, provisions are recognized when there is a probable (more likely than not) chance that an outflow of resources will be required to settle a liability.  

b. Comparing the two companies warranty provision/contingent liability, Lenovo has a warranty provision of  $1,153,855,000.  HP has a warranty contingent liability of about $1,147,000,000. Since U.S. GAAP requires contingent liabilities to be recorded when the probability of occurrence is 70%-90%, I would expect Lenovo’s warranty expense to be slightly higher since they are more conservative when the book the provision.  HP’s revenue is also nearly $20 billion higher than Lenovo, yet Lenovo reports a higher warranty provision.  This makes sense because, as stated previously, Lenovo is more likely to record warranty provisions than HP.

1. Inventories- Inventories under HKFRS are reported at lower of cost or net realizable value.  U.S. GAAP records inventory at the lower of cost or market.  Since U.S. GAAP places a ceiling of the net realizable value on inventory valued at market, U.S. GAAP inventory valuations will at least be the same as HKFRS, if not lower.  Thus, it is likely that if Lenovo reported inventory according to U.S. GAAP, their inventory numbers would be lower.  Total assets are likely overstated in HKFRS.

c. Additionally, Lenovo reports its inventory according to the weighted average cost flow assumption.  HP reports its inventory according to the first-in, first-out cost flow assumption.  This difference in inventory valuations has a number of implications.  Had Lenovo reported inventory using a FIFO method, they would be reporting a higher net income than they currently are because cost of goods sold would be lower.  Additionally, Lenovo would report a higher inventory amount using FIFO than a weighted average method.  These differences are important to note in comparing companies.  

1. Depreciation- Both Lenovo and HP depreciate their property, plant, and equipment on a straight line basis over the estimated useful life or remaining life of the lease, whichever is shorter.  HKFRS uses and estimated useful life of 10 to 50 years, while U.S. GAAP uses an estimated useful life of 5 to 40 years.  Thus, U.S. GAAP is likely to take a larger depreciation expense because they are depreciating their assets over a shorter period of time.  HKFRS will take a lower depreciation expense, and thus report a higher net income.

B. Ratio Analysis

Since HP and Lenovo have many differences, including size (revenues), reporting methods (U.S. GAAP vs. HKFRS), and different world headquarters, it would not be very useful to compare evaluate each company based solely on the financial statement line items.  Reporting that HP brought in $20 billion more in revenue than Lenovo does tell us that HP is the larger company, but it tells us nothing about the company's efficiency.  In order to better compare two different companies, a ratio analysis is useful. A ratio analysis also helps to highlight important company information in simple, easy to read figures.  Below are some major financial ratios for both Lenovo and HP, followed by an analysis of each:

1. Price/Earnings Ratio: Current market price per share / earnings per share

a. HP: 11.84 /2.51 = 4.72

a. Lenovo: 11.20 /7.77= 1.44

ii. The PE ratio indicates the amount an investor is willing to receive $1 of that company’s earnings.  Generally, the higher the PE ratio, the more optimistic investors are about the future of the company.  With this ratio, HP is doing better in terms of investor confidence in the company.

0. Return on Assets: Net Income/ Average Total Assets (in millions)

a. HP: 4,554 / ((106,882+103,206)/2) = 4.3%

b. Lenovo: 836.6 / ((27,081 + 18,357)/2) = 3.7%

i. Return on assets is a measure of efficiency.  Return on assets gives an estimate of how efficient a company is at generating net income by using its assets. HP has the advantage over Lenovo.  HP generates a higher percentage of net income by using its assets than does Lenovo.

0. Profit Margin: Net Income / Net Sales (Revenue) (in millions)

a. HP: 4,554 / 103,355 = 4.41%

b. Lenovo: 836.6 / 46,295 = 1.81%

i. The profit margin ratio gives an excellent measure of efficiency while ignoring the size of each firm.  This shows how well a company can generate revenue and keep costs as low as possible.  HP can recognize 4.41% of revenue in profit for the year; outperforming Lenovo who can only recognize 1.81% of revenue as profits for the year.

0. Current Ratio: Current Assets / Current Liabilities (in millions)

a. HP: 51,787 / 42,191 = 1.22

b. Lenovo: 15, 427 / 17,161 = .899

i. The current ratio measures a company’s ability to pay short term debts with current resources.  Generally, an investor would like to see a current ratio above 1, because that means that the company has enough current resources to pay back current debts.  HP is doing well because they have a ratio above 1; however Lenovo currently does not have enough current resources to pay off its debts.

0. Acid Test Ratio: (Cash + AR + Short Term Investments) / Current Liabilities (in millions)

a. HP: (17,433 + 13,363 + 2,918) / 42,191 = .799

b. Lenovo: (2,855 + 5,177 + 184) / 17,161 = .479

i. The acid test ratio is similar to the current ratio, however it uses the three most liquid current assets to determine how well the company can handle its current liabilities.  The higher the ratio, the better the company can handle current debt as it becomes due.  HP has a higher acid test ratio and is thus in a better position to handle its current liabilities than Lenovo.

0. Accounts Receivable Turnover Ratio: Net Credit Sales / Average Accounts Receivable (in millions)

a. HP: 103,355 / ((16,281 + 16,778) / 2) = 6.25 times

b. Lenovo: 46,295 / ((5,177 + 3,171) / 2) = 11.09 times

0. Days in receivables: 365 / AR Turnover

a. HP: 365 / 6.25 = 58.4 days

b. Lenovo: 365 / 11.09 = 32.9 days

i. Accounts receivable turnover and days in receivables are closely related. AR turnover helps measure a company’s ability to collect its receivables on a timely basis.  An easier way to understand this ratio is by taking the days in a year and dividing it by the AR turnover to produce days in receivables.  This is an average of how long it takes a company to collect payments.  The lower the number the better.  In this case, Lenovo is more efficient at collecting their receivables since it only takes them about 33 days as compared with about 59 days for Lenovo.

0. Inventory Turnover Ratio: COGS / Average Inventory

a. HP: 78,356 / ((6,485 + 6,415) / 2) = 12.15 times

b. Lenovo: 39,613 / ((2,995 + 2,701) / 2) = 13.91 times

0. Average days in inventory: 365 / Inventory Turnover Ratio

a. HP: 365 / 12.15 = 30.04 days

b. Lenovo: 365 / 13.91 = 26.24 days

i. The inventory turnover ratio and average days in inventory are closely related.  The inventory turnover ratio determines how many times a company’s inventory is sold and replaced over a period.  The average days in inventory shows the amount of days that inventory was in the warehouse before it was sold or used.  A company would want a higher inventory turnover ratio, and thus a shorter amount of days in inventory.  Holding inventory is costly and risky, so the shorter amount of time you have responsibility of it the better.  Lenovo is more efficient at moving inventory that HP.

C. Cash Flow Analysis

The Statement of Cash Flows provides investors with some very important financial information.  The first is that it allows investors to predict the amount of cash that will be distributed in the form of dividends.  For the 2014/2015 year, Lenovo distributed $326,930,000 in dividends.  For the previous year, Lenovo distributed about $266,692,000 in dividends.  An increase in distributed dividends certainly looks good to potential and current investors, and indicates enough financial flexibility to distribute partial earnings.  

The second way that the Statement of Cash Flows provides relevant financial information is through an evaluation of operating cash flow.  Operating cash flow is a good indicator of financial health and the ability of the firm to pay back debts with cash on hand.  Lenovo has cash generated from operating activities, which is a good sign for investors.  A free cash flow assessment is another tool investors can use to evaluate a company’s financial health and future growth potential.   A company will make capital purchases to continue to grow and operate, and free cash flow measures the excess cash on hand after accounting for normal growth activities.  The free cash flow is calculated as follows:

1. Free Cash Flow: Cash Flow from operations - current period capital expenditures (in millions)

a. 238 - 258 = -20

i. A negative free cash flow indicates that the company will have to find external sources of financing in order to maintain its current growth and purchase capital assets for the current year.  A negative free cash flow means that the company is not that able to take advantage of unexpected investments because much of their cash is tied up in purchasing capital assets.  This is somewhat concerning for Lenovo.  Even though the difference is not that substantial, the free cash flow deteriorated significantly from the previous year.  Last year, the company had a positive free cash flow of $1,255 million.  This was due to a significant decrease in cash generated from operations, and would probably be a red flag to investors.

V. Conclusion and recommendations