Tuesday, May 9, 2017

Airweave financial analysis

Airweave financial analysis

Financial analysis outline
  • Introduction
  • Capital Structure
  • Financial Statement Background
  • Trend Analysis
  • Cross Sectional Analysis
  • Financial Instrument risk information
  • Conclusion
  • Recommendation
  • Bibliography

Introduction

This article is about the financial analysis of Airweave. Airweave has been selling their core product, mattress pad since 2007. We examine the capital structure of Airweave using Modigliani-Miller theory. We analyse the financial trend of Airweave. We analyse and compare the financial statement of Airweave with other companies in the industry group. The financial instrument risk information will be discussed. Financial instruments are the borrowings and equity that Airweave uses to manage its financing. A conclusion will be made based on the analysis. Lastly, a few recommendations that may be useful for Airweave to manage its financial risks, will be discussed.

Capital Structure

We can use financial theory to explain the optimal debt ratio.

The Modigliani-Miller theorem with taxes, proposition one says that the value of levered firm is equal to the value of the unlevered firm, plus the tax multiplied by debt taken. Since debt borrowings are tax deductible, there are advantages of taking up debt. Leverage adds value to a levered company.

VL = VU + T*D ----- 1.1
where
VL is the value of levered company
VU is the value of unlevered company
D is the amount of debt taken
T is tax rate

The formula above says when we add debt to a company, the value of the company increases.

The Modigliani-Miller theorem with taxes, proposition two states that the cost of equity rises with leverage.
rE = r0 + D/E(r0-rd)(1-T) ----- 1.2
where
r0 is the cost of equity without leverage
T is tax rate
rd is the cost of debt

The formula says when we use more debt to replace equity, the WACC drops and there is an optimal capital structure.

For the optimal capital structure, we can refer to the table below. Firstly, we follow the Modigliani-Miller theory, and say that if the company takes on debt beyond the optimal level, the company will have greater default risk, so its cost of equity goes up, and its cost of debt also goes up. From the table, we find out that the lowest weighted average cost of capital (WACC) happens when D/E is equal to one.

To calculate WACC, we use the WACC formula as shown below:
WACC = Re*E/(D+E) + Rd*(1-T)*D/(D+E) ----- 1.3

According to the table below, the optimal D/E ratio for lowest WACC is when debt is roughly equal to equity.
Table 1: Optimal D/E ratio for lowest WACC
D/(D+E)
Re
Rd
After-tax Cost of Debt
WACC
0
10.50%
8%
4.80%
10.50%
10%
11%
8.50%
5.10%
10.41%
20%
11.60%
9.00%
5.40%
10.36%
30%
12.30%
9.00%
5.40%
10.23%
40%
13.10%
9.50%
5.70%
10.14%
50%
14%
10.50%
6.30%
10.15%
60%
15%
12%
7.20%
10.32%
70%
16.10%
13.50%
8.10%
10.50%

In 2016, the Airweave ratio of total liabilities to total equity is roughly one, which mean D/E is equal to one. So Airweave is close to its optimal capital structure.

For long term, and short term borrowing, the Japanese long term interest rate is at historic low at the moment. There is a risk of interest rate goes up in the next five years during to possible monetary tightening policy of the Bank of Japan. Therefore, Airweave takes advantage of the low interest rate situation by borrowing long term, and locking in lower rates.

Financial Statement Background

From the income statement below, the cost of goods sold is around 50% of its revenue in 2015, and 40% of its revenue in 2016, due to improving economies of scale. The selling and administrative expenses is slowly increasing due to company expansion. For income tax expenses, the corporate tax rate is about 40% in Japan from 2014 to 2016. Airweave pays 10% of its long term borrowing as the finance cost. The depreciation expenses is calculated from the balance sheet.

Items
Yearly/2016
Yearly/2015
Yearly/2014
(31/12/2016)
(31/12/2015)
(31/12/2014)
million yen
million yen
million yen
Income Statement





TOTAL REVENUES
14000
12000
9500
COST OF GOODS SOLD
5500
6000
4500
SELLING AND ADMINISTRATIVE EXPENSES
2200
1610
1250
DEPRECIATION EXPENSES
200
200
200
OTHER EXPENSES
90
90
90
TOTAL EXPENSES
7990
7900
6040
PROFIT (LOSS) BEFORE FINANCE COSTS AND INCOME TAX EXPENSES
6010
4100
3460
FINANCE COSTS
323
233
114
INCOME TAX EXPENSES
2275
1547
1338
NET PROFIT (LOSS)
3412
2320
2008
Other Comprehensive Income Statement





NET PROFIT (LOSS)
3412
2320
2008
EXCHANGE DIFFERENCES ON TRANSLATING FOREIGN OPERATIONS
192
76
-38
TOTAL OTHER COMPREHENSIVE INCOME
3604
2396
1970
DIVIDENDS
200
200
200

From the balance sheet below, the cash and cash equivalent number in 2015 and 2016 are calculated from cash flow statement. The property, plant and equipment, it is increasing because of Airweave company expansion. Similarly, the long term borrowings are increasing because Airweave borrows capital for expansion.

We can see that the ordinary shares and paid up capital are constant. The retained earnings keeps increasing from 2014 to 2016 because of strong financial performance of Airweave. As a result, the total equity of the company increase by 44% from 2014 to 2015, and 47% from 2015 to 2016.

Items
Yearly/2016
Yearly/2015
Yearly/2014
(31/12/2016)
(31/12/2015)
(31/12/2014)
million yen
million yen
million yen
CASH AND CASH EQUIVALENTS
4327
3924
2110
ACCOUNTS RECEIVABLE
3942
3117
2783
INVENTORIES
3433
4389
3468
PREPAID EXPENSES
458
453
367
SHORT TERM INVESTMENTS
434
636
424
OTHER CURRENT ASSETS
624
765
536
TOTAL CURRENT ASSETS
13218
13284
9688
INVESTMENT PROPERTIES
1921
1821
1221
PROPERTY, PLANT AND EQUIPMENTS
6023
3951
1832
Less: Accumulated Depreciation
600
400
200
INTANGIBLE ASSETS
167
167
167
Less: Accumulated Amortization
29
23
17
DEFERRED TAX ASSETS
428
453
367
OTHER NON-CURRENT ASSETS
87
52
13
TOTAL NON-CURRENT ASSETS
9255
6867
3817
TOTAL ASSETS
22473
20151
13505
BANK OVERDRAFTS
300
200
100
ACCOUNTS PAYABLE
1121
2122
1343
CURRENT PORTION OF LONG-TERM LIABILITIES
230
230
230
ACCRUED EXPENSE
1522
2122
1733
OTHER CURRENT LIABILITIES
553
213
121
TOTAL CURRENT LIABILITIES
3726
4887
3527
LONG-TERM BORROWINGS FROM FINANCIAL INSTITUTIONS
3233
2333
1135
LIABILITIES FOR EMPLOYEE RETIREMENT BENEFITS
524
477
165
OTHER NON-CURRENT LIABILITIES
746
453
233
TOTAL NON-CURRENT LIABILITIES
8229
8150
5060
TOTAL LIABILITIES
11955
13037
8587
ORDINARY SHARES
4499
4499
4499
ISSUED AND FULLY PAID-UP SHARE CAPITAL
240
240
240
RETAINED EARNINGS
5460
2248
128
CURRENCY TRANSLATION CHANGES
319
127
51
TOTAL EQUITY
10518
7114
4918

From the cash flow statement below, for the cash from operating activities, the net profits numbers are calculated from income statement. The changes in account receivable, inventories, prepaid expenses, short term investments, other current assets, account payable, accrued expenses, other current liabilities, non current liabilities are from balance sheet.

For the cash from investing activities, the changes in investment properties, property plant and equipments are calculated from balance sheet. For the cash from financing activities, the changes in long term borrowings and retirement benefits are calculated from balance sheet.
Items
Yearly/2016
Yearly/2015
Yearly/2014
(31/12/2016)
(31/12/2015)
(31/12/2014)
million yen
million yen
million yen
NET PROFIT
3412
2320
2008
DEPRECIATION
-200
-200
-200
AMORTISATION
-6
-6
-6
CHANGES IN ACCOUNT RECEIVABLE
-825
-334
-321
CHANGES IN INVENTORIES
956
-921
-345
CHANGES IN PREPAID EXPENSES
-5
-86
-50
CHANGES IN SHORT TERM INVESTMENTS
202
-212
45
CHANGES IN OTHER CURRENT ASSETS
141
-229
-100
CHANGES IN ACCOUNT PAYABLE
-1001
779
343
CHANGES IN ACCRUED EXPENSES
-600
389
212
CHANGES IN OTHER CURRENT LIABILITIES
340
92
46
CHANGES IN OTHER NON-CURRENT LIABILITIES
293
220
101
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
2707
1812
1733
CHANGES IN INVESTMENT PROPERTIES
-100
-600
-100
CHANGES IN PROPERTY, PLANT AND EQUIPMENTS
-2072
-2119
-212
CHANGES IN INTANGIBLE ASSETS
0
0
0
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
-2172
-2719
-312
CHANGES IN LONG-TERM BORROWINGS FROM FINANCIAL INSTITUTIONS
900
1198
500
CHANGES IN LIABILITIES FOR EMPLOYEE RETIREMENT BENEFITS
47
312
93
DIVIDEND PAID
-200
-200
-200
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
747
1310
393
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENT
1282
403
1814
CASH AND CASH EQUIVALENTS, BEGINNING BALANCE
4327
3924
2110
CASH AND CASH EQUIVALENTS, ENDING BALANCE
5609
4327
3924

Trend Analysis

We analyse the Airweave financial data from year 2014 to year 2016.

The company has about the same liabilities and equities in 2016 due to increased borrowings from the bank for company expansion. The Account Receivables is slowly increasing, and Property Plant and Equipments (PP&E) increases significantly over the three years due to increase in fixed assets investment.

Table 2: Airweave overall cash flow analysis
Cash flow analysis Unit:Million yen
Item
2016
2015
2014
Net Cash flow from operating activities
2,207
1,812
1,733
Net Cash flow from investing activities
(2,172)
(2,719)
(312)
Net Cash flow from financing activities
747
1,310
393
Net change in cash
1,282
403
1,814

Table 3: Airweave cash flow analysis showing sources and uses of cash

2016
2015
2014
Revenue
14,000
12,000
9,500
Net Income
3,412
2,320
2,008
Account Receivable
(825)
(334)
(321)
Inventories
956
(921)
(345)
Account Payable
(1,001)
779
1,343
Accrued Expenses
(600)
389
212
Capital Expenditures
(2,072)
(2,119)
(212)
Common Dividends
(200)
(200)
(200)
Long Term Borrowings
900
1198
500

For cash flow from operations, the major source of cash are net income, and increase in Account Payables for year 2014 ad 2015. The major use of cash are Inventories for year 2014 and 2015, Account Receivables from year 2014 to 2016. The Account Payable is a source of cash in 2014 and 2015, and a use of cash in 2016. The Accrued Expenses is a source of cash in 2014 and 2015, and a use of cash in 2016. The cash flow from operations is a positive number and increases from 2014 to 2016.

For cash flow from investing, the major use of cash is purchase of PP&E or capital expenditures. It was used in new shops and capacity expansion. The cash flow from investing is a negative number and highest negative value in 2015.

For cash flow from financing, in 2014 and 2015 and 2016, the major source of cash was an increase in long term borrowings. In all three years, the major use of financing cash flow is the dividends paid. The cash flow from financing is a positive number and has highest positive value in 2015.

In the overall, the net change in cash is positive from 2014 to 2016.

DuPont Analysis

DuPont analysis is useful to measure the financial performance of a company. This analysis method was started by the DuPont Corporation in 1920s. It measures return on assets (ROA) and return on equity (ROE). ROE is the net income as a percentage of total shareholder equity. ROA is the net income as a percentage of total assets. According to DuPont analysis, ROA is broken down into two parts, and ROE is broken down into three parts. The details are shown below.

ROA = NI/Sales * Sales/total Assets
ROE = NI/Sales * Sales/total Assets * Total Assets/Total SH Equity

DuPont Analysis is useful to determine what is driving the company’s financial performance. Profit Margin shows the operation efficient. Asset Turnover shows the asset usage efficiency. The financial leverage shows the degree of leverage of the company.

Table 4: NI/Sales (Profit Margin)
2016
2015
2014
0.2437
0.1933
0.2114

Table 5: Sales/total Assets (Asset Turnover)
2016
2015
2014
0.6229
0.5955
0.7034

Now, we have Profit margin and Asset turnover. We multiply them and obtain the ROA number.

Table 6: ROA calculation
Item
2016
2015
2014
ROA
0.2437*0.6229
=0.1518
0.1933*0.5955
=0.1151
0.2144*0.7034
=0.1508

The Net profit margin is declining from 2014 to 2015, and increases from 2015 to 2016.
The Asset Turnover declines from 2014 to 2015, then increases from 2015 to 2016.

In the overall, ROA declines from 2014 to 2015, and increase from 2015 to 2016. It is a good indicator of company performance.

Table 7: Total Assets/Total SH Equity (Financial Leverage)
2016
2015
2014
2.1367
2.8325
2.7460

Now, we multiply Profit margin, Asset Turnover and financial leverage, we obtain the ROE number.

Table 8: ROE calculation
Item
2016
2015
2014
ROE
0.2437*0.6229*2.137
=0.3244
0.1933*0.5955*2.833
=0.3261
0.2144*0.7034*2.746
=0.4141
The Net profit margin is declining from 2014 to 2015, and increases from 2015 to 2016.
The Asset Turnover declines from 2014 to 2015, then increases from 2015 to 2016.
The equity multiplier increases from 2014 to 2015, then decline in 2016.

In the overall, ROE declines from 2014 to 2016. The decline in 2016 is due to less financial leverage. ROE decline is an indicator that the company is using more equity to generate net income. The more equity comes from increased retained earnings. This is a good sign.

The conclusion of DuPont analysis : Airweave profitability performance is improving from 2014 to 2016. For every Japanese yen that the investors put into AIrweave assets, the return that investors get out of it, is increasing.

Cross Sectional Analysis

Cross sectional analysis is a comparison of company financial performance against industry peers, within the industry group. The purpose is to find out the financial performance of Airweave relative to its industry peers. Airweave is a mattress and mattress pad company. It is not possible to find listed Japanese company that manufactures mattress or mattress pad in the Tokyo Stock Exchange or other stock exchange in Japan. We use Japanese hospital bed manufacturer, Paramount Bed, Dutch mattress and bedroom furniture company, Beter Bed and American bed and mattress company, Sleep Number, as the industry peers. Only one of these companies is located in Japan. The other two companies are not located in Japan but they are mattress company. So we use them for comparison.

Firstly, we will see the fiscal year end of the companies. Their fiscal year end is shown in table below.

Table 9: Fiscal year end of companies
Airweave
Paramount Bed
Sleep Number
Beter Bed
31 December
31 March
31 December
31 December

Next, we find out and compare the financial ratios of the four companies in year 2016. For the easy understanding of the readers, we explain the financial ratios used in the analysis.

Firstly, there is the Liquidity ratio. It is a measure of the company’s ability to pay debt obligations.
Current ratio = Current Assets / Current Liabilities
Quick ratio = (Cash and equivalents + Marketable securities + Accounts receivable) / Current Liabilities
Current ratio measures the company’s ability to pay short term and long term debt. Quick ratio is an indicator of company’s short term liquidity.

Secondly, there is Asset Management ratio. It measures company’s ability to use assets to generate sales.
Inventory Turnover = Sales / Average Inventory
Asset Turnover = Sales / Total Assets
Fixed Asset Turnover = Sales / Fixed Assets
Inventory Turnover measures the company’s management of its inventory. Asset Turnover measures the company’s management of its assets. Fixed Asset Turnover measures the company’s management of its fixed assets

Thirdly, there is Debt Management ratio. It measures the company’s resources coming from debt or from equity. It measures the company’s financial leverage.
Debt ratio = Total Debt / Total Assets
Debt/Equity ratio = Total Debt / Total Assets
Debt ratio measures the level of debt of a company. Debt/Equity ratio measures the degree of leverage of a company. It shows how much debt the company use to finance its assets relative to the amount in equity.

Fourthly, there is Profitability ratio. It measures the business profit compared to its expenses and cost.
Gross Margin = Gross Profit / Revenue
Operating Margin = Operating Profit / Revenue
Net Margin = Net Profit / Revenue
ROA = Net Profit / Total Assets
ROE = Net Profit / Total Equity
The gross margin measures the profitability before operating factors is considered. The operating margin measures the profitability after operating efficiency is considered. The net margin measures the profitability after tax and interest payments are calculated. The ROA and ROE are described in details in DuPont analysis section.

Lastly, there is receivable turnover and payable turnover.
receivable turnover = sales/account receivable
payable turnover = sales/account payable
High numbers in receivable turnover means fast cash recovery, fast cash collection time.
Low numbers in payable turnover means company pays suppliers slowly.

Table 10: Cross sectional analysis
Item
Airweave
Paramount
Sleep Number
Beter Bed
Average
Liquidity ratio
Current Ratio (x)
3.55
3.51
0.61
1.50
2.29
Quick Ratio (x)
2.34
2.98
0.14
0.54
1.50
Asset Management Ratio
Inventory Turnover (x)
4.08
10.19
17.48
6.63
9.59
Asset Turnover (x)
0.62
0.59
2.87
2.86
1.74
Fixed Assets Turnover (x)
2.32
2.46
6.29
8.74
4.95
Debt Management Ratio
Debt Ratio(x)
0.53
0.33
0.65
0.46
0.49
Debt/Equity ratio(x)
1.14
0.48
1.85
0.87
1.08
Profitability Ratio
Gross Margin %
60.71
42.64
61.78
57.76
55.72
Operating Margin %
42.93
13.04
5.85
6.34
17.04
Net Profit Margin %
24.37
8.62
3.92
4.63
10.38
ROA %
15.18
5.06
11.25
13.24
11.18
ROE %
32.44
7.49
32.07
24.73
24.18
Receivable and Payable Turnover Ratio
Receivables Turnover(x)
3.55
3.01
66.55
31.59
26.17
Payable Turnover (x)
12.49
5.69
12.44
12.88
10.87

As can be seen from the table above, we compare the liquidity ratio, asset management ratio, debt management ratio and profitability ratio, and receivable payable turnover ratio.

For easy understanding, the above table is plotted in the graphs below.

Figure 1: Liquidity ratio

Figure 2: Asset Management ratio

Figure 3: Debt Management ratio

Figure 4: Profitability ratio
Firstly, the liquidity ratio, Airweave current ratio is above industry average, and the quick ratio is above industry average too. For the liquidity ratio, the higher the number, the better it is. So Airweave is in good position in terms of liquidity ratio.

Secondly, the asset management ratio, Airweave’s Inventory Turnover, Asset Turnover and Fixed Assets Turnover are below industry average. For the asset management ratio, the higher the number, the better it is. The implication is that Airweave is not generating high enough sales from the existing assets and inventories. Airweave is using more assets to generate sales, compared to its industry average. There is room for improvement in asset management for Airweave. Airweave could improve its asset management strategy.

Thirdly, the debt management ratio, Airweave debt ratio and debt/equity ratio are slightly higher than industry average. Airweave is using more borrowings compared to its industry average. However, Airweave is a young and growth company. It is using leverage to grow its business and generate sales. Its debt/equity ratio is close to one, which is the optimal case for capital structure. Therefore, it is acceptable for a company such as Airweave to borrow up to 50% of its assets because it uses the borrowings to maximise the value of the company.

Fourthly, profitability ratio, the Airweave numbers beat the industry average in every cases. For the profitability ratio, the higher the number, the better it is. It shows that Airweave is well managed, with little operating and administration overhead. It could be because Airweave is a small and tightly run company. Airweave has less overhead and it can achieve a high profitability ratio.

Lastly, the receivable and payable turnover ratio is discussed. The receivable ratio measures the efficiency of company collecting credit sales from customers. The ratio is the higher the number, the better it is. Airweave has the lowest receivable turnover ratio. The payable turnover ratio is the ratio that measures the efficiency of company paying credit sales to suppliers. The ratio is the lower the number, the better it is. Airweave has the highest payable turnover ratio. Airweave is collecting receivables too slow and paying payables too fast.

Furthermore, for further understanding of company performance, we calculate the net operating cycle. Net operating cycle shows how many days it takes to create inventory, sell inventory, and collect money from customers. The lower the number, the better is the company performance.

Net operating cycle = No. of Days of Inventory + No. of Days of Receivables - No. of Days of Payables
Table 11: Net operating cycle comparison of the four companies in year 2016

Airweave
Paramount
Sleep Number
Beter Bed
No. of Days of Inventory
89.46
35.82
20.88
55.05
No. of Days of Receivables
102.82
121.26
5.48
11.55
No. of Days of Payables
29.22
64.15
29.34
28.34
Net Operating Cycle
163.06
92.93
-2.98
38.26
Airweave has the highest Net operating cycle. So it is below the performance of industry peers.

Next, we look at the cash flow of the four companies in year 2016. We will attempt to get a clearer picture of the financial health of the companies from the cash flow analysis.

For USD, we use exchange rate of JPY/USD of 115.
For Euro, we use exchange rate of JPY/EUR of 121.

Table 12: Cash flow comparison of the four companies in year 2016
Unit:Million yen
Item
Airweave
Paramount
Sleep Number
Beter Bed
Net Cash flow from operating activities
2707
9657
17439
4119
Net Cash flow from investing activities
(2172)
(2038)
(4907)
(2391)
Net Cash flow from financing activities
747
(5493)
(13610)
(2178)
Net change in cash
1282
2126
(1078)
(450)

From the table above, we can see that Airweave operating cash flow sizes are smaller than other other three companies. This is expected as Airweave is a smaller company in terms of operation size, and sales. It can be seen that Airweave has a strong positive net change in cash given its smaller net cash flow from operations. Its has an investing cash flow which is almost equal to the cash flow from operations. It is also getting a positive financing cash flows.

Breakeven Point Analysis

The analysis is to find out the minimum number of units required to overcome the variable cost and fixed cost of the company’s operation. A graph illustrating the break even analysis is shown below.
Figure 5: Breakeven analysis
Source: http://www.12manage.com/methods_break-even_point.html

In 2016, the sales is 14000 million yen. The Airweave mattress pad selling price ranges from 50000 yen to 250000 yen. Taking the middle figure of 150000 yen, 14000 million is divided by 150000, the result is 93333 unit sales. Airweave cost of goods sold is 5500 million yen. The 5500 million is divided by by 93333 unit, the result is 58928 yen. This number is the variable cost per unit sold. For the fixed cost, it can be found by adding up the selling and administrative expenses, depreciation expenses, and other expenses. The result is 2490 million yen which is the fixed cost.

To show the calculation:
14000 million / 150000 = 93333 unit (sales)
5500 million / 93333 = 58928 yen (variable cost)

To break even, we can use a formula to calculate. Assuming unit is the number of units to breakeven:
150000 * unit = 2490 million + 58928 * unit
Unit = 27341

Therefore, we can see that 27341 units are needed for the company to break even. The company is selling 93333 units in 2016. It has exceeded the break even point.

Financial instrument risk information

Financial instrument risk is the risk of using the financial instrument in a company’s operation. In Airweave case, it uses long term borrowings, and equity from green tea company to fund its investment. Airweave has roughly one to one of debt to equity ratio in 2016. From the capital structure, Airweave financial instrument (debt, equity) is subject to market risk, such as interest rate risk, currency risk, price risk.

To measure the market risk, we can use Value at risk (VaR) method. Value at risk measures the probability that financial instrument of a firm will lose a certain amount in a given period of time. For example, we can say: with 95% confidence, we expect the investment will not lose $10 million yen over a year.

There are three methods to calculate VaR. There are historical method, variance covariance method, and Monte Carlo method.

The VaR formula is: VaR = Rp - Z * σp

Z is the value of test statistics, it can be of 95% or 99% confidence level.
95%: 1.65
99%: 2.33

For the Airweave debt borrowing, Airweave takes up fixed rate borrowings at low interest rates, so there is very little market risk.
For the Airweave equity, it is subject to currency risk. Airweave equity valuation will decline when its domestic currency appreciates.

To show an example of the application of VaR formula: If return of equity is set at 10%, the standard deviation of return is 10%, at 95% confidence level, the VaR is:
VaR = 0.10 - 1.65*0.10 = -0.065

In 2016, the total shareholder equity capital is 10518 million yen. We multiply 0.065 by 10518 million, the result is 683 million. In this example, the minimum equity capital at risk, or losses, would be 683 million, at 95% confidence level.

Conclusion

Airweave is a growth company. Its total revenue is growing. Its retained earnings is increasing in the three year period from 2014 to 2016. Its net cash flows are positive in the three year period from 2014 to 2016. It has a strong balance sheet, such as strong current ratio, quick ratio, reasonable D/E ratio, and high ROE and ROA and high profit margin. All these numbers show that it is in good financial position.

The negative with Airweave is the asset management ratio. Airweave’s asset management ratio is below its peers. Airweave should improve on asset management, in the way that it should use less assets to generate sales. With expected revenue growth in the coming years, Airweave is expected to continue with its strong financial position.

Furthermore, Airweave has the worst net operating cycle. Airweave should improve on this aspect. Airweave can shorten the number of days in inventory, number of days in receivables.

After three years, when Airweave is listed on the Tokyo Stock Exchange, their financial statements will be available for public viewing. It will help to validate our assumptions in the financial statements.

Recommendation

Airweave is preparing to be listed on Tokyo Stock Exchange before the Tokyo Olympics in year 2020. Airweave is aggressively expanding overseas so it is subject to more currency risk. On a sales revenue of 14000 million, if 30% are from overseas, 4200 million is at risk of exchange rate changes.

To reduce finance risk of Airweave, we propose the following strategies as written below. The strategies make use of derivatives, such as as FX futures, FX forward, FX swap, and swaption. The details of the derivatives are described in the points below.

  1. Use FX futures contract or FX forward contract to hedge the earnings coming from outside Japan, managing the currency risk. FX future is a publicly traded future contract, it is standardised and free of counterparty risk. Counterparty in this case is the exchange. FX forward is a privately negotiated contract between one company and one financial institution. It can be customised and subject to counterparty risk. Both FX future and FX forward are used to lock in the exchange rate in the future.
  2. It can also use FX swap to manage the currency risk. FX swap is a privately negotiated contract between one company and one financial institution, to exchange one currency for another currency.

For item one and two, we can further analyze. Firstly, we see the domestic currency return is made up of:

Rdc = (1+Rfc)(1+Rfx)-1
Where
Rfx = Return of foreign exchange rate
Rfc = Return of foreign currency
And the variance of return σdc2 = σFc2 + σFX2 + 2 σFcσFx COV(FC, FX)

We can hedge foreign currency return, be it USD or SGD or HKD, and convert them to yen.

For example, we can see from table 12 below about how to make hedging decision.

Table 12: Hedging foreign currency

Current spot rate
six month forward rate
six month forecast spot rate
JPY/USD
113.4
116.4
112.6
Airweave is long the USD against JPY, and JPY/USD is selling at a forward premium. Moreover, Airweave expects USD to depreciate against the JPY. This is a case of hedging the USD exposure.

To find the optimal the minimum variance hedge ratio, (the optimal hedging ratio) we can use the formula:

Hedge ratio = correlation(FC, FX)*σFc/σFX

For example, if the hedge ratio is 2.3, for a USD 1 million exposure, Airweave will need short a JPY/USD forward contract of USD 2.3 million.

  1. Manage the interest rate risk, Airweave borrows in fixed interest rate. If interest rate goes down, Airweave will suffer a loss. Airweave can buy a swaption on pay floating, receive fixed swap, Airweave can exercise it if necessary. Swaption is an option to enter into an swap.
  2. Implement an action plan to accelerate collecting account receivables from customers, so that it can increase its receivables turnover.
  3. Implement an action plan to delay paying payables to suppliers, so that it can reduce its payable turnover.

Bibliography

Academic Paper:
[1] Foerster, S., Tsagarelis, J., Wang, G., Are Cash Flows Better Stock Return Predictors Than Profits? Financial Analysts Journal, First Quarter 2017, Vol. 73, No. 1: 73–99. Retrieved Feb 25, 2017, from http://www.cfapubs.org/doi/abs/10.2469/faj.v73.n1.2
[2] Ahmet, F., Prenaj B., A CRITICAL REVIEW OF MODIGLIANI AND MILLER’S
THEOREM OF CAPITAL STRUCTURE, International Journal of Economics, Commerce and Management, June 2015.
[3] Faccio, M., Xu, J., Taxes and Capital Structure, Volume 50, Issue 3 June 2015, pp. 277-300. Retrieved Feb 25, 2017, https://papers.ssrn.com/sol3/papers2.cfm?abstract_id=1781158
[4] Costea, C., Hostiuc, F., THE LIQUIDITY RATIOS AND THEIR SIGNIFICANCE IN THE FINANCIAL EQUILIBRIUM OF THE FIRMS, The Annals of The "Ştefan cel Mare" University Suceava, 2009.
[5] Glickman, M., Modigliani-Miller On Capital Structure: A Post-Keynesian Critique, Fourth International Conference of the International Trade and Finance Association, 1994.

Textbook:
[6[ Brigham. E., Houston. J., Essentials of Financial Management 3rd Edition, 2014.

Websites:
[7] Yen surge 'extremely worrying' warns Japan's finance minister, Retrieved Feb 27, 2017, http://www.telegraph.co.uk/business/2016/05/01/yen-surge-extremely-worrying-warns-japans-finance-minister/
[8] An Introduction to Value at Risk, Retrieved April 17, 2017, http://www.investopedia.com/articles/04/092904.asp
[9]      DuPont Analysis Definition, Retrieved April 17, 2017,
[10] Value of Export and Imports of Japan, Retrieved Feb 27, 2017, http://www.customs.go.jp/toukei/shinbun/trade-st_e/2016/2016_316e.pdf



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