Principles of Financial Markets

Question: Discuss about the Principles of Financial Markets. Answer: Introduction Fundamental analysis is conducted in tow approaches namely a top down and a bottom up analysis. The former analyzes industrial factors that influence the economy with respect to a company in a given industry (Marta Brusuelas, 2009). A bottom up analysis, on the other hand, assesses the financial condition of a particular company and its contribution in an industry. The fundamental analysis compares companies in a sector and not those in different sectors (Murphy, 2013). Top Down Analysis The airline industry faces many significant financial risks that affect the vulnerable returns on stock. Often, these risk exposures emanate from the ever changing economic conditions, the unstable and volatile movements in oil prices, and fluctuations in the exchange rates (Berghfer Lucey, 2014). These three risk exposures are the biggest threats to the stock prices. The risks are related to a competition in price, cyclical demand, capital investment, elevated levels of gearing, regulatory impediments arising from landing rights and ownership restrictions, and the fixed labour and equipment restrictions (Yasmin-Yashodha, et al., 2016). Evidently, the management of these exposures will determine how firms in the aviation industry progress. Companies such as Qantas Airway Limited and the Virgin Australia Group have experienced challenges such as high fuel prices, dwindling revenues, and economic uncertainties. These challenges paved way for low cost carriers to enter the market, especially for the economy class returns. The global financial crisis implied a drop in profits by many companies due to the increase in fuel costs, one-off gains, and a slower demand (Jorge Augusto, 2011). Qantas Airways Limited recorded an underlying profit of 1.53 billion dollars whereas Virgin Australia Group realized a figure of 41.0 million dollars. Despite the high prices both carriers still managed to record profits. Exchange Rate Exposure and the Stock Price Virgin Australia and Qantas are exposed to several risks that influence the companies objectives, both short-term and long-term. Some other factors that determine the stock price include the effects of pandemics, over-capacity in the market, competition on fares, and the low entry barrier of getting into the market. Foreign currency exposure is the sensitivity of the firms market value to unanticipated exchange rate movements. The exchange rate movements are solely determined by the foreign exposure of the firm (Laux, Yan, Zhang, 2015). This foreign exposure is derived from the operating revenue, risks due to costs, and the operating cash flow margin. Currency hedging practices and measurements also determine the exposure. Most of the expenses incurred by airplane carriers are handled in terms of major currencies (Chew, 2008). Consequently, a fluctuation of the currency will affect the profitability of the airlines in a number of ways. When the borrowing costs are handled in different currencies, it is expected that some liabilities will change alongside the equity of the company. The influence of tourism demand from overseas will influence the exchange rate risk factor because of the levels of exchange rate and competition the company is likely to face locally (Lee Hooy, 2012). Companies can thus be forced to adjust their revenue from overseas ventures appropriately. The exchange rate exposure is related to a number of variables. The companys revenue is subject to this exposure. Tickets are sold both locally and to international customers so it is difficult to avoid the exposure (Lima Hong, 2014). The foreign activities may also involve exchange of currency from one value to another and this enhances the level of risk. There is also aggressive competition, particularly in the international routes. This translates to the conversion of currency into the local one. As aforementioned revenues are closely linked to the exchange rates, thus the pricing level can reduce the effects of the exchange rates (Lima Hong, 2014). From a competitive perspective, industry-related factors also significantly affect the exposure levels. The currency exposure movement has an ambiguous effect on revenues. A rise or drop in the value of the domestic currency can either increase or decrease the cost of borrowing foreign debt and other costs. Foreign demand for international and domestic flights moves inversely with the value of the home currency. The demand for domestic travel shares an inverse relationship with the home currency and a demand for international travel changes directly. Hence, any depreciation in currency increases the probability of the residents to favor domestic travel rather than international destinations (Treanor, Simkins, Rogers, Carter, 2014). The competition thus prevents the airlines from preventing their revenues from experiencing currency movements. The significance of the exposure as measured by share returns, is dependent on the specific exchange rate, and varies over time. Airlines with foreign routes or various country offices are likely to have additional foreign sales, and airlines with holdings of international assets are more likely to be exposed to exchange rate movements (Yasmin-Yashodha, Hamid, Habibullah, 2016). With all of these effects offsetting and counteracting each other, the final impact of the currency exposure is uncertain. Fuel Price Exposure The fuel price affects the operational costs of the airline. Of an airlines operational costs, jet fuel accounts for approximately 13% (Laux, Yan, Zhang, 2015). This risk has an economic significance to the airplane carriers in the transportation industry. It is also possible to invest very little especially when the fuel price is high despite the existence of investment opportunities. The investment opportunities and the jet fuel costs in the airline industry have a direct correlation even as the higher costs are consistent with a lower flow of cash (Yasmin-Yashodha, Hamid, Habibullah, 2016). While the costs of jet fuel can be hedged, the airlines may desire to expand and hence hedge future purchases of fuel. Hedging increase the value in capital investment. Short-term cash flows are likely to be directly related to changes in fuel prices due to price change inertia (Marta Brusuelas, 2009). Revenue responsiveness may initially be slow due to advance sales, pre-committed advertised package fares, pre-booked seats, and so on. The fuel price exposure is more likely to be specific to a firm and echo various degrees of competitive power and fuel efficiency across the various airlines (Murphy, 2013). The effects of the price are thus more likely to be transferred because of the uniformity in fuel costs. The cash flows of the airlines are inversely proportional to the changes in fuel prices (Rich, Jones, Heitger, Mowen, Hansen, 2012). The profitability of the airline is thus reduced by the evident costs associated with jet fuel prices. Interest Rate Exposure The interest rate determines the loans, operating, and financial leases that are used to finance the acquisition of airplanes. The sector is relatively capital intensive due to the nature of the assets. Equity investment can be difficult to source because of the high earnings volatility. Equity financing is also greatly reduced due to the characteristic lower than average price-earnings ratios (Baker Filbeck, 2015). Borrowing costs are directly related to interest rate changes especially when the companies have variable rate leases and loans. The progression of the business cycle and the economic conditions are also affected by the interest rate (Berghfer Lucey, 2014). Eventually, the effects are felt in customer demand because here the demand is seasonal and cyclical. The exposure also brings financial distress on the airline industry. This distress is due to the forced sale of assets such as the aircraft fleet at heavily discounted prices because distressed airlines are forced to sell aircraft at below market prices, the purchase of new aircraft due to competition or contractual obligations, above industry average debt levels, and a decrease in revenue due to competition (Jorge Augusto, 2011). In the airline industry, an increase in the interest rates can increase the costs of distress as the operating and financial leverage is also high (Lima Hong, 2014). One reason why firms may under-invest is because of the distress costs. That behavior shows how the firm value can decrease as an indirect consequence of financial distress and under-investment costs. Profitability Analysis This analysis demonstrates how profits can be generated from the revenue. The ratios show how the companys investors have played a role in generating revenue for the company (Holtzman, 2013). The company uses this information to assess the managements effectiveness. The following table compares profitability ratios with respect to Qantas Airways Limited and Virgin Australia Limited. 2016 2015 2014 Gross Profit margin (%) Qantas Virgin Australia 1.11 1.29 1.06 1.14 1.03 1.11 Return on Equity (%) Qantas Virgin Australia 4.98 3.32 4.89 3.14 4.67 2.85 Return on Assets (%) Qantas Virgin Australia 0.97 0.76 0.88 0.72 0.72 0.68 Table 1: Comparative profitability analysis for the last 3-year period The gross margin ratio measures the companys ability to convert its inventory into cash when it sells (Jiambalvo, 2010). Therefore, a high value of gross margin is better because the company can fund its operations. The two companies reported values close to 1 (Maher, Stickney, Weil, 2012). The return on assets ratio is used to evaluate how a company can generate profits from its assets.. This ratio compares the earnings of the company to its total assets (Holtzman, 2013). The ratio is derived from the net profit or loss and the total assets. A high return on assets ration values means that the business realizes more profits from its assets. The value thus indicates how the management make use of the companys assets to generate revenue (Jiambalvo, 2010). The return on equity makes a comparison between the net income and the stockholders equity (Warren, Reeve, Duchac, 2014). The ratio is thus a measure of the profits that an investment from the shareholders has the potential to generate. This ratio is derived by finding the quotient between the net income and the average stockholder equity (Rich, Jones, Heitger, Mowen, Hansen, 2012). High values of ROA are preferred because they underline how management utilizes the stakeholders investments to create more income (Warren, et al., 2014). On comparison, Qantas Airways Limited is more likely to generate better returns as compared to Virgin Australia Limited because the former has performed better. Financial Strength Analysis This method analyzes the business capabilities of paying its long-term and short-term debts (Jiambalvo, 2010). The table below compares the financial strengths of Qantas Airways and Virgin Australia Limited. 2016 2015 2014 Debt to Equity Ratio Qantas Virgin Australia 4.13 4.11 4.09 4.01 3.98 3.95 Debt Ratio Qantas Virgin Australia 0.80 0.98 0.80 0.96 0.81 0.95 Return on Equity (%) Qantas Virgin Australia 4.98 3.32 4.89 3.14 4.67 2.85 Table 2: Financial strength analysis for the past 3-year period The debt to equity ratio represents a companys financing in relation to its creditors and investors. When this ratio is high, it implies that much of the business finance comes from the creditors (bank loans) and not from the shareholders (Holtzman, 2013). The debt to equity ratio is determined from the total liabilities and the shareholders equity by finding their quotient (Holtzman, 2013). Lower values of this ratio are preferred since they indicate less risk in investing into the company (Maher, Stickney, Weil, 2012). The debt ratio measures the level of debt or the liabilities of the business with respect to the total assets (Maher, Stickney, Weil, 2012). It is determined by finding the quotient of the total debt incurred and the total assets of the company. The ratio measures of the quantity of debt that is being financed by the assets owned by the company. The total debt refers to both long-term and short-term debt. A comparison of the ROE value between the two companies shows that investment into Qantas Airways is more likely to generate better returns as compared to investing into Virgin Australia because the former has a higher value. Management Efficiency Analysis Management of efficiency analysis determines how efficient a manager is (Jiambalvo, 2010). To perform the analysis the ROE, fixed asset turnover, and total asset turnover were used for this case. The analysis from the two companies is broken down in the table below. 2015 2014 2013 Asset turnover ratio Qantas Virgin Australia 4.68 3.98 3.13 4.07 2.85 4.13 Return on Equity (%) Qantas Virgin Australia 4.98 3.32 4.89 3.14 4.67 2.85 Total Asset Turnover Qantas Virgin Australia 0.96 0.62 0.89 0.61 0.83 0.57 Table 3: Management efficiency analysis A high total asset turnover figure demonstrates how the company can generate sales despite having limited fixed assets. A low ratio, on the other hand, may indicate that the business has many fixed assets or it needs to rejuvenate its sales (Rich, Jones, Heitger, Mowen, Hansen, 2012). The total assets and net sales are used to determine the ratio. The asset turnover evaluates a business efficiency when it utilizes its assets to create revenue. The sales are analyzed with respect to the assets (Warren, et al., 2014). If the companies were to generate more revenue from very few assets, it will indicate their efficiency at managing their assets (Warren, Reeve, Duchac, 2014). Recommendations Not much research has been documented on the financial risk exposures affecting the aviation industry. However, the fundamental analysis carried out with respect to Qantas Airways Limited and Virgin Australia Limited is sufficient to determine the financial performance of the two companies and the state of the aviation sector in the transportation industry. The financial risks under study: the exchange rate exposure, fuel price risk, and the foreign currency all play a crucial role in the value of a companys stock in this particular industry. The financial analysis helped to underline individual financial performance of the companies. Qantas Airways performed better than Virgin Australia as it had higher values in various ratios. 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