Studying the financial health of a company is never an easy task. Shares Investment (Singapore) hopes that the previous 5 parts of “Understanding Fundamental Analysis” series have helped readers in making good investment decisions. In “Understanding Fundamental Analysis” Part 5, we did mention the importance of reading income statements, cash flow statements and balance sheets. In this issue, we shall go more in detail with regards to this aspect.

Let us take steel-maker FerroChina for this issue’s discussion. FerroChina, once a gem in many analysts’ eyes, shocked investors on 9 October when it announced that it would default on loans worth Rmb706m, making it the first Singapore-listed company that fell victim to the global economic crisis.

FerroChina has been maintaining a very low debt-to-equity ratio (total debts/shareholders’ equity funds) throughout FY05 to 1H08 and as at 30 Jun-08, its debt-to-equity ratio was only 0.7 times. So what has really happened to FerroChina?

Let us look into FerroChina’s FY05 to 1H08 income statements, cash flow statements and balance sheets. As we see in the income statement table, FerroChina’s revenue and earnings have been soaring since its listing on 19 May-05, but its cash flow statement does not look as fantastic. FerroChina relies heavily on credit to fund its working capital on the back of its inconsistent and weak cash flow, which makes it harder for FerroChina to strengthen its balance sheet during a credit crunch.

FerroChina’s balance sheet looks healthy at one glance, with its total assets to total liabilities at 1.8 times and 1.9 times in 1H08 and FY07 respectively. When we delve deeper into the balance sheet, it shows that over the years, it has been increasing its borrowings at a frantic pace. The critical part that pushed the company into its current financial woes was its huge short-term debts of Rmb2.3b. Although FerroChina maintained huge cash in hands (cash plus fixed deposit), it is still insufficient to meet all the short-term obligations as its fixed deposit was pledged as collateral.

Moreover, FerroChina has to service interest payments on its long-term debt of Rmb2.2b, which may approximate to Rmb100m annually.

In addition, FerroChina’s current ratio (current assets/current liabilities) which is approximately equal to 1 suggests that the company would not be adequate to pay off its short-term obligations if they came due at that point, which is definitely not a good sign.

Let us look into FerroChina’s current assets and liabilities in detail. Its trade and other payables piled up to Rmb3.8b on top of its short-term debts. With a large amount of cash locked in both its receivables and inventories, this further exacerbated FerroChina’s liquidity problems.

Compounded by the fact that the world is already reeling from a global credit crunch, most banks would be unwilling to extend large amounts of loans to any bank, let alone any other corporate entity. Raising capital via issuance of shares will also be tough given the pessimism surrounding investors.

FerroChina has raked up too much debt in a bid for expansion and has forgotten the fundamental importance of managing its cash flow and balance sheet well. No wonder Warren Buffett once said: “It takes 20 years to build a reputation and five minutes to ruin it.”