Credit Analysis and Management

Analyse the latest annual Report of Shell

Pakistan Ltd.


Salman Muhammad (1102-BH-BAF-10)





Sir Muhammad Ashraf





June 16, 2014

In Pakistan, Shell has a robust downstream business, supplying,
distributing and marketing a variety of fuels, and is one of the oldest and
largest multinational companies in the country, enjoying a legacy since
1898. It also has a 26% share in the White Oil pipeline operated by Pak
Arab Pipeline Company (PAPCO) and a 30% stake in Pakistan Refinery
Limited (PRL). Shell continues to play a leading role in meeting Pakistans
growing energy demand, while prioritising Health, Safety and
Environment (HSE) practices in all our operations and activities with our
people, assets and communities we work in.

As the world shifts towards a new, low-carbon energy future, Shell is
taking steps today to help build the energy system of tomorrow: producing
more cleaner-burning natural gas; working to deliver advanced fuels and
lubricants and lower-carbon bio fuels; and building capabilities in carbon
capture and storage. It is because of this that Shell is a preferred
innovative energy company.

During 2013, the Company earned a profit after tax of Rs.1, 061 million
against a loss after tax of Rs.1, 935 million (restated) in the same period
last year. The Companys performance has witnessed a significant
recovery and our results have started to reflect the continued focus by
management to improve operating performance. This was achieved by
concerted efforts to increase our market share as well as to restrict costs,
notwithstanding a high inflationary environment.

Despite this significant improvement compared with last year, financial
results of the Company are still not satisfactory. High cost of funding
government receivables, a disproportionate and punitive income tax
regime and extremely low fuel margins continued to affect the profitability
of your Company. The impact of high rupee depreciation in the second half
of 2013 also had
a significant impact on the financial performance.

Overall market conditions remained competitive and despite the
challenges, we continue to maintain our position as the second largest Oil
Marketing Company in Pakistan.

Despite the challenges faced, the Companys underlying operational
performance during 2013 generally improved. The Company gained
market share in both Motor Gasoline and Diesel for Retail business and
significantly grew profitability of its Aviation and Lubricants business
segments.

Financial risk refers to the chances of collapse of a business due to wrong
financing policies/decisions/strategies such as lopsided capital structure
and asset-liability mismatch. Financial risk can plunge a successful
business to the brink of bankruptcy, if not into it. Hence, it is very vital for
a credit decision to have an in-depth financial analysis of the customer.

In order to analysis the financial risks of a company the financial
statements are looked upon for comparison using percentages and ratios.
Financial statements, the end product of accounting, are viewed as proxies
of economic activities and business performance. Analysis of financial
statements enjoys a prominent place in the assessment of the study of
credit risks, lending decisions and on going monitoring of the lending
portfolio.

Four main categories of ratios for credit analysis are:

1. Liquidity Ratios: Indicate the companys ability to meet short-term
obligations, continue operations and remain solvent.
2. Leverage Ratios: Shows the capital structure, the mix of the owners
funds and funds borrowed from others.
3. Profitability Ratios: Indicates the earnings potential and its impact
on shareholder returns.
4. Operating Ratios: Demonstrates how efficiently the assets are
being utilized to generate revenue.



Liquidity Ratios:


The liquidity ratios reflect the sufficiency of cash in the firm to meet its
liabilities. Those liabilities maturing for payment within the next 12
months are termed current liabilities. Such liabilities will be paid through
generating cash and other liquid assets through working capital operating
cycle.










1. Current Ratio:

Numerator: Current Assets Denominator: Current Liabilities




Current Ratio For Shell Pakistan 2013,







The current ration of 0.904 indicates that the current assets in the form of
cash, inventory and receivables are sufficient to pay 90% over the current
liabilities falling due for payment in the next 12 months.


2. Quick Ratio or Acid Test Ratio:


Numerator: Current assets less inventory or cash + account receivables

Denominator: Current Liabilities (Including bank borrowings against
inventory)

In a crisis it may be difficult to dispose off the inventory of a firm. Hence
inventory and other less liquid assets are excluded to determine a
conservative measure of liquid funds of the borrower. A ratio of 1 or more
than 1 is considered satisfactory.

Acid Test Ratio for Shell Pakistan,





The Liquid assets recoverable at hand are only 36% over the current
liabilities, which is not satisfactory for the lending company.


3. Net Working Capital:


The Net Working Capital is a measure of Owners stake or long-term liquid
fund in the firm. It has a close relationship with the current ratio. When
the current ratio equals 1, the net working capital is zero.


Net Working Capital Ratio for Shell Pakistan,



Other measure used to determine liquidity:


Ageing Receivables:

Ageing schedule of accounts receivable. The risk analyst checks the list of
the account receivables and takes note of how old each receivable is and
compares the same with industry profile. Comparatively ageing
receivables reflect poorly on the liquidity of the subject enterprise.



4. Inventory Turnover:

Numerator: Cost of Goods Sold

Denominator: Average Inventory


This Ratio measures the number of times, on average; the inventory is sold
during a year. Its purpose is to measure the liquidity of the inventory.


Inventory Turnover for Shell Pakistan





For Inventory turnover only a comparison with industry average or
historical comparison can be meaningful. So, in 2012 the inventory
turnover is 12.084 and in 2013 it is 14.745. Which means that the average
number of times the inventory sold during the year of Shell Pakistan has
increased which means that the revenue has increased from the previous
year.

Looking at the liquidity ratios for Shell Pakistan the current ratio shows
that the current assets can only cover 90% over the current liabilities in a
period of 12 months.

The Acid test ratio indicates that the recovery of only most liquid assets
possible is at 34%, which is not a very good sign for the financial
institutions.

The net working capital is negative i.e. below unity. The Current liabilities
exceed the current assets by an amount of -3171604, which implies that
the lending bank is running a more than normal financial risk in respect to
Shell Pakistan.


Inventory turnover has increased from the previous year, which is a
positive sign for the lending institutions.


The Liquidity Ratios in respect for Shell Pakistan do not seem to be so
favourable for them when regarded in respect for borrowings by the
lending institutions for approval of finance for the company.


Leverage Ratios:


These Ratios reflect the financial risk inherent in the borrower firm. The
Banks needs to assess the leverage of the borrower from the viewpoint of
debt service, the firm size, and industry practices.

1. Debt-Equity Ratio:

Numerator: Total Outside Liabilities (long + short term liabilities)

Denominator: Tangible Net Worth (Generally equity + reserves
Intangible assets)


This Ratio is intended to measure the long-term solvency of the firm and
the relative stakes of the capital holders of the firm, debt holders vs. equity
holders.





In 2012, Shell Pakistans Debt to Equity Ratio was 6.657 whereas in 2013
it is 4.620, which is a good sign as Shell Pakistan is more relying on its
equity than its debt comparatively to the year 2012.







2. Long-Term Debt to Equity Ratio:

Numerator: Long Term Debt (Existing + Proposed)

Denominator: Tangible Net Worth

This Ratio would indicate long-term solvency of the firm. It is important to
consider the measure/size of this ratio when evaluating long-term project
loan for a company.



The long-term Debt to Equity ratio of the firm indicates that Shell Pakistan
has less long-term debts than the short-term debts. In 2012, the ratio was
0.057 and in 2013 it has improved even more to 0.0462, relying more on
equity than debt.


3. Interest Coverage Ratio:

Numerator: Earnings before interest and taxes (EBIT)

Denominator: Interest Expense.

The larger the ratio, the better for the bank, since it indicates the number
of times the EBIT is larger than the interest due to the bank and other
lenders.



As Shell Pakistan bears no interest expense the ratio equals to zero,
indicating that there is no interest expense but only taxation is deducted
from the EBIT.

4. Debt Service Coverage Ratio:


Numerator: EBIT+ Depreciation + Principal repayment on existing and
proposed loans.

Denominator: Annual Debt service. i.e. total of interest and instalment
payments on existing and proposed loans.

This and its variations are one of the most important ratios for assessing
the debt service capacity of the firm or its new project over a period of
time the ratio measures the number of times the firm can pay its debt
commitments with current earnings.


As there is no debt, interest expense or existing and proposed loans for
Shell Pakistan there is no need for this leverage Ratio.

5. Net Fixed Assets to Tangible Net Worth Ratio:


Numerator: Net Fixed Assets (gross fixed assets less depreciation)


Denominator: Tangible Net Worth


This Ratio Indicates how much of the firms least liquid assets have been
financed by net worth. It also serves as a variation of the equity multiplier,
and shows how much of the owners funds have gone into financing fixed
assets. A higher Ratio also means that more fixed assets have been financed
from debt rather than by internal generation. This ratio is, therefore, a
measure of risk inherent in the borrower firm.

The net fixed assets to tangible net worth ratio Is lower than it was in 2012
which means that Shell Pakistan has used more of its internal financing
than using debts to acquire fixed assets, which also indicates that the
company relies more on its own equity than debt.

6. Dividend Pay-out Ratio:

Numerator: Cash Dividends Paid

Denominator: Net Profit After Tax

The more the dividends paid, the happier the equity holders are. However,
more dividends also mean less cash available as retained earnings.


Shell Pakistan had a loss in profit after tax and still managed to pay cash
dividends in 2012 whereas profit had been earned in 2013 and the
dividends were paid a lesser amount than 2012. Typically a bank is wary of
high dividend payouts by the borrower. The less the equity the more the
risk for the lending bank, and the less the internal generation available for
new projects, the more the demand for bank debt.

Profitability Ratios:

The banks expects the borrowing firm to conduct its business prudently,
mitigate risks, be cost effective and thus generate enough profits to cover
long-term debt obligations; taxes and other statutory payments; pay
reasonable dividends to equity holders; and thereafter leave a surplus for
plough back into reserves or invest in high yielding projects.

1. Return on Equity (ROE):

Numerator: Net Income

Denominator: Average total equity

The amount of net income returned as a percentage of shareholders equity.
Return on equity measures a corporations profitability by revealing how
much profit a company generates with the money shareholders have
invested.



In 2012, Shell Pakistan had a negative return on equity whereas in 2013 it
has a positive ROE, which shows a positive return on shareholders
investment.


2. Return on Assets:

Numerator: Net Income

Denominator: Average Total Assets

The more the assets have been worked for higher returns, the higher the
ROA, further, ROA is the product of the profit margin, a measure of expense
control, and asset utilization, the gross yield on assets.


This Ratio is a measure of the effectiveness and skills of the management as
to how productively have they used the assets of the enterprise to earn
profits, which is totally positive in 2013 but a negative ratio in 2012
because of the net loss of Shell Pakistan.

3. Sales Growth:

Numerator: Change in sales

Denominator: Last periods Sales

A simple and efficient indicator of top line growth. Any credit analysis has
to begin with assessing how realistic the projections of sales growth are.



There has been 17.8% growth in Sales of Shell Pakistan from 2012.

4. Gross Profit Ratio:

Numerator: Net Sales COGS

Denominator: Net Sales


This Ratio measures the manufacturing efficiency in the case of
manufacturing firms and the direct contribution from sales in other firms.
This ratio measures operational efficiency.


Sales have increased from 2012 and hence the gross profit has increased
and so has the gross profit ratio, which shows operational efficiency has
increased comparatively.

Operating Ratios:

Operating ratios measure the operational efficiency and the liquidity of the
current assets of the borrower firm.

1. Debtors Velocity:

Numerator: Average receivables outstanding

Denominator: Average daily sales

This ratio indicates the average number of days required to convert sales
into cash. The actual collection period so obtained is to be compared with
the firms credit policy to establish the firm ability to collect on its
receivables.


2. Creditors Velocity:

Numerator: Average outstanding of accounts payable

Denominator: Average daily purchases

This Ratio indicates the time lag between a purchase and its payment. The
more credit availed from its suppliers; the less a firm requires bank credit.



The Average collection period of sales in 2012 was 2.9 days and in 2013
2.86 days which means that the collection period of sales has decreased
which is good for Shell Pakistan and satisfactory for the Lending
institutions but the average payment period for purchases was 166.83 in
2012 and 138.78 in 2013 which is good from the suppliers perspective and
the lending institutions.

3. Sales To Fixed Assets:



This ratio shows how efficiently the fixed assets are used to generate
production and hence sales. In 2012 the ratio was 19.72 whereas it has
drastically increased in 2013 to 26.84.

4. Sales to Total Assets:



This ratio indicates how efficiently the company generates sales on each
dollar of assets. A volume indicator, this ratio measures the ability of the
companys assets to generate sales. Sales to total assets ratio has increased
in 2013 respective to the one in 2012.

The operating Ratios of Shell Pakistan are considerably good which means
that the operation of Shell Pakistan is quite well comparatively to the
previous years. Where as the profitability ratios also show a growth in
sales and a better return on equity, which may be the indicator that Shell
Pakistan is progressing to a better stage in the Industry.

The Leverage ratios of Shell Pakistan are not of any concern as they are not
involved in any long-term debts and are not paying any kind of interest
expense, which is good to know for the lending institutions but Shell
Pakistan pays out dividends even when loss occurs.

In summary, 2013 has been a year of significant improvement in the
performance of the Company. Shell looks forward to continue
improvement in 2014 and beyond. A critical enabler of this will be
repayment of government receivables and improvements in the regulatory
and tax environment. The management of Shell Pakistan continues to
work on further improving its operational performance as well as
engaging with relevant authorities on resolution of government related
issues.