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Master's Theses

Ratio analysis of financial statements

Donald Eugene Furr

Date of Award

Spring 1957

Document Type

Degree name.

Master of Science

Business Administration

The twentieth century has been witness to a phenomenal rate of growth in accounting. To a large degree this growth can be attributed to large scale production, a characteristic of this complex industrial era. More accountants than ever before are engaged in the tasks of recording, classifying, summarizing and interpreting financial data. Financial statements are the end products of an accountant's task.

For every accountant employed in the construction of a statement, there are scores of people interested in the analysis and use of such statements, particularly the balance sheet and income statements. These persons include creditors, bankers, investors,executives and the general public.

A financial statement which has been carefully prepared must be analyzed and interpreted in the same manner if worthwhile results are to be obtained. Along with the rapid growth of accounting, there has been a continual improvement in the methods used in financial statement analysis. These methods normally include the formulation of significant relationships existing between the main parts of a statement.

This writing will be concerned with the presentation and explanation of significant ratios commonly used in the analysis of the balance sheet and income statements. These ratios may be used to indicate or to infer the financial condition of a company. Emphasis will be placed on the industrial corporation. Prior to the presentation or ratios, a brief description of the general nature o! the statement to be analyzed will be given. However, there will be no attempt to analyze the statement in its entirety; only the essential component parts will be scrutinized.

It must be realized that not all types of analysis discussed herein will be applicable to each line of industry or to all financial statements. Two apparent reasons for this are: (1.) there is a great variety in financial statements, and (2.) the detailed information needed for complete analysis is not always available

Recommended Citation

Furr, Donald Eugene, "Ratio analysis of financial statements" (1957). Master's Theses . 124. https://scholarship.richmond.edu/masters-theses/124

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A STUDY ON FINANCIAL PERFORMANCE USING RATIO ANALYSIS AT ING VYSYA BANK PROJECT REPORT Submitted To UNDER THE GUIDANCE OF

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Financial Reporting Ratio Analysis

Financial reporting and ratio analysis essay, ratio analysis – part one.

Ratio Analysis And Financial Reporting – According to IAS 7 net cash flow from operating activities can be calculated using either of two methods; direct method and indirect method. The direct method shows operating cash receipts and operating cash payments; including cash receipts from customers, cash payments to and on behalf of employees, cash payments to suppliers; all resulting in the net cash flow from operating activities. The indirect method begins with profit before tax and adjusts for non-cash charges and credits such as depreciation and for the movement in working capital items.

In simpler terms, the direct method looks at all actual cash transactions, while with the indirect method you look at the balance sheet items in relation to the previous year to find the cash inflow and outflows from operating activities while adjusting for non-cash charges and credits such as depreciation and goodwill revaluation rather than look at specific transactions.

The main advantage of the direct method is that it shows the operating cash receipts and payments, this specific knowledge of the sources of these cash receipts and for what purposes cash payments were made is especially useful when trying to forecast future cash flows. The preference of IAS 7 is that the direct method be used but does not require it. The main benefit of the indirect method is that it shows the difference between reported profits and net cash flow from operating profits.

There are differing views among national standard setters as well as within the business community. The main issue of disagreement being whether in all cases the benefit to the user outweighed the costs to the company of providing this type of reporting. The ASB in the UK has generally held the indirect method to be preferable, and has only encouraged the use of the direct method when the possible benefit of the users outweighs the cost of providing it in the new revised version of FRS 1.

This is different to the general view of the IASC as well as the FASB in the USA who hold the view that the direct method is preferable. I’m of the opinion that this difference will result in companies giving greater consideration to which method suits them best considering the relevant costs rather than just relying on the advice of a particular standards board; which I think is a positive effect.

David Alexander and Simon Archer the authors of National Accounting/financial reporting standards guide 2013 are of the view that this issue should be viewed from the perspective of the user rather than the prepared and therefore the most beneficial method is the direct method. In an article released by the Institute of Certified Public Accountants in Ireland (CPA) discussing international standards, the CPA expressed the view that most Irish companies are unlikely to adopt the direct method as it requires the segregation of VAT from cash receipts and payments during the year. This is likely to be expensive due to system changes as the accounting programmes are designed to identify VAT at the point of sale or purchase, rather than at the point of cash receipts or payments.

Below I would like to provide a summary of Zotefoams Plc.s financial position and operating performance and in doing so analyse the liquidity, profitability, efficiency and gearing of the company.

From looking at the five year trading report it is clear to see that Zotefoams Plc has managed to steadily increase turnover from £25.2m in 2011 to £30.1m in 2013 that is an increase of £4.9m which is a 16.27% over two years. Also operating profit (excluding exceptional items) has increased from £1.6m in 2011 to £2.8m in 2013; that is an increase of £1.2m or 42.86% rise over two years. Furthermore, earnings per share (excluding exception items) has risen from 3.2 in 2011 to 5.4 in 2013, that is an increase of 2.2 which is a rise of 41% over two years.

In this discussion I have only considered figures excluding the impact of exceptional items as I believe these figures give a clearer view of its true performance and help forecast for the future more accurately, this is a company that is still at a very early stage of its development and hence is likely to have exceptional items more often now than in the future. A figure that should be taken in to consideration is the profit after tax, in 2011 it was £1.2m, in 2012 it was £2.4m, and then £1.2m in 2013, this does not shown a pattern of a down turn as the great increase in 2012 was caused by an exceptional item, this can be further understood by looking at the profit before tax (excluding exceptional items) whish was £1.3m in 2011, then £1.8m in 2012 and finally £2.7m in 2013; this clearly shows a pattern of strong growth over the last three years. Below, I have done ratio analysis in the areas of liquidity, profitability, efficiency and gearing to illustrate better the company’s performance in these areas.

Profitability Ratios

Return on capital employed (roce).

ROCE shows the company’s net profit before interest and tax in relation to total capital invested as a percentage. Generally a decrease in the ROCE percentage from one year to the next could signify various internal or external factors affecting their business, externally a more difficult economic climate for the company which could be caused by a general down turn in the industry or fierce competition, internally it is usually due to poor utilization of its total assets by those entrusted to run the company, either way it is the duty of the management to utilize the assets of the company to gain maximum profits.

The ROCE has decreased from 9.52% in 2012 to 5.41% in 2013, this is a very major decrease, this would normally lead one to think that the management have severely underutilized the assets of the company showing a poor performance on their part, but on closer inspection it is clear that the results have been skewed as the 9.52% figure for 2012 is largely inflated, as the PBIT of £3.472m was inflated by £1.499m of exceptional items (reduction in administration costs) in the profit calculation, and a decrease in profits in 2013 of £1.074m due to exceptional items (increase in administration costs), had these exceptional items not been considered in calculating the ROCE it would have shown a strong increase between 2012 and 2013.

Gross Profit Margin Ratio

Ratio analysis – The gross profit margin ratio shows the gross profit as a percentage of its sales revenue. This shows that it has increased from 22.65% to 25.94%, this is a positive increase of 3.29% from 2012 to 2013.

Net Profit Margin Ratio

The net profit margin shows the net profit before tax as a percentage of its sales revenue. It has decreased from 11.75% in 2012 to 5.32% in 2013; that is a decrease of 6.43%. This would normally be a serious issue to consider, but as explained previously the results have been skewed due to negative exceptional items in 2013 and positive exceptional items in 2012, had these items not been considered in this calculation it would have shown a positive increase.

Liquidity Ratios

Current ratio.

The current ratio is one of the best measures of liquidity. It is generally accepted that a ratio of 2:1 is a strong position to be able to meet the company’s short term liability responsibilities; the higher the ratio is; the more liquidity the company has, making it more likely to be able to cover its short term liabilities. Although it has decreased from 2.41:1 in 2012 to 2.18:1 in 2013, it is still over the accepted 2:1 ratio, therefore there is no reason for investors or the company to fear liquidity problems.

Quick Asset Ratio

Conventional it is held; the most ideal quick assets ratio equals 1. In 2013 and 2012 the quick asset ratio was comfortably over 1, although it has decreased to some extent. It is not good to have too high a current ratio analysis or quick assets ratio, as this would signify the under-utilization of the company assets.

Efficiency Ratios

Debtors collection period (dcp).

The debtors’ collection period ratio analysis shows the average amount of time taken to collect debts from credit sales. In 2012 it is at 80.7 days which has decreased to 74.9 days in 2013, these positive results show that the DCP has significantly decreased from the previous year signifying an improvement in efficiency, this supports the view that its credit control system has functioned more efficiently.

Stock Holding Period (SHP)

The stock holding period ratio analysis shows the average amount of time stock is held before being sold, it has decreased from 66.3 days in 2012 to 62.1 days in 2013, again it shows a improvement in efficiency showing that the company’s stock control systems are running more efficiently than the previous year.

Gearing Ratio

Gearing is calculated to show what proportion of a company’s total capital is provided by loans capital as opposed to equity. The greater the proportion of total capital is provided by loans the greater the vulnerability to a down turn in profits.  This is because the interest on a loan must be paid regardless of the company making a profit.

33.3% gearing is conventionally accepted as medium/high gearing, although this does vary from industry to industry. The gearing ratio of 35.32% in 2012 is not considerably high, this has decreased to 31.02% for 2013; it has been brought down firmly in to the area conventionally accepted as medium gearing thus decreasing the company’s gearing vulnerability to a down turn in profits meaning it is not considered to be a high risk investment.

Ratio Analysis – Part Two

Ratio analysis in the areas of liquidity, profitability, efficiency and gearing are very important when trying to understand the financial position of a company, all of the data required for calculating these ratios are taken from the balance sheet and income statement.

The balance sheet statement summarizes the value of total assets and liabilities, as well as owners’ equity at a specific date. The balance sheet gives the user a good understanding of the company’s value as you can see what it owns and owes. The balance only provides a snapshot of this information on the date of reporting as the items in the balance sheet could change the next day, furthermore the balance sheet can be manipulated in various ways such as incorrectly valuing assets such as work in progress inventory or incorrectly valuing buildings, plant and machinery.

It is not straight forward how all items in a balance sheet are calculated. There are many ways that firms try to hide debt by not recording it on the balance sheet such as the well documented case of Enron who were keeping debts off the balance sheet by offloading the debt to special purpose entities (SPEs). It is important to any investor to know that the company they are buying a share into actually owns tangible assets (less liability) that back up the value of the company’s shares; this reduces the risk of the investment.

Beyond risk to investment capital; the investor will look at profitability as this is the objective behind making an investment, for this purpose the income statement is very useful; as it shows net profit for the previous year as well as a breakdown of how this was calculated including figures for revenue, cost of sales and expenses etc.

Analysis of previous income statements and the five year trading summary will help the user to get a good understanding of how well the company has been performing in the past. The income statement can also be manipulated, such as the abuse of one time charges in the income statement when the usage of one time charges is misused to result in reported profits being lower than expected in one year, and then be seen to dramatically increase the next year, resulting in share prices rising allowing managers and related individuals to cash in on shares purchased at a lower price the previous year.

The cash flow statement shows all cash and cash equivalents entering and leaving the company for the reporting period. It allows investors to see how money is being spent and where it is coming from. It is generally held to be one of the more reliable financial statements as it is less open to manipulation as it deals with simpler and clearly tangible accounting items. Given this there are still ways to manipulate it such as dishonesty in accounts payable by counting cheques in the mail as cash in hand rather than money paid out or the choice of making payments late on purpose.

Efforts have been made by the introduction of further legislation and tightening of regulatory frameworks as well as implementation of further standards; such as international auditing standards (IASs); to counter act these problems namely the Sarbanes Oxley act 2002 in the USA and similar provisions in the UK.

By providing all three financial statements the user will be able to gain a good understanding of the company’s financial position and profitability; each of them provides different useful information. Furthermore it is more difficult to manipulate one financial statement and not result in contradictions with the others. The cash flow statement helps to back up the balance sheet and income statement. Reporting based on international reporting standards are very important, as it means that prepares of reports must treat accounting items as set out by international standards leading to more reliable and comparable financial statements for the user.

Due to international auditing standards one would expect that auditors will find the cases where manipulation and fraud has taken place; which gives the investor more confidence in the financial statements that he must rely upon to make decisions. I would still advise any potential adviser to fully read all reports and notes beyond just the three financial statements.

In this section I will discuss how Zotefoams Plc provides segmented information under IAS 14 and how this will change upon the adoption of IFRS 8 as well as consider the relevance of this information to the company’s current and potential investors.

I would like to begin by explaining IAS 14 and segment reporting. Companies often carry on several types of business or operate in many different geographical locations, with varying opportunities of growth at different levels of risk relative to the geographical location or type of business. It is very difficult for a reader of financial reports to make judgement about the nature of different activities carried out by a company or what impact each activity has on the financial situation of a company unless some segmented analysis of the financial statements are provided.

Segmented reporting is required to help the users of financial statement to more thoroughly understand the past activities of the company and thus make a more informed assessment of the company’s future prospects; as well as be aware what impact will occur on the company if there are significant changes in components of the company. All of this helps to assess better the risks and potential returns for the investor.

IAS 14 was set out to standardize segmented financial reporting by companies. IAS 14 only applies to publicly quoted companies or those that are about to be. Zotefoams Plc is a publicly quoted company and therefore should comply with the provisions of IAS 14. IAS 14 does encourage non-publicly quoted companies to report segmented information, and if they do they should comply with its provisions.

According to IAS 14 a company should report on business and geographical segments showing the groupings of products and services provided by each company segment as well as the composition of the geographical segments. One type of segmentation can be deemed as primary; chosen from either business or geographical, the second should be regarded as secondary. This is usually decided based on the company’s internal management and organisational structures as well as the internal financial reporting system for management. Geographical or business segments can be judged to be reportable when the majority of its sales revenue is gained through sales to customers who are external, plus also:

• The revenue is 10% or above of total revenue of total segments
• Its profit or loss is 10% or more of the combined total of profits or losses
• It assets are 19% or above of total assets of the company (combined total of all segments)

Other segments should be reported if the total external revenue from segments that have been deemed reportable does not reach 75% of total company revenue; more segments should be recognized until 75% of the total consolidated revenue is shown as reportable segments. The following is to be disclosed for each primary reportable segment:

• Revenue, sales to external customers and inter-segment sales disclosed separately, the basis of price setting should be disclosed for inter-segment sales.
• Profits before interest and tax for continuing operations and discontinuing operations should be disclosed separately
• Carrying amount of segment assets
• Segment liabilities
• Cost applicable to the period for acquiring  property, plant and equipment as well as intangibles;
• Depreciation and amortization charges, as well as other significant non-cash expenses or otherwise cash flows from operating, investing and financial activities in line with IAS 7 cash flow statements.

Each secondary segment should disclose:

• Revenue, disclosing separately how much is external sales and how much to other segments
• Segment assets total
• Cost applicable to reporting period for purchasing  property, plant and equipment as well as intangibles

Zotefoams primary segment reporting is reported by business area, the company sells two main types of foam which are Polyolefin and HPP. All of the above disclosures listed above for the primary reportable segment are made in the annual report. Furthermore, the revenue from external customers, segment assets; as well as capital expenditure (on property, plant and equipment as well as intangibles) are reported in the annual report for the secondary segment report which is done by geographical location which is separated in to: UK, Europe, North America and the rest of the world.

All segment reporting is in accordance with IAS 14. HPP is a new product, it can be seen that the HPP segment is making a loss, this is expected as R&D is likely to cause expense to outstrip revenue at such an early stage, you can see from the segment report that the Polyolefin segment is making strong profits, this would not have been clear if segmental reporting was not provided.

I will try to only discuss the differences between IAS 14 and IFRS 8 that are relevant to Zoatfoams plc. IFRS 8 has affected three main areas of segment reporting, they are; the identification of segments, the measurement of segment information and disclosure.

In terms of identification of segments; IFRS 8 states that segments that sell primarily or exclusively to other operating segments of the company can still be deemed an operating segment if it is operated that way. This is different to IAS 14 which reduced reportable segments to be segments which gain most of their sales revenue from customers who are external, IAS 14 doesn’t oblige that the separate levels of a vertically-integrated company be deemed to be separate entities.

I do not believe this will have much effect on Zotefoams Plc as they do not do any inter-segment trade, nor could it be said that from their company structure that it is a vertically-integrated company with separate entities in such a vertical chain to be deemed as separate operating activities.

IFRS 8 requires that the information reported on each segment should be the same information that is provided to the chief decision maker for the activity of allocating resources to that segment and assessing its performance. This may mean for Zotefoams Plc that they may be required to provide more segmental information depending on their internal reporting practices.

Ratio analysis – A major difference between IFRS 8 and IAS 14 is that IFRS 8 requires an explanation of how profit or loss, assets and liabilities are measured for each operating segment, rather than define revenue, expense, result, assets and liabilities for each operating segment. This results in companies having more control over what is included in segment profit and loss in line with their own internal reporting practices. As companies are given greater choice over disclosure this could put investors at greater risk as there will be more room for manipulation of information.

Interest revenue and interest expense must be reported for each of the reportable segments separately if they are used to calculate segment profit or loss unless the majority of the segments revenue is earned by interest resulting in the chief operating decision maker making decisions to allocate resources or judging the performance of the segment based on information mainly on interest revenue.

The aim behind revising IAS 1 was to make it easier for users to be able to understand and compare financial statements and forms of key ratio analysis. Financial information that goes in to financial statements are to be aggregated on the basis of shared characteristics, as well as introducing a statement of comprehensive income. This is being done so that it is more visible to see the impact on the company’s equity resulting from transactions between the company and its owners in that capacity; such as share repurchases, separately from the impact caused by transactions between the company and non-owners such as third parties.

Comprehensive income can be displayed in either a single statement or be separated in to two statements including a income statement and a statement of comprehensive income statement. The ICAEW as well as the ACCA have both disagreed on giving the choice between the two as they believe it will lead to confusion amongst users making comparability more difficult. The ACCA also disagrees with the decision to change the name of the balance sheet to statement of financial position on the grounds that the definition of the balance sheet is well known; they feel this change will only result in more confusion especially when preparers are not obliged to use the new title which will result in some prepares taking it up and others not; making comparison more confusing for users.

The ACCA are also of the view that the decision to include a statement of financial position at the beginning of the reporting period is not needed and will again lead to further confusion; this information if needed could easily be looked up in the previous year’s report.

These changes are not likely to have a major impact on Zotefoams other than the effort required to make these new changes, as the changes have not been made to change how accounting items are treated but rather the changes have just been put in place to affect how some information is displayed as the change in name of the balance sheet, the choice in display of comprehensive income statements and the inclusion of the balance sheet from the beginning of the reporting period, these changes just provide the information to users in a way that it is easier for them to understand the financial position of the company. In the 2013 report a statement of recognized income and expense (SoRIE) was included, by 2009 when the IAS 1 revisions must be implemented; the annual report will have to include a statement of changes in equity in an addition to the SoRIE or choose to combine them into a single statement. This additional information already exists in the annual report in the notes section.

ACCA 2.5 Financial Reporting (international stream) Study Text (2012), FTC – Ratio Analysis

David Alexander and Simon Archer, Miller International Accounting/Financial Reporting Standards Guide (2013), CCH

Barry Elliott and Jamie Elliott, Financial Accounting and Reporting: 11th Edition (2013), Financial Times/ Prentice Hall

Company Law, Jerry DeFreitas, 5th edition (2013), Castlevale Handbooks

Zotefoams Plc, Annual report (2013) Technical summary: IAS 7 Cash flow statements Deloitte, IAS Plus, (December 2013)

IASB, press release, (6 September 2013)

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Ingevity: The Risk-Reward Ratio Is Still Unfavorable

• Ingevity, once considered a growth story, turned out to be a classic example of market cycles.
• While Road Technology and Performance Materials performed reasonably well in the first half of 2024, the Industrial Specialties segment dragged down revenue and net income.
• Given the company's significant debt burden, risk-averse investors should seek safer options within the chemical industry.

tomazl/iStock via Getty Images

Investment Thesis

Cyclical sales decline, high restructuring costs, and debt obligations with variable interest rates can be signs of a potential turnaround opportunity. However, upon taking a closer look at Ingevity (NGVT ), the risk-reward ratio still appears unfavorable at current price levels.

Company Profile

Ingevity is a diversified producer of industrial and construction chemicals as well as gasoline vapor control systems. It was spun off in 2016 from the former WestRock Inc., which has recently merged with Smurfit Kappa . Ingevity operates through three main segments: Performance Materials, Performance Chemicals, and Advanced Polymer Technologies.

The largest segment, Performance Chemicals, contributed 46% of net sales in the first half of 2024. This segment provides additives for road construction and a range of other industrial chemicals, whose production will be affected by Ingevity's current restructuring plans. The majority of these products are derived from crude tall oil (CTO) , a byproduct of paper and cardboard production. The reliance on this single feedstock is a legacy of Ingevity’s roots in the paper industry. However, Ingevity is in the process of diversifying its raw material sources with other plant-based oils, as rising demand for CTO in the biofuel industry has led to generally higher prices.

The second-largest segment, Performance Materials (41%), primarily produces activated carbon products that capture gasoline vapor, enhancing combustion engine efficiency while reducing emissions. The smallest segment, Advanced Polymer Technologies (13%), was acquired in 2019 from Perstorp Holding AB . It focuses on caprolactone-based polymers used in a variety of industrial applications, including coatings, adhesives, and resins.

Past Earnings and Market Action

Ingevity rapidly became a stock market favorite after its separation from WestRock, significantly outperforming the S&P 500. Driven by an astounding 480% earnings growth within two years (from $35 million in net income in 2016 to $169 million in 2018), the stock surged from $25 at its NYSE debut to an all-time high of $117 in 2019, equivalent to a P/E ratio of 29.5. Following the pandemic shock, it traded in the $60-90 range but has since declined to its current level of $36 per share.

Ingevity Corp. stock chart (Seeking Alpha)

This decline likely stems from the market's recognition of the cyclical nature of Ingevity’s business model. Despite sales peaking as late as 2023, margins had already begun to erode starting in 2020. The spin-off from WestRock marked the end of the previous downcycle, which may have created a misleading impression of steadily rising profits since Ingevity became an independent entity.

Margins Ingevity Corp. (2016-2023) (gz.)

Current Earnings and Restructuring

In the first half of this year, Ingevity reported a net loss of $339.7M, translating to -$9.36 per share. Net sales dropped by 16.4% to $730.7M compared to the same period in 2023, with the gross margin slipping from 32.4% to 30.5%.

The large reported loss is largely due to three key factors. The first is the goodwill write-off in the Performance Chemicals. Faced with declining profitability and weak cash flow projections, Ingevity wrote off the entirety of its goodwill in this segment, resulting in a $349.1M charge against Q2 2024 earnings. This part of the business currently poses the greatest challenges for Ingevity. While the asphalt additives held up reasonably well compared to the high levels of 2023 ($174.8M in 1HY2024 vs. $186.7M in 1HY2023), the volume of Industrial Specialties dropped from $282.9M to $157.7M, driven by low demand and the closure of the DeRidder manufacturing plant in Q1 2024. Ingevity faces here a double whammy of rising production costs due to high prices for CTO and low prices for rosin-based products, which prevent the company from passing on higher input costs.

The second drag on earnings is restructuring. The closure of the DeRidder facility is expected to incur total charges of $250M (revised downwards from previously $280M ), of which about $185M is non-cash. Of this amount, Ingevity has already charged $207.6 million, leaving about $42.4M for the upcoming quarters, assuming estimates are accurate.

Additionally, Ingevity recently announced plans to shut down its Crossett plant in Arkansas and move the oleochemical refining to North Charleston, with expected charges of around $100 million. This will not only drag down 2024 results further, but it also leaves me a bit speechless because, as recently as last year, Ingevity invested $22.1 million in transitioning the Crossett plant from CTO to other plant-based feedstocks. Is this a sign of erratic management or of rapidly changing market conditions?

The third factor impacting the first six months' results is the resale of CTO, which had to be purchased due to long-term contracts but was no longer needed following the closure of the DeRidder refining facility. Ingevity recorded a loss of $50M in 1HY2024 for the resale of this excess inventory. Additionally, the company will pay another $100M to Georgia-Pacific for the premature termination of the supply contract, payable in Q3 and Q4.

Outlook and Risks

Overall, it’s safe to say that 2024 results will be affected by multiple special items overshadowing the already weakened operational performance. Meanwhile, a short-term recovery in the chemical industry isn’t yet in sight. However, Ingevity plans to save $65-75M with the closure of DeRidder and another $20-25 million with the closure of the Crossett plant, hoping to bring the EBITDA margin back to the 25-30% level.

Aside from the Industrial Specialties affected by the cost-cutting restructuring measures, the Road Technology product line seems to hold up reasonably well, with only a modest sales decline of 6.4%. This part of the segment has seen impressive growth in sales, increasing from $148.8M in 2016 to $369.8M, representing a compounded annual growth rate of about 13.9%. This growth helps offset the revenue decline in the Specialties line. With modest growth in Performance Materials and a decline in Polymer Sales, 2024 consolidated revenue should fare much better than operating income, positioning Ingevity for margin improvements once the restructuring is complete.

However, a risk not yet addressed is Ingevity’s debt obligations, which stood at $1.5B as of Q2 2024. Approximately half of this debt ($756.3 million) is under a revolving credit facility tied to interest rate fluctuations. In the first half of 2024, the average interest rate for this loan was 6.76%. Only $550M of the total debt is fixed at 3.88% until 2028. In the first half of the year, Ingevity incurred $45.5 million in net interest expense, which was not covered by EBIT (-$361 million) even after accounting for the goodwill impairment charge of $349.1 million.

As mentioned before, some of the charges in 1HY 2024 should be considered “special” in the sense that they recur mainly during downcycles. Furthermore, only 30% of the restructuring charges ($75.9 million) resulted in cash outflows. Considering that capital expenditures were under depreciation charges, it’s fair to conclude that Ingevity currently does not need to take on additional debt to cover its interest charges. Nevertheless, even during a downcycle, this interest coverage is unsatisfactory.

Note: I avoided using Adjusted EBITDA for 1HY 2024 ($175.7 million), which would give Ingevity a coverage ratio of almost 3.9. This figure, which excludes maintenance and restructuring costs, doesn’t reflect the true costs of running the business.

Another difficulty in estimating Ingevity’s future earnings next to the variable interest costs are the fluctuating CTO prices, which in case of increasing demand from biofuel industry, could rise even further in the long term. Although Ingevity has begun diversifying its feedstocks, this only partially mitigates the risk. Conversely, if demand for combustion engines declines significantly, the Performance Materials segment —focused on gasoline vapor recovery— would be negatively impacted.

Peer Comparison and Valuation

Determining a fair value for Ingevity is challenging, particularly because it has not yet experienced a full market cycle as an independent entity. To estimate its value, I compared Ingevity with BASF , a major German chemical manufacturer with a similar product portfolio and exposure to the same market cyclicality.

Prior to the earnings downturn in the first half of 2024, BASF and Ingevity had comparable average earnings from 2016 to 2023: $3.10 versus €3.71, translating to a past earnings P/E ratios of 12.40 and 12.12, respectively. BASF, however, reported in the first six months of 2024 a profit of €2.01 per share and a solid interest coverage ratio of 8 times EBIT. Additionally, it offers a steadily increasing dividend, currently at 7.6%. Given these factors, Ingevity appears overvalued in comparison. I would apply a discount of at least 30% from Ingevity’s current prices to account for the additional risks previously mentioned.

In general, BASF appears to be a safer bet on the recovery of the chemical industry, as its superior financial position allows it to weather adverse developments much better. On the other hand, Ingevity could potentially offer higher returns in a highly favorable scenario, benefiting disproportionately from lower interest rates and increased demand.

At the current price of $38.44, I believe investors are not adequately compensated for the company-specific risks. Therefore, I rate Ingevity a SELL. Although business cycle lows often present attractive buying opportunities, Ingevity’s large and costly senior claims, as well as weaknesses in its input costs and product portfolio, lead me to think otherwise in this case. For those invested, the current price might be an opportunity to switch to a safer issue that is equally well positioned for a recovery in the chemical industry.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This article was written by

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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