What Is Your Critical Number - Research Paper Example

The Critical Number Introduction Of all the aspects of business, the most challenging to the owner or manager is the mastery of interpreting financial statements. The numbers may seem daunting, and yet the most important things one can learn about the operation of the business can be gleaned from the numbers. A keen perception of the implications and significance of financial ratios taken in relation to each other may provide the insight necessary to position a firm to exploit advantages and avoid threats in the business environment. Part 1: Essay Do You Know Your Critical Number? Many businessmen would attribute their company’s long-term and sustainable growth to any number of perceived factors, from the desirability of their products to the creativity of their personnel. However, it is only when one resorts to analysing the hard data – in this case, the financial accounts – that one is able to verify the true strengths and weaknesses of a company (Moyer, McGuigan & Kretlow, 2009). The ease and simplicity with which a company may wish to rationalize its success must be able to stand the cold hard analysis of the figures recorded in its financial statements. The principal method of drawing information from duly audited financial statements would be through ratio analysis, which is the essay’s main topic. In summary, Jack Stack stresses the importance of ratio analysis, but more than just its general approach, he emphasizes that in any one operating year, there is a “critical number” that must be made the focus of attention. The critical number must be informative, and thus the ratio chosen shows where the company is falling behind its competitors, in order to focus on what may still be improved. The search for the critical number may be undertaken by all employees in the company, which serves the dual purpose of engaging them to company goals, and of providing a chance for possible initiatives such as a bonus. Otherwise stated, as ratios provide insight into various facets of the firm’s operations, there will be a ratio (or a set of ratios) that will tend to indicate that the company is at a critical position as against its competitors on that particular aspect of operations. It may be a ratio involving sales, which alludes to the marketing function. It may be refer to any of the profit margins, which may imply inefficiencies in the supply chain or in the production process. It may be any number of things, but the critical ratio will point out that the company is either starting to lag behind the competitor when it used to lead, or conversely, that the company is about to overtake a competitor when it used to lag behind. The critical ratio, or the more friendly-sounding “critical number”, as Stack puts it, will indicate the possibility of a significant development in the firm’s competitiveness. The critical number will tend to point out an emerging strength to take advantage of, or an incipient weakness that the firm has to quickly address. However, the primary importance of a critical number is its significance in pointing out a strategic focus the company must take – Stack’s so-called “hub of the wheel”. Company strengths and weaknesses do not materialize overnight; they develop over the years, and a slight change in trend in the financial ratios may alert management early to the need for more innovative strategies. Likewise, while there may be no material changes within the company, a change in long-standing rankings against competitors may call management’s attention to new developments in the industry which it may not be aware of, but which it must quickly assimilate and address (to adopt, adapt, or exceed) if the company wished to remain in competition. The essay is quite persuasive in its endorsement of the merits of ratio analysis, and rightly so. It has been said that the use of financial ratios is similar to a physician’s use of his stethoscope; it is an instrument for detecting the possibility of an irregularity in health. But while ratios are good indicators, they are merely that – indicators, which may or may not lead to a definite conclusion. It is up to the astute investor (or analyst) to trace the source of the irregularity and to assess its severity and possible solutions. For instance, if ratio analysis shows that gross profit margins have been falling, then it may be because sales are falling with the same level of cost of goods sold, or that cost of goods sold are rising with the same level of sales. If it is the former, then a wise investor will look for market studies in that industry, because slowing demand may mean the market for the product grows increasing non-viable because of better substitutes or newer alternatives. The investor then should decide against buying equity in the company. On the other hand, if it is due to rising cost of materials, information about current and potential suppliers, as well as research reports on new alternative technologies, may, together with the company’s annual chairman’s report and the company website, provide the investor with an idea about whether future prospects for the company have a good chance of success. One of the most important instincts of a savvy investor is his talent for identifying diamonds in the rough – future shiners that are still starting out – and buying equity early enough at a low price before it appreciates (Subramanyam, 2005). Other than ratio analysis, investors should resort to a variety of other sources of information. The usual reports and advisories about the market for the products or services the company deals in, industry studies and even the economy in general provide vital clues to the investor, not only as to choice but also as to timing of investment. But the serious investor has other, more innovative approaches he could resort to. Many listed companies have investor relations officers who will be happy to entertain questions or even sometimes provide guided tours through the office or plant. Investor briefings, in the nature of a stockholders’ meeting, are occasionally held, particularly prior to an initial public offering or rights offering, and this would be a good venue for questions to be answered. There are unconventional ways of discovering potential investments. Sometimes, acquiring information could be as simple as indulging in one’s favourite commodities, restaurants or outlets. Famed investment analyst and past fund manager of Fidelity Magellan Fund, Peter Lynch, was a firm believer in investing only in things that are known, familiar, and easily understood to the investor. The investor, before purchasing, must be able to explain why he is buying. The products and services that investor patronizes thus provide good clues as to what he should invest in, and why (Lynch & Rothchild, 1994). After all, there is a good chance that these businesses enjoy brisk sales and loyal patronages, and may therefore turn in a good return on investment. Part 2: Comparison of Two Companies The companies chosen for this exercise are two pharmaceutical companies. The pharmaceutical company is a manufacturing concern that, because of the constancy of demand for its products despite economic downturns, realizes steady sales, and its production function makes it easier to analyse through ratio analysis, unlike that of intangible services. Six ratios for each company have been computed, and such ratios were obtained for five consecutive years in order to provide an idea as to the average performance of each to the other. Table A: Financial ratios for Company “A” Pharmaceutical Company (Squibb Bristol Myers Annual Reports 2004-2008) Ratio Formula Company A 2008 2007 2006 2005 2004 Current ratio current assets/current liabilities 2.20 1.20 1.59 1.78 1.50 Total asset turnover sales / total assets 0.70 0.70 0.63 0.68 0.64 Debt Ratio total liabilities / total assets 0.59 0.59 0.61 0.60 0.66 Net profit margin net profit after taxes / sales 0.25 0.12 0.10 0.16 0.12 Earnings per share earnings/ no. of common shares 2.63 1.09 0.81 1.52 1.21 Dividends per share cash div / no. of common shares 1.24 1.15 1.12 1.12 1.12 Table B: Financial ratios for Company “B” Pharmaceutical Company (Merck & Co. Annual Reports 2004-2008) Ratio Formula Company B 2008 2007 2006 2005 2004 Current ratio current assets/current liabilities 1.35 1.23 1.20 1.59 1.15 Total asset turnover sales / total assets 0.51 0.50 0.51 0.49 0.54 Debt Ratio total liabilities / total assets 0.60 0.62 0.61 0.60 0.59 Net profit margin net profit after taxes / sales 0.33 0.14 0.20 0.21 0.25 Earnings per share earnings/ no. of common shares 3.66 1.51 2.04 2.11 2.63 Dividends per share cash div / no. of common shares 1.52 1.52 1.52 1.52 1.49 Consistent with the instructions, the ratios shall be compared to each other from the point of view of the manager for Company “A”. Looking at Tables A and B above, each of the ratios chosen represented a particular aspect of the company’s operations, save for the per-share ratios at the end, the two of which pertain to the investors, in support of deciding which of the two stocks should be invested in. The current ratio indicates the liquidity condition of the company. Sufficient liquidity is necessary to address the company’s short term obligations as they come due. Inability to do so could put the company in danger of incurring additional penalties, suffering a downgrade in credit standing, and suspending operations when creditors cease to advance supplies and materials for production (Bull, 2008). In this case, Company A is superior to Company B because it has 2.20:1 current assets to current liabilities, while Company B only has 1.35:1. Company A is thus better able to finance its short-term obligations than Company B can. The activity ratio shown above is the total asset turnover, which shows how much sales is realized for every unit of total assets. Between Companies A and B, Company A has the better activity ratio. Given its total assets, it is able to convert a higher percentage of sales, indicating higher productivity. This may be because Company A is better able to make efficient use of its assets in order to create products, and to convert these products to cash through effective marketing and robust sales. It is also, however, possible that Company A may be producing only just as much as Company B proportional to its assets, or maybe even less, but that Company A’s products may be higher priced that Company B’s , thus yielding higher sales figure (it must be remembered that the sales figure is equivalent to the total of the monetary proceeds of the sale of its products, not the quantity of products sold). What could be said is that Company A is better able to liquidate its inventory to cashflow than Company B. The most popular ratio that measures leverage, or debt, is the debt ratio. It is also an indicator of capital structure, since it shows the proportion of assets that is financed by debt or borrowed capital. The use of debt, or leverage, is desirable to an extent because it enhances the earning power of the equity provided by shareholders. Use of debt increases productive capacity without diluting the ownership and the earning power per share. On the other hand, particularly during a crisis, debt should not be substantial because resort to more debt increases the risk of defaulting on the payments. Debt must be paid a fixed amount of interest on a regular duration, and the payment of the entire principal upon maturity of the loan. If the company is not able to do that because it has not realized sufficient revenues, then the company suffers the penalty. Had the funding been through equity, then when the company does not earn, the shareholders just shoulder the losses, but which does not entail a cash outflow, unlike the service or retirement of a debt. For our purposes, therefore, Company A has a very slight advantage over Company B. For the past four years the two Companies had comparable debt ratios, but in 1994 Company A had a debt ratio of more than 10 percentage points above that of Company B. As far as liquidity, activity and leverage are concerned, Company A is in a more favourable position that Company B. The fourth criteria is profitability, which should be of immense importance to prospective investors. After all, one invests his capital in order to realize profits on it. For the purpose of this analysis, the net profit margin is used. This ratio is given as the net profit after taxes divided by the sales or revenues realized for the period. The purpose is to determine what portion of realized sales is actually profit for the company and the shareholders, after all the costs and expenses of products have been deducted. In Table A, Company A is shown to have a net profit margin of 0.25 for 2008. For the same year, Company registered a 0.33 net profit margin. This means that out of every unit earned by Company A, one fourth goes to profits which is the end objective of going into business; and for Company B, a full one-third of sales becomes profit. Between the two companies, therefore, Company B has the more efficient operations. The sum total of its costs and expenses in the course of converting inputs into outputs is proportionally less for Company B than Company A. With this observation in mind, a revisit of total asset turnover (and any other ratio that may be used containing the sales figure), there is a possibility that the prices of Company A products are positioned higher than the corresponding prices of other competitor companies such as Company B. Higher sales may just not be due to more goods being sold. This possibility must be examined now in light of the higher profitability shown by Company B compared to Company A, according to the net profit ratio. If as per total asset turnover, Company A was realizing more sales than Company B, so it should have followed that Company A should have been more profitable than B. Since Company B exceeded Company A, Company B must be realizing greater efficiencies and lower costs than Company A. This makes Company B a very attractive investment prospect, given the long-term scenario. The last two ratios, earnings per share and dividends per share, are intended to inform investors of the viability of Company A and Company B as alternative long-time investments. They shall thus be discussed in the next part. As to the choice of critical number, it is quite apparent that the critical number for Company A is its net profit margin, where it trails Company B. As its strategy, Company A must now take a good look at its operating expenses and costs, identifying more efficient processes where possible, or lower priced alternatives for sourcing materials. Company A should explore suppliers who provide top quality at more favourable terms, such as longer credit periods or discounts for volume. Where expenses should be cut down, the first to be reduced should be those that have little or nothing to do with production, such as administrative and miscellaneous expenses. The cost of research into new drug development could also be rationalized by exploring partnerships with other drug companies. Part 3: Investment Advisory As earlier mentioned, the pharmaceutical industry had proven to be a resilient investment and a defensive investment sector in the past, because of the constant demand for drugs and medicines despite economic booms and crises. Strong cashflow is usually associated with strong pharmaceutical sales, although the initial outlay in long-term drug research may be substantial, because of the high level of technology involved, and the time duration until an experimental formula becomes commercial- ready. The investor must also consider the possibilities of lawsuits due to tort in the case of unintentional damage to users of its drugs, and thus the additional insurance against such incidents. In deciding which of the two stocks to take position in, it is important to look at the company background just as much as it is to compare the payout and yield ratios. Firstly it was already made evident in the preceding discussion that despite Company A excelling over Company B in terms of liquidity, leverage and activity, certain inefficiencies existed that tended to reduce the profits commensurate to the sales and activity. Upon perusal of the annual report for Company A, it was discovered that the Company embarked on several new researches to explore medicines for serious diseases, which entailed additional expenses for which revenues are not yet being realized. Being in the normal course of business, this should not be seen as wasteful use of money but as investment in future money makers. Company A is known for its leading edge research and that it has made good profit on its patented formulae in the past. However, as several of its patented products are soon going to lose their patent coverage, after which the medicine will be open for duplication by generic drug companies that will bring down the price of the product and drastically cut down the profit margins on these products. They will thus cease to be major cash cows for Company A, for which therefore the firm must prepare. Another ploy used by Company A to control the substantial costs of research and development is to seek smaller, more entrepreneurial pharmaceutical companies that have promising prospects for developing new lines of medicine, but lack the capacity to undertake full-scale development research. By collaborating in several projects such as these with different partner-firms, the risk of losses due to unproductive or over-budget research and development is shared between the collaborating partners, and is thus not as devastating financially than if the company financed the entire research on its own (BMS Annual Report, 2008). In this manner, Company A is able to spread its prospects over several projects, and therefore have greater chances of realizing a successful prospect rather than concentrate all their resources in a few, possibly flawed, undertakings. On the other hand, upon perusal of the annual report of Company B, it appears that its greater efficiency and higher profit margin is attributable to a restructuring of the corporate hierarchy and streamlining of personnel to create a leaner, more aggressive organization. The Company’s annual report claim that the restructuring program has already reduced the number of senior and middle-level executive throughout its global enterprise by some 25 percent, and by the end of 2011 it should have eliminated about 7,200 positions throughout the Company. As to its track record in research and development, Company B is not too far behind Company A, although it had recently had to recall its arthritis and acute pain medication, on the basis of a three-year data and on the face of a case brought against it, apparently due to the proven connection between the arthritis medicine and the incidences of myocardial infarction (“MI”) and ischemic stroke (“IS”) which apparently the arthritic medicine tended to induce. The parties are currently still in litigation, but a possible negotiation is expected to materialize. Nevertheless, Company B has been able to acquire FDA approval of the product Gardasil which is a vaccine for the prevention of vulvar and vaginal cancers. This approval was based on data from three studies that tested more than 15,000 patients and proved the efficacy and safety of the drug (Merck & Co. Annual Report, 2008). While Company B may be expected to earn a windfall from its new medicines, it however has to contend with the upcoming settlement it expects to contract with some 48,100 claimants on the product liability lawsuit involving the arthritic medicine. With these future prospects in mind, a look at the per share ratios may now be more informative. As to earnings per share, Company B has a higher proportion of earnings for each share of the company (Company A has 2.63, while Company B has 3.66). Likewise, Company B has a higher dividend per share figure (1.52) than that of Company A (1.24). These are likely the offshoot of higher profit margins being realized for Company B compared to Company A, and thus resulting in a higher payout ratio. On the other hand, a glance at the market prices of said companies indicates that Company A prices are relatively cheaper at 13 times PER, while Company B commands 18 times PER. This means that for the same earning power, Company A commands a lower price than Company B. This does not necessarily mean that Company A’s stocks have a lower fundamental value than Company B, because many times the prevailing price of the stock may be under the true value of the company, thereby creating a bargain window by which investors could buy cheap what could eventually take off. On the other hand, Company B may be commanding a higher price because of its potential for further growth, thereby attracting more demand that pushes its stock up. Given the problems Company B is facing, there is a possibility that when news breaks out of the impending product liability settlement for 48,000 claimants, the price of the stock may correct on negative sentiment. This does not necessarily mean that the company will collapse or lose value. It simply means that the buying window mentioned for Company A may likewise open for Company B. In short, both Company A and B both present good prospects, as they are both strong names in the pharmaceutical industry. As an investment analyst, I would advise the client to rationalize his investments. There is no need to put the entire £10,000 in one stock. Neither is there a need to put the entire kitty in one industry either, so the client could be advised to divide his investment among several types of investments. For instance, he may invest £6,000 in low-risk fixed income government securities, and the remainder divided between blue-chip stocks and high growth stocks. But for argument’s sake, assuming that the entire £10,000 be put in either or both Company A and Company B, the customer would be well advised to divide this amount between Company A (about 60%, or £6,000) and Company B (the remaining 40%, or £4,000 pounds). As explained, the buying window for Company A is open because it is at an undervalued level, while that of Company B may be slightly overvalued at present. Should the expected bad new materialize and stock price goes down, that is further incentive to buy as lower prices increase the attractiveness of good stocks. By dividing the investment funds among a few choice prospects, risk is reduced and the chance of gains is enhanced because of diversification. Part 4: Lessons learned from this coursework and FIN7200 “Lessons learned” would signify that something was not known or understood before, but now is. Knowledge acquired flows abundant in FIN 7200 and in this coursework in particular. The theories that have been learned in the course, while they remained theories, were strange, confusing, and even at times intimidating, because of the multitude of things to try to remember. Suddenly there are new tools, measures, techniques, and principles that were difficult to make sense of at first, and particularly because they involved numbers which can in itself be daunting to many by the fact that they are numbers. During the coursework, however, the exercise of putting the theories into application began to crystallize into enlightening experience. Certainly, I have not been able to make use of all that I had read about and tried to remember, but the few formulas, concepts, and principles that I had been able to apply had very quickly gained significance for me. When I encountered particular difficulty and struggled with a ratio, much as a detective would, I broke down the ratio into its component parts and tried to interpret what one part meant to the other, and what combining them would signify. Through this slow and sometimes painful process, I began to gain an understanding of what the significance of ratio analysis is and, for this coursework, how it could be practicably used in my career in the future. Because of this coursework and the entire course, I feel I have gained additional competence to successfully meet the challenges of work, as well as my personal life, in the future. For this I am truly grateful. References Bristol-Myers Squibb Company Annual Reports 2004 – 2008. Accessed 25 May 2010 < http://www.asiaing.com/bristol-myers-squibb-2008-annual-report.html> Bull, R 2008 Financial Ratios: How to Use Financial Ratios to Maximise Value. Elsevier Science & Technology. Lynch, P & Rothschild J 1989 One Up On Wall Street, Fireside. Merck & Co Annual Reports 2004 – 2008. Accessed 25 May 2010 Moyer, R C; McGuigan, J R; & Kretlow, W J 2009 Contemporary Financial Management, Cengage Learning Subramanyam, P 2005 Investment Banking: An Odyssey in High Finance, CFM-TMH Professional Series in Finance, Tata McGraw-Hill Publishing Co., Ltd. Read More