Ratio Analysis Is an Important Tool - Essay Example

?Financial Ratios for MNQ company: Formula 2008 2007 2006 2005 2004 Current ratio Current Assets/Current Liabilities 0.92 0.98 0.94 0.98 0.91 Quick ratio (Current Assets-Inventories)/Current Liabilities 0.69 0.73 0.71 0.73 0.68 Cash ratio Cash and cash equivalents/Current Liabilities 0.19 0.20 0.20 0.20 0.19 Total debt ratio Total Assets-Total Equity/Total Assets 59.09% 57.36% 56.35% 58.07% 64.20% Times interest earned EBIT/Interest 11.43 13.53 14.32 7.88 14.23 Cash coverage EBIT+(Depreciation & Amortization)/Interest 18.57 14.29 18.19 8.08 17.34 Inventory turnover ratio Cost of Goods Sold/Inventory 1.80 2.04 1.15 1.80 1.28 Receivables turnover ratio Sales/Accounts Receivable 1.85 1.88 1.77 1.76 1.72 Profit margin Net Income/Sales 15.82% 19.70% 25.49% 14.60% 23.74% Return on assets Net Income/Total Assets 5.75% 7.25% 8.09% 4.69% 8.40% Return on equity Net Income/Total Equity 14.06% 17.00% 18.54% 11.18% 23.47% Price-earnings ratio Price Per Share/Earnings Per Share 5.53 4.27 4.01 7.30 6.02 Market to book ratio Market Value per share/Book value per share 0.78 0.73 0.74 0.82 1.41 Introduction: Ratio analysis is an important tool used to asses a company’s financial standing. The liquidity ratios assesses a company’s ability to meet short term obligations, profitability ratios helps in assessing a company’s profitability and solvency ratios helps in gauging a company’s ability to meet long term obligations. Ratio analysis helps in identifying various trends and helps in identifying potential strengths and weaknesses of a company. The following is the ratio analysis of MNQ Company: Liquidity Ratios: The current ratio is an indicator of company’s liquidity and helps in assessing the company’s ability to meet short term obligations. MNQ Company’s current ratio has remained under 1 for the 5 years from 2004 to 2008. This shows that the company is facing liquidity issues since the current liabilities are greater than current assets. The current ratio of the company increased in 2007 to 0.98 times and fell to 0.92 times in 2008 and the company has to make efforts to improve its current ratio. Moreover, MNQ Company’s quick ratio has also deteriorated to 0.69 times. Quick ratio also helps in assessing a company’s liquidity and deterioration in quick ratio further indicates that MNQ Company’s liquidity position has worsened in 2008. The cash ratio is the strictest measure of a company’s liquidity. MNQ Company’s cash ratio has remained stable from 2004 to 2008. Overall, the company’s liquidity position is not very healthy. Solvency Ratios: The debt ratio indicates a company’s ability to repay its obligations and specifies the percentage of assets that are financed with debt. The total debt ratio of MNQ Company has fallen from 64% in 2004 to 59% in 2008. This is a good sign since the company is reducing its reliance on debt. Companies that have high debt in their capital structure are very risky since most of the cash flows are directed towards debt servicing. But in the case of MNQ Company, the debt ratio has declined and the company has improved its overall solvency position. The times interest earned assesses the ability of the company to service the interest payments to its debt holders. MNQ Company’s times interest earned ratio decreased in 2005 but then showed significant improvement. Currently this ratio stands at 11 times and this shows good standing of the company in terms of interest servicing. The company’s EBIT has fluctuated from 2004 to 2008 which has led to fluctuation I the times interest earned ratio. However, MNQ Company has a high times interest earned ratio of 11 times which shows its strong ability to make timely interest payments to its creditors. Cash Coverage of the company is 18.57 times and has increased from 17.34 times in 2004. Cash coverage ratio also shows the company’s ability to pay the interest payments. MNQ Company has a high cash coverage ratio which shows that the company has significant resources to make timely interest payments. Efficiency Ratios: The inventory turnover ratio shows how many times a company sells its inventory (Investopedia, 2013). MNQ Company’s inventory turnover ratio increased from 1.28 times in 2004 to 1.80 times in 2008. This indicates that MNQ Company sold and replaced its inventory 1.80 times in 2008. MNQ Company’s inventory turnover ratio is very low and this can lead to potential problems for the company. The inventory can become obsolete if it is not replaced very frequently. Furthermore, inventory holding costs can build up if inventory is not replaced on a frequent basis. This in turn can lead to increase in company’s costs. Hence, the company should make efforts to improve its inventory turnover ratio by holding lesser inventory and increasing its marketing efforts to increase the company’s sales. This can be done by offering discounts to the customers on older inventory items. This will enable the company to sell off the obsolete products in the inventory and will help in improving the inventory turnover ratio. The receivables turnover of the company increased from 1.72 times in 2004 to 1.85 times in 2008. The receivables turnover indicates the ability of a company to collect its debts. Although MNQ Company’s receivables turnover ratio has improved in 2008, the ratio is very low indicating that the company takes time to convert its credit sales into cash. This can be detrimental for the company since most of the cash will be stuck up in receivables and hence can lead to cash flow problems for the company. MNQ Company should improve its receivable turnover by offering cash discounts to customers to entice them to pay early. MNQ Company should make efforts to improve its efficiency ratios so that the company has ample cash to meet its short term obligations. Profitability Ratios: The net profit margin, return on assets and return on equity of the company has been on a declining trend indicating that the profitability position of the company is deteriorating. The net profit margin declined to 15.82% in 2008 from 19.7% in 2009. This can be due to increased competition from other players in the industry or due to increase in the prices of raw materials. Return on assets of the company also fell from 7.25% in 2007 to 5.75% in 2008 on account of lower profitability of the company. The net income of the company fell from $217 in 2007 to $190 in 2008 which led to deterioration in the company’s profitability position. A significant increase in depreciation expense from $20 in 2007 to $200 in 2008 majorly contributed to company’s lower profitability. With the fall in net income and subsequent increase in total assets and total equity, the company return on assets and return on equity ratios fell in 2008. Price to earnings ratio of the company increased to 5.53 in 2008. The company’s share price increased and the earnings per share fell in 2008 which led to an increase in the price to earnings ratio. This shows that the share holders are willing to pay $5.53 per $1 EPS generated by the company. MNQ Company’s price to book ratio increased in 2008 on account of increase in company’s share price from $18.5 in 2007 to $21 in 2008. The price to earnings and market to book ratios of the company have remained satisfactory in 2008. Conclusion: Overall, the company’s liquidity and profitability position has deteriorated in 2008. This is due to a significant increase in the depreciation expense from $20 in 2007 to $200 in 2008. Furthermore, the efficiency ratios of the company are also on the lower side and the company needs to make efforts to improve its efficiency ratios. The declining profitability and liquidity position is a weakness of the company and MNQ Company should take appropriate steps to overcome its weaknesses. Works Cited Investopedia. (2013). Inventory Turnover. Retrieved November 16, 2013, from Investopedia: http://www.investopedia.com/terms/i/inventoryturnover.asp Read More