Company X Financial Ratios Analysis - Case Study Example

Company X Financial Ratios Analysis Name Instructor Course Code Due Date Company X Financial Ratios Analysis Purpose of the Report The purpose of this report is to analyze the performance of company X with the view of determining the viability of investing in its share stock. The report will analyze the financial performance using accounting ratios for profitability, efficiency in generating earnings, stability and dividend earnings for equity shares. A financial ratios analysis utilizes raw data from business financial statements and converts it to forms which enable clearer business management insight and measurement of the financial health of companies (Van Horne and Wachowich, 2001). This analysis is aimed at preparing a business report setting out the results of the analysis in order to determine whether or not the company would be attractive as a share investment. Relevant Financial Ratios Below is a table showing the results from the calculations made for the respective financial accounting ratios using the financial statements of the company for the three years from 2009 to 2011. The formulae for the financial accounting ratios are displayed in appendix A of this report. Ratio 2009 2010 2011 Performance Ratios: Profit Margin on Sales (before tax) 0.267 0.173 0.199 Total Assets Turnover 1.237 1.001 1.150 Return on Investments 0.557 0.381 0.437 Return on Equity (pre-tax) 0.492 0.394 0.564 Return on Equity (after-tax) 0.258 0.212 0.285 Efficiency Ratios: Inventory Turnover 4.125 7.154 8.280 Accounts Receivable Turnover 12.0 10.0 9.286 Average Collection Period .000232 .000278 .000299 Liquidity Ratios: Current Ratio 1.156 0.39 0.69 Quick Asset Ratio 0.656 0.209 0.325 Stability Ratios: Debt to Total Assets 0.492 1.088 0.937 Times Interest Earned 13.0 5.396 Per-share Ratios: Earnings per Share (in cents) 84 70 131 Dividend per Share (in cents) 30 60 100 Dividend Cover 2.8 1.17 1.31 Net Asset Backing per Share 2.9 3.9 6.995 Performance Ratios Profit margins on sales (before tax) Profit Margin on Sales (before tax) 0.267 0.173 0.199 This is calculated as the ratio of earnings before income tax to the net sales (Auerbach, 1995). The ratio is seen to decrease from 0.267 in 2009 to 0.173 in the year 2010. The decrease in profit margin on sale is due to reduced profits in the year 2010 since the sales are seen to continue increasing. The slight increase from 0.173 to 0.199 in the year 2011 is as a result of the shoot in profits from 13,000 to 25,900. Even with an increase in revenue, the ratio is still lower than that of 2009 this is because of the great increase in sales in the year 2011 and effect of the varying expenses. This reflects the extent to which the average mark up in goods covers the business expenses and thus resulting to a profit. The decrease in this ratio in the year 2010 shows a danger in the business operation but the increase in the ratio in the year 2011 shows that the business is recovering. More research is needed on and reducing the expenses so as to raise the revenue before tax in order to improve on the unfavorable trend in the ratio (Eric, 1999; Martin, 1994). Total assets turn over Total Assets Turnover 1.237 1.001 1.150 This is calculated as the ratio of net sales to total assets and measures how well a firm is employing its resources in generating earnings and capital value (Atrill and McLaney, 1997). This ratio reduces from 1.237 in 2009 to 1.001 in 2010 and then gradually increases to 1.150 in the year 2011. This trend is moving favorably. This shows that the company is efficiently using its assets in generating sales in the year 2011. And therefore additional capital would be result to more sales and thus more profit for the company. Return on investment Return on Investments 0.557 0.381 0.437 This is a ratio of the net operating income (Gross profit - operating expense) and total assets. This ratio is seen to reduce from 0.557 in 2009 to 0.381 in 2010and then increase to 0.437 in the year 2011. The increase in 2011 shows a good job by the management in managing the company’s assets to bring about profit. This reflects that additional asset would bring about more profit and thus there is need for additional capital (Leopold and Wild, 2000). Return on equity (pre-tax) Return on Equity (pre-tax) 0.492 0.394 0.564 This is the ratio of earnings before income tax to the total shareholders equity. The company is trending favorably as seen in the overall increase of the rate from 0.492 in the year 2009 to 0.564 in the year 2011. Debt financing may bring about the difference between the company’s assets and the value of equity. The high value of return on equity (0.564) in 2011 indicates that the owners’ capital is efficiently being applied in creating earnings for the company (Martin, 1994). Return on equity (after tax) Return on Equity (after-tax) 0.258 0.212 0.285 This is the ratio of earning after tax to the total share holders equity. The ratio is seen to be trending favorably from 0.258 in the year 2009 down to 0.212 in 2010 and then up to 0.285 in the year 2011. This shows the effectiveness of all the equity investors’ investment. The difference between the return on assets and return on equity shows how the company is funding its investments. This would result to deference between return on assets and return on equity. In this specific company the return on equity (after-tax) (0.285) is smaller than return on investment (0.437) thus the company has not borrowed much from investors (Jensen, 1997). Efficiency Ratios Inventory Turnover Inventory Turnover 4.125 7.154 8.280 Inventory turnover being the value of the stock on any given day during the period that the cost of goods sold is calculated the continued increase in inventory turnover is a good sign. In light of modern business models which take the advantage of the efficient supply chain systems the higher the rate of inventory turnover, the more closely the company will conform to the just-in-time procedures. The assumption is that the figures for cost of sales and average stock are taken directly from the income statements cost of sales and the balance Sheet inventory levels. Accounts Receivable Turnover Accounts Receivable Turnover 12.0 10.0 9.286 This is the ratio of net sales to the average net trade receivables. In this specific company, the ratio is decreasing tremendously from 12.0 in 2009 to 9.286 in the year 2011. This ratio shows an increasing liquidity of receivables. This shows that the management is efficient enough in employing the funds invested in the receivables. Average Collection Period Average Collection Period .000232 .000278 .000299 This being the estimated length of time before actual payment for goods or services is made, all sales is made after 30 days. The assumption of the calculation of the average collection period of company X is that credit sales are distributed evenly during any given period. Lack of large deviations in the figures; 0.000232, 0.000278 and 0.000299 in the period of study is an indication that the 30 days credit average is favorable for the company since unfavorable policy would indicate an inflated figure especially at the end of a period (Martin, 1994). Liquidity Ratios These ratios analyze a company’s financial leverage in terms of the debt and financing expenses incurred against the assets and revenue base of the business. The debt liabilities and interest expenses reduce the profitability and asset worth of the company and its performance towards paying dividend earnings to its shareholders (Nissim and Penman, 2003). Current Ratio Current Ratio 1.156 0.39 0.69 Current ratios of Company X indicate a shift from a high of 1.156 and in the following period a drastic drop to 0.39, in 2011 a rise to 0.69.The conspicuous drop in 2010 should be caused by the change in ownership with regard to costs associated with modernization which unfavorably affected the current assets. Quick Asset Ratio Quick Asset Ratio 0.656 0.209 0.325 Company X quick ratio shift from 0.209 to 0.325 is a favorable indicator considering the ratio of 0.656 in 2009 of which was disrupted by the new acquisition showing its potential since in practice a quick ratio of 1.0 is considered okay (Jensen, 1997). Stability Ratios Debt to Total Assets Debt to Total Assets 0.492 1.088 0.937 The increase in Debt ratio from 0.492 to 1.088 and the slight decrease to 0.937 should not be a major concern since although an investor would prefer to see a declining debt ratio the bigger picture is a two sided coin. A fall in assets return implies a fall in income available to make payments on debt. Company X should however take measures to cut off some of its short-term debts (Leopold and Wild 2000). Times interest earned Times Interest Earned 13.0 5.396 This ratio, also referred to as the times-interest coverage ratio, measures the availability of earnings to meet the debt-financing interest obligations using that debt-financing capital. It measures the efficiency of borrowing and of utilizing borrowed capital to generate earnings for the business (Muro, 1998). Times interest earned in regard to Company X displays a decrease from 13.0 to 5.396.This being the number of times in the period that the company earned enough to cover its interest payments the decrease is favorable since in reality an extreme of 10 is expected. This shows that the company is doing well and thus the new investor could pump in his portion of $9 million. Per-Share Ratios These ratios focus on the owners and shareholders interests in a company by translating the overall financial results into ratio calculations comparing earnings performance and profitability in terms of capital share stock (Samuels, Wilkes and Brayshaw, 1998). Earnings per share Earnings per Share (in cents) 84 70 131 This ratio compares the amount of earnings in terms of share of common stock in a company to measure the firm’s ability to generate dividend income and capital value for the shareholders of the company (Nissim and Penman, 2003). Company X’s earning per share shift first from 84 cents to 70 cents and later jump to 131 cents could be an inclination to better management and the result to modernization after acquisition. The earning per share (EPS) figures can only indicate favorable climate for the company mainly because organization change in the year 2010 did not affect the company results, if anything it recorded better results. EPS should not be a major concern for an investor since companies have to meet the challenge of whether to distribute income in form of dividends or retain the income and invest in expansion of operations, research or new products. The company in retaining income is to invest and consequently increase its income, hence making the company more profitable and hopefully increase the market value (Eric, 1999). Divided Per Share Dividend per Share (in cents) 30 60 100 Company X dividend per share displays progressive increase from 30 cents to 60 cents and finally to 100 cents a favorable indicator since it reflects an increasing continuum. However just like with earnings per share indicator this should not be a cause for concern unless the investor has a bias of the alternatives (Martin, 1994). Divided Cover Dividend Cover 2.8 1.17 1.31 Company X’s divided cover indicates that the company is earning adequate revenues to cover the level of divided payment. This is an indication that the company has stabilized and can afford to pay high dividends in the future. Net Asset backing per share Net Asset Backing per Share 2.9 3.9 6.995 This shows that the company’s net tangible assets value per share of stock is increasing favorably. If the company holds low stock prices then it would be undervalued. Ratios of Concern from an investment perspective The ratio analysis examined above for the company provide a useful snapshot of the financial health of the company for each year and for change in the ratios over time. Percentages of the financial statement items in relation to sales for the profit and loss, and in relation to assets for the balance sheet, have also been done to indicate the year-to-year change in the figures for key items in the statements (Muro, 1998). Certain areas of the financial performance of the company elicit concern for a potential investor in the company shares owing to the absolute annual figures and three year trend results. Inventory Turnover Concerns This may be of concern to a potential investor in that turnover rates of less than 10 will be regarded low for a company dealing with perishables. A low rate in this regard would mean the company probably loses too much stock on spoilage. It will be of little concern if the firm deals in computing equipment and accessories since these could afford an annual rate of return of around 3 or 4 mainly since hardware hardly blots. This may however be of concern if the technology is changing fast since this may mean there will loss from items that are thrown out of fashion before they are sold (Atrill and McLaney, 1997). Average Collection Period With modernization of the company any strategies that may have the effect of extending the average collection period substantially would mean the company will lose on potential profit from the uncollected revenues. Opportunity cost will arise because the company will not be converting cash due from its clients into assets that could be generating more income (Leopold and Wild, 2000). Current Ratio Concerns are expected since from a creditor’s perspective a high current ratio indicates the potential for the company to pay back its debts. However the nature of current assets does not actively contribute to generation of income and to a stockholder or the management a very high current ratio shows that the assets are not being maximized (Martin, 1994). Quick Ratio Concerns may arise if company X misleads in the figures of their inventory, by not representing the current replacement cost of the items in the inventory. This is possible since there are different methods of valuing stock an example being the LIFO method is use which assumes that the most lately acquired stock is also the most lately sold. A decrease in the actual costs in purchases for instance in LIFO would lead to an over-valuation in the current inventory hence increasing the value of the current ratio and consequently resulting to underestimated quick ratio (Eric, 1999). Time’s Interest Earned Concerns with company X are expected if the figure of Times interest has features of decreasing further since the measure is a show of how deeply interest charges cut into the future income (Jensen, 1997). A drop to 1.0 for example will indicate the company earns enough only to cover the interest charges leaving no income to pay income taxes, pay dividends or for future investments which can only be possible from retained earnings. The company has been taking on new debt and has started getting interest payment obligations as indicated by its falling figures for this ratio. This translates to decreasing future income and asset value for shareholders of the company. Earnings per Share The investor may have a bias, depending with his/her financial objectives, towards either exclusive of steady revenue in form of dividend over gain by owning the stock for rising market value. In that case the company is most suited for dividend gain in that the earnings per share are shown to be rising steadily each year. Dividend Cover Concerns The investor, depending on his/her financial objectives, may interpret the company past dividend policy as being conducive for long-term capital growth given its rising dividend payouts and steady growth in dividend cover. Companies that plough back are likely to have low divided amount payouts in some years compared to others, but display growing dividend cover ratio over time (Auerbach, 1995). Conclusion and Recommendation Favorable indicators like total assets turnover, return on investments, return on equity (after tax) will form the basis for a medium risk averse investor like our case since it would not only ensure capital invested is not only safe but will be guaranteed of revenue at least in gains in ownership. In an effort to offer professional advice to the client, individual risk appetite would help to understand what type of an investor he/she is since these would then form the guidelines to whether the investment of the client in Company X would result to long-lasting working relationship between the investor and the company (Samuels, Wilkes, Brayshaw, 1998). Since the study was a percentage and trend ratio analysis of Company X for the period of 2009 to 2011 some appropriate allowance for possible changes in accounting policies that occurred during the same period of time especially over the buy in. It would also be more value adding if Company X compares its business with others in similar industry (Leopold and Wild, 2000). Appendix Performance Ratios Profit Margin on Sales (before tax) = Earnings Before Income Tax Net Sales Total Asset Turnover = Net Sales Total Assets Return on Investment = Net Operating Income Total Assets Return on Equity (pre-tax) = Earnings Before Income Tax Total Shareholder Equity Return on Equity (after-tax) = Earnings Before Income Tax Total Shareholder Equity Efficiency Ratios: Inventory Turnover Ratio = Cost of Goods Sold Inventories Accounts Receivable Turnover = Credit Sales Accounts Receivable Average Collection Period = (Accounts Receivable / Annual credit Sales) 360 Liquidity Ratios: Current ratio = Current Assets Current Liabilities Quick asset ratio = Current Assets – Inventories Current Liabilities Stability ratios: Debt to Total Assets, or Debt Ratio = Liabilities Total Assets Times Interest Earned = Earnings Before Income Tax Annual Interest Expense Per-share Ratios: Earnings per Share (in cents) = Net Income Common Shares Outstanding Dividend per share (in cents) = Total assets-total liabilities Total number of shares Dividend cover = Earning per share Dividend per share Net asset backing per share = Total assets –total liabilities Total number of shares References Nissim, D, Penman, S 2003, ‘Financial Statement Analysis of Leverage and How it Informs About Profitability and Price-to-Book Ratios’, Review of Accounting Studies, No. 8, Kluwer Academic Publishers, Neitherlands, p. 531 – 560. Jensen, D 1997, Advanced Accounting, McGraw-Hill College Publishing, USA Auerbach, A 1995, Cash Flow Analysis, 5th Ed, Financial Performers, Inc., Edward Lowe Foundation. Van Horne, J., and Wachowicz, J 2001, Fundamentals of Financial Management, 11th Ed., Prentice Hall, UK. Eric Press, 1999, Analyzing Financial Statements, Lebahar – Friedman, New york. Muro V 1998, Handbook of Financial Analysis for Corporate Managers, AMACOM, USA Leopold B, and Wild, J 2000, Analysis of Financial Statement, McGraw – Hill, U.S.A Samuels J, Wilkes F, Brayshaw R. 1998, ‘Chap. 7 – Financial Analysis and Interpretation’, Financial Management and Decision Making, 1st Ed., International Thomson Business Press, USA Martin M 1994, Accounting for Effective Decision Making, Irwin Professional Press, USA Atrill, P and McLaney E 1997, Accounting and Finance for Non-Specialists, Prentice Hall, New Jersey. Atrill P., McLaney E., 1997, Accounting and Finance for Non-Specialists, Prentice Hall, New Jersey. Read More