Ratio Analysis of McDonalds Company - Essay Example

Mc Donalds Ratio Analysis APA Style Report Please put here 6/19/2008 Introduction A financial ment is a compilation of data, which is logically and consistently organized according to accounting principles. Its purpose is to convey an understanding of some financial aspects of a business firm. It may show a position at a moment in time, as in the case of a balance sheet, or may reveal a series of activities over a given period of time, as in the case of an income statement. Financial statements are the major means through which firms present their financial situation to stockholders, creditors, and the general public. The majority of firms include extensive financial statements in their annual reports, which receive wide distribution. The Nature of Financial Statement Analysis Financial statement analysis consists of the application of analytical tools and techniques to the data in financial statements in order to derive from them measurements and relationships that are significant and useful for decision making (ICFAI Center for Management Research ICMR, 2004). The process of financial analysis can be described in various ways, depending on the objectives to be obtained. Financial analysis can be used as a preliminary screening tool of future financial conditions and results. It may be used as a forecasting tool of future financial conditions and results. It may be used as a process of evaluation and diagnosis of managerial, operating, or other problem areas. Above all, financial analysis reduces reliance on intuition, guesses and thus narrows the areas of uncertainty that is present in all decision making processes. Financial analysis does not lessen the need for judgment but rather establishes a sound and systematic basis for its rational application. The Principle Tools of analysis In the analysis of financial statements, the analyst has a variety of tools available from which he can choose those best suited to his specific purpose. The following are the important tools of analysis. 1. Ratio Analysis - Comparative analysis - Du-Pont analysis 2. Funds flow Analysis Ratio Analysis Ratios are well known and the most widely used tools of financial analysis. A ratio gives the mathematical relationship between one variable and another. The analysis of ratios can disclose relationships as well as bases of comparison that reveal conditions and trends that cannot be detected by going through the individual components of the ratio. The usefulness of ratios is ultimately dependant on their intelligent and skillful interpretation. Ratios are used by different people for various purposes. As ratio analysis mainly helps in valuing the firm in quantitative terms, two groups of people are interested in the valuation of the firm and they are creditors and shareholders. Creditors are again divided into short-term creditors and long-term creditors. Short-term creditors hold obligations that will soon mature and they are concerned with the firm's ability to pay its bills promptly. In the short run, the amount of liquid assets determines the ability clear off current liabilities. These persons are interested in liquidity. Long-term creditors hold bonds or mortgages against the firm and are interested in current payments of interest and eventual repayment of principal. The firm must be sufficiently liquid in the short-term and have adequate profits for the long-term. These persons examine both the liquidity and profitability of the firm. In addition to liquidity and profitability, the owners of the firm i.e. the shareholders are concerned about the policies of the firm that affect the market price of the firm's stock. Without liquidity, the firm cannot pay cash dividends. Without profits, the firm would not be able to declare dividends. With poor policies, the common stock would trade at low prices in the market. Keeping in view the above discussions regarding the category of users, financial ratios fall into three groups as follows: Liquidity ratios Profitability or efficiency ratios Ownership ratios Earnings ratios Dividend ratios Leverage ratios Capital Structure ratios Coverage ratios All the above mentioned categories of ratios are discussed in detail as under. Liquidity Ratios Liquidity implies a firm's ability to pay its debts in the short run. This ability can be measured by the use of liquidity ratios. Short-term liquidity involves the relationship between current assets and current liabilities. If a firm has sufficient net working capital i.e. excess of current assets over current liabilities, then the firm is assumed to have enough liquidity. The current ratio and the quick ratio are the two ratios, which are commonly used to measure liquidity directly. The ratios like receivable turnover ratios and inventory turnover ratios measure the liquidity of the firm indirectly. Liquidity or solvency ratios are used as measures of the company's ability to finance its short-term obligations by its cash and near cash items. Included in these ratios are current, acid test or otherwise known as the "quick ratio", and cash ratios. Current ratio expresses the "working capital' relationship of current assets available to meet the company's current obligations. Cash ratio is an indicator of the extent to which a company can pay current liabilities without relying on the sale of inventory and without relying on the receipts of the accounts receivables (al.., 2000). Higher ratios indicate more liquidity. The table given below shows the different formulae used in the computation of the aforementioned liquidity ratios. Computation of Liquidity Ratios Turnover Ratios As already mentioned above, receivables turnover ratios and inventory turnover ratios measure the liquidity of a firm in an indirect way. Here the measure of liquidity is concerned with the speed with which inventory is converted into sales and accounts receivables converted into cash. The turnover ratios give the speed of conversion of current assets (liquidity) into cash in the above way. Two different ratios are used to measure the liquidity of a firm's account receivables. They are: a. Accounts receivable turnover ratio b. Average collection period The following table shows the different formulae used in the computation of the aforementioned turnover ratios. Computation of Turnover Ratios Ratios Computation Accounts receivable turnover ratio Net credit sales Average accounts receivable Average collection period 360 Average accounts receivable turnover Profitability or Efficiency Ratios Profitability ratios are also called as the Efficiency ratios. As described above they measure the firm's activities and its ability to generate profits. Gross profit Margin: the gross profit margin ratio (GPM) is defined as follows: Gross Profit ------------- Net Sales Where net sales = Sales - Excise duty This ratio shows the profits relative to sales after the direct production costs are deducted. It may be used as an indicator of the efficiency of the production operation and the relation between production costs and selling price. Net profit Margin: This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing, and tax management. Net profit margin, on the other hand, is the ratio of net income to sales. Return on common equity (ROCE) is a variant of return on investment. The return on common equity assesses the rate of return on the investments of common stockholders in the company (Analyzing Company Reports 2005). Another ratio is the turnover ratio which shows to what the extent the company uses its assets to produce revenue. Logically, higher profitability ratios indicate a healthier financial condition. Computation of Profitability Ratios Financial Leverage Ratios Financial leverage ratios provide an indication of the long-term solvency of the firm. They indicate the extent of non-owner claims on the firm's profits as well as the firm's operating capability to meet its obligation. Gearing is the long-term debt to equity ratio which assesses the balance between liabilities and equity in the firm's long term resource structure. Another is the interest coverage ratio which measures the extent to which earnings cover the interest obligation of the company (Strickland, 2002). The table given below shows the different formulae used in the computation of the aforementioned financial leverage ratios. Computation of Financial Leverage Ratios Market value ratios/investor ratios: Investor ratios are financial ratios especially designed to covey to investors the asses the profitability of the company's stock as an investment. Earnings per share shows the return to common stock shareholder for each share owned. Shows the rate earned by shareholders from dividend relative to the stock price, while price to earnings ratio expresses the multiple that the market attributes to a common stock relative to its price (Ormiston, 2004) the following table shows the different formulae used in the computation of the aforementioned investor ratios. Computation of Investor Ratios From the Market Value Ratios, we can get information on earnings of the firm and their effect on price of common stock. PE Ratio: The price-earnings ratio gives the relationship between the market price of the stock and its earnings by revealing how earnings affect the market price of the firm's stock (Morningstar). Supportive Examples of McDonald's ratio analysis (McDonalds) Liquidity ratio of McDonald's Current Ratio: FY 2005 FY 2006 Company1 1.45 1.21 Industry Average 0.4 0.98 Quick Ratio: Company 1.25 1.01 Industry Average 0.4 0.74 COMMENTS ON THE COMPANY'S PROFITABILITY: In the operating cycle of the firm current assets are converted into cash to provide funds for the payment of current liabilities. Hence, if the current ratio is higher it means that the short-term liquidity of the firm is also higher. McDonald's ratings continue to incorporate its leading position in the global quick service restaurant industry, exceptional brand awareness, extensive real estate holdings, franchise income and broad geographic diversity. Profitability Ratios of McDonald's Net Profit Margin: FY 2005 FY 2006 Company 12.72 16.42 Industry Average 7.26 7.97 Return on Assets: Company 0.71 0.73 Industry Average 8.12 8.46 Return on Equity: Company 17.73 23.16 Industry Average 21.78 21.47 COMMENTS ON THE COMPANY'S PROFITABILITY: Most companies in the restaurants industry have generated very low returns on assets over the past five years. McDonalds has posted results that are about average for its industry. Return on Equity for the industry is 21.78 for 2005 and 21.47 in 2006. When this is compared with the company figures, it is clear that McDonalds has given 23.16% return to the equity holders in the year 2006 which is higher when compared to the industry figures though the company's figures were less in the previous year. Thus, it can be concluded that McDonalds has employed its resources productively. Market Value Ratios of McDonald's: PE Ratio: FY 2005 FY 2006 Company 19.3 39.5 Industry Average 29.65 25.9 Market to Book Ratio: FY 2005 FY 2006 Company 3.6 4.7 Industry Average 4.6 5.73 COMMENTS ON THE COMPANY'S MARKET VALUE RATIOS: McDonalds has generated market-like returns over the past 5- and 10-year periods. McDonalds has been one of the strongest performers in its industry over the five-year period. The company has got relatively large number of competitors, and looking at its sales, it is one of the largest players. Bibliography 1. (ICMR), I. C. (2003). Financial Management for Managers. Hyderabad: ICFAI Center for Management Research . 2. al.., C. H. (2000). Accounting 4th edition. New Jersey: Prentice Hall. 3. ICFAI Center for Management Research ICMR. (2004). Financial Accounting & Financial Statement Analysis. Hyderabad: ICFAI Center for Management Research. 4. McDonalds. (n.d.). Company Info. Retrieved 02 08, 2008, from http://www.mcdonalds.co.uk/ 5. MorningStar. (n.d.). British Airways PLC. Retrieved March 20, 2008, from Morning Star: http://quicktake.morningstar.com/StockNet/Valuation10.aspxCountry=USA&Symbol=BAIRY 6. Ormiston, L. F. (2004). Understanding Financial Statements. New Jersey: Pearson - Prentice Hall. 7. Strickland, A. t. (2002). Strategic Management 3rd Edition. New York: Mc Graw Hill. Read More