Ratio Analysis and Statement of Cash Flows Paper: - Essay Example

Financial ratios Ratio analysis is a useful tool to measure the financial strength of a Company. The Operating Profitability Ratio measures the operating profit of a Company as a ratio of its net sales and provides an idea of a firm’s operating margin. This is a measurement of management efficiency because it compares the quality of the firm’s operations with others. For example, if a firm has a higher operating margin than the average industry value, then it has lower fixed costs and a better gross margin (www.

beginnersinvest.about.com). The net operating profitability ratio is given by the formula: Net Operating income / Tangible Net worth.The Net Operating Income is given by Gross Profit – Operating Expenses. In the case of the Merck Company, the net operating income from its 2006 annual statement before taxes is $6221.4 million dollars. (www.hoovers.com/merck). The total revenue or tangible worth is $22,636.00 million dollars. Hence the operating profitability ratio is: 0.27. In the case of Abbott Laboratories, the net operating income from its 2006 annual income statement before taxes is $2276.

4 million dollars, while its revenue is $22476.3 million dollars. (www.hoovers.com/abbott-labs). Thus, its operating profitability ratio = 0.10. Therefore, the Merck company has a higher operating ratio and this shows that the management efficiency is higher, because it has a better gross margin of profits. This is also an indication of the management’s ability to control expenses. Comparative asset utilization of the two Companies is as given below (Values on assets are drawn from the two companies’ balance sheets): Merck AbbottFixed asset 22636/13194.

1 22476.3/6946.4Turnover (Sales/ = 1.71 =3.2Fixed assets)Total Asset turnover 22636/ 44569.8 22476/36,178.2 (Sales/Total Assets) =0.50 =0.621 In comparing the two ratios above, it may be seen that asset utilization ratios are much higher in the case of Abbott Laboratories, therefore the Merck Company is not as successful in asset utilization as it is in profitability.

This ratio thus measures the management’s ability to utilize company assets efficiently and a high asset turnover ratio is an indication of efficient asset management practices and creation of shareholder value (Ang et al, 1999). The cash flow statements of the two companies from the Hoover’s website indicate that Merck has a net operating cash flow of $6756.2 million while the figure for Abbott is $5329.2 million. However Merck’s depreciation and amortization rate is almost double , i.e, $2268.4 as compared to Abbott at $1558.

8 million dollars, which indicates that its investment on its assets are much higher as compared to Abbott. In conclusion therefore, it may be stated that the management at Merck is not utilizing assets as successfully as Abbott, however it is managing expenses better in terms of operating costs and may be able to provide higher short term dividends to its investors. Abbott on the other hand does not demonstrate such a high ratio of profitability and its available cash flows are less than Merck, indicating that it is not managing its cash flows and operating expenses as well , but the efficiency of its asset utilization indicates that its focus is on providing long term shareholder value.

References:* Ang, J, Cole R and Lin, J, 1999. “Agency costs and ownership structure.” Journal of Finance, 55 (81) : 106* “Analyzing your financial ratios” [online] Retrieved August 30, 2007 from: http://www.va-interactive.com/inbusiness/editorial/finance/ibt/ratio_analysis.html* “Operating Income and Operating Profit Margin” [online] Retrieved August 30, 2007 from: http://beginnersinvest.about.com/cs/investinglessons/l/bloperincmarg.htm* Merck and Co Inc, Annual Income Statement, 2006.

[online] Retrieved August 30, 2007 from: http://www.hoovers.com/merck/--ID__10986,period__A--/free-co-fin-income.xhtml* Abbott Laboratories, Annual Income Statement, 2006. [online] Retrieved August 30, 2007 from: http://www.hoovers.com/abbott-labs/--ID__10030,period__A--/free-co-fin-income.xhtml