1. Why are ratios useful? What are the five major categories of ratios? * Ratios are used by managers to help improve firm’s performance, by lenders to help evaluate the firm’s likelihood of repaying debt and by stakeholders to help forecast future earnings and dividends. There are five major categories of ratio profitability, asset management, debt management, liquidity and market value.
2. Calculate Everelite’s 2009 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity positions in 2007, in 2008, and as projected for 2009? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysis have an equal interest in the company’s liquidity ratios?
Current Ratio (2009) = Current Asset/Current Liabilities
= $1985827/ $1073192
Quick Ratio (2009) = (Current Asset – Inventory)/ Current Liabilities
= ($1985827 – $909379)/ $1073192
* The company’s current and quick ratios are low relative to its 2007 (CR=2.02x, QR=1.14x) and the ratios are went slightly downward in 2008 (CR=1.95x, QR=0.87x). Comparing both years; 2007 and 2008, we can see in 2009 the ratios were increased by a small different. * No, they don’t have an equal interest in the liquidity ratio. The following are the specific reasons: * MANAGER: Some of the most basic financial ratios show how much a business or investment will return compared to how much it will cost. When managers are planning new projects, these financial ratios provide the support they need to receive funding from executives to move forward. Executives like to see a high return on investment, or ROI, based on analysis of costs and projected revenues. After projects are completed, the same type of analysis can show the returns actually delivered, and how the investment lived up to expectations, which is useful for future strategy. * CREDIT ANALYST: Credit analysts will be particularly interested in the applicant’s liquidity and ability to pay bills on time.
Such ratios as the quick ratio, receivables, inventory turnovers, the average payable period and debt-to-equity ratio are particularly relevant. In addition to analyzing financial statements, the credit analyst will consider the character of the company and its management, the financial strength of the firm, and various other matters. * STOCKHOLDERS: Interested only in Return on Equity (ROE), Dividend Rate, Gross Margin, Net Income Margin and Quarterly and Annual Growth Ratios. In general, Financial Statement Analysis is used by: a) managers to evaluate and improve performance, b) lenders (banks and bondholders) and bond rating analysts (SP and Moody’s) to evaluate the creditworthiness of a company, and c) stockholders (current or prospective) and stock analysts, to forecast earnings, DIV and stock price.” The five types of ratios are liquidity, asset management, debt management, profitability, and market value ratios.
3. Calculate the 2009 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Everelite’s utilization of assets stack up against other firms in the industry?
Inventory Turnover = COGS/Average Inventory
Days Sales Outstanding = Account Receivable/( Sales/365 days)
= 154.69 days
Fixed Asset Turnover = Sales/Net Fixed Asset
Total Assets Turnover = Sales/Total Asset
* The company inventory turnover has been steadily declining while its days sales outstanding has been changing over the years. While the company fixed assets turnover also has been slopping downward, together with total assets turnover. The company might be having a below average level in industry.
4. Calculate the 2009 debt and time-interest-earned ratios. How does Everelite compare with the industry with respect to financial leverage? What can you conclude form these ratios?
Debt Ratio = Total Debt/Total Assets
= ($1073192 + $656600)/ $2298924
Times-Interest-Earned-Ratios = EBIT/Interest Expenses
= $161726/ $27434
* The company’s debt ratios were increased through years since 2007. This shows that the company has more debt than assets. The company might want to magnify earnings or because selling new stock would mean giving up control.
5. Calculate the 2009 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? Year 2009
Profit Margin = Net Income/ Sales
Basic Earning Power (BEP) = EBIT/Total Assets
Return on Assets (ROA) = Net Income/Total Assets
Return on Equity (ROE) = Net Income/Total Equity
6. Calculate the 2009 price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Year 2009
Price/Earnings Ratio = Price per Share/ Earning Per Share
= Net Income/Share Outstanding
*Find P/E Ratio
Market/Book Ratio = Market Price per Share/ Book Value Per Share *Find Book Value per Share
= Total Equity/Share Outstanding
*Find Market/Book Value
* P/E Ratios of the company are above the industry average. It shows an increasing movement since 2007 while the market/book value are also above the industry average although there is a decrement in 2008 which below the industry average.
7. Use the DuPont equation to provide a summary and overview of Everelite’s financial condition as projected for 2009. What are the firm’s major strengths and weaknesses?
DuPont Equation = Profit Margin X Total Asset Turnover X Equity Multiplier
= 3.89% X 0.9 X (1 – 0.75)
* Strengths: The firm’s Fixed Asset Turnover was below the industry
average. The profit margin is slightly below the industry average, despite its higher debt ratio. This can be proven that the company might spend more than it should which later cause a higher debt. * Weaknesses: Some of the ratios are below than the industry average such as inventory turnover, total asset turnover, times-interest-earned-ratio, ROA, and BEP. These have been identified as poor performance among those ratios because it has not achieved the industry level.
8. Use the following simplified 2009 balance sheet to show, in general terms, how an improvement in the DSO would tend to affect the stock price. For example, if the company could improve its collection procedures and thereby lower its DSO without affecting sales, how would that change “ripple through” the financial statements and influence the stock price? Account receivable $ 877 Debt $1730
Other Current Assets 1109
Net Fixed Assets 313 Equity 569 Total Assets $2299 Liabilities, Equity $2299
Sales per Day = $2069032/365
Account Receivable = $5668.58 X 56 days (Industry Average)
Freed Cash = Old A/R – New A/R
= $877000 – $317440.48
9. Does it appear that inventories could be adjusted? If so, how should that adjustment affect Everelite’s profit ability and stock price?
* The inventory turnover is low. There is a possibility that the inventory is out of production. If the inventory were reduced, this would improve the liquidity ratios, the inventory and the total asset turnover, and the debt ratios. These improvements will affect the company’s stock price and profitability. 10. In 2008, the company paid its suppliers much later than the due date; also it was not maintaining financial ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off, and its bank could refuse to renew the loan when it comes due in 90 days. On the basis of data provided, would you, as a credit manager, continue to sell to Everelite on credit? (You could demand cash on delivery-that is, sell on terms of COD- but that might cause Everelite to stop buying from your company). Similarity, if you were the bank loan officer, would you recommend renewing the loan or demand its repayment?
* With reference to the ratios such as quick, receivable and inventory turnover which show the company’s inability to pay off its’ debts when they fall due. As a credit manager, it is unfavorable to continue providing supplying a portion of its total funds with its current arrangement. Terms of COD might be a little harsh and might push the firm into bankruptcy. Likewise, if the bank demanded repayment this could also force Everelite into bankruptcy. Therefore, renewing the loan is a preferable option.
11. What are some potential problems and limitations of financial ratio analysis?
* Many ratios are calculated on the basis of the balance-sheet figures. These figures are a son the balance-sheet date only and may not be indicative of the year-round position. Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. It gives current and past trends, but not future trends. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. The ratios are only as good or bad as the underlying information used to calculate them. Although ratio analysis is very important tool to judge the company’s performance, following are the limitations of it. Seasonal factors can distort ratios, Window dressing techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons. Sometimes, it is hard to tell if ratio is “good” or “bad.”
12. What are some qualitative factors that analysts should consider when evaluating a company’s likely future financial performance?
The following are some qualitative factors that analysts should consider:
1.) To what extent are the company’s revenues tied to one key customer or to one key product? To what extent does the company rely on a single supplier? Reliance on single customers, products, or suppliers increases risk.
2.) What percentage of the company company’s business is generated overseas? Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.
3.) What are the probable actions of current competitors and the likelihood of additional new competitors?
4.) Do the company’s future prospects depend critically on the success of the products currently in the pipeline or on existing products?
5.) How does the legal and regulatory environment affect the company?