Financial Ratio Analysis of two companies

Abstract

This research paper will evaluate Sample Company using review standard financial ratio analysis techniques and assess its potential as a good investment. This is written in the form of a memo to the CEO of an Alabama-based firm, looking for sound financial advice with regards to whether of not buying stock in Sample Company is a sound investment.

Introduction

This research paper will reveal the financial analysis techniques used to evaluate the financial performance of the Sample Company, and evaluate the company’s worthiness as an investment. The paper is divided into three sections. The first section is the memo, which is the main body of the paper. The second section, Appendix A, includes as a reference contains each of the sets of the four financial statements that show Sample Company’s performance from 1999 to 2001. The third section, Appendix B, contains the actual financial ratio analysis techniques, showing the company’s performance in 2000 and 2001, the percent change in performance between these years, a short description of the meaning of each ratio, as well as a short assessment of the company’s change in performance between 2000 and 2001. Using these appendices to support the financial analysis ideas expressed in the memo, the reader should feel that they have a complete set of facts to substantiate these ideas and provide a reference for them.

Memorandum

Date:July 1, 2003

To:Randall K. Black, CEO

Absolutely Alabama Investments

From:William F. Slater, III, Consultant

Slater Technologies

Subject:Financial Analysis Using Ratio Analysis and Recommendation

Dear Randall:

Thank you for the opportunity to review Sample Company’s financial statements and make this ratio analysis, as well as some recommendations about possible investment in this company.

Using financial statements from 1999, 2000, and 2001, along with standard financial ratio analysis, I have been able to develop what I believe is a clear picture of this company’s financial performance. Note that the financial analysis was done using the financial report data from publicly available financial statements for the years 2000 and 2001. I have included these statements for your review in Appendix A

Appendix B contains other measures of Sample Company’s financial performance, as expressed in standard financial ratio analysis techniques using figures from the financial reports in Appendix A.

Profitability of Sample Company

First, let’s look at the Return on Investment (ROI) for 2000 and 2001, using the Dupont Model, which is margin times turnover. Margin is net income divided by the sales, and turnover is sales / average total assets (Marshall, 2002).

Sample Company ROI for 2000

ROI = MARGIN x TURNOVER

OPERATING INCOME =Operating IncomexSales

AVERAGE TOTAL ASSETSSalesAverage Total Assets

Input: 498 =498 x8,251

7,196 8,251 7,196

Result: 6.9% =6.0%x1.15

Sample Company ROI for 2001

ROI = MARGIN x TURNOVER

OPERATING INCOME =Operating IncomexSales

AVERAGE TOTAL ASSETSSalesAverage Total Assets

Input: 924 =924 x10,359

8,659 10,359 8,659

Result: 10.7% =8.9%x1.20

At over 55.1%, the increase in ROI between 2000 and 2001 is remarkable and shows that Sample Company increased its sales while increasing the utilization of its assets used to generate these sales. And to achieve these results, the sales, operating income and average total assets had to all increase proportionately. In the short term, this would be a good trend, but if it continues, it could be a sign that Sample Company is not keeping a big investment in assets, because not that as the denominator in this ROI calculation, a low asset figure can be used to help drive up the overall result. Meaning that if this trend continues, it may be an indication of increased operations rather than improvement in asset efficiency.

Stock Performance

The common stock value increased 54.8%, from $42/share to $65/share, between 2000 and 2001. This is an indicate that the market likes what it sees in the performance and the management of Sample Company. In addition, it paid 1.2% in dividends for the past two years. Another key indicator, the Price to Earnings Ratio, fell from 12.0 to 10.7. This is not enough to be alarming. In fact, some investors, myself included, feel that lower Price to Earnings Ratios are not necessarily a good thing. The reason being that if a company is struggling to pay out large earnings per share, to make the denominator in the P/E equation large enough to keep the P/E ratio low, then often such financial pressures can take the attention of the management away from the company’s operations and other important issues, like surviving as a going concern in a tough business climate.

Activity of Sample Company

The activity ratios measure the company’s management of asset levels and sales (Marshall, 2002). Between 2000 and 2001, Sample Company showed positive performance with its average days sales by over 25% and decreased its number of day sales in accounts receivable over 2%. Together, these ratios show the efficiency of collection relative to the average age of receivables. The inventory turnover fell by 5.9% and the fixed asset turnover increased by 18.8%. These turnover figures overall would suggest that assets are being used efficiently to produce sales.

Leverage of Sample Company

Leverage is the use of debt to finance company assets (Marshall, 2002). When a company uses leverage, it incurs an additional component in its
operations, put it also increases the ROE relative to the ROI. Between 2000 and 2001, Sample Company’s debt ratio increased 32.3% and its debt / equity ratio increased 21.5%. An assumption of greater debt in order to produce the overall increase in performance that Sample Company delivered in 2001 could almost be expected. A very encouraging sign is the 31% increase in the ratio of the times interest earned ratio, because it indicates that Sample Company has an increasingly strong capability to pay the interest on its debts with the income it is producing. This is a positive sign for investors and could help in part to account for the overall increase in stock price.

Liquidity of Sample Company

The liquidity of a company is the ability to meet its loan obligations as it relates to its current assets and its current liabilities (Marshall, 2002). Appendix B shows that we have analyzed three important liquidity ratios: 1) Current Ration, 2) Acid Test, and 3) Working Capital. Of these three, the best indicators of liquidity, when trying to show trends, are the Acid test and the Current Ratio. A current ratio of 2 and an acid test of 1.0 are considered “adequate liquidity” (Marshall, 2002). Sample Company’s Acid Test numbers for 2000 and 2001 were .84 and .79, and its Current Ratio numbers for 2000 and 2001 were 1.45 and 1.54. Each sets of these ratio figures indicate that Sample Company could possibility have some difficulties in meeting its financial obligations, so these numbers will be important to watch closely in the future.

What Is Necessary to Assess the Company?

Besides doing this detailed financial ratio analysis, it would critical to research the annual reports for 1999 – 2001 and read the explanatory notes and other financial information. There we would find an inside look at organization beyond the numbers, and the bases for how these financial reports were assembled. These notes contain essential information about its significant accounting policies. These policies can and should include information about the depreciation methods that was used, employee benefits, amortization of intangible benefits, earnings per share, stock option and purchase plans. Other types of information that should be disclosed are details of other financial statement amounts (such as detailed explanations of long-term debt), other disclosures such as any possible accounting principle change, business combinations (mergers, acquisitions, dispositions), contingencies and commitments (i.e. disclosures of possible pending lawsuits), events subsequent to the balance sheet date, impacts of inflation, business segment information (i.e. geographic segments), and a possible management’s statement of responsibility.

Other financial information that can found in these reports: a statement showing management’s discussion and analysis, a summary of past financial data, an independent auditor’s report, and a compilation report.

Without the explanatory notes and other financial information, the true picture of an organization’s financial circumstances cannot be known.

Finally, we would want to take additional time to run a Dun and Bradstreet report on the company, to I would want to know how the company pays its bills and treats its creditors. Specifically, I would like to see these Dun and Bradstreet reports on the company: D&B Rating, PAYDEX®, and Score Tables. The US D&B (5A to HH) ratings reflect company size based on net worth or equity as computed by D&B. These ratings are assigned to businesses that have supplied D&B with current financial information (Dun & Bradstreet, 2003).

There is also a Financial Stress Score. The Financial Stress model predicts the likelihood of a firm ceasing business without paying all creditors in full, or reorganizing or obtaining relief from creditors under state/federal law over the next twelve months. Scores were calculated using a statistically valid model derived from D&B’s extensive data files (Dun & Bradstreet, 2003).

There is also a Commercial Credit Score. The US Commercial Credit Score predicts the likelihood of a firm paying in a delinquent manner (90 + days past terms) during the next 12 months, based on the information in D&B’s file. The score was calculated using statistically valid models derived from D&B’s extensive data files (Dun & Bradstreet, 2003).

Dun and Bradstreet reports are among the most respected in the world. Also, if I know how a company treats its creditors, then I will have some idea of how serious the company is about its reputation and about being in business. These reports would give us a greater sense assurance knowing that we now have obtained objective information from one of the world’s most respected sources of financial analysis. To obtain these reports easily, we can go to Dun and Bradstreet at http://dunandbradstreet.com/us/ and order a report on the company using a credit card transaction over the web.

What Ratios Have the Most Value?

Which ratio has the most value, really depends on what aspect of the company you are attempting to measure. For the aggressive investor, that ration will likely be the ROI. For a person who is evaluating the risks associated with the ability of the company to remain solvent, a ratio like the acid test, or the debt ratio will have considerable importance. So the answer to the question of which ratio has the most value is really who is asking and what do they hope to find. To paraphrase a common quip on standards, the nice thing about ratios is that you have so many to choose from.

What Other Factors, Beyond Ratios, Need To Be Considered?

As mentioned above in the section on what is necessary to evaluate the company, we would want to obtain annual reports and also Dun and Bradstreet reports. In addition to all this, we would want evaluate such things as the performance of the company’s competitors, the standard average financial ratios for the industry this company is in, and measure Sample Company’s performance against these averages. Other factors would be the company’s image in the community, any possible litigation the company is involved in either as plaintiff or defendant, customer testimonials (good and bad), the market behavior of the market the company is in, any offshore threats to competition, workforce demographics and availability, and a detailed review of the company leadership, including the executive staff (president and vide presidents), and the board of directors.

What Type of Industry Do You Think The Organization Is and Why?

I think this is probably a manufacturing company because the following indicators are within the range of what would be a manufacturing concern (Marshall, 2002):

RatioSample Company 2001 ValueManufacturing Typical Value

ROI10.7%10% to 15%

ROE16%10% – 15%

Margin8.9%10% – 15%

Asset Turnover1.21.0 to 3.0

How Would Your Assessment Criteria Change If The Company In a Different Industry

The table below shows how my assessment would change if the industry of this company were different.

Changes in Assessment Method

IndustryChange in AssessmentComments

Retail?No change, but closer attention to activity ratios and inventory turnoverInventory turnover and activity ratios are key indicators of efficiency in sales and in managing receivables.

Merchandising?No change, but closer attention to activity ratios and inventory turnoverInventory turnover and activity ratios are key indicators
of efficiency in sales and in managing receivables.

Service?No change, but closer attention to activity ratios and fixed asset turnoverFixed asset turnover and activity ratio are key indicators of efficiency in sales and in managing receivables.

e-Commerce?Similar analysis but closer attention to activity ratios, liquidity, and leverage, in addition to serious scruitiny on ROI projections.And a lot of emphasis on other criteria such as the worthiness of the business model, the target market, who the investors are and why they think the company has a chance, etc.Before the bust, the dot coms had a serious problem with trying to realize revenue too quickly, and overstated revenue from reselling (Marshall, 2002)

Conclusion

So we have seen that a lot of ways to analyze a company’s financial performance. It’s not “rocket science,” but it does take a lot of time and a willingness to crunch the numbers using a spreadsheet, some well organized financial reports, and a good set of ratio guidelines. It also takes a dedication to the truth and being willing to dig deeper than what the average person reads in a 500-word column in the business section of the newspaper.

Finally, would I recommend the purchase of Sample Company’s stock as an investment? The answer is a qualified “Yes”. After more careful research, if my findings were consistent with the financial analysis in this report, then I absolutely would be in favor of buying this company’s stock.

Appendix A – Sample Company’s Financial Statements from 1999 – 2001

STATEMENT 1

SAMPLE CO.

Consolidated Results of Operations

For the Years Ended December 31

(dollars in millions except per share data)

2001 2000 1999

Sales $ 10,359 $ 8,251 $ 7,362

Operating costs:

Cost of goods sold8,011 6,523 6,064

Selling, general, and administrative expenses1,242 1,071 980

Research and development expenses182 159 178

$ 9,435 $ 7,753 $ 7,222

Operating profit $ 924 $ 498 $ 140

Interest expense264 209 197

$ 660 $ 289 $ (57)

Other income 182 170 160

$ 842 $ 459 $ 103

Provision for income taxes262 118 21

Profit of consolidated companies $ 580 $ 341 $ 82

Equity in profit (loss) of affiliated companies36 (22) (6)

Profit–before extraordinary tax benefit $ 616 $ 319 $ 76

Extraordinary tax benefit from foreign tax credit carryforwards – 31 –

Profit $ 616 $ 350 $ 76

Profit per share of common stock before extraordinary tax benefit $ 6.07 $ 3.20 $ 0.77

Profit per share of common stock after extraordinary tax benefit $ 6.07 $ 3.51 $ 0.77

Dividends paid per share of common stock $ 0.75 $ 0.50 $ 0.50

STATEMENT 2

SAMPLE CO.

Changes in Consolidated Ownership

For the Years Ended December 31

(dollars in millions)

2001 2000 1999

Common stock:

Balance at beginning of year $ 827 $ 714 $ 696

Common shares issued, including treasury shares reissued:

2001–1,317,485; 2000–2,601,322; 1999–452,95983 113 18

Treasury shares purchased: 2001–1,326,058 (86) – –

Balance at year-end $ 824 $ 827 $ 714

Profit employed in the business:

Balance at beginning of year $ 2,656 $ 2,363 $ 2,349

Add: Profit616 350 76

Deduct: Dividends paid and payable 88 57 62

Balance at year-end $ 3,184 $ 2,656 $ 2,363

Foreign currency translation adjustment:

Balance at beginning of year $ 82 $ 72 $ 23

Aggregate adjustment for the year 23 10 49

Balance at year-end $ 105 $ 82 $ 72

Ownership at year-end $ 4,113 $ 3,565 $ 3,149

SAMPLE CO.

Consolidated Financial Position

At December 31

(dollars in millions except per share data)

2001 2000 1999

Current assets:

Cash and short-term investments $ 74 $ 155 $ 166

Receivables2,669 2,174 1,808

Refundable income taxes114 130 92

Deferred income taxes and prepaid expense allocable to

the following year474 224 208

Inventories1,986 1,323 1,211

$ 5,317 $ 4,006 $ 3,485

Current liabilities:

Short-term borrowings $ 1,072 $ 623 $ 696

Payable to material suppliers and others1,495 1,351 1,182

Wages, salaries, and contributions for employee benefits485 431 450

Dividends payable30 19 12

Income taxes118 48 10

Long-term debt due within one year 235 286 122

$ 3,435 $ 2,758 $ 2,472

Net current assets $ 1,882 $ 1,248 $ 1,013

Buildings, machinery, and equipment–net2,802 2,467 2,431

Land–at original cost107 96 97

Patents, trademarks, and other intangibles71 47 60

Investments in and advances to affiliated companies288 227 185

Long-term receivables902 665 413

Other assets199 123 90

Total assets less current liabilities $ 6,251 $ 4,873 $ 4,289

Long-term debt due after one year1,953 1,287 1,134

Deferred income taxes 185 21 6

Net assets $ 4,113 $ 3,565 $ 3,149

Ownership (Statement 2):

Common stock of $1.00 par value:

Authorized shares: 200,000,000

Outstanding shares (2001–101,414,138; 2000–101,422,711

[after deducting 23,470 and 2,961 treasury shares, respectively];

1999–98,832,079) at paid-in amount $ 824 $ 827 $ 714

Profit employed in the business3,184 2,656 2,363

Foreign currency translation adjustment105 82 72

$ 4,113 $ 3,565 $ 3,149

STATEMENT 4

SAMPLE CO.

Consolidated Statement of Cash Flows

For the Years Ended December 31

(dollars in millions)

2001 2000 1999

Cash flows from operating activities:

Profit $ 616 $ 350 $ 76

Adjustments for non-cash items:

Depreciation and amortization434 425 453

Other(74) 144 86

Changes in assets and liabilities:

Receivables(777) (699) (765)

Refundable income taxes15 (34) 1

Inventories(598) (124) (68)

Payable to material suppliers and others348 252 (14)

Other–net(39) (80) (4)

Net cash provided by operating activities $ (75) $ 234 $ (235)

Cash flows from investing activities:

Expenditures for land, buildings, machinery, and equipment $ (793) $ (493) $ (331)

Proceeds from disposals of land, buildings, machinery, and equipment30 32 16

Investments in and advances to affiliated companies(24) (65) (52)

Other–net(50) (25) 41

Net cash used for investing activities $ (837) $ (551) $ (326)

Cash flows from financing activities:

Dividends paid $ (77) $ (50) $ (49)

Common shares issued, including treasury shares reissued4 6 3

Treasury shares purchased(86) – –

Proceeds from long-term debt issued371 503 156

Payments on long-term debt(298) (102) (307)

Short-term borrowings–net965 (91) 578

Net cash provided by financing activities $ 879 $ 266 $ 381

Effect of exchange rate changes on cash $ (48) $ 40 $ 41

Decrease in cash and short-term investments $ (81) $ (11) $ (139)

Appendix B – Financial Ratio Analysis of Sample Company

Standard Financial Ratio Analysisfor Sample Company

Percent

Assessment20002001Change Description

Profitability

ROI (%)Great6.910.755.1 Rate of Return on assets invested

ROE (%)Great10.41653.8 Rate of return of Assets provided by owners equity

Margin (%)Great68.948.3 Net income resulting from each dollar of sales

Earnings Per Share ($)Great$3.51$6.0772.9 Profit earned on each share of common stock

Price to Earnings (Ratio)Good1210.7-10.8 Market price of share / earnings per share, measures how expensive

Dividend Payout (%)Good14.212.4-12.7 Proportion of earnings that were paid as dividends to common shareholders

Dividend Yield (%)Good1.21.20.0 Part of stockholders’ ROI: rate of return from annual cash dividend

Market Price per share ($)Good$42.00$65.0054.8 Change in Market Price of stock during the year

Percent

Assessment20002001Change Description

Activity

Inventory Turnover (Times)OK5.14.8-5.9 Efficiency of the firm’s inventory management practices

Fixed Asset Turnover (Times)Good3.23.818.8 Efficiency with which assets are used to generate sales

No. of Days in Accounts Receivable (days)Good96.294-2.3 Average age of accounts receivable and

Average Days Sales ($)OK$22.61$28.3825.5 Relative efficiency of the firm’s collection policies relative to credit trems

Leverage

Debt RatioNot so good35.947.532.3 Total Liabilities / (Total Liabilities + Owners’ Equity)

Debt/Equity RatioNot so good26.532.221.5 Total Liabilities / Total Owners’ Equity

Times Interest Earned (Times)Good3.194.1831.0 Earnings before interest and taxes / Interest expense (Ability to pay its interest)

Liquidity

Current Ratio (Ratio)Marginal1.451.546.2 Liquidity more comparable over time

Acid Test (Ratio)Marginal0.840.79-6.0 Conservative assessment

Working Capital ($)Great$1,248$1,88250.8 Firm’s ability to meet its obligations when they come due