Profitability Ratios: How Profitable is the Company? Net sales/Net profit after taxes The information necessary to determine a company’s profit as a percentage of sales can be found in the company’s income statement. 1. Magnetronics’ profit as a percentage of sales for 1999 was $1,307 divided by $48,769, or 2. 68%. 2. This represented a decrease from 3. 6% in 1995. 3. The deterioration in profitability resulted from a decrease in cost of goods sold as a percentage of sales, and from a decrease in operating expenses as a percentage of sales.
The only favorable factor was the decrease in the income tax paid. Management and investors are often more interested in the return earned on the funds invested than in the level of profits as a percentage of sales. Companies operating in businesses requiring very little investment in assets often have low profit margins but earn very attractive returns on invested funds. Conversely, there are numerous examples of companies in very capital-intensive businesses that earn miserably low returns on invested funds, despite seemingly attractive profit margins.
Therefore, it is useful to examine the return earned on the funds provided by the shareholders and by the “investors” in the company’s interest-bearing debt. To increase the comparability across companies, it is useful to use EBIAT (earnings before interest but after taxes) as the measure of return. The use of EBIAT as the measure of return also allows the analyst to compare the return on invested capital (calculated before the deduction of interest expense), with the company’s estimated cost of capital to determine the long-term adequacy of the company’s profitability. 4. Magnetronics had a total of $15,249 of capital at year-end 1999 and arned before interest but after taxes (EBIAT) $1,824 during 1999. Its return on invested capital is calculated as follows: Earnings before interest but after taxes (EBIAT)/Owners’ equity plus interest – bearing debt In 1999 this figures was %, which represented a decrease from the 14. 67% earned in 1995. From the viewpoint of the shareholders, an equally important figure is the company’s return on equity. Return on equity is calculated by dividing profit after tax by the owners’ equity. Profit after taxes/ Owners’ equity ?? Return on equity Return on equity indicates how profitably the company is utilizing shareholders’ funds. . Magnetronics had $12,193 of owners’ equity and earned $1,307 after taxes in 1999. Its return on equity was 10. 72%, a deterioration from the 15. 22% earned in 1995. Management can “improve” (or “hurt”) its return on equity in several ways. Each method of “improvement” differs substantially in nature. The analyst must get behind the return on equity figures and must understand the underlying causes of any changes. For example, did Return on Sales improve? Did the company’s management of assets change? Did the company increase the use of borrowed funds relative to owners’ equity?
These three possible explanations are combined in the Du Pont system of ratio analysis: ROE ?? Net Income/Sales x Sales/Assets x Assets/Equity Activity Ratios: How Well Does a Company Employ Its Assets? The second basic type of financial ratio is the activity ratio. Activity ratios indicate how well a company employs its assets. Ineffective utilization of assets results in the need for more finance, unnecessary interest costs, and a correspondingly lower return on capital employed. Furthermore, low activity ratios or a deterioration in the activity ratios may indicate uncollectible accounts receivables or obsolete inventory or equipment
Total asset turnover measures the company’s effectiveness in utilizing its total assets and is calculated by dividing total assets into sales: Net sales/Total assets 1. Total asset turnover for Magnentronics in 1999 can be calculated by dividing $48,769 into $22,780. The turnover deteriorated from 2. 17 times in 1995 to 2. 14 times in 1999. It is useful to examine the turnover ratios for each type of asset, as the use of total assets may hide important problems in one of the specific asset categories. One important category is accounts receivables.
The average collection period measures the number of days that the company must wait on average between the time of sale and the time when it is paid. The average collection period is calculated in two steps. First, divide annual credit sales by 365 days to determine average sales per day: Net credit sales/365 days Then, divide the accounts receivable by average sales per day to determine the number of days of sales that are still unpaid: Accounts receivable/Credit sales per day 2. Magnetronics had $7,380 invested in accounts receivables at year-end 1999.
Its average sales per day were $133,614 during 1999 and its average collection period was 55. 23 days. This represented an improvement from the average collection period of 58. 68 days in 1995. A third activity ratio is the inventory turnover ratio, which indicates the effectiveness with which the company is employing inventory. Since inventory is recorded on the balance sheet at cost (not at its sales value), it is advisable to use cost of goods sold as the measure of activity. The inventory turnover figure is calculated by dividing cost of goods sold by inventory: Cost of goods sold/Inventory 3.
Magnetronics apparently needed $8,220 of inventory at year-end 1999 to support its operations during 1999. Its activity during 1999 as measured by the cost of goods sold was $29,700. It therefore had an inventory turnover of 3. 61 times. This represented a deterioration from 4. 76 times in 1995. A fourth and final activity ratio is the fixed asset turnover ratio which measures the effectiveness of the company in utilizing its plant and equipment: Net sales/Net fixed assets 4. Magnetronics had net fixed assets of $5,160 and sales of $48,769 in 1999. Its fixed asset turnover ratio in 1999 was 9. 45 times, an improvement from 7. 8 times in 1995. 5. So far, we have discussed three measure of profitability: They are (a) return of equity (b) return on invested capital and (c) net profit margin. We have also discussed four activity ratios which measure the effectiveness of the company in utilizing its assets: they are (d) total asset turnover (e) asset turnover ratio (f) inventory turnover ratio and (g) average collection period. 6. The deterioration in Magnetronics’ operating profits as a percentage of total assets between 1995 and 1999 resulted primarily from inefficient use of inventory and total assets, increase in COGS and operating expenses as a ercentage of sales. Leverage Ratios: How Soundly is the Company Financed? The third basic type of financial ratio is the leverage ratio. The various leverage ratios measure the relationship of funds supplied by creditors and the funds supplied by the owners. The use of borrowed funds by profitable companies will improve the return on equity. However, it increases the riskiness of the business and, if used in excessive amounts, can result in financial embarrassment. One leverage ratio, the debt ratio, measures the total funds provided by creditors as a percentage of total assets:
Total liabilities/Total assets Total liabilities include both current and long-term liabilities. 1. The total liabilities of Magnetronics as of December 31, 1999, were $10,587 or 46. 47% of total assets. This represented a decrease from 48. 55% as of December 31, 1995. Lenders — especially long-term lenders — want reasonable assurance that the firm will be able to repay the loan in the future. They are concerned with the relationship between total debt and the economic value of the firm. This ratio is called the total debt ratio at market. Total liabilities/(Total liabilities+Market value of the equity)
The market value of equity is calculated by multiplying the number of shares outstanding of common stock times the market price per share. 2. The market value of Magnetronics’ equity is $14,275,000 at December 31, 1999. Its total debt ratio at market was 42. 58%. A second ratio that relates the level of debt to economic value and performance is the times interest earned ratio. This ratio relates earnings before interest and taxes — a measure of profitability and of long-term viability — to the interest expense — a measure of the level of debt.
Earnings before interest and taxes/Interest expense 3. Magnetronics’ earnings before interest and taxes were $2,528 in 1999 and its interest charges were $517 . Its times interest earned was 4. 89 times. This represented a deterioration from the 1995 level of 7. 12 times. A fourth and final leverage ratio is the number of days of payables. This ratio measures the average number of days that the company is taking to pay its suppliers of raw materials and components. It is calculated by dividing annual purchases by 365 days to determine average purchases per day: Annual purchases/365 days
Accounts payable are then divided by average purchases per day: Accounts payable/Average purchases per day to determine the number of days purchases that are still unpaid. It is often difficult to determine the purchases of a firm. Instead, the income statement shows cost of goods sold, a figure that includes not only raw materials but also labor and overhead. Thus, it often is only possible to gain a rough idea as to whether or not a firm is becoming more or less dependent on its suppliers for finance. This can be done by relating accounts payable to cost of goods sold,
Accounts payable/Cost of goods sold and following this ratio over time. 4. Magnetronics owed its suppliers $2,820 at year-end 1999. This represented 9. 49% of cost of goods sold and was an increase from 8. 42% at year-end 1995. The company appears to be less prompt in paying its suppliers in 1999 than it was in 1995. 5. The deterioration in Magnetronics’ profitability, as measured by its return on equity, from 15. 2% in 1995 to 10. 7% in 1999 resulted from the combined impact of faster growth of equity than net income and increased COGS and operating expenses as a percentage of revenues. 6.
The financial riskiness of Magnetronics increased between 1995 and 1999. Liquidity Ratios: How Liquid is the Company? The fourth basic type of financial ratio is the liquidity ratio. These ratios measure a company’s ability to meet financial obligations as they become current. The current ratio, defined as current assets divided by current liabilities, Current assets/Current liabilities assumes that current assets are much more readily and certainly convertible into cash than other assets. It relates these fairly liquid assets to the claims that are due within one year — the current liabilities. . Magnetronics held $17,620 of current assets at year-end 1999 and owed $7,531 to creditors due to be paid within one year. Its current ratio was 2. 34, a deterioration from the ratio of 2. 41 at year-end 1995. The quick ratio or acid test, is similar to the current ratio but excludes inventory from the current assets: (Current assets – Inventory)/Current liabilities Inventory is excluded because it is often difficult to convert into cash (at least at book value) if the company is struck by adversity. 2.
The quick ratio for Magnetronics at year-end 1999 was 1. 25, a deterioration from the ratio of 1. 52 at year-end 1995. A Warning The calculated ratios are no more valid than the financial statements from which they are derived. The quality of the financial statements should be assessed, and appropriate adjustments made, before any ratios are calculated. Particular attention should be placed on assessing the reasonableness of the accounting choices and assumptions embedded in the financial statements. The Case of the Unidentified Industries
The preceding exercise suggests a series of questions that may be helpful in assessing a company’s future financial health. It also describes several ratios that are useful in answering some of the questions, especially if the historical trend in these ratios is examine. However, it is also important to compare the actual absolute value with some standard to determine whether the company is performing well. Unfortunately, there is no single current ratio, inventory turnover, or debt ratio that is appropriate to all industries, and even within a specific industry, ratios may vary significantly among companies.
The operating and competitive characteristics of the company’s industry greatly influence its investment in the various types of assets, the riskiness of these investments, and the financial structure of its balance sheet. Try to match the five following types of companies with their corresponding balance sheets and financial ratios as shown in Exhibit 3. 1. Electric utility B 2. Japanese trading companyD 3. Aerospace manufacturer E 4. Automobile manufacturer A 5. Supermarket chain C
In doing the exercise, consider the operating and competitive characteristics of the industry and their implications for (1) the collection period, (2) inventory turnover, (3) the amount of plant and equipment and (4) the appropriate financial structure. Then identify which one of the five sets of balance sheets and financial ratios best matches your expectations. Exhibit 3Unidentified Balance Sheet – BEST MATCHES EXPECTATONS! | A| B| C| D| E| Balance Sheet Percentages| | | | | | Cash| 7. 6%| 2. 7%| 1. 4%| 7. 2%| 12. 7%| Receivables| 31. 7| 4. 7| 2. 9| 60. 3| 11. 5| Inventories| 5. 3| 2. 0| 23. 0| 8. | 48. 1| Other current assets| 1. 2| 3. 0| 1. 8| 7. 3| 0. 0| Property and equipment (net)| 30. 2| 66. 6| 49. 9| 4. 3| 25. 0| Other assets| 24. 0| 21. 0| 21. 0| 12. 2| 2. 7| Total assets| 100. 0%| 100. 0%| 100. 0%| 100. 0%| 100. 0%| | | | | | | Notes payable| 38. 4%| 4. 2%| 4. 6%| 50. 8%| 0. 9%| Accounts payable| 5. 5| 3. 0| 20. 0| 15. 2| 21. 5| Other current liabilities| 1. 5| 4. 7| 12. 7| 5. 7| 27. 4| Long-term debt| 17. 4| 30. 0| 37. 5| 22. 7| 8. 1| Other liabilities| 26. 5| 22. 9| 9. 8| 1. 3| 8. 1| Owners equity| 10. 7| 35. 2| 15. 4| 4. 3| 34. 0| Total liabilities and equity| 100. 0%| 100. %| 100. 0%| 100. 0%| 100. 0%| | | | | | | Selected RatIos| | | | | | Net profits/net sales| . 04| . 14| . 02| . 01| . 05| Net profits/total assets| . 03| . 05| . 06| . 01| . 03| Net profits/owners’ equity| . 29| . 14| . 41| . 13| . 10| Net sales/total assets| . 78| . 36| 3. 2| 2. 1| . 67| Collection period (days)| 149| 48| 3| 106| 63| Inventory turnover| 11| 10| 10| 23| 1. 1| Total liabilities/total assets| . 89| . 65| . 85| . 96| . 66| Long-term debt/owners equity| 1. 6| . 85| 2. 4| 5. 3| . 24| Current assets/current liabilities| 1. 0| 1. 0| . 8| 1. 0| 1. 4| Quick ratio| . 9| . 9| . 2| . 9| . 5|