In: Finance
FIN101
Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies in which he is now invested, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed here:
Island |
Burger |
Fink |
Roland |
||
Ratio |
Electric Utility |
Heaven |
Software |
Motors |
|
Current ratio |
1.06 |
1.35 |
6.79 |
4.55 |
|
Quick ratio |
0.92 |
0.87 |
5.23 |
3.73 |
|
Debt ratio |
0.69 |
0.45 |
0.04 |
0.34 |
|
Net profit margin |
6.25% |
14.33% |
28.46% |
8.43% |
Assuming that his uncle was a wise investor who assembled the portfolio with care, Robert finds the wide differences in these ratios confusing. Help him out.
Part (a):
As per Current ratio, Fink Software needs to be selected because of a strong liquidity position.
As per the Quick Ratio, Fink Software needs to be selected because of a strong short-term solvency position.
As per the Debt Ratio, Fink Software needs to be selected because of lower risk and at the same time higher returns because of a high percentage investment in Equity.
As per the Net Profit Margin Ratio, Fink Software has the highest profitability.
Note:
The ratios are calculated using the below formulae:
1. Current Ratio = Current Assets / Current Liabilities
2. Quick Ratio = Quick Assets / Current Liabilities
3. Debt Ratio = Debt / Equity
4. Net Profit Margin Ration in % = (Net Profit / Net Sales) * 100
Part (b):
Ratio Analysis can be done within the Industry as well as between different industries.
Part (c):
Inference - The above statement given in the analysis made by Mr. Robert is correct.
Part (d):
The inference made by Robert is correct as The company which has a steady cash flow or profits can take the rish and invest in high amount of debt. This is because interest payment is a fixed cost and also an irrelevant cost for decision-making. Further, tax savings is also available. This increases the retained earnings of the company.
Part (e):
The analysis made by Mr. Robert is correct as high degree of investment in software companies gives higher return with higher risk. There is a famous saying that "Higher the risk is higher the return". This higher risk can be mitigated by diversification of portfolio.