Question

Purpose: To enable students in utilising financial ratios for the purpose of evaluating a firm’s financial performance and financial position as well as in recognising firms facing financial distress and using ratios to make decisions for improvement.

Requirement: Financial Statement Analysis

A Co. and B Co. are competitors in a particular manufacturing sector. An extract of financial statements for each company is as follows: Use them in a ratio analysis that compares the companys’ financial leverage and profitability.

                 Item                                                                               A Co.                        B Co.

Total assets                                                        RM10,000,000       RM10,000,000

Total equity (all common)                                   9,000,000                5,000,000

Total debt                                                                   1,000,000              5,000,000

Annual interest                                                                         100,000                       500,000

Total sales                                                                25,000,000              25,000,000

EBIT                                                                                6,250,000               6,250,000

Earnings available for

common stockholders                                           3,690,000                3,450,000

Required:

Calculate the following debt and coverage ratios for the two companies. Discuss briefly their financial risk and ability to cover the costs in relation to each other.

Debt ratio.                                                                                                                             

Times interest earned ratio.                                                                                                                                      

(b) Calculate the following profitability ratios for the two companies. Discuss briefly their profitability relative to each other.

Operating profit margin.                                                                                                (1.5 marks)

Net profit margin.                                                                                                             (1.5 marks)

Return on total assets.                                                                                                    (1.5 marks)

Return on common equity.                                                                                           (1.5 marks)                                                          

(c) In what way has the larger debt of B Co. made it more profitable than A Co.? What are the risks that B Co.’s investors undertake when they choose to purchase its stock instead of A Co.’s?                                                                                                                               

                                                                                                                                                                                    

(d) “While ratio analysis can provide some useful information concerning a company’s operations and financial condition, it does have limitations”. Discuss briefly.                                                    

                                                                                                                                                           

                                                                                                                                                                      (Total:15 marks)

Answer 1

Part A debt and coverage ratios

Debt ratio = total debt / total assets

A Co. = 1,000,000/10,000,000 = 0.10

B Co. = 5,000,000/10,000,000 = 0.50

The financial risk of B Co. is higher as its debt ratio is higher than A Co. 50% of B Co.’s assets are financed through debts

Times interest earned ratio =EBIT/Annual interest

A Co. = 6,250,000/ 100,000 = 62.5

B Co. = 6,250,000/ 500,000 = 12.5

Times interest earned ratio of B Co. is lower than A Co. This is indicates B Co. is unable to continue its debt service as it has fewer earnings compared to A Co. to pay interest on its debt.

Part B

Operating profit margin = EBIT / total sales

A Co. = 6,250,000/ 25,000,000 = 25%

B Co. = 6,250,000/ 25,000,000 = 25%

Operating costs controlling efficiency of both companies is same as the operating profit margin of both companies is equal i.e. 25%

Net profit margin = Earnings available for common stockholders / total sales

A Co. = 3,690,000/ 25,000,000 = 14.76%

B Co. = 3,450,000/ 25,000,000 = 13.80%

The higher net profit margin ratio of A Co. compared to B Co. states that larger proportion of A Co.’s revenue is converted into the revenue.

Return on total assets = Earnings available for common stockholders / total assets

A Co. = 3,690,000/ 10,000,000= 36.90%

B Co. = 3,450,000/ 10,000,000= 34.50%

The higher return on total assets ratio of A Co. compared to B Co. indicates that A Co. uses its assets more efficiently to generate revenues.

Return on common equity = Earnings available for common stockholders/ Total equity

A Co. = 3,690,000/ 9,000,000= 41%

B Co. = 3,450,000/ 5,000,000= 69%

The higher return on common equity ratio of B Co. compared to A Co. indicates that it has better ability to generate more profits from the investments made by the shareholders.

Part C

Larger proportion of debt in B Co. is beneficial for it as interest payment of debt is tax deductible. When investors choose to invest in B Co. instead of A Co. they should keep in mind the financial risk associated with B Co.

Part D

• There is manipulation of financial data to produce favorable ratios.
• Ratio analysis is based on historical costs and fail to consider changes in price level due to inflation.
• They are based on quantitative aspects and completely ignores qualitative aspects.
• They just point out the loopholes and fails to provide measures to correct the loopholes.