Question

Your friend prepares an annual report and has calculated several financial ratios in this regard. Unfortunately, he has difficulties interpreting some ratios. In this context, he asks for your help in identifying the economic reasons for the following trends (explain each example in a few sentences): a. days in inventories has increased considerably b. Net profit margin has steadily decreased but ROIC has remained stable c. Company's net working capital has increased from 1 million to 2 millions eur d. The company's share P / E ratio is significantly lower than for its main competitors

Answer 1

a. days in inventories has increased considerably

Economic reasons behind this can be one or two or all of the following:

• Poor sales
• Purchasing too much of inventory
• Sudden or significant drop in sales
• Decline in demand for your product

b. Net profit margin has steadily decreased but ROIC has remained stable

ROIC = EBIT x (1 - T) / Invested capital; If ROIC is stable, EBIT should be stable or improve, however Net profit margin is steadily decreasing. The reason can be increasing levereage in the firm leading to higher interest expenses. Higher leverage might have burdened the firm with higher interest cost and hence, even though EBIT remain stable, there is a hit on the net profit margin.

c. Company's net working capital has increased from 1 million to 2 millions eur

This can be because of any of the following reasons:

• Increase in credit sales
• Increase in the credit period offered to the customers
• Credit customers are just not paying
• Increase in inventory holding period
• Prompt payment to suppliers
• Reduction in the credit period received from the suppliers

d. The company's share P / E ratio is significantly lower than for its main competitors

This may be due to:

• Lower stability or higher variablity in the EPS of the company
• Quality of earnings may be poor
• The firm might not have performed as per markets expectations.
• The market expectations about the future performance may be declining
• The firm might be losing the competitive edge.