Question

You are a financial consultant who has been retained to analyze the company's performance and find out what's going wrong. The following additional information is provided with the financial statements. Depreciation for 20X7, 20X8, and 20X9 was $200, $250, and $275 million respectively. No stock was sold or repurchased, and like many fast growing companies, Prospec paid no dividends. Assume the tax rate is a flat 34% and the firm pays 10% interest on its debt.

Calculate the indicated ratios for all three years:

Current ratio, quick ratio, accounts receivable days, inventory turnover, fixed asset turnover, total asset turnover, debt ratio, debt equity, TIE, ROS, ROA, ROE, equity multiplier

Analyze trends in each ratio and compare each with the industry average

	20X7	20X8	20X8
Sales	$1,578	$2,106	$3,265
COGS	631	906	1,502
Gross Margin	$   947	$1,200	$1,763
Expenses
Marketing	$316	$495	$882
R & D	158	211	327
Admin.	126	179	294
Total Expenses	$   600	$   885	$1,503
EBIT	$347	$315	$260
Interest	63	95	143
EBT	$284	$220	$117
Tax	97	75	40
EAT	$187	$145	$ 77

	20X7	20X8	20X9
ASSETS
Cash	$     30	$     40	$     62
Accounts Receivable	175	351	590
Inventory	90	151	300
Current Assets	$    295	$    542	$    952
Fixed Assets
Gross	$1,565	$2,373	$2,718
Accum. Depreciation	(610)	(860)	(1,135)
Net	$   955	$1,513	$1,583
Total Assets	$1,250	$2,055	$2,535
LIABILITIES
Accounts Payable	$56	$81	$134
Accruals	15	20	30
Current Liabilities	$71	$101	$164
Capital
Long-Term Debt	$630	$1,260	$1,600
Equity	549	694	771
Total Liability & Equity	$1,250	$2,055	$2,535

Answer 1

Computation of ratios:

CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES

For 20x7 = 295 / 71 = 4.15

For 20x8 = 542 / 101 = 5.37

For 20x9 = 952 / 164 = 5.80

The ideal current ratio is 2:1. Clearly in all the years the company is able to clear of its liabilities but the ratio is increasing. It means that the company is having higher amount of cash idle with them.

QUICK RATIO = CURRENT ASSETS - PREPAID EXPENSES - INVENTORY/ CURRENT LIABILITIES

For 20x7 = 295 - 90 / 71 = 2.89

For 20x8 = 542 - 151 / 101 = 3.87

For 20x9 = 952 - 300 / 164 = 3.98

The ideal quick ratio is 1:1. The company is having an increasing ratio. It means that the company has liquid assets in higher amount. The company is having greater ratio than desired.

INVENTORY TURNOVER RATIO = COST OF GOODS SOLD / AVERAGE INVENTORY

For 20x8 = 906 / 90 + 151 / 2 = 7.52

For 20x9 = 1502 / 151 + 300 / 2 = 6.66

The inventory ratio declined. It defines that the company used its inventory more in 20x8 than in 20x9. It states that the company have not sold it its inventory in 20x9 at the same pace at it was in 20x8.

FIXED ASSET TURNOVER = NET SALES /NET FIXED ASSETS

For 20x7 = 1578 / 955 = 1.65

For 20x8 = 2106 / 1513 = 1.39

For 20x9 = 3265 / 1583 = 2.06

The company has decreased its investment in fixed assets for 20x8 and had a jump and increase in 20x9.

TOTAL ASSET TURNOVER = NET SALES / TOTAL ASSETS

For 20x7 = 1578 / 1250 = 1.26

For 20x8 = 2106 / 2055 = 1.02

For 20x9 = 3265 / 2535 = 1.29

As the company has decreased its investment in fixed assets for 20x8 thus the total assets also decreased and the ratio declined and had a jump and increase in 20x9. It states that the company has increased its investments in assets.

DEBT RATIO = TOTAL LIABILITIES / TOTAL ASSETS

For 20x7 = 71 + 630 / 1250 = 0.56

For 20x8 = 101 + 1260 / 2055 = 0.66

For 20x9 = 164 + 1600 / 2535 = 0.69

The debt ratio is increasing each year. It means that despite having sufficient balance to pay off current liabilities the company is not paying off its liabilities. The company is hence increasing a bad reputation and increasing the creditors.

DEBT EQUITY RATIO = DEBT / EQUITY

For 20x7 = 630 / 549 = 1.15

For 20x8 = 1260 / 694 = 1.81

For 20x9 = 1600 / 771 = 2.07

The ideal ratio is 2:1. In initial year the company is having higher debt but not as much as twice of equity. The ratio is increased in subsequent years. The company has invested more in long term borrowings than equity in year 20x9. The company shareholders are decreasing.

TIME INTEREST EARNED = EBIT / INTEREST EXPENSE

For 20X7 = 347 / 63 = 5.51

For 20X8 = 315 / 95 = 3.31

For 20X9 = 260 / 143 = 1.82

Generally a higher ratio is favorable but it does not signifies that the company is managing its debts significantly. As the debts increased so the interest expense. The ratio is having a downward trend since 20x7.

RETURN ON SHAREHOLDERS FUND = NET INCOME / SHAREHOLDERS EQUITY

For 20X7 = 187 / 549 = 0.34

For 20X8 = 145 / 694 = 0.21

For 20X9 = 77 / 771 = 0.09

Higher the ratio is preferred. But the company is having a decline pace. The ratio declined significantly and is a matter of concern to the company.

RETURN ON ASSETS = NET INCOME / TOTAL ASSETS

For 20X7 = 187 / 1250 = 0.15

For 20X8 = 145 / 2055 = 0.07

For 20X9 = 77 / 2535 = 0.03

The ratio is declining. It means that the company is not using its assets effectively. Generally a higher ratio is a sign of stronger company.

RETURN ON SALES = PROFIT / SALES

For 20X7 = 947 / 1578 = 0.60

For 20X8 = 1200 / 2106 = 0.57

For 20X9 = 1763 / 3265 = 0.54

The ratio is declining. The company is having higher costs and thus, the profits are decreased. A lower ratio is not preferred.

EQUITY MULTIPLIER = TOTAL ASSETS / SHAREHOLDERS EQUITY

For 20X7 = 1250 / 549 = 2.28

For 20X8 = 2055 / 694 = 2.96

For 20X9 = 2535 / 771 = 3.29

A lower ratio means that the company is having a lower financial leverage. The ratio is increased from the initial year hence the company is having sound financial leverage.