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. The turnover ratio of the company's total assets is lower than that of its main competitors

b. The company's cash conversion cycle has significantly lengthened

c. The company's leverage and interest expense coverage ratio have increased

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

Answer 1

a)

The asset turnover ratio measures the value of a company's sales or revenues relative to the value of its assets. The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its assets to generate revenue.

if a company has a low asset turnover ratio than its competitors, it indicates it is not efficiently using its assets to generate sales.

b)

When a company – or its management – take an extended period of time to collect outstanding accounts receivable, has too much inventory on hand or pays its expenses too quickly, it lengthens the CCC.

A longer CCC means it takes a longer time to generate cash, which can mean insolvency for small companies.

c)

a higher interest coverage ratio indicates stronger financial health – the company is more capable of meeting interest obligations. However, a high ratio may also indicate that a company is overlooking opportunities to magnify their earnings through leverage.

However, a high ratio may also indicate that a company is overlooking opportunities to magnify their earnings through leverage. As a rule of thumb, an ICR above 2 would be barely acceptable for companies with consistent revenues and cash flows. In some cases, analysts would like to see an ICR above 3. An ICR lower than 1 implies poor financial health, as it shows that the company cannot pay off its short-term interest obligations.

d)

Investors usually compare P/E ratios of stocks that are in some way similar, such as businesses in the same industry and at the same point in their life cycles. For instance, you might compare the P/E ratios of two tech startups to determine if one appears to be a better bargain than the other. You can usually find published numbers for average P/E ratio ranges in various industries.

A low P/E ratio isn't always good or always bad, but it can be a sign that a stock is a relative bargain compared to competing companies. That's because you can theoretically buy a share in the company's earnings for less than it would cost to buy into the same earnings from another firm.

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