Question

The Elite Mutual Fund associate director intends to invest in the stock of ABC Company. ABC Company is a merchandiser buying and selling mobile phones. ABC Company also provides mobile phones repairing services. Around 50% of the company’s revenues come from the sale of mobile phones. The remaining company’s revenues come from mobile phones repairing services.

The following are financial ratios for ABC Company and comparative ratios for ABC Company’s industry. Computations of the financial ratios for ABC Company are based on the information from ABC Company’s financial statements.

Aspect of financial ratios	Industry average	ABC Company
(i) Market measures
Price-to-book	9.1	8.9
Dividend payout rate	2.1%	0%
Dividend yield	0.6%	0%
Earnings yield	8%	8.2%
Price-to-earnings ratio	29.1	27.9
(ii) Asset utilization
Total assets turnover	4	3.95
Fixed asset turnover	15.65	15.4
Working capital turnover	9.81	8.6
Sales to inventory	28.8	30
Accounts receivable turnover	8.25	7
Cash turnover	39	40.9
(iii) Operating performance
Net profit margin	8.1%	8.3%
Pre-tax profit margin	14.55%	15%
Operating profit margin	16%	16.8%
Gross profit margin	34.4%	36.1%
(iv) Return on investment
Return on common equity	50.1%	52.7%
Return on assets	30.1%	31.5%

(v) Capital structure and solvency
Times interest earned	9.99	9.3
Long-term debt to equity	0.401	0.369
Total debt to equity	0.691	0.675
(vi) Liquidity ratios
Days to sell inventory	18.39	18.48
Collection period	36.7	42.29
Acid-test ratio	1.95	2.68
Current ratio	3.2	3.55

Required:

1. You are required to interpret the ratios of ABC Company. From your interpretation, draw relevant inferences regarding ABC Company’s financial condition and financial performance. (Note: Ignore the industry average ratios.)

2. You are required to repeat the analysis in (a) with full knowledge and understanding of the industry average ratios.

3. Show which financial ratios you may consider to deviate from the industry average norms. For each of the ABC Company’s financial ratio that deviates from the industry average norms, give suggestions for two possible explanations.

Answer 1

Ans a) i) ABC limited has a good liquidity position as denoted by its current ratio which shows 3.5x of current liabilities liquidity. This the company is in a good position to meet its short term liability without failing. This is further supported by close to 2.7x of acid test ratio.

ii) The company has a debt of little above than half its equity, which is sufficiently supported by the company's ability to service it as denoted by the high times interest earned ratio

iii) Return of investment generated by the Company is very lucrative as every dollar of sale generates 52 cents of profit which is also equal to 32 cents of every dollar of investment in the assets.

iv) The company has good margins as reflected in gross margin of 36% and net margin of 8%

v) Asset Utilisation of ABC Ltd is quite high as shown by its asset turnover of 4x and inventory turnover of 30x

vi) The company is not paying any dividend and has an earnings yield of 8.7% and p/e ratio 28x

Ans b)

Aspect of financial ratios	Industry average	ABC Company	Remarks(from company's point of view)
Market Measures
Price-to-book		9.1		8.9
Dividend Payout		2.10%		0.00%		Unfavourable
Dividend Yield		0.60%		0.00%
Earnings Yield		8.00%		8.20%		Favourable
PE ratio			29.1		27.9		Favourable
Asset Utilisation
Total Asset Turnover	4		3.95		Unfavourable
Fixed Asset Turnover	15.65		15.4		Unfavourable
Working Capital Turnover	9.81		8.6		Unfavourable
Sales to Inventory		28.8		30		Favourable
Acc Receivable turnover	8.25		7		Unfavourable
Cash Turnover		39		40.9		Favourable
Operating Performance
Net Profit Margin		8.10%		8.30%		Favourable
Pre tax profit margin	14.55%		15.00%		Favourable
Operating profit		16.00%		16.80%		Favourable
gross profit margin		34.40%		36.10%		Favourable
Return on Investment
Return on common equity	50.10%		52.70%		Favourable
Return asset		30.10%		31.50%		Favourable
Capital Structure
Times Interest Earned	9.99		9.3		Unfavourable
Long term debt to equity	0.401		0.369		Favourable
Total debt to equity		0.691		0.675		Favourable
Liquidity Ratios
Days to sell inventory	18.39		18.48		Unfavourable
Collection period		36.7		42.29		Unfavourable
Acid test			1.95		2.68		Favourable
Current Ratio		3.2		3.55		Favourable

Ans c) I) Price to Book ratio, as the industry average may be distorted and ABC Ltd may have certain specific economic moat or advantage over business peripheral (pricing, cost, geography dominance etc)

Dividend Payout and Dividend Yield, as ABC Ltd may have better investment opportunity at hand and thus wants to plough-back the earnings for the purpose of reinvestment

Price to Earnings ratio, as this reflects market sentiment about a particular company's share price to its earnings