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 if increased means the company is not able to convert its inventories into sales at the same pace at which it was doing earlier. The primary reason for such increase in inventory days is drop in sales of the company or the company is stocking more goods than it was doing before.

b. Net Profit Margin = Net Income / Total Sales.

ROIC (Return on Invested Capital) = Net Operating Profit After Tax (NOPAT) / Invested Capital.

  NOPAT – Operating profit in the income statement minus taxes. It should be noted that the interest expense has not been taken out of this equation.

Hence, reason for Net profit margin steadily decreasing but ROIC has remaining stable may be due to increase in Interest expense of the company.

c. Working capital = Current Assets - Current Liabilities.

A company's net working capital may increase due to increase in Current Assets or decrease in Current Liabilities. Increase in Current Assets may be due to increase in Receivables of the company or decrease in Current Liabilities may be due to company paying off short term debts.  

d. P/E ratio refers to Price Earnings ratio.

If The company's share P / E ratio is significantly lower than for its main competitors it implies we can buy a share in the company's earnings for less than it would cost to buy into the same earnings from another firm.