Question

You are comparing the financial statements of General Motors (an automaker) and Sears (a department store). Provide four items that you should consider if you are attempting to compare the future growth prospects of both firms.

Answer 1

Solution:

1. Capital structure: Ratio of debt to equity or total capital employed is important to understand how much fixed debt service cost a company incurs and it also impacts the cash flows and retained earnings (internal accruals which are the cheapest source of financing) of a company. Low debt or debt-free companies tend to have a lower fixed financing costs due to which they are better poised to withstand the shocks of economic downturns as there is lower or no commitment to pay debt cost. The result is better flexibility and control over the use of its retained earnings which can be channeled into more profitable investments at lower cost (cost of equity) to bring more growth prospects.

2. Retention and dividend payout: Dividend policy is an important determinant of what the company retains after payout of dividend. Of course, stockholders do expect dividend, but the challenge is to balance the retention out with dividend payout such that while the company pays out atleast the minimum expectation of stockholders, the opportunities for retaining profits that can be employed gainfully are not lost.

3. Profitability: Profitability of the company's business and its trend over a period, say 5 years is an indication of growth of the company. The return on capital employed ratio can also be used as a good measure of utilization to understand and compare how gainfully the company employs its assets and its future growth prospects.

4. Fixed Assets to Total Assets: Fixed to total assets is a measure of the funds locked up in long term capital investments and indicates the capital intensiveness of the business. High Fixed Asset to Total Assets also is to be used along with return on capital employed ratio as a higher return on capital employed can improve the Fixed Assets to Total Assets ratio as working capital and short term funding improves. Also, a higher fixed asset to total asset could also mean the company can benefit from depreciation allowances and reduce its tax cost thereby improving profitability and retention.