Question

The following ratios have been calculated for MORT Oil and Gas Company for two years 2019-2018.

Financial ratios	2019	2018
Leverage Debt ratio (%)	70.2	68.1
Long-term debt to total capital (%)	60.0	67.5
Debt to equity (times)	3.2	3.1
Times interest earned (times)	2.5	0.9
Cash interest coverage (times)	3.9	2.7
Fixed charge coverage (times)	1.0	0.7
Cash flow adequacy (times)	0.4	1.1
Profitability Gross profit margin (%)	14.2	11.1
Operating profit margin (%)	2.3	0.8
Net profit margin (%)	(1.4)	(3.1)
Cash flow margin (%)	9.1	4.3
Return on assets (%)	(0.7)	(2.1)
Return on equity (%)	(3.1)	(9.8)
Cash return on assets (%)	8.7	5.7

Instructions:

You are an analyst and investors ask you to analyze the capital structure, long-term solvency, and profitability of Al MORT Oil and Gas Company, and give them a feedback regarding the decision to invest in this company or not.

Answer 1

AI MORT Oil & Gas Company is in the Oil & Gas industry which is Capital intensive. For the company to succeed, the company has to generate good returns consistently. When we analyse the various ratios we find that :-

1. Long term solvency ratios :- Here we take a look at trend of Debt to Equity ratio along with Times Interest earned, Cash interest coverage and Fixed Charge coverage ratios. Cash flow adequacy is also considered.

Debt Equity ratio :- This ratio is calculated by Total Liabilities / Shareholders funds of the company. For Capital intensive industries this ratio can be greater than 2. In case of MORT it is greater than 3 which indicates heavy borrowals.

Times Interest earned ratio :- This ratio is calculated by Income before interest and expense / Interest amount. A good ratio would be greater than 2.5. MORT is just touching this threshold in 2019.

Cash interest coverage ratio is an extension of times interest and is improving for MORT.

Fixed Charge coverage ratio indicates ability to pay fixed expenses. The ratio is improving in case of MORT.

Cash flow adequacy :- This ratio is determined as net free cash flow to average annual value of debts. 1 or above is considered as a good ratio in this context. For MORT this ratio has declined year on year indicating shortfall in cash flow.

2. Capital Structure ratios :- Here we consider, Leverage debt ratio and Long term debt to capital ratio.

Leverage debt ratio compares assets with debts of the company. This ratio is increasing year on year indicating assets of the company are financed through debts.

Long term debt to total capital ratio :- From risk perspective this ratio should be closer to 40%. Ratio of 60% and above indicates difficulty in borrowing.

3. Profitability ratios :- Here we consider Gross profit, Operating profit and net profit ratios along with return on assets and equity.

Gross Profit & operating profit margin have improved year on year and are showing an increasing trend. Operating profit margin of 6% and above is prescribed for Oil & gas industry.

Net Profit margin of 6.5% is considered ideal for Oil & Gas industry. In case of MORT it is net loss.

Return on assets and equity are in negative. Cash flows and cash returns are showing signs of improvement.

Considering all the ratios and looking at the trend, it can be inferred that AI MORT Oil & Gas Company is not an ideal investment at this point of time. This company will need to start generating profits consistently and can be considered for a future date.