Question 1: Why is it necessary for business students who do not plan to major in finance to understand the basics of finance?
Question 2: What are some mechanisms that encourage managers to act in the best interests of stockholders?
Question 3: Is profit maximization an appropriate goal for financial managers?
Question 4: What are the main financial statements, and what information do they provide?
Question 5: Differentiate between net cash flow and accounting profit.
Question 6: Which of the following actions will, all else equal, increase the amount of cash on a company’s balance sheet?:
- The company issues $2 million in new common stock.
- The company invests $3 million in new plant and equipment.
- The company generates negative net income and negative net cash flow during the year.
- The company increases the dividend paid on its common stock.
Data for Fox Computer Company and its industry averages follow:
- Calculate the indicated ratios for Fox.
- Outline Fox’s strengths and weaknesses as revealed by your analysis.
- Suppose Fox had doubled its sales as well as its inventories, accounts receivable, and common equity during 2001. How would that information affect the validity of your ratio analysis? (Hint: Think about averages and the effects of rapid growth on ratios if averages are not used. No calculations are needed.)
Fox Computer Company: Balance Sheet as of December 31, 2007 (In Thousands of US $)
Net Fixed assets
Other current liabilities
|Total assets||947,500||Total liabilities and equity||947,500|
Fox Computer Company: Income Statement for Year Ended December 31, 2007
(In Thousands US$)
Cost of goods sold
Heat, light, and power
General and administrative expenses
Earnings before interest and taxes
Earnings before taxes (EBIT)
|Current assets/current liabilities
Days sales outstanding (365 day-year)
Sales / Total assets
Net income / sales
Net income / total assets
Net income / common equity
Total debt / total assets
Brief History of Square Pharmaceuticals & Liquidity Ratios
Square Pharmaceuticals Ltd. is a renowned company in Bangladesh. It is a flagship company in the pharmaceutical industry which has reached this mountain of success by fighting many potential competitors like BEXIMCO Pharma, INCEPTA, ACME, RENETA, OPSONIN, SK+F, SANOFI-AVENTIS etc. It initially started as a Partnership in 1958. It was incorporated as a Private Ltd. Company in 1964 and converted into Public Limited Company in 1991. Its initial public offering started in Dhaka and Chittagong stock exchange simultaneously in 1995. Their mission is to produce and provide quality & innovative healthcare relief for people, maintain stringently ethical standard in business operation also ensuring benefit to the shareholders, stakeholders and the society at large.
Financial ratios are useful indicators of a firm’s performance and financial situation. Financial ratios can be used to analyze trends and to compare the firm’s financials to those of other firms.
Financial ratios can be classified according to the information they provide. The following types of ratios frequently are used:
- Liquidity ratios
2. Asset management ratios
3. Debt management ratios
4. Profitability ratios
5. Market value ratios
Liquidity ratios are the first ones to come in the picture. These ratios actually show the relationship of a firm’s cash and other current assets to its current liabilities. Two ratios are discussed under Liquidity ratios. They are:
- Current ratio
2. Quick/ Acid Test ratio.
- Current ratio: This ratio indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. Current assets normally include cash, marketable securities, accounts receivables, and inventories. Current liabilities consist of accounts payable, short-term notes payable, current maturities of long-term debt, accrued taxes, and other accrued expenses (principally wages).
Current Ratio=Current Assets/Current Liabilities
Following table shows the Current ratios of Square Pharmaceuticals in different years:
|Current ratio||1.78 times||1.66 times||1.62 times|
Following graph shows the change of Current ratios over different periods:
From the analysis, we can see that in 2003-04 the current assets were 1.62 times than the current liabilities that has not fluctuated much through out these three years. A minimal increase is seen in 2004-05 and it went up to 1.66 times which kept slightly increasing and resulted at 1.78 times in 2005-06. The reason for such stability can be there not investing remarkably on assets and not making any huge loan or financing from outside. If we take a closer look on the balance sheet, this assumption gets a more realistic touch. Year by year assets have gone slightly up and the liabilities as well, but proportionately assets were a littler higher than the liabilities which actually reflected as a marginal increase in the ratio.
- Quick/ Acid Test ratio: This ratio indicates the firm’s liquidity position as well. It actually refers to the extent to which current liabilities are covered by those assets except inventories.
Quick Ratio=(Current Assets-Inventories)/Current Liabilities
Following table shows the Quick/ acid test ratios of Square Pharmaceuticals in different years:
|Quick ratio||1.19 times||1.08 times||.98 times|
Following graph shows the change of Current ratios over different periods:
Analysis of this ratio speaks in a same language as current ratio. In 2003-04, the quick ratio was .98 times which increased very silently just like current ratio and resulted as 1.19 times in 2005-06. Both of these ratios portray the idea that square has so far an almost constant liquidity position which is good at some point, but at the same token it can be said that they have not been able to improve them-selves. Standing at this point, we can make an assumption that may be their profit margin was not so high that they can make some investments paying off the liabilities that could result in an increase in assets and decrease in liabilities to make the liquidity position far better. This assumption can only be proved as we go on analyzing their financial statement and calculate the profitability ratios.
Asset Management Ratios of Square Pharmaceuticals
ASSET MANAGEMENT RATIOS
Asset management ratios are the financial statement ratios that measure how effectively a business uses and controls its assets. Below are discussed five types of asset management ratios:
1. Inventory turnover ratio
2. The days sales outstanding
3. Average payment period
4. Fixed asset turnover ratio
5. Total asset turnover ratio
1. Inventory turnover ratio: The ratio is regarded as a test of efficiency and indicates the rapidity with which the company is able to move its merchandise.
Inventory turnover ratio = Gross Turnover / Inventories
Following table shows the Inventory Turnover ratio of Square Pharmaceuticals in different years:
|Inventory Turnover Ratio||5.27 times||5.41 times||6.89 times|
Analysis shows a gradual declination of Inventory Turnover Ratio over the last three yeas. In 2003-04, the ratio was 6.89 times, then it rapidly declined to 5.41 times in following year and dropped further to 5.27 times in the year 2005-06.
The company’s balance sheets show increase of inventory with declining turnover every year. Declining inventory turnover commonly indicates that the company is not being able to flush its inventory very well as it was doing in the previous years. A low turnover rate may point to overstocking, obsolescence, or deficiencies in the product line or marketing effort. High inventory levels are unhealthy because they represent an investment with a zero rate of return in addition to the increased cost associated with maintaining those inventories. It also opens the company up to trouble should prices begin to fall. However, in some instances a low rate may by appropriate, such as where higher inventory levels occur in anticipation of rapidly rising prices or shortages.
In order to improve Inventory Turnover ratio, at first an end-to-end view in addressing inventory needs to be looked at. Supply chains need to be optimized, production processes should have to be efficient as well, so that the suppliers become able to produce and deliver materials in a timely, low cost fashion that allows the company to minimize their inventory and cost of materials. Collaborative relationships with customers can allow them to make their demand for products more predictable thereby allowing to minimize finished product inventory without failing to meet their needs for volume and timeliness.
Discount-driven sales may generate a boost in sales. Such discounts can erode the company’s profit margins but will boost revenue and rate of inventory turnover. The company might look like it is becoming leaner, when in fact it may simply be pushing products into the marketplace using artificial low pricing. However, before it can be done, the gross margins reported by the business needs to be analyzed carefully. If gross margins decrease as a percentage of sales in spite of an increase in inventory turnover, they should not apply this policy.
Supplier-financed inventory may reduce inventories and show improved inventory turnover by forcing suppliers to carry the inventory for the company. The suppliers assume the cost of maintaining inventory and passes that cost on. Alternatively, the company may reduce inventory by the use of express shipment or other costly means of delivery to ensure the availability of materials and supplies when needed. Solutions of maintaining inventory that simply shift cost to suppliers return the cost in added mark-ups to the materials and supplies purchased. This results in a rise in unit product unit cost.
2. The Days Sales Outstanding: The Days Sales Outstanding ratio shows both the average time it takes to turn the receivables into cash and the age, in terms of days, of a company’s accounts receivable. This ratio is of particular importance to credit and collection associates.
Days Sales Outstanding (DSO) = Trade Debtors/(Annual gross turnover/365)
Following table shows the DSOs of Square Pharmaceuticals in different years:
|DSO||14.87 days||15.75 days||14.99 days|
Analysis shows that DSO was 15.75 days in 2003-04; highest among the three years. In 2003-04, it was 14.99 days and in 2005-06 it was 14.87 days; lowest among the three years.
Since the DSO was the highest in 2004-05 that indicates that customers were taking longer times to pay their bills, which may be a warning that customers were dissatisfied with the company’s product or service, or that salespeople were making sales to customers that are less credit-worthy, or that salespeople have to offer longer payment terms in order to seal the deal. Long credit policy might be used deliberately to boost sales temporarily. Of course, it could also mean that the company has an inefficient or overtaxed accounts receivables department. However, the significant improvement in 2005-06 signifies that the company collected its outstanding receivables quicker than the previous years and that the credit terms are getting more realistic. It also connotes that the company had greater control over quality of its customer relationship management (CRM) during the following year.
- Average payment period: The accounts payable turnover ratio includes all outstanding obligations that a company owes its creditors.
Average Payment Period (APP) = Payables / (Cost of goods sold/365)
Following table shows the APPs of Square Pharmaceuticals in different years:
|APP||234.07 days||225.27 days||161.25 days|
Analysis shows a gradual increase of company’s average payment period. In 2003-04, the average payment period was 161.25 days, and then it became 225.27 days and 234.07 days consecutively for the following two years.
The underlying reason for the ratio to go up is the significant increase of company’s debt; especially short and long term bank loans (which made the current portion of long-term loans high). Each year this amount is getting higher than the previous years. Furthermore, in 2004-05 there was a huge sum trade credits unpaid. All these played key role for the payables to increase. A long payment period at first improves the company’s liquidity, but my also be an indicator for liquidity problems. Therefore, it is important to keep the value equal or close to the average value. Since the company’s payment period is getting longer, i.e. the company pays too late, then it means the liquidity problem of the company. The company probably lacks of the money to pay its liability. Hence, questions may arise on the company’s credit worthiness and paying habits. It has long been recognized that late payment of business debt is a serious problem for suppliers of goods and services. Late Payment can make it necessary for a company to increase borrowing and to extend overdraft facilities. Time and resources can be taken up on maintaining and collecting late payments instead of being devoted to other areas of business.
- Fixed asset turnover ratio: The Fixed Asset Turnover ratio measures the effectiveness in generating Net Sales revenue from investments in Net Property, Plant, and Equipment back into the company evaluates only the investments.
Fixed assets turnover ratio (FATO) = Gross Turnover / Net fixed assets
Following table shows the FATO ratios of Square Pharmaceuticals in different years:
|FATO||1.35 times||1.33 times||1.42 times|
Analysis shows that the fixed asset turnover ratio was as high as 1.42 times among three years. However, it declined to 1.33 times in the following year. In 2005-06 the turnover somewhat increased to 1.35 times.
The rapid declination of turnover in 2004-05 occurred because sales did not keep pace with the increase of company’s fixed assets. Company’s capital work-in-progress increased substantially in the year 2005-06. 2004-05 capital work-in-progress was also higher then the previous year. It may happen if the company was not being able to utilize its assets efficiently. However, conclusions should not be drawn solely on the numerical results of this ratio. A careful study on the balance sheet shows that large amount of investments were made during that year that inflate the dollar volume of fixed assets, and give an impression of mismanagement. The case is applicable for the 2005-06 as well. The turnover was highest in 2003-04 only because no significant investments were made during that period and the capital work-in-progress was lowest amongst the three years. Therefore, enough evidence is not available from this ratio analysis whether the company is really performing inefficiently or it is the investments that pulled down the turnover. Perhaps total asset turnover ratio can tell more about what really went wrong.
5. Total asset turnover ratio: The Total Asset Turnover is similar to fixed asset turnover since both measures a company’s effectiveness in generating sales revenue from investments back into the company. Total Asset Turnover evaluates the efficiency of managing all of the company’s assets.
Total assets turnover ratio (TATO) = Gross Turnover/Total Assets
Following table shows the TATO ratios of Square Pharmaceuticals in different years:
|TATO||0.76 times||0.78 times||0.93 times|
Analysis shows a gradual fall of company’s total asset turnover. In 2003-04, it was 0.93 times, declined to 0.78 times in the following year and then again declined slightly to 0.76% in 2005-06.
It may be an indicator of company’s pricing strategy as company with high profit margins tends to have low asset turnover. It is in fact might be one of the reasons for why the assets turnover was low in the year 2004-05. Profit margin went up from 17.69% in 2003-04 to 20.25% in the next year. However, there are other reasons as well. In 2004-05 total assets increased by 25.68% while sales increased by only 11.57%. Other than investment in marketable securities, every other asset especially long-term investments, inventories, short-term loans and cash balance had gone up substantially. Same is the case for the year 2006-06 as sales could not keep up with assets. Long-term investment, capital work-in-progress, inventories, short-term loan was also high during this year. On the other hand, the profit margin was only 16.45%. So it could be concluded than higher profit margin may not be the actual reason for the turnover to go down. Perhaps the company is not utilizing its assets efficiently.
Debt Management Ratios of Square Pharmaceuticals
Debt Management Ratios
Debt management ratios reveal 1) the extent to which the firm is financed with debt and 2) its likelihood of defaulting on its debt obligations. These ratios include:
- Debt ratio
2. Times-Interest-Earned (TIE) ratio
1. Debt ratio: The ratio of total debt to total assets, generally called the debt ratio, measures the percentage of funds provided by the creditors.
Debt ratio = Total Debt / Total Assets
Following table shows the Debt ratios of Square Pharmaceuticals in different years:
Calculating the debt ratio, we came to see that this company is not that highly leveraged one. In 2003-04, it was 37%, in 2004-05, it suddenly went up to 46%, and than again in 2005-06, it climbed down to 31%. A little bit of fluctuation is seen here in debt management, which is actually nothing but their strategic move. The reason behind such fluctuation is better understandable form the balance sheet. In 2004-05, the company has issued long-term loan, which happens to be BTD 389,193,080 that is way too high than the previous year’s loan, which is BDT 36,544,158 that actually increased the total debt thus resulting in a high debt ratio. Again, in the following year they paid off the loans and have not made any huge financing from outside which decreased.
2. Times-Interest-Earned (TIE) ratio: This ratio measures the extent to which operating income can decline before the firm is unable to meet its annual interest cost.
TIE ratio = EBIT / Interest Charges
Following table shows the times-interest-earned (TIE) ratios of Square Pharmaceuticals in different years:
|TIE ratio||11.30 times||14.92 times||11.12 times|
We can see from this ratio analysis that, this company has covered their interest expenses 11 times in 2003-04, 15 times in 2004-05 and 11 times in 2005-06. It means they have performed pretty much same in 2003-04 and 2005-06 but has taken a different look in 2004-05. As in 2004-05 they issued a little high number of long-term loans and does not have good liquidity position, their EBIT became high thus making TIE a little high as well.
Profitibility Ratios of Square Pharmaceuticals
Profitability is the net result of a number of policies and decisions. Profitability ratios show the combined effects of liquidity, asset management and debt on operating results.
There are four important profitability ratios that we are going to analyze:
- Net Profit Margin
2. Gross Profit Margin
3. Return on Asset
4. Return on Equity
- Net Profit Margin: Net Profit Margin gives us the net profit that the business is earning per dollar of sales. The equation is as follows:
Net Profit margin = Net income available to the stockholders / gross turnover
Following shows the Net Profit Margin of Square Pharmaceuticals in different years:
|Net Profit Margin||16.45%||20.26%||17.69%|
Therefore, the Net Profit Margin was 17.69% in 2003-04, increase to 20.26% in 2004-05 and then again decreased to 16.45% in 2005-06.
The main reason that the profit margin declined is high cost. High cost, in turn, generally occurs due to inefficient operations. Profit margin also declined because in 2005-06 Square Pharmaceuticals used a lot of long-term debt. This invariably resulted in more interest cost, which brought the Net income down.
2. Gross Profit Margin: Gross Profit Margin gives us the amount of Gross profit a firm is earning per dollar of its sales. The equation is as follows:
Gross Profit Margin (GPM) = Gross profit / Gross trunover
Following shows the Gross Profit Margin of Square Pharmaceuticals in different years:
|Gross Profit Margin||36.19%||35.04%||34.78%|
So, the Gross Profit Margin has remained pretty much stable throughout the whole three years. It increased slowly each year. It indicates that Square Pharmaceutical is managing its Sales and Cost of Goods Sold very well.
Return on Total Assets (ROA): Return of total asset measures the amount of Net Income earned by utilizing each dollar of Total Assets. The equation is:
Return on Total Assets (ROA) = Net income available to total common shareholders / Total assets
Following shows the Return on Total Assets of Square Pharmaceuticals in different years:
So, return on total assets decreased gradually throughout the years. This may have occurred because Square used more debt financing in 2005-06 and 2004-05 compared to 2003-04 which resulted in more interest cost and brought the Net income down.
4. Return on Equity (ROE): Return on Equity measures the amount of Net Income earned by utilizing each dollar of Total common equity. It is the most important of the “Bottom line” ratio. By this, we can find out how much the shareholders are going to get for their shares. The equation is:
Return on Equity (ROE) = Net income available to common shareholders / Total common equity
Following shows the Return on equity of Square Pharmaceuticals in different years:
|Return on Equity||18.21%||22.55%||21.13%|
Therefore, the Return on Equity increased in 2004-05 but decreased a little in 2005-06. This again may have happened due to the issue of more long-term debt in 2005-06.
Market Value Ratios of Square Pharmaceuticals
MARKET VALUE RATIOS
The final group of ratios, the market value ratios relates the firm’s stock price to its earnings and book value per share. These ratios give management an indication of what investors think of the company’s past performance and future prospects. In this section, we are going to have a discussion mainly on two types of ratios:
1. Price/ Earnings ratio
2. Market/ Book ratio
- Price/ Earnings ratio: The Price/ Earnings ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the income or profit earned by the firm per share.
P/E ratio – Price per share / earnings per share
- Market/ Book ratio: The ratio of book value to market value of stocks.
Market/Book ratio (M/B) = Market price per share / Book value per share
Following table shows the P/E and M/B ratios of Square Pharmaceuticals in different years:
|P/E Ratio||9.70 times||12.95 times||8.43 times|
|M/B ratio||1.77 times||2.92 times||1.78 times|
The P/E ratio was 8.43 times in 2003-04 and increased further to as high as 12.95 times in the following year. However, in 2005-06 it declined to 9.70 times which is an alarming signal for the potential investors.
The M/B ratio was 1.78 times in 2003-04 and increased further to 2.92 times in the following year which was excellent to draw the attention of investors. However, in 2005-06 it became as same as 2003-04 value.
The main reason behind the declination of P/E and M/B ratio is the fall of price per share. Price of share may fall for several reasons. Failing to meet market expectations is one of the main reasons for the market to lose interest in a share. Shares are usually valued according to what investors reckon the company will do in future. Therefore, when a business fails to meet those expectations then it is not unreasonable for investors to reconsider their position. We can see this fact applicable for this company too. As the company was doing well in 2000-05, the share price was higher than among the three years. Interestingly, the impact on shares depends to a large degree on the influence that they have on the market as well. During 2005-06 financial year the capital market situation deteriorated to the level that the DSE General Index fell by 14.91%. The overall hostile market situation put a negative impact on Square Pharmaceutical’s stock price too. Therefore, the investors should not be concerned much about the particular company’s P/E and M/B ratio.
Overall Financial Summary of Square Pharmaceuticals
OVERALL FINANCIAL SUMMARY
After analyzing all the ratios, we have found out the following information:
- Liquidity Ratios: In the liquidity ratio we can see that both current ratio and quick ratio improved over time marginally. The situation was almost stable.
- Asset Management Ratios: Inventory turnover, Total Asset Turnover, Fixed Asset Turnover all had been relatively stable throughout the three years. Average Collection period is also very good. The only problem here is the Average collection period which is way high. However, such a situation is actually pretty much normal for big companies.
- Debt Management Ratios: Here Debt ratio has improved over time and TIE has remained pretty much stable.
- Profitability Ratios: Apart from Gross Profit Ratio, most of the Profitability ratios have actually decreased in 2005-06. Although the decrease rate is very minimal still it is a problem for Square and they need to try to improve these ratios.
- Market Value Ratios: Both P/E ratio and M/B ratio declined in the year 2005-06. But this happened mostly not because of the company’s failure but for the fact that the whole market was not so friendly for investment in that year.
From the total analysis, we can summarize that Square Pharmaceuticals Ltd. has been doing pretty good through out the years. It is true that last year there return did decline but it is still pretty much satisfactory. Therefore, we can conclude that Square Pharmaceuticals Ltd. is a good enough company to invest on.
All the ratios below are calculated for 2005-06 financial year:
1. Current ratio = 1.78 times
2. Quick ratio = 1.19 times
3. Inventory turnover ratio = 5.27 times
4. Days Sales Outstanding (DSO) = 14.87 days
5. Average Payment Period (APP) = 234.07 days
6. Fixed assets turnover ratio (FATO) = 1.35 times
7. Total assets turnover ratio (TATO) = 0.76 times
8. Debt ratio = 31%
9. TIE ratio = 11.30 times
10. Net Profit margin = 16.45%
11. Gross Profit Margin (GPM) = 36.19%
12. ROA = 12.54%
13. ROE = 18.21%
14. P/E ratio = 9.70 times
15. Market/Book ratio (M/B) = 1.77 times
16. Book value per share = BDT 1,288,65
Notes on Analysis:
1. In 2003-04 and 2004-05 Quick ratio analysis, STOCK has been used as Inventory.
2. In 2003-04 and 2004-05 TIE ratio analysis, NET PROFIT AFTER WPPF has been used as EBIT and FINANCIAL EXPENSE found in cash flow statement has been used as INTEREST EXPENCE.