Chin, Diane Valery Hinolan, Jorge King Tupas, Stvenson George BABA2A MWF 1:30-2:30 a.

.) Why are ratios useful? What are the five major categories of ratios? Ratios are important because it enables the business owner and managers to detect trends in the company and to compare its performance and condition with the average performance of similar businesses in the same industry. Ratios also helps us identify and quantify a companys strengths and weaknesses, evaluate its financial position, and understand the risks involved in the company. Ratio can help managers implement plans that improve a companys profitability, liquidity and financial structure. The five major categories of ratios are; Liquidity Ratios, Asset Management Ratios, Debt Management Ratios, Profitability Ratios and Market Value Ratios. b.) Calculate Everelites 2009 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys liquidity positions in 2007, in 2008, and as projected for 2009? We often think of ratios as being useful (1) to managers help run the business. (2) to bankers for credit analysis and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the companys liquidity ratios?
= = =
1,985,827 1,073,192

= 1.85

1,985,827909,379 1,073,192

= 1.00

In 2007, Everelites current ratio is slightly below the industry average. However, its quick ratio is higher compared to the industry average. Thus, the firm can pay their current liabilities if they will not rely on the sale of their inventories. In 2008, as shown in its liquidity ratios, both below the industry average, Everelite, could not be able to meet its short term debts. In 2009, both current and quick ratios increased relative to last years. However, current ratio is lower than the industry average by .2 while its quick ratio levels the industry average. This means that basing solely from the current and quick ratios, improvement is expected but it is safe to say that the liquidity position of the firm is weak. No, they don't have an equal interest in the liquidity ratio. The following are the specific reasons: MANAGER: Some of the most basic financial ratios show how much a business or investment will return compared to how much it will cost. When managers are planning new projects, these financial ratios provide the support they need to receive funding from executives to move forward. Executives like to see a high return on investment, or ROI, based on analysis of costs and projected revenues. After projects are completed, the same type of analysis can show the returns actually delivered, and how the investment lived up to expectations, which is useful for future strategy.

CREDIT ANALYST: Credit analysts will be particularly interested in the applicant's liquidity and ability to pay bills on time. Such ratios as the quick ratio, receivables, inventory turnovers, the average payable period and debt-to-equity ratio are particularly relevant. In addition to analyzing financial statements, the credit analyst will consider the character of the company and its management, the financial strength of the firm, and various other matters. STOCKHOLDERS: Interested only in Return On Equity (ROE), Dividend Rate, Gross Margin, Net Income Margin and Quarterly and Annual Growth Ratios. In general, Financial Statement Analysis is used by: a) managers to evaluate and improve performance, b) lenders (banks and bondholders) and bond rating analysts (SP and Moody's) to evaluate the creditworthiness of a company, and c) stockholders (current or prospective) and stock analysts, to forecast earnings, DIV and stock price." The five types of ratios are liquidity, asset management, debt management, profitability, and market value ratios.

c.) Calculate the 2009 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Everelites utilization of assets stack up against other firms in the industry? =

2,069,032 909,379

= 2.28x
876,897 (
2,069,032 ) 365

= /365 =

= 5,668.58 = 154.69

876,897

2,069,032 313,097

= 6.61

= 2,298,924 = 0.90

2,069,032

Inventory turnover is below the industry average and is getting worse, maybe because they have old inventories or its control might be poor. No improvement is currently forecasted (In fact, the opposite). The firm collects its receivables too slowly (2007: 135.60 days, 2008: 108.32 days. 2009: 154. 69 days) as compared to the 56 days norm. This suggests the managements poor credit policy. The companys fixed assets turnover declines with time, and is expected to go way lower than the industry average. This shows that it does not use its long term assets effectively so as to generate higher sales. Total assets turnover is not in line with other companies in the same industry. As time passes by, it continues to turn down. This is caused by excessive current assets (Accounts Receivable/Inventory) To sum up; Everelite is inefficiently using its assets. d.) Calculate the 2009 debt and times-interest-earned ratios. How does Everelite compare with the industry with respect to financial leverage? What can you conclude from these ratios? =

= 2,298,924 = 75.24% =
161,726 27,434

1,729,792

= 5.90

As compared to the industry average, Everelite's financial leverage is relatively higher which means that a large fraction of their assets are primarily financed by the creditors. Since the company uses great financial leverage, it is subject to higher risks.

e.) Calculate the 2009 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? =

= 2,069,032 = 7.82% = 2,069,032 = 3.89%

161,726 80,575

161,726

= 2,298,924 = 7.03%

() =

= 2,298,924 = 3.50% = 569.132 = 14.16%

80,575

80,575

() =

It may be recalled that the profitability ratios bring together the asset and debt management ratios and show their effects on ROE. Though Everelites operating margin, profit margin, basic earning power and return on assets have shown improvements compared to last years, still, they are way lower than the industry average. This implies the firms poor utilization of assets. However, its ROE is above the industry norm. This may be attributed to the use of too much leverage which exposes the firm to a higher risk. Using leverage does not guarantee the firms good results of operations. In Everelites case, the use of leverage leaves the firm in a near-to-bankruptcy position. f.) Calculate the 2009 price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? / =

= 0.80575 = 23.82

19.20

/ =

19.20 5.69

= 3.37

Both the P/E and M/B ratio are above the industry norm. A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth. Hence, as a generalization, stocks with this characteristic are considered to be growth stocks. The growth investor views high P/E ratio stocks as attractive buys and low P/E stocks as flawed, unattractive prospects On the other hand, the firms high P/B ratio is often a sign that a business has rosier future prospects than past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead. g.) Use the DuPont equation to provide a summary and overview of Everelites financial condition as projected for 2009. What are the firms major strengths and weaknesses?
( ) =

( ) =

( ) = 2,069,032 ( ) = 14.16%

80,575

2,069,032 2,298,924

2,298,924 569,132

Strengths: The firms ROE shows a great increase. This indicates that managers did an effective utilization of the resources given by stockholder by generating profits that will result to an accretion of the investors equity.

Weaknesses: The firms liquidity position is weak; all its asset management ratios are poor); its debt management ratios are poor and most of its profitability ratios are low (except return on equity). The company is currently achieving low productivity from its inventory and fixed assets. It is also not collecting from its customers as quickly as the industry. It needs to improve its sales and/or reduce inventories and fixed assets to better match its competitors.

h.) Use the following simplified 2009 balance sheet to show, in general terms, how an improvement in the DSO would tend to affect the stock price. For example, if the company could improve its collection procedures and thereby lower its DSO without affecting sales, how would that change ripple through the financial statements (shown in thousands below) and influence the stock price? Accounts receivable $877 Debt $1,730

Other current assets

1109

Net fixed assets

313

Equity

569

Total assets

$2,299

Liabilities plus equity

$2,299

Sales / day = $2, 069, 032 / 365 = $5, 668. 58 Reducing Accounts Receivable will have no effect on sales. Old Accounts Receivable = $877, 000

New Accounts Receivable = $5, 668.58 x 56 days Cash freed up: $ 559, 560 Initially shows up as addition to cash.

= $317, 440

Effect of reducing receivables on balance sheet and stock price Added Cash Accounts receivable $560 317 Debt $1,730

Other current assets

1109

Net fixed assets

313

Equity

569

Total assets

$2,299

Liabilities plus equity

$2,299

Improving the companys collection procedures without affecting sales by lowering its DSO from 154. 69 days to the 56 days industry average would result to an addition to cash. The freed up cash could be utilized to repurchase stock, expand the business, and reduce debt. All of these actions would likely improve the stock price. i.) Does it appear that inventories could be adjusted? If so, how should that adjustment affect Everelite's profitability and stock price? The inventory turnover ratio is low. It appears that the firm either has excessive inventory or some of the inventory is obsolete. If inventory were reduced, this would improve the current

asset ratio, the inventory and total assets turnover, and reduce the debt ratio even further, which should improve the firms stock price and profitability. j.) In 2008, the company paid its suppliers much later than the due dates; also, it was not maintaining financial ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off, and its bank could refuse to renew the loan when it comes due in 90 days. On the basis of data provided, would you, as a credit manager, continue to sell to Everelite on credit? (You could demand cash on delivery that is, sell on terms of COD but that might cause Everelite to stop buying from your company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or demand its repayment? With reference to the ratios such as quick, receivable and inventory turnover which show the company's inability to pay off its' debts when they fall due. As a credit manager, it is unfavorable to continue providing supplying a portion of its total funds with its current arrangement. Terms of COD might be a little harsh and might push the firm into bankruptcy. Likewise, if the bank demanded repayment this could also force Everelite into bankruptcy. Therefore, renewing the loan is a preferable option. k.) What are some potential problems and limitations of financial ratio analysis? Many ratios are calculated on the basis of the balance-sheet figures. These figures are as on the balance-sheet date only and may not be indicative of the year-round position. Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. It gives current and past trends, but not future trends. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. There are differences in

approach among financial analysts on how to treat certain items, how to interpret ratios etc. The ratios are only as good or bad as the underlying information used to calculate them. Although ratio analysis is very important tool to judge the company's performance, following are the limitations of it. Seasonal factors can distort ratios, Window dressing techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons. Sometimes, it is hard to tell if ratio is good or bad. l.) What are some qualitative factors that analysts should consider when evaluating a company's likely future financial performance? The following are some qualitative factors that analysts should consider: 1.) To what extent are the company's revenues tied to one key customer or to one key

product? To what extent does the company rely on a single supplier? Reliance on single customers, products, or suppliers increases risk. 2.) What percentage of the company company's business is generated overseas? Companies

with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability. 3.) What are the probable actions of current competitors and the likelihood of additional new

competitors? 4.) Do the company's future prospects depend critically on the success of the products

currently in the pipeline or on existing products? 5.) How does the legal and regulatory environment affect the company?

Industry 2009E Current Quick Inventory turnover Days sales outstanding (DSO) Fixed assets turnover Total assets turnover Debt ratio TIE Operating margin Profit margin Basic earning power ROA ROE Price/earnings Market/book Book value per share 1.85x 1.00x 2.28x 154.69 days 6.61x 0.90x 75.24% 5.90x 7.82x 3.89% 7.03x 3.50% 14.16% 23.82x 3.37% $5.59 2008 1.78x 0.87x 2.47x 108.32 days 8.83x 1.11x 68.55% 4.57x 6.16% 2.89% 6.82% 3.20% 10.17% 23.17x 2.36x $6.62 2007 2.02x 1.14x 3.10x 135.60 days 11.22x 1.21x 64.50% 19.17x 11.91% 6.78% 14.38% 8.18% 23.03% 14.49x 3.34x $6.53 Average 2.05x 1.00x 6.10x 56 days 9.30x 2.10x 50.00% 6.20x 13.00% 9.00% 15.00% 6.50% 12.00% 10.00x 3.00x n.a

Note: E indicates estimated. The 2009 data are forecasts.

a

Calculation is based on a 365-day year