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balance sheets and financial ratios because each industry has its own
characteristics.
I. Objective
Magnetronics, Inc. is a hypothetical company that we will analyze. We use the
data from income statement and balance sheet to calculate four types of
financial ratios (profitability ratios, activity ratios, leverage ratios, liquidity
ratios). We also compare these ratios for 1986 and 1990 to answer the two
overall questions:
Has the financial condition of the company changed during the 4-year
period?
What are the most significant changes, as indicated by the financial
ratios?
From these analyses we can conclude whether the companys financial condition
shows the improvements or deteriorations during 1986 until 1990 and what is
the cause of this improvements or deteriorations.
II. Analysis
A. Profitability Ratios: How Profitable is the Company?
Profitability is a necessity over the long run. It is strongly influence:
Retun on Assets=
EBIT
Total Assets
Retun on Equity=
Net sales
Total assets
Total asset turnover for Magnetronics in 1990 can be calculated by dividing
$48,769 into $22,780. The turnover had deteriorated - or low activity
activity ratios - from 2.175 times ($32,513 divided by $14,949) in 1986 to
2.141 times ($48,769 divided by $22,780) in 1990 which may indicate
uncollectible accounts receivables or obsolete inventory or equipment.
One important category of specific asset is account receivables. The average
collection period measures the number of days that the company must wait on
average between the time of sale and the time when it is paid. There are two
steps of calculation:
First, divide annual credit sales by 365 days to determine average sales per day:
Net sales
365 days
Second, divide the accounts receivables by average sales per day to determine
the number of days of sales that are still unpaid:
Accountsreceivable
Average sales per day
Magnetronics had $7,380 invested in accounts receivables at year-end
1990. Its average sales per day were ($48,769 / 365) $133.614 during
1990 and its average collection period was ($7,380 / $133.614) 55.234
days. This represented an improvement from the average collection period
of ($5,227 / ($32,513 / 356)) 58.68 days in 1986.
Other activity ratio is the inventory turnover ratio which indicates the
effectiveness with which the company is employing inventory. Inventory is
recorded on the balance sheet at cost (not at its sales value), it is advisable to
use cost of goods sold as the measure of activity. The inventory turnover figure is
calculated by dividing cost of goods sold by inventory:
The last one of activity ratio is the fixed asset turnover ratio which measures the
effectiveness of the company in utilizing its plant and equipment.
Net
Net sales
assets
Magnetronics had net fixed asset of $5,160 and sales of $48,769 in 1990.
Its fixed asset turnover ratio in 1990 was ($48,769 / $5,160) 9.451 times,
an improvement from ($32,513 / $ 4,073) 7.983 times in 1986.
So far, we have discussed three measure of profitability: They are net
profit margin, return on invested capital, and return on equity. We have
also discussed four activity ratios which measure the effectiveness of the
company in utilizing its asset: They are total asset turnover, average
collection period, inventory turnover ratio, and fixed asset turnover ratio.
The deterioration in Magnetronics operating profits as a percentage of
total assets between 1986 and 1990 resulted primarily from less efficient
use of inventory, less efficient use of total asset, increase in COGS as a
percentage of sales and increase in operating expenses as a percentage of
sales.
Total debt
Total assets
Total debt includes both current and long-term liabilities
The total debt of Magnetronics as of December 31, 1990, was $10,587, or
46.47% ($10,587 divided by $22,780) of total assets. This represented a
decrease from 48.55% ($7,257 divided by $14,949) as of December 31,
1986.
Annual purchases
365 days
Accounts payable are then divided by average purchases per day to determine
the number of days purchases that are still unpaid.
Accounts payable
Average purchases per day
To gain a rough idea as to whether a firm is becoming more or less dependent on
its suppliers for finance, it can be done by relating accounts payable to cost of
goods sold:
Accounts payable
Cost of goods sold
Magnetornics owed its suppliers $2,820 at year-end 1990. This
represented 9.49% ($2,820/$29,700) of cost of goods sold and was an
increase from 8.42% ($1,615/$19,183) at year-end 1986. The company
Current assets
Current liabilities
Assumes that current assets are much more readily and certainly convertible into
cash than other assets. It relates these fairly liquid assets to the claims that are
due within 1 year the current liabilities
Magnetronics held $17,620 of current assets at year-end 1990 and owed
$7,531 to creditors due to be paid within 1 year. Its current ratio was 2.34
($17,620/$7,531), a deterioration from the ratio of 2.41 ($10,876/$4,507)
at year-end 1986.
The quick ratio or acid test is similar to the current ratio but excludes inventory
from the current assets:
Current assetsInventory
Current liabilities
Inventory is excluded because it is often difficult to convert into cash (at least at
book value) if company is struck by adversity
The quick ratio for Magnetronics at year-end 1990 was 1.25 (($17,620$8,220)/$7,531), a deterioration from the ratio of 1.52 (($10,876-$4,032)/
$4,507) at year-end 1986.
industries, and even within a specific industry, ratios may vary significantly
among companies. The operation and competitive characteristics of the
companys industry greatly influence its investment in the various types of
assets, the riskiness of these investments, and the financial structure of its
balance sheet. Consider the collection period, inventory turnover, amount of
plant and equipment, and appropriate financial structure of the company
A = Automobile manufacturer quite large in PPE, quite high in receivables,
long collection period low inventory turnover.
B = Electric utility
very large in PPE
C = Supermarket chain short collection period which means the payment
transactions occur quickly, quite large inventories,
inventory turnover quite quick.
D = Japanese trading company high in notes payable and receivables, very
long collection period, high in total liabilities/total
assets ratio which means this companys main
activities are in liabilities trading sector, quick
inventory turnover.
E = Retail jewelry chain little investment in PPE, very high in inventories,
very low inventory turnover
3.2 Recommendation
Magnetronics should use their assets and inventories more efficient so the
COGS not so high
Magnetronics should restructure their financial policies so the growth of
equity not faster than net income, meanwhile the capability to turn the
additional equity into profit also needs to fix.