Abstract

In this writing, a comprehensive financial ratio analysis of two of the companies, namely McPherson and Housewares are performed. Ratio analysis for two of these companies is performed in the following areas: degree of leverage, asset utilization ratio, liquidity ratio, profitability ratio and market price ratio. The values for these ratios are calculated and analyze to compare the relative attractiveness and financial strength of the two companies. In judging the attractiveness and viability of the two companies, it is found that McPherson is more aggressive, with more leverage and higher profitability. However, the solvency ratio and liquidity ratio is not as good as compared to Housewares’s ratio. Housewares, despite its lower profitability, is still quite a good company, since it still able to drive a ROE of 10%, a percentage which is higher than the overall economic expansion for the country. The company is relatively conservative, and having cash on hand for further expansion. Thus, we could conclude that McPherson should be a good company for growth-style investors while Housewares could be a better candidate for value-style investors.

1.0 Introduction

Financial statement analysis seeks to evaluate management performance in several important areas, including profitability, efficiency and risk. Although we will necessarily analyze historical data, the ultimately goal of this analysis is to provide insights that will help us to project future management performance, including pro forma balance sheets, income statements, cash flows and risk. It is the firm’s expected future performance that determines whether we should lend money to a firm or invest in it (Reilly and Brown, 2003). In the following sections, a financial statement ratio analysis will be performed to compare 2 companies, namely: McPherson and Housewares. First of all, the balance sheet and income statement of these two companies are obtained from the annual reports. Then, ratio analyses are performed in the following areas: degree of leverage, asset utilization ratio, liquidity ratio, profitability ratio and market price ratio. Lastly, after the comparisons, conclusions on the attractiveness of the companies are reported.

2.0 Balance Sheet and Income Statement from Annual Reports

Figure 1: Income Statement of McPherson in 2006

Figure 2: Balance Sheet for McPherson in 2006

Figure 3: Income Statement for Housewares in 2006

Figure 4: Balance Sheet for Housewares (HWI) in 2006

Table 1: Calculation of Ratios from Excel

3.0 Ratio Analysis

In finance, a financial ratio or accounting ratio is a ratio of selected values on an enterprise’s financial statements. There are many standard ratios used to evaluate the overall financial condition of a corporation or other organization. Financial ratios are used by managers within a firm, by current and potential stockholders (owners) of a firm, and by a firm’s creditors. Values used in calculating financial ratios are taken from the balance sheet, income statement, cash flow statement and (rarely) statement of retained earnings. These comprise the firm’s “accounting statements” or financial statements (Wikipedia).

Leverage ratio

Formula Used:

Interest burden = (EBIT- interest expense)/ EBIT

Interest coverage (times interest earned) = EBIT/ interest expense

Debt to equity ratio = Total debt/ shareholders’ equity

Leverage ratio means the measure of debt to total capitalization of a firm. Comparing the leverage ratios of a company with others in the same industry indicates its competitive position and its ability to ride out adverse economic times. Often, a moderate leverage is a good indicator of a company’s stamina, its ability to survive when the going gets tough (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003).

Interest burden ratio. Interest burden ratio is a good indicator to judge if a company able to service its interest payment from its operating profit. A good business should have interest burden ratio that is closer to 1. This means that, the earning capability of the company is very strong and thus, EBIT is very high relative to interest expense. From the analysis, the interest burden for McPherson is 0.62 while it is 0.73 for Housewares. McPherson have a relatively leverage as compared to Housewares. In other words, McPherson has higher risk as the company has to service more interest expense from a proportion of its EBIT. However, this does not means McPherson is a better company, as we would need to judge other ratio as well to determine if the higher leverage ratio employed by McPherson is justified from other perspectives, such as the profitability ratios.

Interest coverage ratio. Interest coverage is another leverage ratio used to judge the earning capability of a firm relative to the interest charges the firm is obligated to pay. Generally, the lower the interest coverage ratio; the higher the degree of leverage for the company. Again, it is shown that McPherson has a lower interest coverage ratio of 2.63 as compared to Housewares’s interest coverage ratio of 3.73. Both the company got a relatively high interest expense to service, and should the economy turn bad, the companies could face insolvency should the revenue reduced and they cannot service the huge amount of debt relative to the earning capability. Again, from this figure, it is found that McPherson is more risky.

Debt to equity ratio. One of the measure that gives us good idea of a company’s solvency (ability to survive during bad times) and leverage position is debt to equity ratio. Essentially, this is the total debt, both long term and short term, divided by the shareholder equity. If the number is higher than 1, we know that the company is funded primarily by debt rather than equity investments. Often, it pays to compare this number with that of other companies in the same industry. A stable business such as a public utility can service more debt than a young technology company that needs cash to reinvest in R&D of new products. Generally, a high debt to equity ratio means that a company has been financing its growth by borrowing. High leverage position is a double edge sword; it makes a company becoming more volatile in the business cycle. Usually, for conservative investors, the lesser debt on the balance sheet, the grater the margin of safety.

Asset utilization ratio

Formulas Used:

Total asset turnover = sales/ average total assets

Fixed asset turnover = sales/ average fixed assets

Inventory turnover = COGS/ average inventory

Asset utilization ratios are useful in helping us to understand a firm’s ratio of sales to assets to compute comparable efficiency-of-utilization, or turnover, ratio.

Total asset turnover ratio. The total asset turnover ratio indicates the effectiveness of the firm’s use of its total asset base. It is essential for us to compare this ratio to the other firms in an industry because this particular ratio varies substantially between industries. For this, we should consider a range of turnover values consistent with the industry. It is poor management to have an exceedingly high asset turnover relative to the industry average because this might imply too few assets for the potential business (sales), or it could be due to use of outdated, fully depreciated assets. It is equal poor management to have a low relative asset turnover because this implies tying up capital in an excess of assets relative to the needs of the firm (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003). Both the companies have total asset turnover around the same range, that is, 2.46 for McPherson and 2.25 for Housewares.

Fixed asset turnover ratio. Similarly with the concepts stated in the above mentioned paragraph, fixed assets turnover ratio measure the efficiency of a firm. For this ratio, McPherson has a turnover of 10.54 while Housewares have a turnover value of 40.27. This shows that Housewares are better using its fixed asset in generating revenue. The efficiency in using fixed assets for Housewares is significantly 4 times higher than McPherson, and in this context, Housewares is a better company.

Inventory turnover ratio. Inventory turnover ratio can be calculated relative to sales or cost of goods sold. It is argued that the preferred turnover ratio is relative to the cost of good sold (COGS) because COGS does not include the profit implies in sales (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003). Inventory turnover ratio for McPherson is 6.45 while it is 3.64 for Housewares.

Liquidity ratio

Formulas Used:

Current ratio = current assets/ current liabilities

Quick ratio = (cash + marketable securities + receivables)/ current liabilities

Cash ratio = (cash + marketable securities)/ current liabilities

Working capital = current asset – current liabilities

One of the most important aspects of the balance sheet is liquidity. Liquidity is the amount of cash the company can lay its hands on in the short term. Liquidity provides the flexibility to withstand down cycles in the economy, pay dividends to shareholders, buy back share, and take advantage of future opportunities. Liquidity and interest coverage ratios are of great importance in evaluating the riskiness of a firm’s securities. They aid in assessing the financial strength of the firm. Ideally, we want to ensure that a company is not overly burdened with debt, and that there is enough capital to stay in business during bad times (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003).

Current ratio. This ratio reveals a company’s ability to pay its short term obligations. A rough rule of thumb is a ratio of two to one, that is, the company has twice the amount of liquid assets as it has short term debts and obligations. However, it is also noted that various industries may have different optimal current ratio. When compared against the industry average; a lower ratio may indicate possible liquidity problems. Generally, if a current ratio is steadily declining year over year, this could indicate a serious liquidity problem is developing (Anthony, Hawkins & Merchant, 1999). The current ratio for McPherson is 2.02 while it is 2.99 for Housewares. Both the companies have relatively same numbers, and as such, it is harder to get meaningful comparison from this ratio.

Quick ratio. A variation of the current ratio, known as the quick ratio, removes inventory from the calculation. The logic behind is, although inventory can usually be converted to cash, it may be impossible for the company to receive full value for inventory if it is subject to fire sale. This is also called the acid test ratio and gives a clear view of a company’s cash position versus its bills. Furthermore, a rising inventories may indicate a product that has decreased in popularity and will be difficult to sell at a profit (Reilly et. al., 2003). The quick ratio for McPherson is 1.11 while it is 1.54 for Housewares. Again, the numbers are relatively close and we shall look at the cash ratio to make better comparisons.

Cash ratio. Cash ratio is an even more stringent measure of liquidity. However, the basic concepts behind the ratio are essentially the same as the current ratio stated above. Nevertheless, the cash ratio for McPherson is just 0.02 while it is 0.23 for Housewares. Obviously, Housewares is having more cash at hand, and thus a more conservative position. This cash disposable at hand could be used as reserve at bad times, or serve as the require capital for further operation expansion. From this aspect, Housewares is a better company that offer more conservative financial position.

Working capital. It is also helpful to examine the relationship of current assets and current liabilities in cash term. We get working capital figure by subtracting current liabilities from the current assets. Generally, the more working capital is better (for conservative value investors). It is crucial to monitor is this figure is increasing or decreasing over the years (Anthony, Hawkins & Merchant, 1999).

Profitability ratio

Formula Used:

Return on assets = EBIT/ Average total assets

Return on equity = Net income/ average stockholders’ equity

Return on sales (gross profit margin) = EBIT/ Sales

Profitability ratios are measures used to judge the profitability of a particular company. The profitability is often judged as the revenue or profit earned by the company from the income statement perspective. Revenue or sales are the lifeblood of the company. Generally, revenue growing over time is good; conversely, declining revenues may be a cause for concern (Wild, 2000; Reilly et. al., 2003).

Return on assets. A company with a high return on capital has a much greater chance of financing growth with self-generated cash than one with a low return. For this ratio, a steady trend indicates stability, which is a good sign. This shows that management is doing an adequate job of investing and managing the reinvested profits each year (Reilly et. al., 2003). The return on assets for McPherson is 24% while it is 14% for Housewares. This means McPherson is seemingly a more profitable company. However, the source of the profitability could be due to the highly leverage position of McPherson, and we cannot conclude that McPherson is a better company as compared to Housewares, solely on return on assets ratio.

Return on equity. Shareholder equity, often also known as book value, is the figure we obtain when we subtract all that a company owes from all that is owns. This figure is the ultimate measure of how equity has built up over the years both from money raised and earnings retained and reinvested in the business. Due to the importance of this figure, return on equity is a very crucial and popular ratio used by analysts in determining the attractiveness of a company (Reilly et. al., 2003). Again, McPherson got a higher profitability as measured by return on equity, which is a 15% as compared to 12% only by Housewares. From this measure, we can conclude that McPherson is delivering more value to the equity shareholders as compared to Housewares. However, we cannot conclude that the extra value delivered is solely due to the better management or the higher leverage position (i.e., usage of debt for expansion) by McPherson.

Return on sales (gross profit margin). The steadier the gross profit margin, the better the business. If a company can grow its profit margins over time, every new dollar of good sold has a leveraged impact on sales. On the other hand, a falling margin could indicate bloated overhead and careless management, or cutthroat competition, something we should avoid as investors (Reilly et. al., 2003). The profit margin for McPherson is 10%, higher than Housewares’s profit margin of 6%. This means McPherson’s product is on better demand. Besides, judging from the fatter profit margin enjoy by McPherson, we could roughly guess that McPherson should have some competitive advantage that enable the company to command a higher profit margin in the market place.

Market price ratio

Formula Used:

Market price to book = price per share/ book value per share

Price to earning ratio = price per share/ earning per share

Earning yield = earning per share/ price per share

Market price ratios are often used by investors to judge the attractiveness of a company value relative to the market price.

Market price to book ratio. Net worth is simply everything a company owns – a real estate, buildings, equipment inventory, and cash, minus what it owes. Subtracting what a company owes from what it owns, we could get what is called book value. The book value per share then is simply the net worth divided by the number of shares outstanding. Low market price to book value ratio is what a value investors look for. That is, when searching for stocks that are a bargain compared with the company’s asset value, value investors start with those companies selling below book value per share (Reilly et. al., 2003).

Price to earning ratio. Price to earning ratio is among the most popular market based measured used to determine the attractiveness of a company by shareholders. Comparing two companies with same business prospect and of equal financial conditions, the company with the lower P/E ratio is considered cheaper and undervalued. However, in reality, this simple comparison is often not available in the stock market. Often, stocks with lower P/E ratio indicate that the investment fraternity has low expectation on the company prospects compared to the companies selling for higher P/E (Reilly et. al., 2003).

Earning yields. Earning yields is essentially the inverted figure from price to earning ratio. Generally, we would want to have a higher earnings yield than a lower one. We would rather the business earn more relative to the price we are paying than less (Anthony, Hawkins & Merchant, 1999).

4.0 Conclusion

As conclusion, both companies have their pros and cons, and it is very subjective to determine which company will better suit a particular investors. Precisely, a particular investor’s preference for aggressive style or conservative style of investing will determine which company he should choose to invest in. In judging the attractiveness and viability of the two companies, it is found that McPherson is more aggressive, with more leverage and higher profitability. However, the solvency ratio and liquidity ratio is not as good as compared to Housewares’s ratio. Housewares, despite its lower profitability, is still quite a good company, since it still able to drive a ROE of 10%, a percentage which is higher than the overall economic expansion for the country. The company is relatively conservative, and having cash on hand for further expansion. Thus, we could conclude that McPherson should be a good company for growth-style investors while Housewares could be a better candidate for value-style investors.

5.0 References

Robert N Anthony, David F Hawkins and Kenneth A Merchant (1999). Accounting: Text and Cases, 10^th international edition, McGraw-Hill.

John J. Wild (2000). Financial Accounting-Information for decision, McGraw-Hill

Weygandt, J., Kiero, D., and Kimmel, P. (1998). Financial Accounting, 3/e, John Wiley

Meigs, R., Williams, J., Haka, S. and Bettner, M. (1999). Accounting: The Basis For Business Decisions, 11/e, McGraw-Hill

Warren, C. S., Reeve, J. M., and Fess, P. E. (1999). Accounting, 19/e, International Thomas Publishing

Skousen, K., Albricht, W., Stice, J. Stice, E. and Swain, M. (1998). Accounting: Concepts and Applications, 7/e, International Thomson Publishing

Horngen, H. and Izan, B. F. (1997). Accounting, 2/e, Prentice Hall.

Reilly, F. K. and Brown, K. C. (2003). Investment Analysis and Portfolio Management (7^th edition). International Thomson Publishing.

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