EXECUTIVE SUMMARY

Assessing the long-term financial health of company is an important task for

outsiders and insiders. The key issue in this task is whether the corporate system
of goals product market strategies, investment requirements, and financing
capabilities are in balance. The following are some of the questions that seem
important in assessing a companys future financial health.
1. What are managements goals for the company?
2. In which product market does management plan to compete?
3. What are the market, competitive, and operating characteristics of each
product market?
4. What volume and nominal sales growth are likely for the company?
5. What investments must be made in accounts receivables, inventory, and
plant and equipment? What will happen to the level of total assets over
the next 3-5 years?
6. What is the outlook for profitability?
7. Will the company need to raise additional finance over the next year or 3-5
years?
8. How soundly is the company financed?
9. Does the company have assured access on acceptable terms to external
sources of funds in amounts needed to meet its needs?
10.Are the companys goals, product market choices and strategies,
investment requirements, financing needs, and financing capabilities in
balance?
11.Will the companys goals, strategies, investment requirements, financing
needs, and financing capabilities remain in balance if the firm is struck by
adversity?
Many of these questions also required understanding of: future industry structure
and competitive behavior, competitive and operating characteristics of business,
long-term goals and plan of management, lending criteria of various segment of
the capital markets, soundness of management. So, the financial statement is
only one part of a complete analysis of a companys future financial health. Its
also clear that evaluation of a firms financial health can vary substantially,
depending on the perspective of the individual making the evaluation.
Income statement and balance sheet are two basic sources of financial data for a
business entity. From the figures found on these two sources, one can calculate
profitability ratios, activity ratios, leverage ratios, and liquidity ratios. This article
takes us to see and analyze the financial statement of a company (Magnetronics,
Inc.) using financial ratios and financial analysis. This analysis needed to answer
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?
The last section from this article also asks us to identified balance sheets of
some companies in different industries. We will be led to understand the
characteristics of companies in some industries through the analysis of the

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:

1. the companys access to debt nance,

2. the valuation of the companys common stock,
3. the companys Willingness to issue common stock, and
4. the companys sustainable sales growth.
Profitability of a business measures profit as a percentage of sales, as
determined by this equation:

Net Profit Margin=

Net profit after taxes

Net Sales

The information necessary to determine a companys profit as a

percentage of sales can be found in the companys income statement.
From Exhibit 1, we could see that Magnetronicss profit as a percentage of
sales for 1990 was $1,307 divided by $48,769, or 2.68%. This represented
a decrease from 3.60% ($1,171 divided by $32,513) in 1986.

 The deterioration in profitability resulted from an increase in cost of goods

sold as a percentage of sales, and from an increase in operating expenses
as a percentage of sales. The only favorable factor was the decrease in
the income tax paid.
Companies operating in businesses requiring very little investment in assets
often have low profit margins but earn very attractive returns on invested funds.
Therefore, it is useful to examine both the level and the trend of the companys
operating profits as a percentage of total assets. This examination uses EBIT
(earnings before interest and taxes). Operating profit as a percentage of total
assets is calculated as follows:

Retun on Assets=

EBIT
Total Assets

The purposes of using EBIT are:

a. to increase the compatibility across companies within the same industry
b. to allow the analyst to focus on the profitability of operations without any
distortion due to tax factors or the method by which the company has
financed itself
Magnetronics has a total of $22,780 invested in assets at year-end 1990
and earned before interest and taxes $2,528 during 1990. So, the return
on assets was 11.09%, which represented a decrease from the 17.21%
($2,572 divided by $14,949) earned in 1986.
On the other hand, shareholders view the companys return on equity is equally
important. It indicates how profitably the company is utilizing shareholders
funds. It is calculated as follows:

Retun on Equity=

Profit after taxes

'
Owne rs equity

Magnetronics had $12,193 of owners equity and earned $1,307 after

taxes in 1990. Its return on equity was 10.72%, a deterioration from the
15.22% ($1,171 divided by $7,692) earned in 1986.
B. Activity Ratios: How Well Does a Company Employ Its Asset?
Activity ratios indicate how well a company employs its asset. Ineffective
utilization of asset results in the need for more finance, unnecessary interest
costs and a correspondingly lower return on capital employed.
Total asset turnover measures the companys effectiveness in utilizing its total

assets calculated by dividing net sales into total asset:

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:

Cost of goods sold

Inventory
Magnetronics apparently needed $8,220 of inventory at year end 1990 to
support its operations during 1990. Its activity during 1990, as measured
by the cost of goods sold was $29,700. It therefore had an inventory

turnover of ($29,700 / $8,220) 3.613 times. This represented

deterioration from ($19,183 / $4,032) 4.758 times in 1986.

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.

C. Leverage Ratios : How soundly Is the Company Financed?

The various leverage ratios measure the relation between funds supplied by
creditors and funds supplied by the owners. The use of borrowed funds by
profitable companies will improve the return on equity. One leverage ratio, the
debt ratio, measures the total funds provided by creditors as a percentage of
total assets:

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.

The ability of Magnetronics to meet its interest payments can be estimated by

relating its earnings before interest and taxes (EBIT) to its interest payments:

Earning before interest taxes

Interest charges
The ratio is called the times interest earned ratio.
Magnetronics earnings before interest and taxes were $2,528 in 1990,
and its interest charges were $517. Its times interest earned was 4.89
times ($2,528/$517). This represented a deterioration from the 1986 level
of 7.12 times ($2,572/$361).
A ratio similar to the times interest earned ratio is the fixed charge coverage
ratio. This ratio recognizes that lease payments under long-term contracts are
usually as mandatory as interest and principal payments on debt:

EBIT + Lease payments

Interest charges+ Lease payments
Magnetronics had annual lease payments of $760. Its fixed charge
coverage in 1990 was 2.6 times (($2,528+$760)/($517+$760)).
Number of days of payables ratio measures the average number of days that the
company is taking to pay its suppliers of raw materials. It is calculated by
dividing annual purchases by 365 days to determine average purchases per day:

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

appears to be less prompt in paying its suppliers in 1990 than it was in

1986.
The deterioration in Magnetronics profitability, as measured by its return
on equity, from 15.2% In 1986 to 10.7% in 1990, resulted from the
combined impact of equity that is growing faster than net income and
increased expenses like COGS and operating expense as a percentage of
revenues.
The financial riskiness of Magnetronics increased between 1986 and 1990
D. Liquidity Ratios
The fourth basic type of financial ratio is the liquidity ratio. Liquidity ratios
measure a companys ability to meet financial obligations as they become
current. The current ratio, defined as current assets divided by current liabilities

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.

The Case of Unidentified Industries

It is important to compare the actual absolute value with some standard to
determine whether the company is performing well. Unfortunately, there is no
single current ratio, inventory turnover, or debt ratio that is appropriate to all

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

III. Conclusion and Recommendation

3.1 Conclusion
From the analysis of four ratios above, we can conclude that the financial
condition of Magnetronics has changed during the 4-year period. The changes
are:
- Decrease in profitability
- Decrease in return on assets
- Decrease in return on equity
- Decrease in total asset turnover
+ Improve in average collection period
- Decrease in inventory turnover
+ Improve in fixed asset turnover
- Decrease in debt ratio
- Deterioration in times interest earned ratio
- Increase dependent on its suppliers for finance increase
- Decrease in abilities to meet financial obligations when it comes to due
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.
The deterioration in Magnetronics profitability, as measured by its return on
equity, from 15.2% In 1986 to 10.7% in 1990, resulted from the combined impact
of equity that is growing faster than net income and increased expenses like
COGS and operating expense as a percentage of revenues.

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.