FIN604 - HW03 - Farhan Zubair - 18164052 [PDF]

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RATIO ANALYSIS The Corrigan Corporation’s 2017 and 2018 financial statements follow, along with some industry average ratios. a. Assess Corrigan’s liquidity position, and determine how it compares with peers and how the liquidity position has changed over time. Answer: Current Ratio for 2018 = total current assets/total current liabilities = 1,405,000/602,000 = 2.33 times Current Ratio for 2017 = 1,206,000/571,500 = 2.11 times Industry average for current ratio was 2.7 rimes. On December 31, 2018, the current ratio of Corrigan Corporation was 2.33 times, which means the current assets was only 2.33 times of its current liabilities which has increased from 2.11 times of 2017, but substantially low compared to the industry average of 2.7 times. Quick ratio for 2018 = (current assets-inventories)/current liabilities = (1,405,000894,000)/602,000 = 0.85 times Quick ratio for 2017 = (1,206,000-813,000)/571,500 = 0.69 times The current assets except inventories is 0.85 times of current liabilities in 2018 which has increased from 0.69 times of 2017. Cash ratio for 2018 = cash/current liabilities = 72,000/602,000 = 0.12 times Cash ratio for 2017 = 65,000/571,500 = 0.11 times Cash is 0.12 times of the current liabilities in 2018 which has increased from 0.11 times of 2017. Based on the above liquidity ratios above, we can say that, although there is an increasing trend in the above three ratios, the current ratio is significantly below the industry average, as such, the



liquidity position of Corrigan Corporation is not satisfactory. b. Assess Corrigan’s asset management position, and determine how it compares with peers and how its asset management efficiency has changed over time. Answer: Receivable turnover ratio for 2018 = sales/Accounts receivables = 4,240,000/439,000 = 9.66 times Receivable turnover ratio for 2017 = 3,635,000/328,000 = 11.08 times In 2018, Corrigan collected its average accounts receivables 9.66 times whereas it collected 11.08 times in 2017. Average receivables collection period in 2018 = 365/receivable turnover ratio = 365/9.66 = 37.78 days Average receivables collection period in 2017 = 365/11.08 = 32.94 days Industry average for average receivables collection period or days sales outstanding is 32 days. In 2018, it took on an average 37.78 days to collect the receivables from customers by Corrigan, whereas it took only 32.94 days in 2017. However, it is above the industry average of 32 days. The asset management performance in terms of Average receivable collection period is not satisfactory. Inventory turnover ratio in 2018 = Sales/inventories = 4,240,000/894,000 = 4.74 times Inventory turnover ratio in 2017 = 3,635,000/813,000 = 4.47 times Industry average for inventory turnover ratio was 7.0 times In 2018, Corrigan sold out and restocked its inventory 4.74 times whereas it was 4.47 times in 2017. However, it is substantially below the industry average of 7.0 times. Hence, the performance in terms of inventory turnover ratio is not satisfactory. Average inventory processing period in 2018 = 365/inventory turnover ratio = 365/4.74 = 77 days



Average inventory processing period in 2017 = 365/4.47 = 81.66 days In 2018, it took on an average 77 days to completely sold out and replenish the inventory whereas it took 81.66 days in 2017. Payables turnover ratio for 2018 = Cost of goods sold/Accounts payable = 3,680,000/80,000 = 46 times Payables turnover ratio for 2017 = 2,980,000/72,708 = 40.99 times In 2018, Corrigan paid off the suppliers on an average 46 times during the year and it was 40.99 times on an average during 2017. The extension of credit might be tighten up by the suppliers which is not good for Corrigan and it might look for new suppliers with liberal credit terms or renegotiate with the existing suppliers for extending credit terms. Payables payment period for 2018 = 365/payable turnover ratio = 365/46 = 7.93 days Payables payment period for 2017 = 365/40.99 = 8.90 days In 2018, on an average, it took 7.93 days to pay the payables to the suppliers and it dropped from 8.90 days of 2017 which is not good for Corrigan and puts additional pressure on liquidity as well. Cash conversion cycle for 2018 = receivable collection period + inventory processing dayspayables payment period = 37.78+77-7.93 = 106.85 days Cash conversion cycle for 2017 = 32.94+81.66-8.90 = 105.7 days In 2018, it took 106.85 days to convert the investment back into cash and it increased from 105.7 days of 2017, which shows a detrimental performance due to a greater increase in the cash collection period for receivables. Fixed asset turnover ratio in 2018 = sales/fixed assets = 4,240,000/431,000 = 9.84 times Fixed asset turnover ratio in 2017 = 3,635,000/461,000 = 7.89 times Industry average for fixed asset turnover ratio was 13 times



In 2018, every 1 dollar worth of fixed assets of Corrigan generated 9.84 dollar of sales whereas it was 7.89 dollars in 2017. However, it is far below of the industry average of 13 times in 2018. Hence, the performance is poor in terms of fixed asset turnover ratio. Total asset turnover ratio in 2018 = sales/total assets = 4,240,000/1,836,000 = 2.31 times Total asset turnover ratio in 2017 = 3,635,000/1,667,000 = 2.18 times Industry average for total asset turnover ratio in 2018 was 2.6 times In 2018, every 1 dollar worth of total assets of Corrigan generated 2.31 dollars of sales whereas it was 2.18 dollars in 2017. And, it is below industry average of 2.6 times. Hence, we can say that the performance is poor in terms of total asset turnover ratio. Based on the above ratios, we can say that the performance of Corrigan in terms of asset management is not satisfactory as the ratios are below industry averages, although the performance has slightly improved compared to 2017. c. Assess Corrigan’s debt management position, and determine how it compares with peers and how its debt management has changed over time. Answer: Debt-to-capital ratio in 2018 = Total debt/Total capital = (476,990+404,290)/(479,990+404,290+575,000+254,710) = 51.42% Debt-to-capital ratio in 2017 = (457,912+258,898)/(457,912+258,898+575,000+261,602) = 46.14% Industry average of Debt-to-capital ratio is 50% Total capital is considered the interest bearing debts (in this case, notes payable and long term debt only) and shareholders’ equity and under total debt only the interest bearing debts (Long term debts and notes payable) are considered



In 2018, the total interest bearing debt of Corrigan was 51.42% of its total capital whereas it was 46.14% in 2017. However, industry average was 50%. Hence, we can say that Corrigan is relatively slightly highly leveraged to the other firms in the industries which could led to detrimental results. Time interest earned in 2018 = EBIT/Interest expense = 97,680/67,000 = 1.46 times Times interest earned in 2017 = 202,950/43,000 = 4.72 times In 2018, Corrigan’s EBIT was only 1.46 times higher than its interest expense, whereas it was 4.72 times in 2017. Based on the above ratios, we can say that Corrigan is a slightly highly leveraged company in contrast to the other firms in the industry and the debt servicing capacity has reduced drastically from 2017 to 2018, which might impact the debt servicing capacity of the company. d. Assess Corrigan’s profitability ratios, and determine how they compare with peers and how its profitability position has changed over time. Answer: Gross Profit Margin in 2018 = Gross Profit/Net Sales = 560,000/4,240,000 = 13.21% Gross Profit Margin in 2017 = 655,000/3,635,000 = 18.02% In 2018, every 100 dollars of sales generated in 13.21 dollars of gross profit and it dropped from 18.02 dollars in 2017, which is not favorable for Corrigan. Operating profit margin in 2018 = operating profit/Net sales = 97,680/4,240,000 = 2.30% Operating profit margin in 2017 = 202,950/3,635,000 = 5.58% In 2018, every 100 dollars of sales generated in 2.30 dollars of operating profit and it dropped from 5.58 dollars in 2017, which is not favorable for Corrigan. Net profit margin ratio in 2018 = net profit/net sales = 18,408/4,240,000 = 0.43%



Net profit margin ratio in 2017 = 95,970/3,635,000 = 2.64% Industry average of profit margin in 2018 was 3.5% In 2018, every 100 dollars of sales generated 0.43 dollars of net profit and it drastically dropped from 2.64 dollars of 2017. Also, it is significantly below the industry average of 3.5%. Hence, the performance of Corrigan in terms of net profit margin is not satisfactory. Return on total invested capital = (net income + interest expense)/total capital Total capital is considered the interest bearing debts (in this case, notes payable and long term debt only) and shareholders’ equity Return on total invested capital in 2018 = (18,408+67,000)/ (476,990+404,290+575,000+254,710) = 4.99% Return on total invested capital in 2017 = (95,970+43,000)/ (457,912+258,898+575,000+261,602) =8.95% Industry average of return on total invested capital is 14.5%. In 2018, Corrigan earned 4.99 dollars for every 100 dollar worth of investment and it dropped from 8.95 dollars of 2017. Also, it is drastically below the industry average of 14.5%. Hence, we can say that the profitability performance in terms of return on total invested capital is not satisfactory. Return on total equity in 2018 = Net income/ Total equity = 18,408/ (575,000+254,710) = 2.22% Return on total equity in 2017 = 95,970/ (575,000+261,602) = 11.47% Industry average of return on equity in 2018 was 18.2% In 2018, the shareholders of Corrigan have earned 2.22 dollars for every 100 dollar investment into the company which has drastically dropped from 11.47 dollars of 2017. Also, it is significantly below the industry average of 18.2%. Hence, it is prominent that, Corrigan is performing very poorly in terms of return on total equity.



Return on asset in 2018 = net income/total asset = 18,408/1,836,000 = 1% Return on assets in 2017 = 95,970/1,667,000= 5.76% Industry average of return on assets in 2018 was 9.1% In 2018, Corrigan generated 1 dollar of net profit for every 100 dollars invested as total asset and it dropped form 5.76 dollars of 2017. Also, it is well below the industry average of 9.1%. Hence, we can say that Corrigan is performing very poorly in terms of Returns on Assets ratio. Overall, in terms of profitability Corrigan is not performing well. All of the profitability ratios are well below the industry average and exhibits a declining trend. e. Assess Corrigan’s market value ratios, and determine how its valuation compares with peers and how it has changed over time. Assume the firm’s debt is priced at par, so the market value of its debt equals its book value. Answer: Price to earnings ratio in 2018 was 15.42 (=12.34/0.8) times whereas it was 5.65(=23.57/4.17) times in 2017 and industry average is 6 times. We observe a spike in the P/E ratio from 2017 to 2018, mainly due to the drop of the price by nearly half and the drop of EPS to a great extent, which indicates the poor performance of Corrigan. M/B ratio = market capitalization/ book value = (market price× number of common shares outstanding)/ (Total assets - total liabilities) M/B ratio of 2018 = (12.34×23,000)/ {1,836,000-(602,000+404,290)} = 0.34 M/B ratio of 2017 = (23.57×23,000)/ {1,667,000-(571,500+258,898)} = 0.65 Industry average of M/B ratio was 1.5 In 2018, the market price of the stocks is only 0.34 times of the book value as perceived by the market and it dropped from 0.65 of 2017. Also, it is significantly lower than the market average of 1.5. Here, the market does not even perceive the market value of the stocks equal to book value.



The declining profit trend and increasing inefficiency in asset management might be the reason for such perceptions of the market, which is detrimental to attract new investment and to raise the share price.



EV/EBITDA ratio =



Market capital+Debt−cash and cash equivalent Earning before interest,tax,depreciationa nd amortization



EV/EBITDA ratio for 2018 =



EV/EBITDA ratio for 2017 =



(23,000×12.34)+(476,990+404,290)−72,000 97,680+159,000 (23,000×23.57)+(457,912+258,898)−65,000 202,950+154,500



= 4.26



= 3.34



Industry average for EV/EBITDA ratio is 6.0 In 2018, the enterprise value of Corrigan was only 4.26 times of the EBITDA and it increased from 3.34 times of 2017, whereas the industry average was 6. This ratio has increased because of the tremendous increase in debts which outturned the significant market capital of Corrigan. Based on the above three market value ratios, we can say that, the rapid increase in P/E ratio and slight improvement in EV/EBITDA ratio could be misleading if considered in isolation as it happened only due to reduction in share price, EPS and rapid increase in debts. The perception of the market is exhibited in the poor M/B ratio. Hence, the market performance based on market value ratios of Corrigan is very poor. f. Calculate Corrigan’s ROE as well as the industry average ROE, using the DuPont equation. From this analysis, how does Corrigan’s financial position compare with the industry average numbers? Answer: ROE2018 = profit margin × Total asset turnover × Financial leverage =



net income Sales



×



sales Total assets



×



total assets total common equity



= (18,408/4,240,000)×(4,240,000/1,836,000)×{1,836,000/(575,000+254,710)} = 2.22% ROE2017 =(95,970/3,635,000)×(3,635,000/1,667,000)×{1,667,000/(575,000+261,602)} = 11.47% ROE of Industry Average = profit margin × Total asset turnover × Financial leverage = 3.5% × 2.6 ×



1 0.5



= 18.20%



ROE has significantly dropped from 11.47% in 2017 to 2.22% in 2018. Also, ROE is significantly below the industry average of 18.20%. Hence, the performance of Corrigan is very poor in terms of ROE. The contributors for poor ROE are the very low profit margin, lower asset turnover ratio compared to the industry average. However, the increased financial leverage indicates higher debt ratio which is very risky. g. What do you think would happen to its ratios if the company initiated cost-cutting measures that allowed it to hold lower levels of inventory and substantially decreased the cost of goods sold? No calculations are necessary. Think about which ratios would be affected by changes in these two accounts. Answer: As the cost of goods sold will be reduced, it will eventually positively impact the gross profit, operating profit and net income leading to an increase in both profitability and market value ratios. If the inventories are reduced, it will also reduce the Accounts Payable as less inventories will be purchased at a time on credit leading to a positive impact on liquidity ratios. Due to holding of lower level of inventories, the total asset will also be lower, hence increasing the inventory turnover and asset turnover ratios. Lower level of inventory and higher level of income will lead to better debt ratios as working capital financing through debt will be reduced along with better capacity to service the debts.