coverage ratio

Financial Accounting & Analysis

CASE STUDYAdept Chemical Inc.

Submitted By:Utkarsh Grover (106)Mehul Gupta (107)Priyam Gupta (108)Ankit Jain (308)Suneet Jain (309)

Financial Accounting & Analysis 2010

Table of Contents

Performance parameters......................................................................................................................3

LIQUIDITY RATIO:...................................................................................................................................3

Current ratio:.........................................................................................................................................3

Quick ratio:............................................................................................................................................4

DEBT RATIOS..........................................................................................................................................4

Debt to equity ratio:..............................................................................................................................4

Debt to total asset:................................................................................................................................5

Long term debt to total capitalization:..................................................................................................5

Coverage ratio:......................................................................................................................................6

Receivable to turnover Ratio.................................................................................................................6

Operating Cycle.....................................................................................................................................8

Total Asset Turnover.............................................................................................................................8

Gross Profit margin................................................................................................................................9

Payable Turnover Ratio.........................................................................................................................9

Inventory Turnover Ratio.....................................................................................................................11

Net Profit Margin.................................................................................................................................12

Return on Assets..................................................................................................................................13

Return on Equity..................................................................................................................................13

Return on Equity: DuPont Approach...................................................................................................14

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Performance parameters

Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment.

In context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing

Apply Ratio Analysis to Financial Statements to analyze the success, failure, and progress of your business.

Ratio Analysis enables the business owner/manager to spot trends in a business and to compare its performance and condition with the average performance of similar businesses in the same industry.

An overview of some of the categories of ratios is given below.

Leverage Ratios which show the extent that debt is used in a company's capital structure. Liquidity Ratios which give a picture of a company's short term financial situation or

solvency. Operational Ratios which use turnover measures to show how efficient a company is in its

operations and use of assets. Profitability Ratios which use margin analysis and show the return on sales and capital

employed. Solvency Ratios which give a picture of a company's ability to generate cashflow and pay it

financial obligations.

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LIQUIDITY RATIO:

They measure the ability of a firm to pay its short term debts. Higher ratio value represents the fact that the company can pay off its debts in cash or near cash settlements along with satisfying its ongoing operational needs.

Current ratio:

It is to establish the credibility of a company’s short term assets to clear its short term liabilities. In theory, the higher the current ratio, the better.

Current ratio= Current assets Current liabilities

2007($) 2006($) 2005($)Current assets 156,909 114,217 100,150Current liability 153,152 115,270 139,812Current ratio 1.02 0.99 0.72

The increase in the value of the current ratio shows that its short term financial strength is increasing with each year. Although the increase is a positive indication, yet the investors should not be completely dependent on it to get an idea of the liquidity state of a company. The constituents of the current asset play an integral role on that front.

Quick ratio:

It is similar to current ratio but is more conservative measure. It does not include inventory, prepaid expenses, etc. since they might take some time to convert into cash.

Quick ratio= Current assets-(prepaid expenses + inventory)Current liabilities

2007 2006 2005Current assets 156,909 114,217 100,150Prepaid expenses 4,388 3,483 2,075Inventory 19,908 17,943 20,281Current liability 152,152 115,270 139.812Quick ratio 0.86 0.80 0.56

The readily- available assets show a drastic increase in the 2nd year which shows movement to a profitable state. The raising quick ratio for ADEPT CHEMICALS INC. shows its increasing capacity

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to meet its liabilities at hand. Since there is a significant difference in the figures of current ratio and quick ratio, it shows accountable reliance of current assets on inventories for liquidation.

DEBT RATIOS

These ratios give users a general idea of the company's overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy.

Debt to equity ratio:

It shows the relative proportion of the total liability (long term debts) and shareholder’s equity, which are used to finance the assets of a company

Debt to equity ratio= Total liability /Shareholder’s equity

2007 2006 2005Total liability 328,392 295,270 319,812Shareholder’s equity (78,535) (120,766) (150,868)Debt to equity ratio (4.18) (2.45) (2.11)

Negative ratio indicates that net worth of the company is negative and thus it’s a danger bell for the company. The increase in the ratio emphasizes the risk involved. The company policies might be restricted by external influence since they have a larger share in the company than its equity holders.

Debt to total asset:

It gives a fair idea about the amount of leverage being used by the firm.

Debt to total asset= Total liability/Total asset

2007($) 2006($) 2005($)Total liability 328,392 295,270 319,812Total asset 249,857 174,504 168,944Debt to total asset 1.31 1.69 1.89

There has been a decrease in the ratio for the past three years thus it shows that the dependency of the company on its leverages is decreasing which might be attributed to the

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increase in the current assets of the company. A high measure of the ratio shows high reliance of the company on the money borrowed and thus more risk.

Long term debt to total capitalization:

This ratio gives a clear picture of a company’s leverage usage.

Long term debt to total capitalization= long term debt Long term debt + share holder’s equity

2007 2006 2005Long term debts 175,240 180,000 180,000Share holder equity -78,535 -120,766 -150,868Long term debt to total capitalization

-1.81 -3.04 -6.18

Similar to the negative debt to equity ratio, a negative ratio in this scenario is a trouble signal. Although the negative value is decreasing over the years, indicating the constructive efforts put in by the company. A low figure shows a financially sound company structure which has more freedom of choice while making any financial and economic decisions as the share of external creditors is small as compared to equity holders.

Coverage ratio:

The coverage ratio measures the firm’s ability to service the fixed liabilities or its ability to meet a particular expense. This ratio serves as one measure of the firm’s ability to meet its interest payments and avoid bankruptcy. Higher ratio means more the safety to lenders and shareholders.

The interest coverage ratio also known as ‘times interest earned ratio’ is indicative of firm’s ability to meet interest obligations. This also throws light on the firm’s capacity to take a new debt. If the interest coverage ratio is smaller than 1, it indicates that the property produces insufficient income to cover both operating expenses and the mortgage payment.

How to calculate Coverage Ratio:

Interest Coverage Ratio = EBIT Interest Expense

EBIT – Earning before interest and taxes, is used in the numerator because the ability to pay interest is not affected by tax burden. This is calculated as:

EBIT = Gross Profit – Operating Cost – Payroll Tax (in this case) - Interest

Calculation for the case in point:(Figures taken from the case study)

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2007 2006 2005EBIT (in $) 22835 13437 (22132)Interest Expense (in $) 12569 9496 6775Interest Coverage Ratio 1.82 1.42 (3.26)

Analysis based on the calculation:

When the company established itself, being a new entrant into the market experienced heavy losses. This is clearly visible from the ICR of its year of establishment. This indicates excessive use of the debts by the company or its inefficiency in its operations.

Slowly the company gained momentum and tried to make its foothold strong in the market. A noticeable increase in the ICR indicates that the company improved a lot and is now in a position to meet its interest obligations.

Receivable to turnover Ratio

This ratio is a part of the Activity ratio that measures how effectively the firm is able to use its assets. The receivable turnover ratio (RT) gives an insight into the quality of the firm’s receivables and how successfully the firm is able to collect them. Actually, the main thing behind this ratio is, the speed with which the firm is able to collect the receivables affects the liquidity position of the firm.

How to calculate RT:

RT = Annual Net Credit SalesReceivables

Calculation for the case in point:

2007 2006 2005Net Credit Sales (in $) 859,679 634,715 496,084Receivables (in $) 132613 92791 77794RT 6.48 6.84 6.37


The ratio is providing a fair idea about the number of times accounts receivable have been turned over into cash during the year. If we compare the RT of Adept (6.48) with that of ECOLAB (6.03) for the year 2007, we notice that Adept’s receivables are faster in turning over than those of ECOLAB. Since ECOLAB gives a tough competition to the new player, a comparison between the two can judge the standing of Adept in the market to some extent.

Receivable to Turnover in days:

This figure tells us the average number of days for which the receivables are outstanding before being collected. If we compare a firm’s RTD with the median industry, it can give a fair picture of the

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performance of the company taken into account. This gives an overview of financial efficiency of the firm.

How to calculate RTD:RTD = Days in the year

Receivable turnover

Calculation for the case in point:2007 2006 2005

Days in the year 365 365 365Receivable turnover 6.22 6.69 6.18RTD (days) 59 55 59

Analysis based on the calculation: Taking the data of ECOLAB for the year 2007 (60.5 days) and comparing it to the Adept’s

RTD (59 days), we can conclude that the performance of the company is very much appropriate as Adept is just in its nascent stage.

The collection period of the company shows a constant trend over the three years. In 2006, it did manage to reduce it. This number is lucrative for the investors as well, and the way Adept has been performing can definitely attract more number of investors.

Operating Cycle

A firm’s operating cycle is the length of time from the commitment of cash from purchases until the collection of receivables resulting from the sale of goods. This figure helps in analysing the firm’s current asset needs. How to calculate Operating Cycle:

Operating Cycle = Inventory Turnover in days (ITD) + Receivable Turnover in days (RTD)


Inventory Turnover in days

15 21 30

Receivable Turnover in days

59 55 59

Operating Cycle (days) 74 76 89

Analysis based on the calculation: The numbers indicate that Adept Chemicals have a high operational efficiency. A simple rule

tells us that the longer your money is out there in the market, the more risk you are taking. ‘Shorter is better’, this might seem to be the case with the number but for measuring the

efficiency and we cannot completely rely on only one factor. Other factors like short payments etc. are also affecting the overall efficiency.

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Making a comparison between the Operating cycle of ECOLAB and Adept, the latter is very much ahead in terms of operational efficiency with 74 days as the operating cycle as compared to 115 days of ECOLAB.

Total Asset Turnover

The total asset (or capital) turnover ratio tells us the relative efficiency with which the firm utilizes its total assets to generate sales or revenue. It also indicates pricing strategy: firm’s with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.

How to calculate Total Asset Turnover:

Total Asset Turnover = Net Sales Total Assets

Calculation for the case in point:

2007 2006 2005Net Sales (in $) 859,679 634,715 496,084Total Assets (in $) 249,857 174,504 168,994Total Asset Turnover 3.44 3.63 2.93

The numbers are indicating that the firm’s is efficiently utilizing its total assets to generate sales. The firm is able to generate a good amount of sales with few dollars invested in the receivables and the inventories and thus increasing the total asset turnover which is quite good for the firm.

Gross Profit margin

This ratio gives the profitability in relation to the sales made by the firm after reducing the cost of the goods sold. It’s an indication of the firm’s operation and how the product is priced. It might not provide the exact pricing strategy but it definitely gives a good indication of financial health the firm.a

How to calculate Gross Profit Margin:

Gross Profit Margin = Net Sales – Cost of goods soldNet Sales


Net Sales (in $) 859,679 634,715 496,084Cost of goods sold (in $)

489,142 311,270 247,266

GPM (in %) 43.10 50.95 50.15

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For a good company, the Gross Profit Margin must not fluctuate much unless the company is undergoing major changes. The figure for the three years display that for the initial years, the company was quite stable and in 2007 there is a decline in the GPM. This is very much accountable to the changes the company has undergone like the deal with Cargill.

Payable Turnover Ratio

It shows how many times the payables have been turned over in a year. It is used to quantify the rate at which company pays off to its suppliers.

Payable turnover ratio= Annual net credit PurchasesAccount Payables

Note:

If the net credit purchases figures are not available, we use total purchase figures. If there are no payable figures available, we make an assumption to take current liability as

payable.

Calculations

Annual net credit purchases = Closing inventory + Cost of goods sold – Opening Inventory.

Payable turnover ratio for Adept Chemical Inc. in year 2007.

Annual net credit purchases = Closing inventory + Cost of goods sold – Opening Inventory = 19,908 + 402,833 + 27,784 – 17,943 = 432,582 $

Payables = 113,750Payable turnover ratio = 432582 / 113750

= 3.80

Assumptions:Cost of goods sold includes product purchases and Equipment purchases. For Adept, product purchases included cost of finished goods and 15% paid to Sodrox.

Payable turnover ratio for Adept Chemical Inc. in year 2006.

Annual net credit purchases = Closing inventory + Cost of goods sold – Opening Inventory = 17,943 + 248,771 + 11,092 – 20,281 = 257,525 $

Payables = 65,944Payable turnover ratio = 257525 / 65944

= 3.90

Conclusion:

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The payable ratio is falling from 3.90 to 3.80. This signifies that company is taking longer to pay off its suppliers than it was before. This indicates that company might have liquidity problem which can also be harmful for its relationship with suppliers.

Payable Turnover Ratio in days

It helps us to see promptness of payments to suppliers.

Payableturnover ratio∈days= Days∈the yearPayable turnover

Calculations:

Payable turnover ratio in days for Adept Chemical Inc. in year 2007.Days in the year = 365Payable turnover = 3.80Payable turnover ratio in days = 365 / 3.80

= 96.02 ≈ 97 days.

Payable turnover ratio in days for Adept Chemical Inc. in year 2006.Days in the year = 365Payable turnover = 3.90Payable turnover ratio in days = 365 / 3.90

= 93.59 ≈ 94 days.Conclusions:

The payable ratio in days is rising from 94 to 97 days. This signifies that company is taking longer to pay off its suppliers than it was before. This indicates that company might have liquidity problem which can also be harmful for its relationship with suppliers.

Inventory Turnover Ratio

It helps us to determine how effectively the firm is managing inventory. It is also used to gain an indication of the liquidity of inventory. Higher ratio is better but it is to be ensured firm doesn’t suffer stock outs.

Inventory turnover ratio=Cost of goods soldInventory

CalculationInventory turnover ratio for Adept Chemical Inc. in year 2007.Cost of goods sold = 402,833 + 27,784 = 430,617Inventory = 19,908Inventory turnover ratio = 430617 / 19908

= 21.63Assumptions:Cost of goods sold includes product purchases and Equipment purchases. For Adept, product purchases included cost of finished goods and 15% paid to Sodrox.

Inventory turnover ratio for Adept Chemical Inc. in year 2006.Cost of goods sold = 248,771 + 11,092 = 259863Inventory = 17943

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Inventory turnover ratio = 259863 / 17943 = 14.48

Inventory turnover ratio for Adept Chemical Inc. in year 2005.Cost of goods sold = 189,677 + 8,375 = 198052Inventory = 20,281Inventory turnover ratio = 198052 / 20281

= 9.77ConclusionThe inventory turnover ratio rises from 9.77 to 21.63 within two years. This signifies that company is performing well and having strong sales, which is rising every year.

Inventory Turnover Ratio in daysIt tells us how many days, on average, before inventory is turned into amount receivable through sales.

Inventory turnover ratio∈days= Days∈the yearInventory turnover

CalculationsInventory turnover ratio in days for Adept Chemical Inc. in year 2007.Days in the year = 365Inventory turnover = 21.63Inventory turnover ratio in days = 365 / 21.63

= 16.87 ≈ 17 days.

Inventory turnover ratio in days for Adept Chemical Inc. in year 2006.Days in the year = 365Inventory turnover = 14.48Inventory turnover ratio in days = 365 / 14.48

= 25.21 ≈ 26 days.

Inventory turnover ratio in days for Adept Chemical Inc. in year 2005.Days in the year = 365Inventory turnover = 9.77Inventory turnover ratio in days = 365 / 9.77

= 37.35 ≈ 38 days.Conclusion:The inventory turnover ratio in days has fallen from 38 to 17 within two years. This signifies that company is performing well and having strong sales, which is rising every year.

Pre Tax Margin

Formula: Earning BeforeTax(EBT )

Net SalesShows rate of earning on sales after the interest cost but before tax.

Case Study AnalysisEBT= Net Profit after tax+Payroll Taxes (Including payroll taxes)

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YearNet Profit After Tax

Payroll Taxes($)

Net Sales($) EBT($)

Pre Tax Margin %

2007 42231 6827 859679 49058 0.057 5.712006 30102 7169 634715 37271 0.059 5.872005 (7504) 7853 496084 349 .00070 0.07

Conclusion

In 2005 Adept EBT is very low mainly due to two reasons. First one was low profit margins on their detergents products. Strict regulations of Canadian Food Inspection agency rose their operating cost more than adept’s gross profit which resulted in negative EBT in 2005. Secondly, in 2004 adept’s decided to focus on new sales on their four legally protected specialized sanitizers. Most of adept’s investments were taken in constructing new plants and in expanding the current plants.

In 2006 due to their four specialized sanitation products which were unique from other competitor’s products raised their gross profit (greater than operating cost) because of high margin than other detergent products and also increased the sale. Due to low operating efficiency their pretax margin reduced by 0.16%

Net Profit Margin

Formula: Net Profit After Tax

Net Sales

Measures profitability of sales after adjusting all income, expenses and taxes

Case Study Analysis


Net Sales($)

Net Profit Margin %

2007 42231 859679 0.049 4.92006 30102 634715 0.047 4.72005 (7504) 496084 (.015) (1.51)

Conclusion

In 2005, adept net profit margin is very neagtive due to same two reasons discussed earlier i.e. First one was low profit margins on their detergents products and secondly adepts investment in setting of new plants and expanding the current plants for their four specialized sanitation products. In 2006 their net profit margin rose very high as compared to 2005 due to introduction of new products in market. In 2006 and 2007 adept’s net profit margin increased by .1%

Return on Assets

Formula: Net Profit After TaxTotal Assets

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Show profitability of a company relative to its total assets.

Case Study Analysis

YearNet After

Profit Tax ($)

Total Assests($

)Return on

Assest %2007 42231 249857 0.169 16.902006 30102 174504 0.173 17.252005 (7504) 168944 (0.044) (4.44)

Conclusion

Adept’s ROA is very low in 2005 due to because of two reasons mentioned earlier. In 2006 ROA has increased 12.81% due to introduction of their new product i.e. their four specialized sanitary products. ROA has decreased by .35% this year because of increase in total assets in the current year. Ecolab has a ROA of 9.6% less than adepts 16.90%. This means adept is getting more profit out of each dollar invested in it. Adapt has more money for research and marketing as compared to Ecolab.

Return on Equity

Formula: Net Profit AfterTaxShareholder Expenses

Measures earning power on shareholder’s investment.

Case Study Analysis


Shareholder Expenses($)

Return on Equity %

2007 42231 (78535) (0.5377) (53.77)2006 30102 (120766) (0.2493) (24.93)2005 (7504) (150868) .0497 4.97

Conclusion

Negative equity shows adept inefficiency in generating profits from every unit of shareholder’s equity. Adept’s customers are not willing to pay as much for company’s product or the product has become too expensive to produce. Adept is compelled to spend more in research and marketing.

Return on Equity: DuPont Approach

It compares net profit after taxes to equity that shareholders have invested in the firm. It tells us the earning power on shareholders’ book value investment. It helps in finding outwhy on firm.

Return on equity = Net Profit Margin * Total asset turnover * equity multiplier

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Calculations

Return on equity for Adept Chemical Inc. in year 2007.

Return on equity = Net Profit Margin * Total asset turnover * equity multiplierNet profit margin = 0.05Total asset turnover = 3.44Equity Multiplier = (3.18)Return on equity = 0.05 * 3.44 * (3.18)

= (0.55)= (55%)

Return on equity for Adept Chemical Inc. in year 2006.Return on equity = Net Profit Margin * Total asset turnover * equity multiplierNet profit margin = 0.05Total asset turnover = 3.64Equity Multiplier = (1.44)Return on equity = 0.05 * 3.64 * (1.44)

= (0.26) = (26%)

Return on equity for Adept Chemical Inc. in year 2005.Return on equity = Net Profit Margin * Total asset turnover * equity multiplierNet profit margin = (0.02)Total asset turnover = 2.78Equity Multiplier = (0.66)Return on equity = (0.02) * 2.78 * (0.66)

= 0.04 = 4%

Conclusion

The company’s return on equity has fallen from 0.04 to (0.55) which is significant in faster growing companies due to new investments. This also indicates increase in net profit margin which indicates company is performing well also there is decrease in equity multiplier.

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coverage ratio

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