Buenaflor, Raymond L. July 15, 2011

08-00741 THW 1:00-2:30

Machine Problem #1

Financial Statements Analysis Report

Financial Statements Analysis

Financial ratios would be an important tool in assessing the financial condition and

performance of Martin Manufacturing Company during 2009. In evaluating the ratios computed,

it is also important to know the industry that the company is in. Due to the lack of information

about the company, the analysis focuses only on the values of the ratios computed. It sets aside

the external factors that can affect the company, and instead, it only focuses on internal factors.

The analysis is divided into the five distinct types of ratios namely liquidity, activity,

debt, profitability, and market. With this division, it becomes easier to pinpoint problems with

regards to the financial performance of the company. Also, it becomes more logical to interpret

the values of the ratios when they are of the same category. Lastly, it also makes it easier to have

comparisons when the ratios are analysed by type.

The analysis made is based on time-series and cross-sectional. With the time-series

analysis, the company’s ratio values for 2007 and 2008 (supplied) are compared with the 2009

ratio values. With the cross-sectional analysis, the 2009 industry average ratios (also given) are

compared with the company’s ratio values for 2009. The summary of the financial ratios of

Martin Manufacturing Company including the industry average for 2009 is given below.

Actual 2007 Actual 2008 Actual 2009 Industry average 20091.7 1.8 2.5 1.51.0 0.9 1.3 1.25.2 5.0 5.3 10.2

50.7 55.8 57.9 46.01.5 1.5 1.6 2.0

45.8% 54.3% 57.0% 24.5%2.2 1.9 1.6 2.5

27.5% 28.0% 27.0% 26.0%1.1% 1.0% 0.7% 1.2%1.7% 1.5% 1.1% 2.4%3.1% 3.3% 2.6% 3.2%33.5 38.7 34.5 43.41.0 1.1 2.8 1.2

Martin Manufacturing CompanyHistorical and Industry Average Ratios

Ratio

Total asset turnover (times)Debt ratioTimes interest earned ratioGross profit margin

Current ratioQuick ratioInventory turnover (times)Average collection period (days)

Market/book (M/B) ratio

Net profit marginReturn on total assets (ROA)Return on common equity (ROE)Price/earnings (P/E) ratio

$5,075,000.00$3,704,000.00$1,371,000.00

$650,000.00$416,000.00$152,000.00

$1,218,000.00$153,000.00$93,000.00$60,000.00$24,000.00$36,000.00$3,000.00

$33,000.00$0.33

Less: Preferred stock dividendsEarnings available for common stockholdersEarnings per share (EPS)

Total operating expense

General and administrative expenses

Less: Interest expense

Martin Manufacturing CompanyIncome Statement

for the Year Ended December 31, 2009

Less: Taxes (rate = 40%)

Less: Cost of goods soldSales Revenue

Net profits after taxes

Gross profits

Selling expense

Depreciation expense

Less: Operating Expenses

Operating profits

Net profits before taxes

2009 2008

$25,000.00 $24,100.00$805,556.00 $763,900.00$700,625.00 $763,445.00

$1,531,181.00 $1,551,445.00$2,093,819.00 $1,691,707.00

$500,000.00 $348,000.00$1,593,819.00 $1,343,707.00$3,125,000.00 $2,895,152.00

$230,000.00 $400,500.00$311,000.00 $370,000.00$75,000.00 $100,902.00

$616,000.00 $871,402.00$1,165,250.00 $700,000.00$1,781,250.00 $1,571,402.00

$50,000.00 $50,000.00$400,000.00 $400,000.00$593,750.00 $593,750.00$300,000.00 $280,000.00

$1,343,750.00 $1,323,750.00$3,125,000.00 $2,895,152.00

$11.38Par value $4.00Outsatnding shares of common stock 100,000

Price per share

Retained earningsTotal stockholders' equity

Total liabilities and stockholders equity

Long-term debtTotal liabilities

Preferred stock (2,500 shares, $1.20 dividend)Common stock (100,000 shares at $4 par)Paid-in capital in excess of par value

Current liabilitiesAccounts payableNotes payableAccruals

Total current liabilities

Liabilities and Stockholders' Equity

Inventories

Gross fixed assets (at cost)Less: Accumulated depreciationNet fixed assetsTotal assets

Current assets

Stockholders' equity

Martin Manufacturing CompanyBalance Sheet

December 31,Assets

CashAccounts Receivable

Total current assets

LIQUIDITY RATIOS

Current Ratio

Time-series: From 2007

to 2009 the company has a

current ratio greater than one. It

means that the company has the

ability to meet its short-term

obligations with its current

resources available. It has a

current ratio of 1.7 and 1.8 for

the years 2007 and 2008

respectively, and a current ratio

of 2.5 for 2009. This shows that current ratio is increasing in trend. Also, it can be observed that

there is an enormous increase in the current ratio from 2008 to 2009. This could be caused by an

increase in current assets and/or a decrease in current liabilities. Based on the comparative

balance sheet (2008 and 2009), there is an enormous decrease in current liabilities specifically in

accounts payable and accruals. What does this indicate? It means that the company is not

depending much on loans/credits/advances to finance its operations.

Cross-sectional: Comparing the company’s current ratio to the industry average, the

company has a relatively higher current ratio. It means that the company is very liquid. The

company wouldn’t have a hard time fulfilling its short-term obligations. But, there is an

implication with having a very liquid condition – low profitability. The company might be

foregoing some opportunities because it is investing a lot of its cash to its current assets. (More

will be discussed in the activity ratios portion of the analysis.) In addition, according to L.J.

Gitman, it is advisable for a manufacturing company to have a current ratio that is near to one.

Cash flows for a manufacturing company are predictable and the company wouldn’t have

problems in fulfilling its short-term obligations because it can easily forecast how much money it

will be receiving/disbursing for the year.

Quick Ratio

Time-series: The firm has a normal/good quick ratio. It has a ratio of 1.0 for the year

2007, and a ratio of 0.9 by

2008 – basically, the trend

is decreasing. But by the

year 2009, its quick ratio

increased to 1.3. Again,

there is a tremendous

increase from the value of

the ratio from 2008 to

2009. It is because of the

decrease in the company’s current liabilities for the year 2009.

Having a quick ratio that is greater than one means that the company has the ability to

meet its current liabilities using its most liquid asset. This ratio is to be compared with the

current ratio. The company’s current ratio is very high compared to its quick ratio. It means that

there is a build-up in the least liquid portion of its current assets (its inventories). Is it good or

bad? Basically, a build-up in the least liquid portion of a company’s current assets might be a bad

indication for profitability of the company. Aside from the threat of not being able to convert it

into the most liquid asset which is cash, the company might also be incurring irrelevant cost

because of storage, etc. Also, a build-up in the least liquid portion (inventories) of current assets

is an indication of poor marketing strategy of the company. The marketing department might not

be achieving its quota when it comes to sales or there is a poor forecasting of the demand for the

product.

Cross-sectional: Having a quick ratio that is very near to the industry average means that

the company is in line with its industry. It is a good indication as for the liquidity of the

company. Less risk for the company because it can pay its debt/liabilities as they come due.

Recommendation:

It is advisable for the company to decrease its current ratio by reducing the cash invested

to its current assets especially accounts receivable and inventories. It is very expensive to store a

lot of inventories because of theft and obsolescence, and it is also risky to have a large amount of

accounts receivable due to default risk. By reducing the cash invested to these assets, the

company can earn more by investing it to marketable securities that will yield dividends or

interest.

ACTIVITY RATIOS

Inventory Turnover

Time-series: The

company’s turnover ratio plays

around 5.0 to 5.3 for the past

three years of its operations.

On a regular basis, an

inventory turnover of 5.3 for

2009 indicates normal

inventory management because

it is the normal ratio for the

company as observed with its

previous years. The company is

not performing very well in turning inventory into sales, but at least it is also not performing

badly – just right.

Cross-sectional: The company’s inventory turnover of 5.3 for 2009 is very low compared

to 10.2 industry average. It is an unfavourable remark for the company in terms of the industry

that it is in. It can convert its inventory into sales only half of what the industry can. It indicates a

poor inventory management than the industry and that the company holds excessive inventory

stock. Instead of responding to the demand of the product, the company is over-stocking which

leads to additional cost for the company. Stated previously, it is not advisable to store excessive

amount of inventory because of cost issues. In addition, excessive inventory stock indicates poor

sales and poor logistics.

Average Collection Period

Time-series: The

shorter the collection time,

the better. For the past

three years of operation of

the company, there is an

increasing trend on its

average collection period.

It is bad for the company

because instead of

reducing the time for the

collection of the receivable, the company works the opposite way. The company is becoming

lenient with its credit customers. This can lead to an increase in bad debts and a change in credit

policy of the company. Since the credit policy of the company is not given, we cannot be certain

whether the collection period is reasonable or not. But on the onset, a high average collection

period is bad for a company especially in the manufacturing industry. We will leave the final

judgment to the cross-sectional analysis because it becomes significant to compare the

company’s collection period to the industry average.

Cross-sectional: The company’s 2009 average collection period of 57.9 days is relatively

high compared to the industry average of 46.0 days. It is an indication of problems in the

collection period of the company. Although a relaxed credit collection policy can induce sales, it

is still not advisable going far beyond the industry average. Aside from encountering more and

more bad debts, it can also affect the future operation of the company. When receivables are not

collected as they come due, delayed in the payments of the company’s obligations will follow.

Receivables form part of the sales and profit of the company. When it is not monitored properly,

the company might end up increasing its debt in order to continue its operations.

Total Asset Turnover

Time-series: Total

asset turnover for 2007 and

2008 were 1.5 while for 2009

it was 1.6. The values were

almost the same for the past

three years. This means that

there is not much

improvement in the utilization

of assets to generate sales. It is

just normal for the company to

generate same amount of sales with a minimal change in its assets.

Cross-sectional: The industry has a total asset turnover of 2.0. Compared with the

company’s 1.6 ratio, it is clear that it is generating less sales revenue per dollar of asset

investment than the industry. The company is less efficient than the industry. There might be a

problem in the efficiency on utilizing the company’s assets. The causes might be over-

investment in accounts payable, in inventories and/or in fixed assets, and in the case of Martin

Manufacturing, it is a combination of those three. It has a large amount of accounts payable and

inventory and it might have been buying/keeping fixed assets beyond what the company can use

to produce its products. Excessive investment in assets can also affect the profitability of the

company. More assets require more workers and also more administrative and operating

expenses. If there is excessive investment in the assets, the company will end up paying more

workers than it generally needs. And so other operating expenses will follow leaving the

company less profit than it should be generating.

Recommendation:

It is recommended that the company increases its inventory turnover by reducing its

inventory to lower its cost or by generating more sales through extra marketing efforts. A good

demand forecasting is also important in this aspect. Also, it is advisable to take into

consideration its collection period and collection policy. It can restrict issuance of credit to

customers, tighten its credit policy or build relationship with its customers to encourage customer

loyalty in paying their necessary obligations/debt to the company. But before doing such things,

it is important to assess if a change in credit policy or restrictions in issuance of credit to

customers will greatly affect future sales of the company. Cost-benefit analysis can be useful.

Lastly, the company should decrease its investment to the non-relevant assets of the company.

Instead, it can use its cash to invest to marketable securities rather than investing in additional

assets which will only generate the same amount of sales.

DEBT RATIOS

Debt Ratio

Time-series: The

higher the debt, the higher

the interest expense and

the less the profitability

for the company. The debt

ratio for the year 2009 of

the company is 57.0%.

This means that 57% of

the company’s assets are

supported by debt

financing. It can be

observed in the graph that the trend on the debt ratio is increasing. From 45.8% in 2008 to 54.3%

in 2009, its debt ratio increased to 57% by 2009. This only shows that more and more assets are

being financed by debt as time goes on. It also shows that about 43% of the company’s assets are

supported by shareholders wealth. This means that the company is becoming more and more

dependent to debt than to its shareholders in financing its assets. What we can conclude here is

that the company should monitor its debt ratio because the higher it is, the greater the financial

risk to the company.

Cross-sectional: The debt ratio on the industry is 24.5%. There is a very wide disparity

between the industry ratio and the company’s. As stated before, the higher the debt ratio, the

higher the financial risk. Therefore having a ratio which is a lot larger than the industry would

mean that the company is not in line with the industry. The company becomes very dependent

with creditors rather than the owners. Having a larger ratio than the industry would also mean

that the company is not earning enough to meet its need on financing its assets. If the company is

earning well, it will not make such dependence on its creditors.

Times Interest Earned ratio

Time-series: The higher

this ratio is the better for the

company. It can pay its interest

payments easily if it has a

higher times interest earned

ratio. But with the trend in the

company’s ratio, it seems that

it becomes more and more

difficult to pay interest

payments as the years go by.

From 2.2 on 2007, it decreased to 1.9 by 2008, and even diminished more by 2009 with a ratio of

1.6. The trend is decreasing. The probability that the company can pay its interest expenses using

its profit becomes lower. The profit is becoming inadequate to pay the interest from its debt.

Also, a decreasing times interest earned ratio is a bad sign for future credit that the company

would make. Because it shows that it is becoming difficult for the company to pay debts and

interest through the profit from its operations.

Cross-sectional: The company has a lower times interest earned ratio than the industry

average which is 2.5. This would have two possible causes. First, the company might be getting

more debt than needed. Second is that they are not utilizing the cash they get from debts to

increase its sales and/or profit.

Recommendation:

It is recommended that the company analyse and screen its plan for future financing.

Having a large debt ratio than the industry increases the company’s risk on its finances. If the

company won’t be able to assess whether its debt are still reasonable, it might end up paying

interest which are not necessary or those that doesn’t contribute to its profitability. And therefore

it won’t be useful for the future operation of the company.

It is also recommended that they monitor their times interest earned ratio since a higher

ratio will have an impact to the credibility of the company in terms of paying not only the

interest expenses, but also the debt itself. The company is using much of the debts for its

financing. In fact, most of its liabilities are long-term debt. It is advisable to reduce the debts that

they have to reduce its interest expense and increase the times interest earned ratio.

PROFITABILITY RATIOS

Gross Profit Margin

Time-series: Based

on historical data, the

company’s gross profit

margin plays around 27%

to 28%. The efficiency of

the company’s operations

did not change for the past

three years. The gross

profit margin for 2009 was

27%. This means that 27%

of its sales are composed of its gross profit while the remaining 73% is the cost of goods sold. It

is reasonable percentage since it is its normal ratio based on previous years. The company is

efficient not only with its operations but also with the pricing of its products.

Cross-sectional: With an industry median of 26%, it can be said that the company is

better off with the industry in the operation and pricing of its products. It is more effective and

efficient in generating profits from its operations.

Net Profit Margin

Time-series: Based on

the graph, the company’s net

profit margin is declining. It is

a bad sign for the company’s

profitability. Only 0.7 cents of

every sales dollar goes to the

net profit. This ratio is to be

compared with the gross profit

margin. The company’s gross

profit margin is slightly unchanged from its previous years of operations while its net profit

margin is decreasing. Clearly, the decrease in the net profit margin is caused by increasing

selling, administrative and depreciation expense. It might also be due to a higher tax rate charged

on the company’s profit. Either way, it is best to monitor the operations especially in the selling

of products. The company might be overspending on its marketing (selling) and human resources

(administrative) areas.

Cross-sectional: the company’s net profit margin is lower than the industry median of

1.2. It indicates that Martin Manufacturing is not in line with the industry in terms of its

expenditures with its selling and administrative expenses.

Return on Total Asset

Time-series: the

ROA of the company is

decreasing. From 1.7 on

2007, it turns down to 1.5

by 2008 and even

decreased to 1.1 by the

year 2009. Based on the

income statement and

comparative balance sheets

of the company, the decrease in ROA was due to a decrease in net profit rather than an increase

in assets. There is not much change in the assets of the company for the past two years (2008 and

2009), and therefore, the change was due to poor sales and/or big administrative and selling

expenses.

Cross-sectional: The company’s ROA of 1.1% is unfavourable as compared to the

industry average of 2.4%. It means that the company employs more asset to generate profit than

a typical firm in the industry. In addition, its earning power is less than the industry since it needs

more assets for generating earnings/profit from its operations.

Return on Common Equity

Time-series: The ROE

of the company decreases from

3.3% by 2008 to 2.6% by

2009. It was due to a decrease

in the net profit of the

company since the

stockholders’ investment

stayed the same for the

consecutive years 2008 and

2009. The firm became less

efficient in utilizing stockholders’ wealth to generate profit. In addition, the firm’s acceptance of

investment opportunities and expense management is becoming lower.

Cross-sectional: the company’s ROE is lower than the industry average of 3.2%. It is

because of the fact that it has a low total asset turnover and low net profit margin. This means

that it has a large amount of assets that generate low profit for the company. It is using more

asset than the industry to generate profit. As a result, its ROE became lower than the industry.

Recommendation:

Although the gross profit margin of the company is higher than the industry average, it is

still better if it can be increased. The strategies to increase the ratio include increasing the

marginal profit by either increasing the price or selling more than the company used to sell. It

can also increase it by having efficient production/operations.

It will help the company if it can assess its selling and administrative expenditures. Based

on the 2009 income statement, a large portion of its expenditures come from those factors. And

since the company is still selling the same amount of products for the past three years (based on

gross profit margin), it would be better off if it can maintain only a reasonable sales force and

office workers.

MARKET RATIOS

Price/Earnings Ratio

Time-series: The

P/E ratio of the company

for the past three years is

fluctuating. It has a 33.5

for 2007, 38.7 by 2008 and

34.5 by 2009. This means

that for the year 2009,

investors were paying

$34.5 for each $1 of the

company’s earnings.

Cross-sectional: Comparing the ratio to the industry average of 43.4, it can be concluded

that investors is paying far less on the earnings of the company than a typical firm in the

industry.

Market/Book Ratio

Time-series: an

increasing book value means

that investors are becoming

more favourable with the

company by paying more and

more each year for each $1

book value of the company’s

stock. It is a good indication that the investors becoming devoted with the business. In addition,

it also means that the stocks of the firm are performing well in the market.

Cross-sectional: The company has a favourable M/B ratio with the industry since I has a

higher value. This means that the company may have increased their market share in the

industry. Also, investors view the company favourably since they are paying more than the

market value of a typical firm in the industry.