Profitability ratios and working capital management
A company should earn profits to survive and grow over a long period of time. Profits are the ultimate output of a firm, and it will have no future if it fails to make sufficient profits. Besides management, creditors and investors are also interested in the profitability of the company. Several profitability ratios will be discussed in relation to the operational efficiency of Intel Corporation and IBM (International Business Machines).
The first profitability ratio in relation to sales is the gross profit margin (or simply the gross margin), which is calculated by dividing the gross profit by sales. The gross margin reflects the efficiency with which management produces each unit of its products. The ratio also indicates the average spread between the cost of goods sold and the sales revenues. As seen from the above table, Intel Corp. has a higher gross margin than IBM. The higher gross margin ratio relative to the industry average, or in this case, Intel’s higher gross margin in comparison with IBM could imply that Intel is able to produce at a relatively cheap cost. The rising gross margins for both companies could indicate a combination of variations in sales prices and production costs, with the margin widening.
- Gross profit margin:grossprofit/sales
- Net profit margin:netearningsafter taxes/sales
- Operating ratio: costof goodssold + operating expenses/sales
The net profit margin ratio is computed by dividing net earnings after taxes by the sales figure. The ratio indicates management’s efficiency in manufacturing, administering, and selling products. The net profit margin generally measures a company’s ability to turn each unit of dollar sales into net earnings. Both Intel and IBM have reasonably healthy net profit margins, meaning that the firms will be able to achieve satisfactory returns on owner’s equity. The high net profit margins will protect the firms in case of a harsh economic environment, and they indicate high earning power for the two firms.
A more detailed analysis reveals that Intel’s net profit margin has been declining, implying that the operating expenses relative to sales have been increasing. IBM, the firm with the higher net margin ratio, has a better capacity to withstand adverse economic conditions characterized by falling sales prices, rising costs of production, or declining demand in the market. Similarly, IBM may take better use of favorable economic conditions such as rising sales prices, falling costs of production, or increasing demand in the market for its products. Therefore, IBM will be able to accelerate its profits at a higher rate than Intel due to the former’s higher profit margin.
The profitability of a firm can also be measured in relation to investment. (Sottini, 96) notes “the return on assets (ROA) is determined by dividing net profit after taxes by the company’s total assets.” This ratio sounds conceptually unsound as it excludes interest charges from the net profit figure. The total assets have been financed by the pool of funds supplied by creditors and shareholders of the company. To know how well the pool of funds has been used, the return can be compared with the cost of using the cost of funds. Since net profit after taxes in the numerator excludes interest charges, resulting in an understatement of the earnings generated by the pool of funds, the interest charges should be included in the net profit after taxes.
Return on assets: net profitafter taxes + interest/totalassets
Intel (2009): 4.369m + 163m/53.095m = 0.08535 or 8.535%
IBM (2009): 13.425m + 402m/109.022m= 0.1268 or 12.68%
From the above, IBM has a higher return on assets (ROA), which means that the company’s assets bring in more profits than those of Intel. The return on assets is a useful measure of the profitability of all financial resources invested in the firm’s assets and evaluates the use of total funds without regard to the sources of the funds. From the ROA figure, IBM has invested $7.88 in its assets for every $1 of profit while Intel has invested $11.71 in its assets to produce the same amount of profit.
The return on capital employed (ROCE) measures how well management has used the funds supplied by creditors and owners. The higher the ratio, the more efficient the firm is using funds entrusted to it. IBM has a higher ROCE than Intel, meaning that the company has relatively more operating efficiency.
Return on capital employed (ROCE) = earning before interest ∧taxes/totalassests-current liabilities
Intel (2009) ROCE: 5.867m/53.095m – 7.591m = 0.1289 or 12.89%
IBM (2009) ROCE:18.540m/109.022m – 36.002m = 0.2539 or 25.39%
The operating ratio helps in explaining changes in the net profit margin ratio. The operating ratio is calculated by proportioning all overhead costs; cost of sales, marketing expenditures, general and administrative expenditures against the firm’s incomes. The result indicates the percentage of sales that have been consumed by the cost of goods sold and operating expenses, while the remaining percentage (100 percent minus the operating ratio percent) shows the amount that has been left to cover interest, income taxes, dividends, and the company’s needs to retain earnings for expansion strategies.
Working capital can also be used as a measure of liquidity working capital is attained by deducting current liabilities from the current assets. It is considered that, between two firms, the one having the larger amount of working capital has a greater ability to meet its current obligations. This is not necessarily the case since the measure of liquidity is the relationship, rather than the difference between current assets and current liabilities. Therefore, it is the current ratio or the quick ratio which are better indicators of the firm’s liquidity than the amount of working capital.
Chandra (63) notes “the total assets turnover is measured by dividing total turnover (sales) by the total assets of the firm, indicating how efficiently the company’s assets are being utilized in the generation of sales.” The total assets turnover ratio is a significant ratio since it shows the firm’s ability to generate sales from all the financial resources committed to the firm. As the ratio increases, the more the revenue generated per dollar of total investments in assets.
Asset turnover ratio=total turnover/total assets
For Intel, the total asset turnover in 2008 and 2009 are given as:
2008:37.586m/50.472m = 0.74
2009:35.127m/53.095m = 0.66
For IBM, the total asset turnover ratios for the two years are given as:
2008: 58.892m/109.524m = 0.54
2009: 55.128m/109.022m = 0.51
From the above calculations, Intel has a higher ability to produce a large volume of sales from its assets, thereby allowing the firm to save on maintenance costs of idle or improperly used assets. The total assets turnover should be cautiously interpreted. In the denominator of the ratio, assets are the net of depreciation. Hence, older assets that are still in use with a low book value may create a misleading impression of a high asset turnover. More detailed analysis as to the composition of assets would be necessary in order to provide for a more comprehensive analysis.
Liquidity analysis
Liquidity ratios determine the capability of the firm to cover its current and upcoming financial commitments. Cash flow statements help illustrate the liquidity of a firm, but liquidity ratios, by establishing a relationship between cash and other current assets to current obligations, provide a quick measure of liquidity or solvency position of the firm. Efficient firms try to strike a proper balance in their cash positions by ensuring that they do not suffer from a lack of liquidity and that they are not highly liquid.
Current ratio=current assests/current liabilities
Intel current ratio:
- 2008:19.871m/7.818m = 2.542
- 2009:21.157m/7.591m = 2.787
IBM current ratio:
- 2008:49.004m/42.435m = 1.1155
- 2009:48.935m/36.002m = 1.359
The current ratio is calculated by dividing a firm’s current assets by its current liabilities (Sottini, 26). From their financial statements, Intel’s current ratios for 2009 and 2008 are 2.787 and 2.542 respectively while IBM’s current ratios are 1.359 and 1.155 for years 2009 and 2008 respectively. Whereas a current ratio of 2-to-1 is considered satisfactory, a high ratio could indicate idle assets. Since the two firms are in the same industry, an analyst could conclude that Intel is more liquid than the two since it has a higher margin of safety, but IBM could be doing better than Intel since it is utilizing its assets at a better rate.
Further analysis through the quick ratio could indicate the quality of the assets of both firms. The quick ratio is calculated in the same manner as the current ratio, but only quick or liquid assets are considered in place of total current assets. One would have to deduct inventories, prepaid expenses, and deferred assets from the current assets figure since they cannot be easily converted into cash with year.
Gearing ratios and capital structure
Liquidity ratios, as discussed in the previous section, are calculated to indicate the current financial position of a company. To judge the long-term financial position of the firm, leverage or capital structure ratios are calculated (Shim and Siegel, 101). Capital structure ratios measure funds provided by creditors and owners of the company. The debt-equity ratio is the measure of the relative claims of creditors and owners against a firm’s assets. (Brigham and Erhardt, 39) notes “the debt ratio is calculated by dividing a company’s total debt by its total assets, whereby both current and noncurrent liabilities are used.” The debt-equity ratio can be determined by dividing total long-term debt by the shareholders’ equity. “Long term debt can be obtained by subtracting current liabilities from the company’s total liabilities.” (Chandra 89)
Debt-equity ratio=totallong termdebt/shareholders equity
Intel (2009) =2.049m+555m+1.003m+193m/41.704m = 0.091
IBM (2009) = 86.267m – 36.002m/22.637m = 2.22
From their 2009 financial statements, Intel has a debt-equity ratio of 0.091 to 1, while IBM has a debt-equity ratio of 2.22 to 1. This implies that for each equity dollar invested, Intel has raised 0.091 dollars in long-term debt while IBM has raised 2.22 dollars, or that IBM’s long-term debt is 222 percent of equity. IBM’s high ratio indicates that the claims of creditors are greater than those of owners. A high ratio is unfavorable from the firm’s point of view as it introduces inflexibility in the company’s operations due to increasing interference and pressures from creditors. A major advantage that IBM investors may experience is the high earnings per share (EPS) resulting from high leverage especially if the company has satisfactory profits. A low ratio, as is the case with Intel, can worry shareholders as the company is not using debt to its best advantage.
Investment ratios
Investment ratios are used to measure the profitableness of shareholders’ investments. One investment ratio is the earnings per share (EPS); it is measured by proportioning the total earnings after taxes minus preference dividends against the total outstanding shares. EPS calculations made over years indicate whether or not the firm’s earning power on a per-share basis has changed over that period (Frisdon and Alvarez, 61). Both companies have provided their multi-year earnings per share, as well as diluted EPS. Diluted EPS signifies a situation whereby outstanding shares increase as a result of certain events, such as a preference shareholder converting all his preference shares into common stock, employees of the company exercising their stock options (Maguire, 28).
Intel Corp. has $0.79 and 0.93 basic EPS for years 2009 and 2008 respectively, while if diluted, EPS stands at 0.77 and 0.92 for the two years. IBM has a basic EPS of $10.12 and 9.02 for years 2009 and 2008 respectively and diluted earnings per share of $10.01 and 8.89 for the two years respectively. Intel’s EPS has reduced in the period in focus, signifying a drop in profits as the company has not split or offered more shares in the market. IBM, on the other hand, has increased its EPS as a result of higher profits.
For the two companies, IBM has a higher variance between diluted EPS and basic EPS, meaning that Intel shareholders are more likely to get a share of the company’s earnings than IBM investors. A high variance between the basic earnings per share and diluted earnings per share means that there is a higher risk of dilution of the outstanding shares, thus reducing the share of profits available for each shareholder.
The price-earnings ratio, or P/E ratio, is the reciprocal of the earnings yield or the earnings yield ratio. The P/E ratio can be therefore be calculated by dividing the market value per share figure of a company by its EPS (Sharpe et al., 524). The price-earnings ratio is widely used by security analysts to evaluate the firm’s performance as expected by investors. The P/E ratio indicates investors’ judgment or expectations about the company’s overall performance.
Management is also interested in this market appraisal of their company’s performance and would like to find out the causes of a decline in the price-earnings ratio. The surge in P/E ratios for both companies indicates that investors are upbeat about their performance, with Intel investors particularly optimistic about the company’s future performance. This means that Intel investors have a higher expectation about the growth in the firm’s earnings since both companies lie within the same industry.
The net profits after taxes belong to a company’s shareholders; although the income that they receive is the number of earnings distributed and paid in form of cash dividends. Therefore, there is a large class of present and potential investors are more interested in the dividend per share, rather than the earnings per share, such as pension and insurance firms. The dividend per share (DPS) is the earnings paid to individual equity holders for each share held.
Companies will usually provide the dividends per share figure in their financial statements (Chandra, 57). IBM has dividend per share of 1.9 in 2008, and 2.15 DPS in 2009. On the other hand, Intel has a lower DPS of 0.5475 and 0.56 in the years 2008 and 2009 respectively. The rise in dividends per share for IBM represents a 13.16 percent increase, while Intel’s corresponds to a 2.23 percent increase. Investors who are more focused on dividends would therefore opt for IBM shares as they promise higher dividends.
The dividend yield is the dividends per share divided by the market value per share and signifies the shareholders’ return about the market value per share. The information on the market value per share is generally not available from the financial statements and has to be collected from external sources such as the stock exchange (prices used were derived from the MSN money website). IBM has a dividend yield of 1.31 percent ($2.15/$164.82) while Intel’s dividend yield is 2.58 percent ($0.56/$21.69). Although IBM has a higher dividend, IBM has a better dividend yield because of its relatively cheap share price.
Chandra (45) notes” the dividend cover measures the ability of a firm to pay dividends from its profits.” The ratio is determined by dividing the net profit available to shareholders by the number of dividends paid out by the firm in the course of the year. “The dividend cover can also be measured by dividing the earnings per share by the dividends per share. The higher the dividend cover, the greater a company’s ability to sustain dividends in the event that profits decline.” (Brigham and Ehrhardt 66).
From the table above, it can be held that IBM has a healthy dividend cover, implying that it can distribute up to 4 times the amount of dividends from the company’s profits. Intel has a lower dividend cover, meaning that shareholders have a higher risk of being impacted by a shortfall in profits. The high dividend cover could explain why IBM can increase dividends per share by 13.61 percent. The implication of this to investors is that they would be safer investing in IBM shares in order to protect their dividends. In case of a downturn in the economy, Intel may be forced to dig into its retained earnings if the company wants to maintain issuing dividends. Dividends may also contain a signaling effect; hence investors and analysts may translate the hike in IBM dividends means that the company expects better future prospects.
Problems of relying only on public financial information
Publicly-traded companies are required by state laws to publish annual and quarterly financial information in accordance with the established accounting principles. While this is the case, investors should be wary of relying solely on published financial statements. Although companies may comply with government regulations and release true and fair financial statements, managers may opt to disclose that information which will portray their company in a positive way. Managers may also take advantage of other legal methods that will inflate earnings, such as setting high depreciation rates for their assets in their books of accounting. Disposal of an asset could be included in revenues figures, thereby overstating revenues from operating activities.
References
Brigham, Eugene and Ehrhardt Michael. Financial management: theory and practice. New York: Cengage Learning, 2008. Print.
Chandra, Prasanna. Financial Management. 7th ed. New Delhi: Tata McGraw-Hill, 2008. Print.
Frisdon, Martin and Fernando Alvarez. Financial statement analysis: a practitioner’s guide. New Jersey: John Wiley and Sons, 2002. Print.
IBM (NYSE: IBM). Financial statements. NYSE. 2009. Web.
Intel Corp (NASDAQ: INTC). Financial statements. NASDAQ. 2009. Web.
Maguire, Marion. Financial Statement Analysis. New York: GRIN Verlag, 2007. Print. msn money. Investing. Moneycentral. 2011. Web.
Sharpe, William F., Alexander, Gordon J. and Jeffery V. Bailey. Investments. 6th ed. New Jersey: Prentice-Hall, 2008. Print.
Shim, Jae and Siegel Joel. Financial Management. New York: Barron’s Educational Series, 2008. Print.
Sottini, Maxime. It Financial Management. Zaltbommel, Netherlands: Van Haren Publishing, 2009. Print.