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MBA 608 Financial Statement Analysis a Proposed Investment

1. As per the case, perform the necessary financial ratio analysis of the Milroy Manufacturing organization. Be sure to labor your ratios as to what the ratio is and what group of ratios (i.e. profitability, liquidity, solvency, etc.) it belongs to. Note that a Dupont analysis is one of the required ratios. 
2. Be sure to show your calculations. 
3. Ensure that your analysis includes a trend analysis of the key ratios as well as a comparison to the industry averages that are provided. 
4. In preparing the strengths and weaknesses, do not simply state that a ratio is higher or lower than the industry average but connect it to possible reasons for the variance, relevant other ratios, etc. This case is about integrating what we have learned not simply about calculating the ratio and stating the obvious. 
5. If you feel it is important, state and clarify your assumptions. 
6. At the end of the day, the question is whether you as the financial analyst would recommend buying the stock that has come available or if you would not make this recommendation. Be sure to support your answer.

Answer:

Introduction:

An investor’s main objective of investment is to earn maximum amount of profit in the short run and to maximize its wealth in the long run. The both objectives would only be achieved if an investor take decision of investment after conducting necessary due diligence on different investment proposals. In case of investment in the shares of a company it would be compulsory to assess the financial performance and financial position of such organization. In this document an honest effort has been made to provide an investor with necessary information to help him take an informed decision in relation to a proposed investment.    

The life-long friend Brian Edwards who is interested to acquire 20% stake in Milroy Manufacturing has made a proposal to David Milroy. The financial statements of the company, i.e. Milroy Manufacturing show


that the company has earned a 25% growth in sales in the year 2015 and 2016 compare to moderate industry growth rate of 10% and 12% respectively for the respective years. With the motive of earning profit in his investment and since the company does not pay cash dividend the only available option to earn profit from such invest is by selling the shares after acquiring them. Thus, the investment must be worthy to fetch such return to the investor. In order to assess the desirability of the investment Milroy Manufacturing an in-depth discussion shall be made on the financial performance and financial position of the company to recommend Mr Edwards whether it would be good idea to invest in the company or not. In order to assess the financial performance and financial position of the target company in which the proposed investment is to be made an effort has been made to calculate the profitability ratios, growth ratios, liquidity ratios, asset efficiency ratios and solvency ratios. Analysing these ratios would help us to assess the financial performance and position of the target company better. Comparison of these ratios with the industry standards would help Mr Edwards to assess the actual financial position and performance of the company to take important decision of investment in the company.

Problems: 

Profitability and asset efficiency ratios:

Years

2014

2015

2016

Net profit ratio (%)

7.35

6.12

6.384

(Net profit X 100 / Sales)

 

 

 

Industry average

7.71%

7.82%

7.96%

Growth in sales (%)

 

25

25

Industry average

 

10%

12%

Return on assets (%)

 

 

 

Total assets

1100000

1350000

2100000

Net profit plus interest  

123200

136800

204700

Return on assets (%)

11.2

10.1333

9.74762

Industry average

7.94%

8.86%

8.95%

Return on equity

15.9034

14.2017

13.982

Industry average

14.31%

15.26%

16.01%

Receivable turnover

7.05882

5.79151

5.20833

Industry average

9.02

8.86

9.31

Average collection period

51.7083

63.0233

70.08

Industry average

39.9

40.6

38.7

Inventory turnover

5.21739

5.74713

6.46552

Industry average

4.24

5.1

5.11

Total asset turnover

1.09091

1.11111

0.89286

Industry average

1.05

1.1

1.12

Liquidity ratios: 

Particulars

2014

2015

2016

Current ratio

 

 

 

Total current assets

450000

585000

710000

Total current liabilities

220400

340000

540000

Current ratio

2.04174

1.72059

1.31481

Industry average

1.96

2.25

2.4

Quick ratio

 

 

 

Total current assets less inventories

220000

324000

420000

Total current liabilities

220400

340000

540000

Quick ratio

0.99819

0.95294

0.77778

Industry average

1.37

1.41

1.38

Solvency Ratios and growth rate: 

 

2014

2015

2016

Times interest earned

 

 

 

Profit after tax plus interest

123200

136800

204700

Interests

35000

45000

85000

Times interest earned

3.52

3.04

2.40824

Industry average

6.5

5.99

6.61

Growth in EPS (%)

 

4.08163

2.94118

Industry average

 

10.10%

13.00%

Question responses:

Analysis of the company and Comparison to the Industry

Though the company has earn a better growth rate in sales of 25% in both 2015 and 2016 however compare to 10% and 12% industry growth in sales, the profitability ratios indicate that the company’s performance is below the standard of the industry performance. The industry has continuously increase its net profit ratio to reach 7.96% in the year 2016 however, the net profit ration of the company has declined over the years to reduce to 6.38% in the year 2016. Return on assets of the company in 2016 with 9.75% is certainly higher than the industry average of 8.95% however, the ratio is on decline as in 2014 it was 11.20%. Industry average on return on equity with 16.01% in 2016 is higher than the 13.98% of the company for the same period. The receivable turnover of 5.20 of the company is much worse than the industry average of 9.31 in the year 2016. The average collection period of the company in the year 2016 has increased 70.08 days from 51.81 day in the year 2014. The industry averages mere 38.7 days to collect its receivable in 2016 shows that the company has way to go to improve its collection from receivables. Inventory turnover of the company in 2016 with 6.47 times is certainly better than the industry average for the same period of 5.11 times of inventory turnover. However, the total asset turnover has reduced substantially in the year 2016 with 0.89 for the company for which the industry has an average of 1.12.

The industry average for current and quick ratio for the year 2016 2.40 and 1.38 are far better than 1.31 and 0.78 of the company for the corresponding period. Debt to total asset of the company in 2016 of 33.52% is better than the industry average of 44.10% for the same period. However, the industry average for times interest earned with 6.61 times is far better than the company’s 2.41 for the year 2016. Growth in industry EPS is 13% for the year 2016 is also far better than the growth 2.94% in EPS of the company for the year 2016.

DuPont Analysis

The DuPont Analysis takes into account the three important component of the return on equity:

  • Profit margin;
  • Total assets turnover;
  • Financial leverage;

The DuPont analysis states that a business can increase the return on equity by increasing the above three component (Vogel, 2014). Therefore, this analysis is helpful in identifying the reason for decrease in return on equity. The formula is

Return on equity= Profit margin X Total Assets turnover X Financial Leverage

DuPont Analysis

Particulars

2014

2015

2016

Profit margin

7.35%

6.12%

6.38%

Total Assets Turnover

1.09091

1.11111

0.89286

Financial Leverage

0.58601

0.5625

0.82222

Return on Equity

4.70%

3.83%

4.69%

The calculation above shows the return on equity based on the DuPont Analysis model. It can be seen that the ROE declined in 2015 from 2014 level then it further recovered in 2016. The main reason that can be identified for decline in the ROE is the decline in the profit margin.  The profit margin is mainly affected due to the huge increase in interest expenditure in the year 2016. However, in general all the expenditures have increased in the year 2016 which have affected the return on equity (Kallala et al., 2015).  

Strength and Weakness

The strengths of Milroy are as following:

  1. Growth in sales.
  2. Return on assets.
  3. Solvency position, i.e. better debt to equity ratio than the industry average.

The weaknesses of Milroy are as following:

  1. Weak profitability than the industry.
  2. Weaker liquidity position than the industry average.  
  3. Lack of growth in EPS compare to the industry average.
  4. Inefficient utilization of assets as the asset efficiency ratios of the company is not up-to the industry mark.

Recommendation: 

However, considering that the company’s growth in sales is substantially higher than the industry average both in 2015 and in 2016. In addition to continuous posting of significant profit in all the year reported along with stable liquidity and solvency position. The proposal of investment in the company will certainly be a profitable one provided the cost of such investment is properly assessed and accordingly paid.   However, it suggested that special attention should be given in maintaining higher profitability margin as it helps in improving the Return on equity.

Reference

Kallala, R. F., Vanhegan, I. S., Ibrahim, M. S., Sarmah, S., & Haddad, F. S. (2015). Financial analysis of revision knee surgery based on NHS tariffs and hospital costs. Bone Joint J, 97(2), 197-201.

Vogel, H. L. (2014). Entertainment industry economics: A guide for financial analysis. Cambridge University Press.

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