Introduction

Microchips PLC is a public listed company on the stock exchange. The company is involved in manufacturing of electronic components for sale to the audio and visual industry. The company serves as the OEM for some of the famous consumer electronics brand, such as Sony, Panasonic, Samsung and etc. In this writing, a detail analysis on the financial information of the company will be carried out. The various financial information, data and ratio of the company will be compared to another business of similar size in the same industry.

Financial Performance of Microchips PLC

Financial statement analysis seeks to evaluate management performance in several important areas, including profitability, efficiency and risk. Although we will necessarily analyze historical data, the ultimately goal of this analysis is to provide insights that will help us to project future management performance, including pro forma balance sheets, income statements, cash flows and risk. It is the firm’s expected future performance that determines whether we should lend money to a firm or invest in it (Reilly and Brown, 2003). In this section, a financial ration analysis of Microchips PLC to the industry norms as well as the similar sized competitors is performed. Table below outline all of the relevant financial information that is useful as the input to our financial ratio analysis.

Other related financial information is as follow:

Profitability

Profitability ratios are measures used to judge the profitability of a particular company. The profitability is often judged as the revenue or profit earned by the company from the income statement perspective. Revenue or sales are the lifeblood of the company. Generally, revenue growing over time is good; conversely, declining revenues may be a cause for concern (Wild, 2000; Reilly et. al., 2003). A review of the revenue trend of Microchips indicates that the sales of the company are increasing in a steady manner from 2006 to 2009. Similarly, the profit after tax and interest is increasing steadily as well. However, a review of the revenue and profit trend may not be accurate, as a review of profitability ratios is also essential to understand the true profitability picture of the company.

Return on capital. A company with a high return on capital has a much greater chance of financing growth with self-generated cash than one with a low return. For this ratio, a steady trend indicates stability, which is a good sign. This shows that management is doing an adequate job of investing and managing the reinvested profits each year (Reilly et. al., 2003). A review of the return on capital ratio for Microchips PLC is dropping from 3.40% to 2.70% from 2006 to 2007. Such a trend is negative as the company profitability ration judging from the total capital employed perspective is deteriorating. Besides, both the competitor’s and the industry’s return on capital employed ratio is higher than those of Microchips PLC. This is unfavorable to Microchips PLC. The management of Microchips PLC should try to enhance the return on capital by formulating strategy that enables the company to generate more profit from an equal amount of capital.

Return on equity. Shareholder equity, often also known as book value, is the figure we obtain when we subtract all that a company owes from all that is owns. This figure is the ultimate measure of how equity has built up over the years both from money raised and earnings retained and reinvested in the business. Due to the importance of this figure, return on equity is a very crucial and popular ratio used by analysts in determining the attractiveness of a company (Reilly et. al., 2003). The ROE figure for Microchips is fluctuating at a range of 5% from year 2006 to 2009. However, this figure is significantly lower than the competitors’ ROE of 7.5% and the industry average of 10%. This indicates that the profitability of the firm from ROE perspective is unsatisfactory. Apparently, the firm is having among the lowest ROE in the industry. This means that it is likely that the firm management is less effective and competitive if compared to the other management in the industry.

Return on sales (gross profit margin & net profit margin). The steadier the gross profit margin, the better the business. If a company can grow its profit margins over time, every new dollar of goods sold has a leveraged impact on sales. On the other hand, a falling margin could indicate bloated overhead and careless management, or cutthroat competition, something we should avoid as investors (Reilly et. al., 2003). It is observed that there is a trend of declining gross profit margin for the firm from year 2006 to 2009. One of the possible reasons for such a trend is due to the increasingly competitive business environment, in which the various industry players are dropping their price in order to secure market share in the marketplace. Another possible reason is that the company is not controlling the expenses well, thereby hurting the profit margin of the firm.

Liquidity

One of the most important aspects of the balance sheet is liquidity. Liquidity is the amount of cash the company can lay its hands on in the short term. Liquidity provides the flexibility to withstand down cycles in the economy, pay dividends to shareholders, buy back share, and take advantage of future opportunities. Liquidity and interest coverage ratios are of great importance in evaluating the riskiness of a firm’s securities. They aid in assessing the financial strength of the firm. Ideally, we want to ensure that a company is not overly burdened with debt, and that there is enough capital to stay in business during bad times (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003).

Current ratio. This ratio reveals a company’s ability to pay its short term obligations. A rough rule of thumb is a ratio of two to one, that is, the company has twice the amount of liquid assets as it has short term debts and obligations. However, it is also noted that various industries may have different optimal current ratio. When compared against the industry average; a lower ratio may indicate possible liquidity problems. Generally, if a current ratio is steadily declining year over year, this could indicate a serious liquidity problem is developing (Anthony, Hawkins & Merchant, 1999). A comparison of the current ratio of Microchips to the competitor as well as the industry average indicates that the company has better liquidity position in the industry. With better current ratio, the industry is less likely to be suffering from liquidity issues.

Quick ratio. A variation of the current ratio, known as the quick ratio, removes inventory from the calculation. The logic behind is, although inventory can usually be converted to cash, it may be impossible for the company to receive full value for inventory if it is subject to fire sale. This is also called the acid test ratio and gives a clear view of a company’s cash position versus its bills. Furthermore, a rising inventories may indicate a product that has decreased in popularity and will be difficult to sell at a profit (Reilly et. al., 2003). A review of the quick ratio indicates that the liquidity position of Microchips is deteriorating seriously from year 2006 to 2009. In the recent years, the quick ratio of Microchips even becomes worse than the competitors as well as the industry average. A review of both the current ratio as well as the quick ratio indicates that Microchips is actually building up inventory over the years. This can be a bad news, as it implies that the goods are becoming less sellable in the marketplace.

Cash ratio. Cash ratio is an even more stringent measure of liquidity. However, the basic concepts behind the ratio are essentially the same as the current ratio stated above. However, there is no information concerning cash ratio for Microchips is provided.

Working capital. It is also helpful to examine the relationship of current assets and current liabilities in cash term. We get working capital figure by subtracting current liabilities from the current assets. Generally, the more working capital is better (for conservative value investors). It is crucial to monitor is this figure is increasing or decreasing over the years (Anthony, Hawkins & Merchant, 1999). A study of the working capital turnover ratio of Microchips indicates that the figure is deteriorating in the recent years. Not only that, the working capital turnover of the firm is also less competitive if compared to the competitor’s or to the industry average.

Efficiency

Asset utilization ratios are useful in helping us to understand a firm’s ratio of sales to assets to compute comparable efficiency-of-utilization, or turnover, ratio.

Total asset turnover ratio. The total asset turnover ratio indicates the effectiveness of the firm’s use of its total asset base. It is essential for us to compare this ratio to the other firms in an industry because this particular ratio varies substantially between industries. For this, we should consider a range of turnover values consistent with the industry. It is poor management to have an exceedingly high asset turnover relative to the industry average because this might imply too few assets for the potential business (sales), or it could be due to use of outdated, fully depreciated assets. It is equal poor management to have a low relative asset turnover because this implies tying up capital in an excess of assets relative to the needs of the firm (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003). The figure of stock turnover (in days) as well as stock turnover ratio of Microchips is not in a good shape if compared to the competitor’s or the industry average. Firstly, the stock turnover for the firm is higher than the competitor and the industry average. This means that the selling of inventory is slower in the firm. Apart from tat, the stock turnover ratio Microchips is also lower than the competitors and the industry average.

Cash Operating Cycle. Cash operating cycle is really about how long the cash is required to convert back to the company. The shorter the days are required for a cash operating cycle, the better it is. The cash operating cycle of Microchips is too long if compared to the competitor’s or to the industry average. Not only that, the trend of cash operating cycle for Microchips is in fact worsen along the year of 2006 to 2009. This indicates that more cash is actually stuck in the value delivery process of Microchips to the customers.

Investment-Related Ratio

Market price ratios are often used by investors to judge the attractiveness of a company value relative to the market price. Several investment-related ratios for the company is discussed in the following paragraphs.

Price to earnings ratio. Price to earnings ratio is among the most popular market based measured used to determine the attractiveness of a company by shareholders. Comparing two companies with same business prospect and of equal financial conditions, the company with the lower P/E ratio is considered cheaper and undervalued. However, in reality, this simple comparison is often not available in the stock market. Often, stocks with lower P/E ratio indicate that the investment fraternity has low expectation on the company prospects compared to the companies selling for higher P/E (Reilly et. al., 2003).A review of the Microchips indicate that the company is having a higher and higher P/E ratio in the recent years. In fact, the P/E ratio is higher than the competitor’s. This is somewhat surprising as the financial condition of the firm is actually less favorable than of the competitor’s (as we have discussed extensively in the above section). Purely from a comparative ratio analysis, the competitor’s stock is a better stock for long term investors.

Dividend yields. Dividend yield is calculated as the total dividend distributed to shareholders relative to the pricing of the stock in the stock market (Anthony, Hawkins & Merchant, 1999). It is generally widely agreed that company that pays higher dividend is a less risky investment if compared to other stocks that pay zero dividend. The dividend yield of Microchips is decreasing from year 2006 to 2009. It is pretty obvious that the fundamentals of the company are deteriorating and thus, the management is forced to declare lesser and lesser dividend in the recent years. Another possible reason is that as the share prices of the company are increasing, the dividend yield of Microchips is decreasing to reflect higher share prices. Compared to the competitor’s dividend yield, the dividend yield of the competitors seems more attractive for any conservative investor. Although the dividend yield of the company is decreasing, it is still much higher than the average dividend yield of the industry.

Gearing & Leverage Ratios

Leverage ratio means the measure of debt to total capitalization of a firm. Comparing the leverage ratios of a company with others in the same industry indicates its competitive position and its ability to ride out adverse economic times. Often, a moderate leverage is a good indicator of a company’s stamina, its ability to survive when the going gets tough (Anthony, Hawkins & Merchant, 1999; Wild, 2000; Reilly et. al., 2003).

Gearing ratio. The gearing ratio is calculated as the ratio of long term debt to total capital employed. A review of the gearing ratio of Microchips indicate that the firm is becoming a highly leveraged company in the recent years – as the company employ higher and higher proportion of long term debt in the recent years. Currently, the gearing ratio of the firm is much higher than that of the competitors as well as the industry average.

Interest coverage ratio. Interest coverage is another leverage ratio used to judge the earning capability of a firm relative to the interest charges the firm is obligated to pay. Generally, the lower the interest coverage ratio; the higher the degree of leverage for a company. The interest cover ratio analysis for Microchips indicates similar information about the company as being depicted by gearing ratio. In short, Microchips is becoming a more risky company, as the usage of debt is increasing and the interest payment is becoming higher and higher in the recent years.

Conclusion

Overall, the profitability of Microchips is decreasing. The company is using more and more debt, but the return on the debt used is not justified. The company is becoming a highly leveraged firm, and insolvency may occur when the financial crisis hit the industry. Several efficiency ratios also indicate that the company is not effective and efficient in using its assets. It is reasonable for us to conclude that the company is facing some critical problems in the recent years. However, the stock of the company still command a high pricing, as measured by the P/E ratio in the marketplace. Investors should sell the company’s stock and buy the competitor’s stock instead.

The Use of Financial Ratio in Assessing a Company

Generally speaking, there are five categories of financial ratios widely used by investors or businesses to analyze the financial position of a company. The five categories of financial ratio are: profitability ratio, efficiency ratio, liquidity ratio, financial gearing ratio, and investment-related ratio. There are mainly three ways the ratios can be used to analyze a business or firm. Firstly, the ratios can be compared to historical ratios of a company. This is useful to understand if the financial position of a company has improved or not in the recent years. Secondly, the ratios can be compared to the other similar businesses in the industry. This enables the analysts to understand which firm in a similar industry is better in managing its financial position. Thirdly, the ratios can also be used to compare with the other planned performance. This will enable the management of a company to investigate if the gals or targets set by the management in earlier planning stage is being achieved by the operation teams. Nonetheless, financial ratios analyses do have its respective limitations. Among the limitations are:

1. It is highly dependent on the quality of the financial statement presented by management.
2. It does not consider the impacts due to inflation.
3. It is only relevant as a basis for comparison.
4. Off-balance sheet items may not be reflected in the analysis.
5. Other important quality of a company, such as the competency of the management is not directly being revealed under financial ratio analysis.

Other Information Useful in Assessing Possible Failure of a Corporation

Besides, financial ratio analysis, there are also some other methods that can be used to advice on probable corporate failure. They are:

Other information in the published accounts. Some data in the published accounts might not be relevant under ratio analysis, but can still be an indicator of financial difficulties. Some of the popular examples are: (a) very gigantic increases in intangible fixed assets; (b) a worsening cash plus cash equivalents position in the cash flow statement; (c) huge amount of contingent liabilities; and (d) important post balance sheet events.

Information in the chairman’s report and the directors’ report. The report of the chairman or CEO of a firm in Annual Report can be very revealing. Such a report is likely to try to paint a rosy picture of the company’s affairs; any difficulties the company has had and not yet overcome will probably be discussed in it. There might also be warnings of issues expected to happen in the future.

Published information in the press. Newspapers and financial journals are a source of information about firms, and the troubles or successes they are having. There may be reports of employees’ related issues, redundancies and factories closures. It is very common that there are often articles in newspaper which focus on particular companies. If a company is in financial distresses, adverse comments might appear in the mass media.

References and Bibliography

Robert N Anthony, David F Hawkins and Kenneth A Merchant (1999). Accounting: Text and Cases, 10^th international edition, McGraw-Hill.

John J. Wild (2000). Financial Accounting-Information for decision, McGraw-Hill

Weygandt, J., Kiero, D., and Kimmel, P. (1998). Financial Accounting, 3/e, John Wiley

Meigs, R., Williams, J., Haka, S. and Bettner, M. (1999). Accounting: The Basis For Business Decisions, 11/e, McGraw-Hill

Warren, C. S., Reeve, J. M., and Fess, P. E. (1999). Accounting, 19/e, International Thomas Publishing

Skousen, K., Albricht, W., Stice, J. Stice, E. and Swain, M. (1998). Accounting: Concepts and Applications, 7/e, International Thomson Publishing

Horngen, H. and Izan, B. F. (1997). Accounting, 2/e, Prentice Hall.

Reilly, F. K. and Brown, K. C. (2003). Investment Analysis and Portfolio Management (7^th edition). International Thomson Publishing.