Case Study: Tech Ltd
In deciding whether Tech Ltd is a company that we would buy, we evaluated the profitability, liquidity, efficiency, financial leverage and market ratios of the company. Profitability
The profitability ratios of Tech Ltd tells the story of an improving company with healthy profitability. The gross margin has been fairly steady at a return of around 16% for the past 2 years, and the net margin is showing that the business has become more efficient at generating profits from sales, increasing from 4.8% in 20x3 to 5.4% in 20x4, showing an increase of 15%. Assets are being used more efficiently in the generation of profits, having increased by 18% in 20x4 meaning that they are now being utilised at their most efficient rate in the past 4 years. This efficient use of assets and increase in the net profit margin come through strongly when looking at the return on equity, which has increased by 24%, which is a very good sign showing an increase in value of the business. Liquidity
The current ratio has been declining over the years, although it has not experienced a dramatic decline. The ratio of 1.7 in 20x4, is telling us that the company would be able to pay off short term liabilities with their short term (current) assets. However, the acid test ratio of 0.7 shows that the company ‘s current assets, excluding inventory, cannot cover current liabilities.
The efficiency of Tech Ltd in producing, selling as well as making and receiving payments has shown improvements over time. Both the fixed and total asset turnovers have been relatively constant over the past 4 years, with the total asset turnover increasing gradually every year. This shows us that the rate at which new assets have been purchased has not had an adverse effect in the ability to generate sales from fixed assets, and the number of days that this stock is kept on hand has been decreasing over the last 3 years which is a good sign, following the inventory build-up that was seen in 20x1 and 20x2. In line with this increase in sales, the payment of creditors and receipt of payments from debtors is being well managed in that the credit settlement period has increased and the debtor collection period has decreased. This in turn creates a more efficient cash flow management Financial leverage
The debt ratio has slowly been increasing, evidence of the financial leverage that is taking place, which is seen in the increase of both long term interest bearing liabilities and current liabilities. Through this gearing, the net profit has increased steadily to the high of 20x4, which was 46% up from 20x3. Although the increase in assets is creating a desired profit effect, due to this leverage, the financing costs from borrowing have been rising at a rate of at least 50% p.a. for the past 3 years. Interest cover at 5.4 in 20x4 does however mean that there is no threat of Tech Ltd not being able to meet interest payments. Market
Investors in the market are seeing a decrease in the dividends received in relation to the price paid for the shares, making the shares less attractive to dividend seeking investors every year since 20x1. The earnings yield is increasing, showing that the market is considering this a riskier investment year on year, with the P/E ratio showing that the market does not value this share. Conclusion: Would we buy this company?
The profitability ratios, return on equity for example, are telling us that this is a profitable company. The market is not completely pricing in the company’s potential to generate profit, and might be over-factoring in the risk of debt that has been taken on and the possible liquidity issues, meaning that the share price could be undervalued at this point in time, indicated by the low PE ratio of 5.9. The liquidity of the business is a concern, but the ability of the business to generate a high return on equity, due to the leveraging which has resulted in an increase in...
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