Leverage Ratios Analysis - Case Study Example

Liquidity ratio analysis a. Current ratio 2005 2006 % of change Current Assets $45,661 $44,660 Current liabilities 35,152 40,091 Current ratio 299 1.114 -14.2417 b. Acid test ratio 2005 2006 % of change Current assets $45,661 $44,660 Inventory 2,841 2,810 Prepaid expenses 2,941 2,539 Ratio 1.134 0.981 -13.4920 There significant decrease in current ratio of 14.242 in 2006 due to the decrease in cash and significant increase in liability. These changes can be attributed mainly to the implementation of “The Pension Protection Act of 2006 (the Act) was enacted into law in 2006”(IBM 2006) where IBM has to meet its contractual obligations. In addition, its current assets decreased by $1,001 million ($45,661 - $44,660 million) due to “Decline of $3,030 million, net of a favorable $202 million currency impact, in Cash and cash equivalents and Marketable Securities due to current-year requirements in pension funding, share repurchase, dividend payments, tax payments, acquisitions and capital spending”(IBM, 2006). There was also an inverse increase in current liability of $4,939 ($40,091 - $35,152 million) which adversely affected the company’s liquidity ratio. This decline also reflected in acid test ratio or the ability to settle obligation immediately as it also declined by 13.492. 2. Leverage ratios analysis a. Debt to-total-assets ratio (Total liabilities/total assets) 2005 2006 % of change Total debt $22,682 $22,641 Total assets 105,748 103,234 Ratio .687 .724 5.386 b. Debt-to-equity ratio 2005 2006 % of change Total debt $22,682 $22,641 Total equity 28,506 33,098 Ratio 2.195 2.621 19.40 c. Long-term debt-to-equity ratio 2005 2006 % of change Long-term debt 15,425 $13,780 Total equity 28,506 33,098 Ratio .466 .483 3.648 d. Times-interest-earned ratio   2005 2006 % of change Income from continuing operations before tax 12,996 13,317 Net interest expense 220 278 Ratio 59.07 47.90 -.18 The decline in current assets and increase in liability however did not affect leverage ratios because total assets still managed to increase by $2,514 million ($105,748 - $103,234 million) because it generated net cash from operations in 2006 “excluding a year-to-year change in Global Financing receivables, of $15.3 billion — an increase of $2.2 billion” (IBM, 2006). Changes in liability decreased minimally but still, the increase in total assets helped drive debt to asset ratio up by 5.386 %. Since debt was almost constant in 2006, debt to equity ratio significantly went up when IBM registered a profit in the previous year, where portions of the net gain were retained as equity. 3. Activity ratio analysis a. Inventory turnover 2005 2006 % of change Net Sales 91,134 91,424 Inventory 2841 2840 Ratio 32.07 32.53 .01 b. Fixed assets turnover 2005 2006 % of change Net Sales 91,340 91,424 Net fixed assets 60,087 58,574 Ratio 1.517 1.561 2.900 c. Total assets turnover 2005 2006 % of change Net Sales $91,340 $91,424 Total Assets 105,748 103,234 Ratio .862 .886 2.784 d. Average collection period Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days (IBM, 2006 pg. 79). With regard to activity ratios, IBM did a good job of maintaining its level of inventory to 2841-2840 million despite the increase in sales in 2006 ($91,424 million). It only meant that IBM has a very good internal control and monitoring of its inventory. In sum, the activity ratio of IBM increased by 2.784 % which can be mainly attributed to its ability to maintain its inventory despite the increase in sales. With regard to collection period, IBM adopts “Payment terms for inventory and accounts receivable financing generally range from 30 to 90 days” (IBM, 2006 pg. 79). 4. Profitability ratio analysis a. Gross profit margin 2005 2006 % of change Gross profit margin 36,532 38,295 Net Sales 91,134 91,424 Ratio .401 .419 4.488 b. Operating profit margin Operating profit margin 0.134 0.146 0.012 8.95522388% c. Net profit margin ratio 2005 2006 % of change Net profit after tax 79,940 94,920 Net Sales 91,340 91,424 Ratio 0.087 0.104 19.54 d. Return on assets 2005 2006 % of change Net profit after tax 79,940 94,920 Total Assets 105,748 103,234 Return on assets .76 .92 21.05 e. Return on shareholders' equity 2005 2006 % of change Net profit after tax 7,994 9,492 18.739 Shareholder’s equity 33,098 28,506 Ratio 0.24 0.33 37.50 f. Earnings per share (EPS) 2005 2006 % of change Net profit after tax 7,994 9,492 Number of outstanding shares 157,300 150,600 Ratio 5.08 6.30 24.01 a. Price-earnings ratio 2005 2006 % of change Earnings per share 6.20 4.96 20 % Profitability ratio improved by 4.488% in gross profit margin while operating margin improved to 8.955% which were achieved primarily “by remixing our business to higher-value segments and by driving efficiency through global integration”(IBM, 2006). The consolidation of its operation resulted in net efficiency which improved its profitability ratio indicating the efficacy of its management and yielded a 19.54 % increase in net profit margin. The increase in profitability ratios that was a result of its global integration also reflected on its return on assets where IBM generated an additional profit (net after tax) of $14,980 ($94,920-79,940) with a reduced resources as the assets used to realized the additional profit was reduced by $2,514 (105,748-103,234). In effect, the net income after tax was really $17,494 after considering the savings in the use of assets to realize the additional profit. The consolidation of its operation through its global integration proved to be working well as indicated by the return on asset ratio. Thus, this efficiency reflected on a net profit increase of 18.739% after tax. It is important in the return on shareholder’s equity ratio is its significnat increase of 37.50 percent compared to previous year which is attributed to decreased number of shareholders and incresed operational efficiency. The number of shareholder’s equity decreased due to the “$8.1 billion share repurchase and $1.7 billion through dividends”(IBM, 2006). This explains the significant 37.50 % increase in shareholders equity as there were few shareholders in 2006 compared to 2005. The number of shareholders decreased by 4,592 million (33,098-28,506 million). This decreased in the number of shareholders reflected in the earnings or dividends per shareholder which increased significantly by 24.01 %. Consequently, price -earnings ratio (P/E), the ratio which is often used as a measure of value of the company also improved by 20% (lower or negative ratio meant improvement) as a result of the company’s general efficiency that made it profitable yielding more dividends and value both to the company its shareholders. 5. Comparative industry analysis Ratio IBM (2006) HP Microsoft Average Current ratio 1.114 1.377 2.183 1.558 Quick ratio 0.981 1.159 2.118 1.41933 Debt to total assets ratio 0.724 0.519 0.424 0.55567 Debt to equity ratio 2.621 1.08 0.735 1.47867 Long term debt to equity ratio 0.483 0.091 0.044 0.206 Times interest earned 46.903 - - 46.903 Inventory turnover 18.803 0.95 7.77 9.17433 Fixed assets turnover 1.561 2.551 2.151 2.08767 Total assets turnover 0.886 1.121 0.636 0.881 Accounts receivables turnover - - - #DIV/0! Average collection period - - - #DIV/0! Gross profit margin 41.9% 23.29% 82.7% 49.297% Operating profit margin 14.6% 4.023% 37.2% 18.608% Net profit margin 10.4% 2.77% 28.4% 13.857% Return on assets 20.65% 7.31% 38.7% 22.22% Return on share holder’s equity 45.74% 9.02% 45.5% 33.42% Earnings per share 6.06 0.82 1.20 2.69 Price earnings ratio - - - #DIV/0! Sales 91424 86325 44282 74010.3 Net income 9492 2398 12599 8163 Dividends per share 4.96 dollars - 0.35 2.655 Comparing IBM’s ability to settle its short term obligation to other companies (Microsoft and HP) in the industry, IBM’s figures suggest a weakness because it is the poorest in the industry. Its current ratio and quick ratio of 1.114 and 0.981 respectively whcih were almost half with the Microsoft. From a creditor’s point of view, IBM does not look good especially with its high debt to total assets ratio and debt to equity ratio of 0.724 and 2.621 which indicates that they owe a lot compared to their assets and existing capital. Moreso, when they have worst figure in the industry. IBM’s strength however lies in its internal control as manifested with its high turnover rate. It meant that they incur the least opportunity cost because theiy have the fastest inventory turnover in the industry at 18.803 which is more than twice compared to Microsoft and 1,700% faster compared to HP. With regard to profitability, IBM may have performed significantly better than 2005 with an increase of 41.9 % but it is only considered average in the industry with Microsoft registering an 82.7 % gross profit margin. This would translate to net profit which IBM is expected to perform average in the industry at 10.4%. The global integration of IBM may have significantly improved its efficiency in terms of assets use as indicated on return on assets ratio, but this is still considered average in the industry with Microsoft again having an ROA of 38.7%. Dividend payment to shareholders looks very pretty with IBM registering the highest in the industry despite being average on profit margin. There is a caveat to it however because IBM spent $8.1 billion to buy back its shares of stocks which declined by 4,592 million shares (33,098-28,506 million). Thus, this translated to a 6.30 earnings per share because there are fewer shareholders sharing the pie. Also, buying back of shareholders will have the effect of improving the price earnings ratio to 4.96, a 20% improvement compared to 2005 of 6.20 without creating additional value because it reduces the ratio of the company’s cash requirement to generate additional share which improves company position on paper. It is also worth noting that IBM has a higher sales compared to HP and Microsoft due to diversified nature of its business interest. References IBM (2006). IBM Annual Report. Retrieved from [ftp://public.dhe.ibm.com/annualreport/2006/2006_ibm_annual.pdf] IBM (2005). IBM Financials Only. Retrieved from ftp://public.dhe.ibm.com/annualreport/2005/2005_ibm_financials.pdf Read More