Finding the Market Price Ratio of Exchange

When the acquiring company knows the ratio of exchange, it can be used to find the market price ratio of exchange. The market price rate of exchange is found as follows:

(MP of acquiring company * ratio of exchange)/ MP of the target company

Where: MP refers to the market price per share.

The market price ratio of exchange indicates how much of market price per share of the acquiring firm is exchanged for every $1.00 of the market price per share of the target company.

It is normal for the market price ratio of exchange to be above 1. This is an indication that the acquiring company pays a premium above the market price to acquire a target company.

Test yourself:

ABC (acquiring company) is acquiring BCD (target company) with the use of a stock swap transaction. ABC’s market price is $60 and BCD’s market price is $55. However, during merger negotiations, ABC agreed to a 1.5 ratio of exchange where it valued BCD’s shares at $90.

Find the market price per share in the ABC/BCD merger.

Solution:

(60*1.5)/55=1.6

This means that ABC gives $1.6 of its market price in exchange for every dollar of the BCD’s market price.

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Net Profit Margin Ratio

Net profit margin ratio (NPMR) is one of the profitability ratios and measures how much of each sales dollar is remaining after all costs are deducted. In other words it measures how successful the firm is in terms of its earnings on sales.

Net profit margin ratio (NPMR) = Net Profit/Sales

For example, if ABC has a net profit of $300,000 and sales of $3,000,000. The NPMR is calculated as follows.

= 300,000/3,000,000

= 0.1 or 10%

Test yourself


Dillon Corporation has a net profit of $500,000 and sales of $3,500,000.

Required: Find the Net profit margin ratio (NPMR)

Solution:

The calculation of Net profit margin ratio (NPMR) of Dillon Corporation will be as follows:

= 500,000/3,500,000

= 0.14 or 14%

The higher the Net profit margin ratio (NPMR), the better it is for the company’s health.

Gross Profit Margin Ratio

Gross profit margin ratio (GPMR) is one of profitability ratios. It measures how much of each sales dollar remains after costs of goods are deducted. In other words it measures the relative costs of goods sold.

Gross profit margin ratio (GPMR) = Gross Profit/Sales

EXAMPLE:

For example, if ABC has a gross profit of $1,000,000 and sales of $3,000,000, then the Gross profit margin ratio (GPMR) is calculated as follows:

= 1,000,000/3,000,000 = 0.3333 or 33%

Test yourself


Dillon Corporation has a gross profit of $1,200,000 and sales of $3,500,000.

Required: Find the Gross profit margin ratio (GPMR)

Solution:

The calculation of  Gross profit margin ratio (GPMR) of Dillon Corporation will be as follows: = 1,200,000/3,500,000 = 0.34 or 34%

Conclusion:

The higher the Gross profit margin ratio (GPMR) the lower the relative cost of goods sold. Therefore, the higher the  Gross profit margin ratio (GPMR), the better.

Times Interest Earned Ratio (Interest Coverage Ratio)

Times Interest Earned Ratio (TIER), also known as the Interest Coverage Ratio, measures the ability of the enterprise to meet its financial obligations (interest payments on debt due). The formula for TIER is as follows:

Times Interest Earned Ratio = EBIT/interest charges

EBIT refers to earnings before interest and taxes, which is also called operating profit (refer to the format of an income statement to see how it is calculated).

Example


Assume ABC Company has an operating profit of $550,000 and interest charges of $100,000. The Times Interest Earned Ratio (TIER) of ABC is as follows:

$550,000/$100,000=5.5

It is generally advisable that the Times Interest Earned Ratio should be between 3 and 5.

ABC’s Times Interest Earned Ratio (TIER) could be too high. It may be possible that the firm is unnecessarily careful in using debt as a source of capital. This means the risk taken may be lower than average, but so is the return.

Things to note about this ratio


When using the Times Interest Earned Ratio (TIER), it is important to remember that interest is paid with cash and not with income (since some income may still be in the form of accounts receivable). Therefore, the real ability of the firm to make interest payments may be worse than indicated by the Times Interest Earned Ratio (TIER). It is also important to remember that debt obligations include repayment of principal debt as well as payment of interest.

One should compare debt ratios of individual firms to industry averages, to obtain a better understanding. There is a large variability of debt ratios industry averages between industries. This is because different industries have different operations requirements.

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Debt-equity ratio analysis

Debt-equity ratio analysis is one of several debt ratio analyses. Debt ratios measure the degree or financial leverage of the firm. The more debt the firm uses, the higher its financial leverage, the higher its financial risk (the risk of bankruptcy) and the higher the potential returns.

It measures the degree of indebtedness of the enterprise. It measures how much of equity and how much of debt a company uses to finance its assets. It is also referred to as leverage or gearing.

The formula is as follows:

Debt-equity ratio = Total liabilities/Shareholders equity

This formula is sometimes presented simply as:

Debt-equity ratio = Debt/Equity

Example of a debt-equity ratio analysis


Assume Gold Co. currently has total debt of $1,000,000 and shareholders equity of $1,800,000. The debt-equity ratio for the Gold Company is conducted as follows:

$1,000,000/$1,800,000=0.56

The result is less than 1 and indicates that business uses mainly equity to finance its operations. The financial risk of Gold Company seems to be under control. However, it is possible that company may have lower than possible returns due to being too careful with using debt financing. However, a closer investigation is required before any conclusions can be made.

Things to note about this ratio


If the debt-equity ratio shows a result of less than one, then it means that equity is mainly used to finance operations. However, if the debt-equity ratio is more than one, then it means that the debt is mainly used for financing of operations. If the result of debt-equity ratio analysis is equal to one, then it means that a half of financing comes from debt and a half comes from equity.

The more debt compared to equity the firm uses in financing its assets, the higher the financial risk and the higher the potential return. Financial risk refers to the risk of the firm being forced into bankruptcy if the firm does not meet its debt obligations as they come due.

The results should be compared to industry averages, to the firm’s past ratio trends and to a similar analysis of leading competitors within the industry.

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The debt ratio

A direct measure of debt of the firm is the debt ratio. Debt ratio measures how many of the firm’s assets are financed by debt. The higher the debt ratio the higher the degree of financial leverage (amount of debt) in the capital structure of the enterprise and the higher the risk and potential return.

The formula for the debt ratio is as follows:

Debt Ratio = Total liabilities/Total assets

If the debt ratio is higher than 1 than it means that an enterprise has more debt than assets. If the debt ratio is lower than 1 than it means that an enterprise has more assets than debt.

EXAMPLE:

Assume that ABC’s total liabilities are $1,700,000 and total assets are $4,000,000.

The debt ratio of ABC is as follows: $1,700,000/$4,000,000=42.5%

This means that ABC’s capital structure is 42.5% of debt and 57.5% of equity.

Test yourself


Dillon Corporation has total liabilities of $4,000,000 and total assets of $5,500,000.

Required: Find the debt ratio of Dillon Corporation

Solution:

The ratio is calculated as follows:

$4,000,000/$5,500,000 = 73%

This means that Dillon Corporation’s capital structure is 73% of debt and 27% of equity. A debt ratio of 73% is generally considered to be a very high debt ratio and may indicate a problem of a very high indebtedness and very high financial risk. However, as with all financial ratios, the debt ratio of Dillon Corporation should be compared to the industry average before any conclusions are drawn.

 

Acid-Test Ratio

The acid-test ratio, along with the current ratio analysis, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (excluding inventory). In other words, the ratio allows us to determine the ease with which business can pay its bills as they come due. It is also sometimes referred to as the quick ratio.

A declining ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy increases further if the ratio falls significantly below 1. A ratio below 1 indicates a situation whereby current assets (excluding inventory) can no longer cover current liabilities.

The formula for the ratio is as follows:

Acid-test ratio = (Current assets – Inventory)/Current liabilities

Example of an acid-test ratio analysis


Assume Dynasties Inc. has current assets of $550,000, inventory of $300,000 and current liabilities of $300,000. The acid-test ratio of the of Dynasties Inc. is calculated as follows:

$550,000-$300,000/$300,000=0.8

This could indicate a ratio which may be too low. However, acceptable ratio values vary between industries. Therefore, the result must always be used in context via a comparison to industry averages as well as in comparison to the ratio of leading firms in the industry and Dynasties own historical ratio analysis.

Things to note about this ratio


A positive ratio is a must. A ratio of 1 or greater is generally advisable. If a company has a ratio of 1, it means that it has current assets (excluding inventory) which would be able to cover current liabilities once.

An acid-test ratio is similar to the current ratio. However, it differs from the current ratio because the former excludes inventory when calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Therefore, it is assumed the acid-test ratio shows a better representation of a firm’s liquidity for businesses which experience slow conversion of inventory into cash.

It is also important to note the acid-test ratio analysis ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business as an healthy acid-test ratio. However, most of its current assets are in accounts receivable, which can only be converted into cash in 4 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy acid-test ratio, a business’s liquidity may be unsatisfactory to meet short-term commitments of the business.

Lastly, as per the above, one should compare the ratios of individual firms to industry averages to obtain a better understanding. There is a large variability of ratio values between industries. This is because different industries have different operating requirements.

Current Ratio Analysis

Current ratio analysis, along with the acid-test ratio, measures liquidity. Liquidity refers to the ability of the firm to meet its short-term obligations (obligations over the next 12 months) with its current assets (such as cash, marketable securities and inventory). In other words, current ratio analysis allows us to determine the ease with which business can pay its bills as they come due.

A declining current ratio is an indicator of declining liquidity, which usually serves as a warning of potential financial difficulties for the business. Such financial difficulties may even result in bankruptcy. The risk of bankruptcy especially increases if the current ratio falls below 1 (a point at which current assets can no longer cover current liabilities). Current ratio analyses is also sometimes referred to as working capital ratio, real ratio, cash ratio, liquidity ratio and cash asset ratio.

The formula for current ratio analyses is as follows:

Current ratio = Current assets/Current liabilities

Example of current ratio analysis

Assume Dynasties Inc. has current assets of $550,000 and current liabilities of $300,000. The current ratio of the of Dynasties Inc. is calculated as follows:

$550,000/$300,000 = 1.8

Current ratio analyses of the Dynasties Inc. could indicate that the ratio may be too low. However, an acceptable current ratio value varies between industries. Therefore, the result must always be assessed in the context of industry averages as well as to current ratios of leading firms in the industry and the Dynasties own historical current ratio analysis.

Things to note about current ratio analysis

A positive current ratio is a requirement. A current ratio of two is generally advisable. If a company has a current ratio of two, it means that it has current assets which would be able to cover current liabilities at least twice.

Current ratio analyses is similar to the acid test ratio. However, an acid-test ratio differs from current ratio because an acid-test ratio excludes inventory in calculating current assets. Inventory is excluded as it is seen as the least liquid form of current assets. Acid-test ratio shows a better representation of firm’s liquidity for businesses which experience slow conversion of inventories into cash.

It is also important to note that current ratio analyses ignores the timing of how quickly current assets can be converted into cash and how soon current liabilities come due. For example, imagine a situation where the business has a healthy current ratio. However, most of its current assets are in inventory which can only be converted into cash in 2 months time and most of its current liabilities are due within next 30 days. In such a situation, despite a healthy current ratio, a business’s liquidity may be unsatisfactory to meet the short-term commitments of the business.

Lastly, as per above, one should always compare the current ratio analyses of individual firms to industry averages, to obtain a better understanding. There is a large variability of current ratio industry averages between industries. This is because different industries have different operations requirements.

Average Collection Period

The average collection period is one of the activity ratios which measures the relationship between accounts receivable and average credit sales per day. Activity ratios help businesses to measure how efficiently various accounts are converted into sales or cash. Other activity ratios include average payment period, total asset turnover and inventory turnover analysis.

It calculates how efficiently accounts receivable are collected. It indicates the quality of debtors of the business (how promptly debtors pay their bills as they come due). It is also referred to as the average age of accounts receivable, debtors collection period ratio or a collection ratio.

The formula to calculate the average collection period ratio is as follows:

Average Collection Period = Accounts receivable/Average sales per day

The figure for accounts receivable is obtained from the balance sheet and the figure for sales is obtained from the income statement. Sales must be further adjusted to credit sales, by excluding cash sales. Further, credit sales must be divided by the number of days per year to finally obtain average sales per day (average credit sales per day).

Average sales per day = Credit sales/365

Example calculation


Assume Heroic Company has accounts receivable of $750,000 and credit sales of $4,050,000. Heroic Company has credit terms of 30 days. Assume 365 days year.

The average collection period of Heroic Company is calculated as follows:

Average sales per day = Credit sales/365

= $4,050,000/365

= $11,095.89

Average collection period = $750,000/$11,095.89=67.6 days = 68 days.

It takes on average 68 days to collect the accounts receivable. However, the credit terms of Heroic Company is 30 days. This means that company’s customers have 30 days to settle their accounts.

In light of this information, it is evident that collection of accounts receivable and/or process of granting the credit to customers is inadequately managed. The performance and processes of credit and collection departments should be investigated to draw further conclusions.

Things to note about this ratio


Results are only relevant when compared to a company’s credit terms.

The average collection period ratio therefore allows business to gain a better understanding of the cash inflows to be anticipated. Understanding of cash inflows are vital for successful operation of the business.

It also allows to identify trends in the collection of the accounts receivable. This can bring to management’s attention important variables that must be investigated to ensure successful operation of the business. For example, if the average collection period of the business increased from 30 to 68 days over 1 year, a further investigation will be required to understand such a large increase in this ratio.

Furthermore, to obtain a better understanding, one should compare the average collection period ratio to industry averages, to the ratio of leading firms in the industry and to the firms own historical results.

 

Inventory Turnover Analysis

Inventory turnover analysis measure the liquidity of a firm’s inventory. It measures how many times the company turns over (sells, uses or replaces) its inventory during a period, such as the financial period.

It is calculated by dividing cost of goods sold by inventory. The formula is as follows.

Inventory Turnover = Cost of goods sold/Inventory

The results can be conveniently used to calculate the average age of inventory (also called average number of days sales in inventory or inventory turnover days) with the following formula:

Average age of inventory = 365/Inventory Turnover

Example of inventory turnover analysis


Assume Gold Co. has cost of goods sold of $1,850,000 and inventory of $680,000. Assume there are 365 days in the year. The inventory turnover analysis and average age of inventory analysis for the Gold Company is conducted as follows:

Inventory turnover analysis:

$1,850,000/$680,000=2.7

This indicates the business turns over its inventory 2.7 times per year.

Average age of inventory:

365/2.7=135.2

Things to note about inventory turnover analysis


The results are only meaningful when used in comparison. It can be compared to industry averages, to the firm’s past inventory ratios and to ratios of competitors.

Industry averages differ significantly between industries for this ratio. This ratio is positive (higher than zero) as long as the firm has any inventory. Generally, a high ratio is considered to be a good indicator.

However, the norm would differ significantly between industries. If the ratio is too high when compared to the norm within the industry, it may mean the company keeps too little inventory and, therefore, may lose some sales. On the other hand, a low ratio may indicate excess inventory and inferior sales. Excess inventory is usually considered to be undesirable as inventory is an investment without return, holding inventory implies costs and prices of goods to be sold may start decreasing.

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