7.2 Comparison of Financial ratios for investment decision

 

Financial ratios are determined relationships from financial information of a company which are used for the purposes of comparison (Editorial, n.d.). In this case of study the compared companies are fashion forward and dream design. Prior to the calculation of the two companies’ financial ratios, some important definitions and articulations are based on the following discussion,    

1. Definition, calculation and articulation of every financial ratios

a.       Profit margin ratio is remaining profit from sales after having been paid the expenses

Profit margin ratio:  ( Total Revenue - Total Expenses ) / Total Revenue  (Team, 2021).

Profit Margin = Net income / Revenue (Segal, 2021)

5% profit margin is considered low, 10 % is average and 20 % is high  (Anonimous,2021)

b.      Return on asset (ROA)

Net income / Total average assets 

In general, ROA > 5% are considered good and > 20% are excellent (Hargrave, 2021).

c.       Current ratio

Current Ratio = Current assets / Current liabilities (Fernando, 2021a). Good current ratio is 1.2 to 2 meaning that the current assets are 1.2 to 2 times the liabilities

d.      Quick ratio 

QR = (CE + MS + AR)/CL

Note :

QR = Quick ratio

CE = cash and equivalence

MS = marketable securities

AR = accounts receivable

CL = Current liabilities

(Seth, 2021)

 

Idealized quick ratio is 1 : 1 meaning that meeting current liabilities is not required in the context of technical solvency purposes. (Vaidya, n.d.).

e.       AR turnover ratio

Account receivable turnover ratio = Net credit sales / Average account receivables (Murphy, 2021)

An average of 10 is considering the company stays behind the peers and the greater the less behind.

(Planergy, n.d.) 

f.       Average collection period

It is the average number of days for clients to pay for their bills (Bdc, n.d.). Division of the average balance of AR by total net credit sales for the period, then multiplication of the result by the number of days in the period or  dividing the number of days in the period by the AR turnover. (Kenton, 2021).

g.      Inventory turnover ratio

COGS / average value of inventory (Fernando, 2021b). COGS = Cost Of Good Sold = cost of sales.

Idealized inventory turnover ratio is between 5 and 10 which means that every one or two months roughly the company will restock, sell and restock the inventory (Jenkins. 2020)          

h.      Average sales period

365 / Inventory turnover ratio (Heisinger, & Hoyle. (n.d.))

i.        Debt to equity ratio

Debt/Equity= Total Liabilities / Total Shareholders’ Equity​​
the less the ratio, the better the financial health of the company meaning that the debt is not more than the equity. (Fernando, 2021b)

2. Results, Comparisons of the two companies, Computational evaluation and explained meanings

No	Financial ratios	Fashion forward	Dream design	Difference	Comparison (Fashion Forward)
1	Profit Margin Ratio	0.0546	0.03935185185	0.01524814815	Higher
2	Return on Assets	0.04917146974	0.04812455768	0.001046912062	Higher
3	Current Ratio	1.165688488	1.386200106	-0.2205116185	less
4	Quick Ratio	1.805643341	1.948496554	-0.142853213	less
5	AR Turnover Ratio	10	24.68571429	-14.68571429	less
6	Average Collection Period	36.5	14.78587963	21.71412037	higher
7	Inventory Turnover Ratio	12.5	16.25	-3.75	less
8	Average Sales period	29.2	22.46153846	6.738461538	less
9	Debt to Equity Ratio	0.7985098801	0.7804939516	0.01801592853	Higher

 

No	Financial ratios	Standardized Evaluation	Meanings
1	Profit Margin Ratio	<10 %(low profit margin)	FF has higher Profit Margin
2	Return on Assets	<5% (Not good ROA)	FF has better return on asset
3	Current Ratio	1.2 to 2 (good Current ratio)	DD has better current ratio
4	Quick Ratio	> 1 (both are not ideal)	FF is near to 1 than DD
5	AR Turnover Ratio	>=10 more and more lagging behind the peers	FF has better ARturnover ratio
6	Average Collection Period	< 30 days is better	DD has better collection period
7	Inventory Turnover Ratio	ideal ratio : between 5 and 10.	FF is nearer to 10
8	Average Sales period	the less period of sales the better	DD has better average sales period
9	Debt to Equity Ratio	the less ratio the better	DD has better DtoE ratio

3. Well rationally supported recommendation

No	Financial ratios	Meanings	FF	DD
1	Profit Margin Ratio	FF has higher Profit Margin	1	0
2	Return on Assets	FF has better return on asset	1	0
3	Current Ratio	DD has better current ratio	0	1
4	Quick Ratio	FF is near to 1 than DD	1	0
5	AR Turnover Ratio	FF has better ARturnover ratio	1	0
6	Average Collection Period	DD has better collection period	0	1
7	Inventory Turnover Ratio	FF is nearer to 10	1	0
8	Average Sales period	DD has better average sales period	0	1
9	Debt to Equity Ratio	DD has better DtoE ratio	0	1
		The winner is FF	5	4

 

Based on the above analysis, the winner for investment is the Fashion forward. The company should invest in fashion forward retail.

 

References

Editorial, I. (n.d). Financial ratios - encyclopedia - business terms. Inc.com. Retrieved October 20, 2021, from https://www.inc.com/encyclopedia/financial-ratios.html.

Segal, T. (2021, October 13). Profit margin. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/p/profitmargin.asp.

Anonimous. (2021, January 2). Profit margin. Corporate Finance Institute. Retrieved October 21, 2021, from https://corporatefinanceinstitute.com/resources/knowledge/accounting/profit-margin/.   

 Team, I. E. (2021, February 23). How to calculate a profit margin ratio. Indeed Career Guide. Retrieved October 20, 2021, from https://www.indeed.com/career-advice/career-development/how-to-calculate-profit-margin-ratio.

 Hargrave, M. (2021, October 18). Return on assets definition. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/r/returnonassets.asp.

Fernando, J. (2021a, October 13). What is the current ratio? Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/c/currentratio.asp.

Liquidity. (2021, October 1). What is a good liquidity ratio? FreshBooks. Retrieved October 21, 2021, from https://www.freshbooks.com/hub/accounting/good-liquidity-ratio. 

Seth, S. (2021, October 20). Quick ratio. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/q/quickratio.asp.

Vaidya, D. (n.d). Quick ratio. Wallstreetmojo. Retrieved October 21, 2021, from https://www.wallstreetmojo.com/quick-ratio/.    

Murphy, C. B. (2021, October 13). Why the receivables turnover Ratio Matters. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/r/receivableturnoverratio.asp.

Planergy. (n.d.). How to calculate AR turnover ratio.. Retrieved October 21, 2021, from https://planergy.com/blog/accounts-receivable-turnover-ratio /

Kenton, W. (2021, October 12). Average collection period definition. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/a/average_collection_period.asp. 

Bdc (n.d.). Average collection period standard. Retrieved October 21, 2021, from https://www.bdc.ca/en/articles-tools/entrepreneur-toolkit/financial-tools/accounts-receivable-benchmarking-tool-entrepreneurs 

Fernando, J. (2021b, October 13). Inventory turnover: Formula and calculation. Investopedia. Retrieved October 21, 2021, from https://www.investopedia.com/terms/i/inventoryturnover.asp.

Jankins, A. (2021, November 16). Inventory turnover defined : Formula, tips & examples. Oracle netsuit. Retrieved October 21, 2021, from https://www.netsuite.com/portal/resource/articles/inventory-management/inventory-turnover-ratio.shtml.  

Fernando, J. (2021c, October 13). Debt-to-equity (D/E) ratio. Investopedia. Retrieved October 20, 2021, from https://www.investopedia.com/terms/d/debtequityratio.asp. 

Heisinger, & Hoyle. (n.d.). Average sale period.Ratio analysis of  financials. Retrieved October 21, 2021, from https://2012books.lardbucket.org/books/accounting-for-managers/s17-03-ratio-analysis-of-financial-in.html

 

 

 

 

7.1 Initial Steps of Krakatau Steel’s Financial Analysis

 

The three most important lines of balanced sheets are assets, liabilities and equities (Ross, 2021). Figure 1-3 reports the balanced sheet of Krakatau Steel Inc as the chosen manufacturing company for the most recently reported 5 years data (Journal, 2020).  Figure 1 mentioned the information that trends of the total asset increase or have positive growth percentage from 2016 to 2017, decrease or have linearly negative percentage from 2017-2019, and increase or have positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of the total asset which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

Figure 1. Krakatau steel’s assets obtained from balanced data (Journal, 2020)

 

Figure 2 mentioned the information that trends of the total current liabilities increase or have positive growth percentage from 2016 to 2019, decrease or have linearly negative percentage from 2019-2020. The values of relatively equal size of the total current liabilities which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

Figure 2. Krakatau steel’s current liabilities obtained from balanced data (Journal, 2020)

Figure 3 mentioned the information that trends of the total equity increase or having positive growth percentage from 2016 to 2017, decrease or having linearly negative percentage from 2017-2019, and increase or having positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of the total equity which can be seen in the blue right tabular figure and the amount difference are in the year of 2016 and 2017.

 Figure 3. Krakatau steel’s total equity obtained from balanced data (Journal, 2020)

The three most important lines of income statements are revenues, expenses and net profits. Over all expenses, I choose SG&A expenses as the most important one. The following figure reports the income statement of Krakatau Steel Inc as the chosen manufacturing company for the most recently reported 5 years data (Journal, 2020). Figure 4 mentioned information that the trends of the sales /revenue from 2016 to 2018 is linearly increasing and from 2018 to 2020 is linearly decreasing with subsequent positive growth until 2018 and negative growth afterwards. The values of relatively equal size of revenues are in the year of 2020 and 2017 with the difference in the amount of (19684467 – 19390485 = 293982) millions of IDR. The SG&A expenses get more and more expensive from 2016 to 2019 also depicted in the SG&A’s positive growth until the corresponding year which continues to fall down or negatively grows in the next year 2019 to 2020. The values of relatively equal size of SG&A expenses which can be seen in the blue right tabular figure and the amount difference are in the year of 2017 and 2018.     

Figure 4. Sale revenues and SG&A expenses obtained from Krakatau Steel’s Income Statement (Journal, 2020)

Figure 5 mentioned the information that the trends of the net income increase or have positive growth percentage from 2016 to 2017, decrease or have linearly negative percentage from 2017-2019, and increase or have positive growth percentage again in the year of 2019 to 2020. The values of relatively equal size of net income which can be seen in the blue right tabular figure are in the year of 2016 and 2018.     

Figure 5. Net income obtained from Krakatau Steel’s Income Statement (Journal, 2020)

Overall, the steps in completing a thorough financial analysis can be performed by using some ways including absolute decreases and increases, negative and positive growth percentages  of an item periodically as we did in the above analysis. Therefore the next step should be the percentage of the single items to the aggregated total and the so-called financial ratios (Boundless, n.d.)

References

Ross, S. (2021, October 14). The main focus points when analyzing a balance sheet. Investopedia. Retrieved October 19, 2021, from https://www.investopedia.com/ask/answers/050615/what-items-balance-sheet-are-most-important-fundamental-analysis.asp. 

Journal, W. S. (2020). Kras.id | Krakatau Steel annual income statement - WSJ. The Wall Street Journal. Retrieved October 19, 2021, from https://www.wsj.com/market-data/quotes/ID/XIDX/KRAS/financials/annual/income-statement. 

Boundless. (n.d.). Boundless accounting. Lumen. Retrieved October 19, 2021, from https://courses.lumenlearning.com/boundless-accounting/chapter/next-steps-in-financial-statement-analysis/. 

 

6.3 Methods Of Capital Budgeting Decision (Rate and Profit or Loss Sharing Ratio Comparison)

 

The three main capital budgeting tools usually performed are NPV, IRR and Payback period. In more detail definition,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. A present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is the sum of all available periods. Positive NPV means that, in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.      IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows as follows, (Fernando, 2021).

In general, higher IRR means better investment based on the definition to make total NPV quickly go to zero (Ganti, 2021). General excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other words, it is the time for the investment to reach the Break Even Point (BEP) (Kagan, 2021). In the technical excel sheet, the calculation uses the fact that the payback period is the time at exactly zero cumulative cash flow. If the cash flow data show no zero cumulative cash flows then we can use the linear regression technique to find the linear equation between two points consisting of the last negative and the first positive cumulative cash flows. In detail, the required payback period is the year on the x axis where cumulative cash flow is exactly zero at the y axis.   

 

The best and the least information can be based on the critics to the above theories. The critics to the net present value (NPV) and (Internal rate of return) IRR which are closely related to the TVM (Time value of Money) are as follow :

1.    Due to the above  present value factor in relation to the future value, the theory of NPV closely related to disconto theory let money rely on the time period. Adiawarman in (Ilyas, 2017) mentioned The TVM concept is intervention to the biological concept in economy, making money as a biological cell which can grow by itself using the formula : Pb = Po (1+g)^t, where Pb is growing cell, Po is initial cell, g is growing factor and t is time. The adopted financial formula is FV = PV(1+r)^n . The critic is that money can not be made similar with biological cell since it’s spread must only be generated to be as an exchange to the goods and service transaction and money must not be made as commodities.

2.    Time value of money (TVM) is defined as “a dollar today is worth more than a dollar in the future because to get a return a dollar today can be invested”. This means TVM always predicts positive return, while in contradiction,  Adiwarman in (Ilyas, 2017) said this definition is not accurate since every investment always has probability to get negative, positive or even no return. 

3.    The IRR (Internal Rate of Return) and NPV using the required rate of return introduce the concept of rate which is in contradiction with the concept of profit/loss sharing due to the fact that all investments and businesses have profit or loss probabilities.

In conclusion the last concept of payback period and even the NPV and IRR becomes the least information if the present cash flow data are sourced from the required rate of return and becomes the best information if the present cash flow data are sourced from the profit or loss sharing ratio (Ruminta,2020). 

Additional Note :  Considering the unstable value of money, further available choices of more stable concepts of capital budgeting analysis are using golds such as those in the Hamdi’s model (Gold Value Method (GVM), Gold Index (GI) and Investible Surplus Method (ISM) ) (Hamdi at all , 2021)     

References 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp.  

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp.  

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp.  

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp.  

Ilyas, R. (2017). Time value of money Dalam Perspektif Hukum islam. AL-'ADALAH, 14(1), 157. https://doi.org/10.24042/adalah.v14i1.1991

Ruminta, D. (2020, April 1). Analisis Perbandingan Perhitungan Kelayakan finansial Konvensional Dan syariah. Jurnal ECODEMICA. Retrieved October 15, 2021, from https://ejournal.bsi.ac.id/ejurnal/index.php/ecodemica/article/view/7603. 

Agustin, H., Azmi, N., Armis, & Asril. (2021). Analisis Pengembangan usaha nenas Sakinah Berdasarkan Aspek Keuangan konvensional dan syariah (Hamdi’s method). Jurnal Tabarru': Islamic Banking and Finance, 4(1), 219–230. https://doi.org/10.25299/jtb.2021.vol4(1).6749 

 

6.2 Conventional Capital Budgeting Analysis of A Manufacturing Company (Being corrected)

 

Capital budgeting is the process of undertaking the evaluation of potential major investments or projects. Some examples of projects that require capital budgeting before approval or rejection can be the big investment in outside ventures or new plant construction (Kenton, 2021). In the case of a manufacturing company being concerned, the company is evaluating two new equipment options to be chosen as a new product suitble for the production enhancement. The company’s manager requested the finance and accounting department to give recommendations on how to choose the best option based on capital budgeting analysis.

The three main capital budgeting calculations to be performed are NPV, IRR and Payback period. In more detail explanation, in relation to the available data of the problem, they can be defined and articulated as,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. In my detail calculations, a present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is sum of all available periods. Positive NPV  means that ,in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments  and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.       IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows  (Fernando, 2021).

0 = NPV = sum_t=1^t=T (C_t ​/(1+IRR)^t  - C₀ )

​where :

C_t ​ = Net cash inflow during the period t

C₀ = Total initial investment costs

IRR=The internal rate of return

t=The number of time periods​
 

In general, higher IRR means better investment based on the definition to make total NPV quickly goes to zero (Ganti,2021). In this research, general excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other word, it is the time for the investment to reach the Break Even Point (BEP) (Kagan , 2021 ). Our detail calculation purpose in the excel sheet uses the fact that the payback period is the time at exactly zero cumulative cash flow. In the two options, no zero cumulative cash flows are available. Therefore, we use the linear regression technique to find the linear equation to find the Payback period which is the year as the x axis at which cumulative cash flow is exactly zero at the y axis.     

 

Based on the above definition and articulation, further summary of calculation can be done by the following table,

Required rate of return for both options

0.08

For Option 1 :

Therefore, for Option1 :

Present value = total cash * PV (Present Value) factor

NPV = sum(B14:I14) = $ 56470.64163

IRR = IRR(B10:I10,0.1072) = 18% ;  (Note : 0.1072 is a guessing value )

Payback Period = 4 years 10.13114754 months

(the x value =295500/61000 =4.844262295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 61000x -295500)

For Option 2 :

Therefore, for Option 2 :

Present value = total cash * PV (Present Value) factor

NPV =SUM(B29:I29) = $ - 9336.578665

IRR = =IRR(B25:I25,0.1072) = 9% ;  (Note : 0.1072 is a guessing value )

Payback Period = 5 years 9.401055537 months

(the x value =597225/103265 = 5.783421295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 103265x -597225)               

Based on the calculation results, the meaning of the option 1 NPV value > 0 was previously discussed as indication of profitable investment. While the option 2 NPV value < 0 indicates unprofitable investment. IRR option 1 (18%) which is greater than IRR option 2 (9%) indicates that the IRR of option 1 is better than that of Option 2 since the higher IRR is the better investment. Moreover, the payback period of option 1 with the amount of 4 years 10.13114754 months is faster than the payback period of option 2 with the amount of 5 years 9.401055537 months.   

In conclusion, based on the above NPV, IRR, and payback period comparisons between the two options, the manufacturing company should choose the option 1 as a new equipment product suitable for the production enhancement. The analysis of preferring the option 1 is also proven right by considering the other factors that even though the price of the option 1 with no salvage value is more expansive than option 2 with salvage value of $10,000, materials, labors and maintenance costs of the option 1 is  cheaper than those of the option 2. Therefore, the option 1 is the best choice.

Note : This conventional calculation was performed using required rate of return. In the Islamic perspective, the cash flow data are based on profit and loss sharing. 

References 

Kenton, W. (2021, October 13). What is capital budgeting? Investopedia. Retrieved October 14, 2021, from https://www.investopedia.com/terms/c/capitalbudgeting.asp. 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp. 

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp. 

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp. 

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp.