The paper is devoted to the analysis of financial ratios of Continental Tire AG and its two competitors in the world market – Michelin and Goodyear. Full ratio analyses include Liquidity, Leverage, Profitability, and Management Ratios analyses which will be represented in this research proposal. Companies’ balance sheets and income statements as of 2011 will be analyzed for the purposes of this paper.
Input data for analyses of the three companies is included in Appendix 1, full ratio analyses is in Appendix 2. The first group of the ratios belongs to the liquidity financial analysis. There were three ratios (current, quick and net working capital) taken for the purposes of financial liquidity analysis. Leverage ratios analyses are represented by the debt to equity ratios and interest coverage ratio. Profitability analyses include gross margin ratio and net profit margin ratio. Finally, management ratios analyses are represented by the inventory turnover, accounts receivable turnover, return on assets and return on investment ratios. All of the ratios calculated were compared to each other with appropriate conclusions made.
Current Ratio
Current ratio is the common measure of general liquidity of the company in a short-term period helping to estimate current financial position of the company and estimate whether company immediate obligations could be covered by its short-term assets. Current ratio aims at providing assurance that the company can satisfy its short-term obligations. The value of the current ratio depends on the duration of the operating cycle and indicates the efficiency of the investment into assets (Brigham & Houston, 2009).
Current ratio is calculated using the following formula:
Current Ratio = Current Assets/Current Liabilities.
In accordance with the results obtained, Michelin Company has the highest current ratio while Continental AG has the lowest ratio. However, all of the ratios of the companies analyzed are acceptable because their measure lies between 2 and 1. The current ratio of the auto parts industry is 1 (Bloomberg, 2012). A Continental AG current ratio is critical because its value is the closest to 1 (1.06). However, this ratio is higher than that of the industry. On the other hand, current ratios of the company competitors (Michelin - 1.84 and Goodyear – 1.65) are significantly higher if compared to Continental AG current ratio. Thus, the ability to cover company short-term liabilities is satisfactory, but it performed worse than its competitors. It means that the company competitors are more attractive to the investors from this perspective. Contrarily, high current ratio may indicate heavy investing into low-earning assets, thus, an analysis of efficiency of investing into assets is needed.
The company’s management should pay attention to the fact and take steps to paying out some debts, convert non-current assets into current assets, increase current assets at the expense of equity, put profit back to business or increase current assets from loans or borrowings with a long-term maturity to improve company current ratio.
Quick Ratio
As well as the current ratio, quick ratio (acid test) indicates the ability of the company to cover its liabilities. However, it does not take into account inventory. The ratio shows whether the company is able to cover its current liabilities at the expense of its most liquid assets. This ratio does not depend on inventory and shows if the amount of accounts receivable lags behind the schedule for covering current liabilities (Brigham & Houston, 2009).
The following formula is used for the computation of quick ratio:
Quick Ratio = (Current Assets – Inventories)/Current Liabilities.
An ideal measure of quick ratio is 1:1 when the amount of the most liquid assets equals current liabilities that should be covered in case of emergency.
Continental AG must be treated cautiously by the investors since its quick ratio of 0.77 is significantly lower than 1 that indicated that its urgent expenditures cannot be covered by assets (Walch, 2006). Quick ratios of Michelin and Goodyear are ideal - 1.02 and 1.00 respectively (The Bradow Company, 2010). The average industry level is 0.97, thus, the quick ratio of Continental AG is comparatively low. Low quick ratio means that Continental AG relies on inventory or other current assets to cover its current liabilities. Many investors pay great attention when making a decision because inventory may not be easily converted into cash.
Net Working Capital Turnover Ratio
Net working capital together with current and quick ratios is often used for measuring cash flow and it must possess positive value. If the company relies on creditors’ money as a source of financing assets, than high liquidity ratios should be expected. The higher liquidity ratios, the better total company liquidity.
In accordance with Brigham & Houston (2009), net working capital turnover ratio is calculated with the help of the following formula:
Net Working Capital Turnover = Sales/Net Working Capital;
Net Working Capital = Total Current Assets – Total Current Liabilities.
Working capital turnover indicates the efficiency of using working capital. Continental AG has the highest working capital turnover among the three companies (50.49) and its value is significantly higher than those of Michelin (4.39) and Goodyear (5.86). It means that working capital is utilized more efficiently by the Continental AG than by its competitors. The ratio of 50.49 indicates an excellent ability of net working capital of Continental AG to generate sales. High working capital turnover shows that the company has enough financials resources and there is no or little need in additional investment.
On the other hand, higher working capital turnover ratio means shortage of sufficient working capital that could be a sign of over-trading that may cause financial difficulties for business.
Debt to Equity Ratio
Debt to equity ratio indicates the extent to which the business relies on debt financing. The analysis of debt to equity ratios showed that European companies (Continental AG - 3.64 and Michelin – 2.58) have close values of the measure while American company Goodyear has much higher debt to equity ratio (17.33). The higher the ratio the more risky creditors are exposed in the business (Brigham & Houston, 2009).
If compared to the industry level of 29.6, the ratio of 3.64 is significantly low. However, lower ratio means that the company does not rely too much on debt financing and its business does not depend much on volatility of the interest rate.
The following formula is used for computation of debt to equity ratio:
Debt to Equity Ratio = Total Liabilities/Total Shareholder Equity.
A high debt to equity ratio, like in the case with Goodyear, generally means that a company has been aggressive in financing its growth with debt. Higher ratio means higher potential for financing and, thus, generating earnings without outside financing. At the same time high value of this ratio may mean high volatility in interest expense. This ratio depends on the industry. The value of 3.64 can be considered normal for manufacturing auto parts which is capital-intensive industry.
Goodyear Company excessively depends on debt financing because the cost of debt may outweigh company returns generated from debt that could lead to bankruptcy.
Interest Coverage Ratio
This ratio shows the ability of the companies to provide interest payments on outstanding debt (Brigham and Houston, 2009).
Interest coverage ratio is calculated in the following way:
Interest Coverage Ratio = Operating Income/Interest Expense;
Operating Income = Gross Income – Operating expenses – Depreciation.
Lower ratio indicates the extent to which the company is burdened by the cost of debt. The value of the ratio that is lower than 1.5 shows questionable ability of the company to meet interest expenses.
The best value of interest coverage ratio among others the Michelin Company has – 8.53 indicating excellent ability to meet interest expenses. The value of this ratio of Goodyear Company is worse than that of Michelin, but much better than that of the Continental AG Company. Continental AG ratio is negative and it shows that the Company does not have a formidable ability to cover interest payments. The value of ratio that is below 1 reveals weak ability to generate sufficient cash flows to cover the debt interest as well. The value of the ratio that is less than 1 negatively influences credit rating of the company making service a debt questionable.
Gross Margin Ratio
The gross margin ratio reflects the percentage of total sales revenue retained by the company after incurring the direct costs related production of the goods. The higher the ratio, the more funds the company retains on each dollar of sales to service its obligations (Brigham and Houston, 2009).
The following formulae are used for computation of this ratio:
Gross Margin Ratio = Gross Profit/Net Sales;
Gross Profit = Net Sales - Cost of Goods Sold.
Gross margin ratio is higher of Continental AG (0.21) is higher than that of the Goodyear Company (0.03), but lower that that of Michelin (0.28) while industry ratio is 0.32. The ratio of 21% means that Continental AG retains 21 cent from each dollar of revenue generated. This ratio revealed that Continental AG business is weaker than Michelin’s, but stronger than Goodyear’s (U.S. Securities and Exchange Commission, n.d.).
The level of gross margin ratio may vary from one industry to another. Gross margin of manufacturing firms are much lower than gross margin of software companies.
Net Profit Margin Ratio
Accordingly to Brigham and Houston (2009), net profit margin ratio shows the amount of net profit per $1 earned in this kind of business. It takes into account the administration, distribution and selling costs, and tells financial analytics the amount of which tax, interest and dividends will be paid. It gives the insight company indirect costs structure (marketing, finance, administration costs) when comparing gross margin ratio and net profit margin ratio.
The formula for the calculation of this ratio is:
Net Profit Margin Ratio = Net Profit before Tax/Net Sales.
Net profit margin made up 0.06, 0.07 and 0.03 for Continental AG, Michelin and Goodyear respectively. Net profit margin ratio of Continental goes in line with the gross margin ratio showing relative financial health of the company (Appendix 2).
Continental AG gross profit margin is 0.21 while net profit margin is 0.06 meaning that the share of indirect costs in the structure of costs is relatively high (28.57%) while these costs made up 25% in the structure of costs of Michelin. Continental AG should consider the opportunity to improve its costs structure because cost reduction policy is the basement for the development of competitive advantage.
Inventory Turnover Ratio
Being one of the efficiency ratios, inventory turnover ratio measures the number of times the inventory was sold during the fiscal year or how many times inventory was turned into sales (liquidity of the inventory).
The formula for the calculation of inventory turnover ratio is as follows:
Inventory Turnover Ratio = Net Sales/Average Inventory at Cost.
The value of inventory turnover is the highest among the companies analyzed. Continental AG inventory turnover ratio is 10.84. It is more than twice higher than the value of this ratio in the industry – 5.1 and Michelin Company – 4.95 (Bloomberg, 2012). This ratio is higher than that of Goodyear Company as well – 6.66. It means that the management of inventory is well-organized. This means that the company does not have any problems with sales, no overstocking or obsolescence. The liquidity of the inventory is high. As it was mentioned above, the company relies on inventory too much when it comes to liquidity issues because inventory turnover goes in line with quick ratio. However, high inventory turnover may indicate possible shortages and inadequate level of inventory, ineffective buying (the company buys often in small quantities that results in high buying price) or inability to completely satisfy customers’ demand (Brigham and Houston, 2009). This ratio concurs with net profit margin that means that a regulation of costs is needed. High costs of production may finally lead to losses.
Sometime high inventory level is unhealthy because it may mean an investment with zero rate of return. If the prices for the products begin to fall the company may find itself in a trouble. If multiply inventory turnover by gross margin, the figure of 228% which is more than 100% tells the analytic that the average inventory is not high to save the necessary balance.
Accounts Receivable Turnover Ratio
Accounts receivable turnover is a measure of effectiveness in credit extension and its ability to collect debts. It is an activity ratio which shows the efficiency of using the company assets (Brigham and Houston, 2009).
For the computation of account receivable turnover the following formula is used:
Account Receivable Turnover = Net Sales/Average Account Receivable.
The value obtained for receivables turnover of Continental AG of 6.23 is somewhat lower than that of Michelin (6.74) and significantly lower than that of Goodyear (7.99) that could mean receivables are converted into money relatively slow. The industry value of this ratio is 10.67 that shows that neither Continental AG nor its competitors manage to collect debts effectively. The maintenance of accounts receivable firms may extend interest-free loans to the customers. Higher ratio implies that the company is operating on a cash basis or shows the efficiency of the credit extension and, as a result of this extension, collection of receivables. In this case Continental AG has the lowest ratio in comparison both to its competitors and to the industry. It means that the company, as well as its competitors, should re-assess its credit policy to ensure timely collection of receivables or credit. High value of this ratio may mean that the company is too restrictive in its collection policies and does not extend credit to the customers. Moderately high ratio means that the customers of the company are paying their bills in a timely manner.
Return on Assets Ratio (ROA)
Return on assets (ROA) is an indicator of company ability to generate profits effectively using assets. It shows how many dollars of returns resulted from each dollar of the company assets. This ratio shows the efficiency of generating profits using available assets. Low level of this ratio usually means inefficient use of the company assets. The higher ROA than better company financial performance since it is associated with debt and equity financing efficiency (Brigham and Houston, 2009).
Return on assets ratio is computed in the following way:
Return on Assets = Net Profit before Tax/Total Assets.
Return on assets ratio shows profitability of the company. As the value of this ratio of Continental AG is the same with Michelin company value (0.07 or 7%) and is much higher than that of Goodyear (0.04 or 4%), it can be considered normal. The interpretation of the ratio is that the company for each dollar of assets earned 7 cent of returns in 2011. It also means that the company effectively employs assets for profit generation. Taking into account that the industry value of this ratio is negative (-2.1%), the analytic can conclude that the level of ROA of Continental AG is satisfactory. Michelin challenges Continental AG since the companies have the same value of the ratio. Michelin uses its assets better than Continental AG or Goodyear because it has fewer assets which generate higher profits. Thus, for generating profit of $1,325.2 million Continental AG uses $26,038.4 of assets while Michelin uses $20,888.0 for generating a little bit higher profit of $1,342.0 million.
On the contrary, Goodyear Company is an example of inefficient use of assets because profits generated by the company are disproportionally fewer than its assets. Wise allocating of the resources available is the main purpose of the company management. Good management aimed at generating large profits with little investment available because making profit of large amount of investment is not a problem.
Return on Investment Ratio (ROI)
Return on investment is a performance measure aimed at evaluation of the efficiency of an investment. It refers to the proceeds received from selling the investment. This ratio is a popular metric because of its simplicity and versatility. Versatility of this measure means that various inputs can be used for the calculation of this ratio depending on the results anticipated. The general meaning of this ratio is the profitability of the investment (Brigham and Houston, 2009).
Return on investment is calculated as follows:
Return on Investment = Net Profit before Tax/Shareholder Equity.
Return on investment of Continental AG (0.26) is higher than that of Michelin (0.18) and more than twice lower than that of Goodyear
(0.61). Highest ROI of Goodyear Company indicates better ability to generate return on investment in comparison to Continental AG and Michelin. It means that despite of lowest shareholders’ equity available, the company succeeded to generate good return on investment.
This measure is considered the most important since it shows the percentage of return on invested capital. The general meaning of this ratio is that it shows whether leading this kind of business is worthwhile.
Five Questions to Ask the Management of the Continental AG
What concrete measure are you going to undertake to improve current ratio?
How are you going to check if the company’s working capital is sufficiently used and there is no a lack of this capital?
Do not you think that interest coverage ratio is too low and it needs to be improved?
Do not you think that low value of quick ratio may negatively influence potential investors?
What is your opinion regarding increase a share of debt financing rather than financing business through equity?
Comparison of the Risks Analysis of the Companies
Quick ratio is quite low in all three companies that may identify low liquidity. This is the best measure of liquidity and it worth to pay attention. There is a risk for all companies not to meet current obligations if there are no any earnings from sales.
The risks are different for Continental and its competitors in working capital and interest coverage management. Michelin and Goodyear have normal net working capital turnover while Continental AG possibly has inefficient working capital management. Michelin is a stronger competitor since the company management succeeded to utilize its assets more efficiently generating higher profits.
Interest coverage ratio is satisfactory for the company’s competitors, but is negative for Continental AG that means that interest payments are not covered by operating income. It means that possibly the company is exposed to the risk of becoming bankrupt if the situation does not change in the nearest time.
Currently the company emphasizes on the reduction of indebtedness and this is the right strategy because cutting cost may improve profitability. Profits could be a good source of R&D investments that was a long-term strategy of the company. The management of the company also pays attention to the leverage ratio improvement.
The company should take steps to improve its liquidity to become more attractive to the investors. Current liabilities should be reduced to achieve necessary balance between current assets and current liabilities. Particular attention should be paid to the sufficient use of working capital. Management of accounts receivable should be improved because it is the lowest now among the three companies. The utilization of investment resources also may be improved. Inventory turnover is comparatively but it could be a bad sign when inventory turns too fast.
References
Annual Report. (2011). Continental AG. Retrieved from http://www.conti-online.com/generator/www/com/en/continental/portal/themes/ir/financial_reports/01_reports/form_en.html
Annual Report. (2011). The Goodyear Tire and Rubber Company. Retrieved from http://www.goodyear.com/investor/pdf/ar/2011ar.pdf
Annual Report. (2011). Michelin. Retrieved from http://www.michelin.com/corporate/finance/documents
Brigham, E., F. & Houston, F. J. (2009). Fundamentals of Financial Management. (12 ed.). Mason: Cengage Learning.
The Brandow Company. Free business statistics and financial ratios. (2010). Retrieved from http://www.bizstats.com/corporation-industry-financials/manufacturing-31/transportation-equipment-manufacturing-336/motor-vehicles-and-parts-336105/show
U.S. Securities and Exchange Comission. (n.d.) Continental AG CIK. Retrieved from www.sec.gov
Walch, C. (2006). Key Management Ratios: master the Management Metrics that Drive and Control Your Business (Financial Time Series). (4 ed.). London: Prentice Hall.
Bloomberg Businessweek. (2012). US Auto Parts Network Inc. (PRTS:NASDAQ GS).
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