Ratios: definitions, properties, and applications

Ratios

a) Protek is in a weak financial situation. While the current and quick ratios are still at an acceptable level, they have declined rapidly in the past two years from the industry average range to far below that. If the current trend in the company's liquidity continues, Protek will be faced with significant challenge meeting its financial obligations. In terms of operating metrics, it is disconcerting to note the decline in the company's efficiency. With declines in both receivables and inventory turnover, the company's cash conversion cycle is longer now than it was two years ago. This is contributing to the decline in the company's liquidity, but is not wholly responsible for it. The company is also beginning to underperform the industry on most key efficiency metrics.

The company is less profitable than firms in the industry. Despite declines in its performance elsewhere, Protek has improved its profitability in the past couple of years. Unfortunately, however, it still sits below its industry peers in this respect and the improved profitability and returns have not been reflected in improvements to other ratios. The improved profitability, for example, has not allowed the company to lower its debt. Debt levels are still healthy in general, but there has been a significant escalation in the company's debt in the past couple of years. Protek is also more highly leveraged that its industry peers.

The most important thing to know about Protek's current financial situation is that it is not in dire health yet. There are no red flags among metrics, if only a single year is taken. The trend analysis, however, reveals a couple of major red flags. The first is that most metrics (other than profitability) have declined significantly in the past couple of years. The strong declining trends -- especially in the cash conversion cycle and in liquidity -- are cause for concern because those trends are leading to disaster within a year or two. That the company has gone from being about average in its industry for financial performance to generally underperforming the industry is also cause for significant concern. A deterioration in financial condition vs. its peers indicates that Protek's problems are firm-specific, not attributable to general industry weaknesses or the business cycle.

This is critical because although the company has seen its ROE and ROA increase, this should result in an improved financial condition. Thus, while the company is doing some things right, it has not been able to translate such minor successes into significant financial condition improvements. Protek's financial condition is not as good as it should be, given recent margin and ROE/ROA improvements.

b) The DuPont ratio is based on the premise that the ROE is impacted by operating efficiency, asset efficiency and financial leverage. The formula is ROE = profit margin * total asset turnover * equity multiplier. It shows which factors are responsible for the change in the ROE. For Protek, the ROE is 18.76% in 2008, an improvement from 7.42% in 2006.