Financial Ratios Essay

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ratio analysis of Google and Microsoft. The initial component of the paper is a rundown of some key ratios and their definitions. Then, the ratios of the companies are calculated and discussed.

Ratio analysis is a tool by which companies in the same industry can be compared. The use of ratio analysis helps to offset the differences in size between companies -- for example one company may have a larger profit number, but a smaller profit margin, than a competitor. The ratio -- profit margin -- may be a better indicator o which company is actually more profitable. In this analysis, Microsoft and Google will be compared. Microsoft has a variety of multi-billion dollar businesses, including servers, Office and Windows, while Google makes most of its money on advertising sales. Yet, both companies are wildly profitable, and both have similar situations with regards to excess cash flow. They are also two of the major driving forces in the Internet business, and are competitors with their browsers and mobile operating systems.

Ratio Definitions

Step 1. The current ratio is a liquidity ratio that tells us about the firm's ability to meet its financial obligations for the coming year.

The quick ratio is another liquidity ratio. It is similar to the current ratio, but removes inventories from the numerator. The reason for this is that it cannot be assumed that inventories can be liquidated for book value.

Accounts receivable turnover indicates how quickly the company collects on its bills. This ratio helps tell about the company's cash conversion cycle. This is significant because old accounts that have yet to be collected are at risk of being unpaid.

Days receivable is the same thing as accounts receivable, stated differently.

The inventory turnover tells about how fast the inventory turns over. The significance is that inventory that older inventory is harder to sell, or sell at full value, so a higher rate of inventory turnover is desirable.

Days' inventory is a different way of stating the inventory turnover. The underlying numbers are the same.

The asset turnover is a reflection of sales/assets. This is an efficiency ratio that reflects how well the firm's assets are being used to earn revenue.

Invested capital ratio complements the asset turnover ratio -- it tells the same story but using (1- assets) as the denominator instead of assets.

Equity turnover reflects the degree to which owners' equity is converted into revenue, so is another efficiency ratio, one that removes debt from consideration.

Capital intensity reflects sales over a specific asset class (plants, property, equipment), again reflecting the efficiency by which capital assets are converted to revenue.

The gross margin reflects the bargaining power that the firm has over buyers and suppliers. The higher this bargaining power is, the greater the gross margin will be.

Net margin is incorporates all of the firm's costs, not just the COGS. When used with the gross margin, it can help management to tell if changes in the net profit margin were the result of changes in the gross margin, or in changes within the company's internal and fixed cost structures.

Earnings per share reflects, roughly, what the shareholders get out of the company's operations. This measure is not as important from an operating perspective, because # of shares (the denominator) is not an operating metric, but shareholders pay close attention to this number, which means management has to as well.

Step 2.

STEP 3: Print this tab & review each item's analyses. Make notes on trends or issues to discuss in your paper.

MSFT

Year 1

Year 2

Year 3

Year 4

Investment & Asset Utilization

2009

2010

2011

2012

Working Capital

$22,246

$29,529

$46,144

$52,396

#18

Current Ratio

1.82

2.13

2.60

2.60

#19

Acid Test (Quick) Ratio

1.16

1.41

1.83

1.93

Accounts Receivable Turnover

5.22

4.80

4.67

4.67

times times times #14

Days Receivables

69.91

76.02

78.21

78.13

(or Collection Period)

days days days #16

Inventory Turnover

16.95

16.75

11.35

15.42

times times times #15

Days of Inventory

21.53 21.79

32.15

23.

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67

days days days #9

Asset Turnover

0.75

0.73

0.64

0.61

times times times #10

Invested Capital Turnover

1.35

1.22

1.01

0.96

times times times #11

Equity Turnover

1.48

1.35

1.23

1.11

times times times #12

Capital Intensity

7.76

8.19

8.57

8.92

Profitability Measures

#5

Gross Margin Percentage

79.2%

80.2%

77.7%

76.2%

#6

Profit Margin (Percentage)

24.9%

30.0%

33.1%

23.0%

#7

Earnings Per Share

$0.002

$0.002

$0.003

$0.002

(Common Stock)

GOOG

Year 5

Year 6

Year 7

Year 8

2009

2010

2011

2012

$26,420

$31,566

$43,845

$46,117

10.62

4.16

5.92

4.22

8.91

3.50

5.01

3.35

7.39

5.86

6.14

5.84

times times times

49.40

62.27

59.43

62.45

days days days

0.00

0.00

40.86

times times times

0.00

0.00

0.97

8.93

days days days

0.58

0.51

0.52

0.53

times times times

0.66

0.63

0.62

0.67

times times times

0.66

0.63

0.65

0.70

times times times

4.88

3.78

3.95

4.23

62.6%

64.5%

65.2%

58.9%

27.6%

29.0%

25.7%

21.4%

$16.641

$21.691

$24.833

$27.362

*Normally I would have hidden the MSFT columns, but the spreadsheet being locked made it impossible to do that.

Step 3 Discussion.

First a note on citations -- the spreadsheet above is the source of the data. The figures used came from MSN Moneycentral. All data comes from this source unless otherwise stated. Any further notes will be cited as needed.

Both of these companies have recorded exceptional performance. Microsoft has increased its working capital significantly over the past five years. A healthy current ratio is around 1.0 in most industries, and Microsoft outperforms that metric -- its acid test ratio has increased to 1.93 by 2012. With $52 billion in working capital and healthy liquidity ratios, liquidity is not an issue for Microsoft.

Microsoft has a somewhat sluggish accounts receivable turnover. There are two factors of concern. The first is that the receivables turn trend is downward, from 70 days in 2009 to 78 days in 2012. This means that the company is taking longer to collect from its customers, especially the enterprise customers that make up the majority of its base. That the company, with $63 billion in cash and equivalents, does not need the money should not encourage it to be cavalier about receiving payment, especially in businesses where competition in minimal (i.e. Windows, Office).

Inventory turnover is more rapid. Though Microsoft has experienced a generally negative trend towards slower inventory turnover, inventory (at $1.137 billion in 2012) comprises a minimal amount of the company's current assets. Whether the company's inventory turn is fast or slow is not going to affect the company's financial outcomes in any material way.

The asset turnover has been on a downward trend as well. This indicates that the company has added assets faster than it has added sales. Thus, it is not the increase in cash that is causing this number, but the increase in assets that do not have the same ROA as the company's older assets. Invested capital turnover and equity turnover are also slowing on a four-year trend, highlighting that whatever Microsoft is plugging money into lately is not returning the same as it's prior activities. There are a few possible explanations for this, but the rapid increase in working capital is one. If Microsoft has a lot of cash on the sidelines -- and it does -- then that money will not earn as much return as its actual businesses. The more money piles up for Microsoft, the less efficient the company becomes, which is why all three of its efficiency ratios are declining.

It is also possible that a decline in gross margin is contributing to the lower returns. Microsoft's gross margin has declined in each of the past four years, indicating either that its pricing power in existing businesses is being reduced, or that it is entering new businesses are not as profitable as its traditional businesses. The profit margin has not behaved in the same way as the gross margin, which indicates that Microsoft is taking steps to adapt to lower gross margins, cutting.....

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