Ratios in Order to Estimate the Profitability

Ratios

In order to estimate the profitability of companies, several measures have been worked out which can lead investors to right decisions. Liquidity analysis ratios include current ratio, quick ratio and net working capital ratio and they reflect the current or short-term situation within company finances. Profitability analysis ratios include return on assets, return on equity and return on common equity, profit margin and earnings per share and are more mid-term ratios reflecting pricing company strategy and ability to generate earnings. Asset turnover ratio, accounts receivable turnover ratio, inventory turnover ratio are measures of activity analysis for companies. Capital structure analysis ratios include debt to equity ratio and interest coverage ratio. There are also capital market measures. We shall incorporate some of each segment of financial performance measures to compare operations of two companies and draw our conclusions as for possible investment opportunities.

The story of one of the greatest multinational corporations, Johnson & Johnson, begins in the 1880s, when Robert Wood Johnson heard the idea of known English surgeon to develop a treatment to kill the airborne germs in the hospital room by sterilizing instruments and thus protect more wound area on the body to decrease the existing then postoperative mortality rate of 90%. Mister Johnson joined his two brothers and the first were a form of improved medicine plasters containing antisepsis. Later, they discovered to include together with plaster package talc for patients to soothe the skin. With years passing by, affiliates of Johnson & Johnson were created in more than 50 countries of the world employing more than 113,800 workers.

Eli Lilly company was founded by another entrepreneur in 1876 Eli Lilly whose main idea was to produce drugs of the highest possible quality, based on best science of the day and the medicine should be dispensed only by the advice of the doctors. Now the company has over 129 years of productive history and 8,400 of only researchers working for it.

In order to compare financial performance of both companies and thus draw conclusions which of them increases the shareholders' wealth that should be the main goal for both of them, we shall review the following financial efficiency ratios. The first ratio is the receivable turnover which equals to annual credit sales divided by average accounts receivables and thus reflects the company ability to use credits in promoting their sales and also the company ability to collect debts. The receivable turnovers ratio for Johnson & Johnson is 6,9 while it is only 4,4 for Eli Lilly. High receivable turnover ratio implies a tight company credit policy and thus fewer credit systems offered, predominance of cash operation by company or good efficient debt management policy and few bad debts, short-term debts or favorable credit conditions which allow customers to pay out their debts in shorter periods. In contrary, low receivable turnovers ratio is suggestive of poor credit collection policy, thus the amount of goods sold in credit to the customers exceeds several times the average receivable fund from them. Usually corporate financial statements report only on the total amounts of sales not distinguishing between cash and credit sales. This can mislead not proficient in finance clients and small investors as the total sales volume must be compared with amount of goods sold in cash and in credit and even more importantly the recovery of these credits from the clients. Not using credit instruments in sales promotion is not most efficient use of corporate opportunities for sales growth, but implementing credit policy requires working out efficient debt management system which is the major tool to make credit policy have positive affect on total company performance and not just increases in sales volumes. The Eli Lilly company should reassess its' credit policy and must reduce account receivable as this is short-term no interest credit offered for clients of the company and thus is a resources loss. The total accounts receivable for Eli Lilly company for year 2004 have amounted to $2,058.7 and for J& J. this number is at the range of $6,831 millions while the information on average annual goods sold in credit is not available from annual reports of both companies.

The second financial efficiency ratio we shall use in our financial analysis is the net profit margin which is equal to net profit or net income divided by net sales, thus reflecting how much out of each dollar of sales the company keeps in earnings as all the costs and taxes are excluded. It reflects how much the company is able to control its' costs and it is a good measure to compare competitiveness of companies operating within the same industry as the products are comparable and thus if a company is able to produce the same products with less costs, it is more efficient and is able to generate more profit. Net profit margin for J& J. indicates that the company is able to keep $0,127 of each dollar of sales, while Eli Lilly is able to keep $0,193 and thus the costs are lower for each dollar of sales. This is a good measure of whether increasing sales are accompanied with increasing profits as growing earnings do not always tell the whole truth. If the earnings are increasing but the costs necessary to generate these earnings have increased at even larger scale and the cost per each unit produced is not optimal, the profit margin will be decreasing thus the total company profit will be lower. In this case the company must manage the costs rationally and find the optimal ratio of production/sales volume which will not lead to lower profit margins. In competitive markets the company is not able to generate higher than market prices for comparable products and the only way to manage profit margins is to minimize costs. Low pretax profit margin can lead to the conclusion that the company is suffering from low operating income and thus should not offer as many discounts, take trade discounts, should change sales mix and reduce specific costs to approach optimal profit margin. Also, low pretax profit margin can mean that overheads are too high and are subject to reduction. The more competition the company experiences, the lower is the profit margin and the company must manage the product life circle efficiently.