Question

Heavy Machinery manufacturing Company (HMM) manufactures and sells heavy equipment used in mining, construction and shipbuilding industries.

The management is concerned about its financial performance. It considers Metal Stamping Company (MS) as a major player in the industry and would like to compare its performance with that of MS. One of the managers suggests that it is also useful to compare the performance with that of Hi-tech Software Company (HTS) to get a better picture. HTS is involved in providing software solutions to Machinery manufacturing companies. The balance sheet, income statement and relevant ratios for HMM, MS and HTS are shown in Exhibit 1.

Ratios

HMM                   MS                        HTS

Return on equity                             10.50%                14.00%                26.67%

Return on Assets                             4.20%                   5.25%                   24.00%

Total Asset Turnover                     0.75                      0.625                    1

Current Asset Turnover                 3                            4.17                      5

Fixed Asset Turnover                     1                            0.74                      1.25

Gross Profit margin                        40.00%                30.00%                80.00%

Operating profit margin                13.33%                20.00%                40.00%

Net profit margin                            5.60%                   8.40%                   24.00%

Total Liabilities/assets                   60.00%                62.50%                10.00%

Long-term debt to assets             40.00%                50.00%                0.00%

Long-term debt to equity             100.00%              133.33%              0.00%

Interest Coverage                          3.33                      3.33                      NA        

Inventory turnover                         4.50                      11.67                    6.67

Average Collection period            48.00                    36.00                    36.00

Accounts Payables Turnover       2.25                      3.50                      2.00

Net working capital turnover      15.00                    25.00                    10.00

Equity Multiplier                             2.50                      2.67                      1.11

(a) Analyse the difference in the return on equity of HMM and MS during 2015. Use the Du Pont system.

(b) Analyse whether comparing the performance of HMM against HTS will be meaningful. (

Answer 1

a]

ROE = Net profit margin * Total Asset Turnover * Equity Multiplier

HMM = 5.60% * 0.75 * 2.50 = 10.50%

MS = 8.40% * 0.625 * 2.67 = 14.02%

MS has a higher ROE due to its higher net profit margin, higher total Asset Turnover and higher equity Multiplier

b]

Comparing the performance of HMM against HTS will not be meaningful because :

• HMM is in the heavy manufacturing sector whereas HTS is in the service sector
• HTS has high return on equity and assets, high margins and high turnover ratios relative to HMM
• HTS has a low equity multiplier relative to HMM