Question

QUESTION 1

Read the following passage and answer the question that follows.
You are an independent investment analyst. One of your clients, Mr. Watson recently approached you about a potential investment in Make A Lot Manufacturing corporation (hereafter Make A Lot) . He is an auditor and does not know how to read financial statements. Make A Lot is the parent company of a group of business engaged in the manufacturing of heavy duty machinery and value added service to heavy duty machine operators which command leadership positions in their respective markets.
Mr. Watson completed analysis of the year ended 31 March 2016 and 2017. He also obtained industry ratios from a local university which keeps track of the industry. He summarized the information and presented as below.

	2017
	make a lot	industry
return on equity	16.23%	17%
return on asset	5.89%	12%
net profit margin	12.84%	12%
total asset turnover	0.46 times	1 time
*financial leverage multiplier	75 times	1.42 times

	2016
	make a lot	industry
Return on equity	9.48%	15%
return on asset	3.7%	10%
net profit margin	8.79%	10%
total asset turnover	0.44 times	1 time
*financial leverage multiplier	50 times	2.45 times

*Financial Leverage Multiplier = Total Assets / Total Equity
Financial Leverage multiplier uses the ratio between the company’s total assets to its stockholder’s equity to measure a company’s financial leverage. It is an indication of a company’s gearing, ie. How much debt is being used in the capital structure.

Required:
Comment on the Make A Lot financial information and recommend to Mr. Watson whether he should invest in the company or not.

Answer 1

• ROE is significantly lower than industry in 2016, whereas ROE became close to industry average in 2017
• From Dupont formula ; ROE= net profit margin* asset turnover* leverage ; we can see that the company has raised the leverage significantly( from 50 to 75) and hence increased the ROE.
• Also the leverage of the company is almost 20 time in 2016 compared to industry and around 50 times in 2017 compared to industry standards
• Similarly other ratios like ROA, Asset turnover etc are substandard compared to the industry average.

Hence analysing all these investing in Make a lot company will be too much riskier because of its debts and will result below average returns compared to the risk taken.