Question

Financial Statement Analysis Case

Ragatz, Inc.

Ragatz, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP.

	2017 (000)
Current liabilities	\(554,114
Convertible subordinated debts	648,020
Total liabilities	1,228,313
Stockholder’s equity	176,413
Net income	58,333

Analysts attempting to compare Ragatz to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt.

Instructions

(a) Compute the following ratios for Ragatz, Inc. (Assume that year-end balances approximate annual averages.)

(1) Return on assets.

(2) Return on common stock equity.

(3) Debt to assets ratio.

(b) Briefly discuss the operating performance and financial position of Ragatz. Industry averages for these ratios in 2017 were ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain.

(c) Assume you want to compare Ragatz to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Ragatz’s convertible bonds is \)150,000, how would you adjust the analysis above to make valid comparisons between Ragatz and Merck?

Short answer

(a) Financial ratios

Return on assets	4.15%
Return on equity	33.06%
Debt to asset	87.44%

(b) The company is performing well, but the company's financial position is not good.

(c) Financial ratios under IFRS

Return on assets	4.15%
Return on equity	17.87%
Debt to asset	76.76%

Step-by-step solution

Definition of Financial Ratios

The comparison made for financial analysis between the various items reported on the financial statement is known as financial ratios. These ratios are used for making a summarized report on the company’s performance.

Calculation of ratios

(1) Return on assets

$\begin{array}{c}Returnonassets=\frac{NetIncome}{TotalAssets}\times 100\\ =\frac{\$58,333}{\$176,413+\$1,228,313}\times 100\\ =\frac{\$58,333}{\$1,404,726}\times 100\\ =4.15\%\end{array}$

(2) Return on common stock equity

$\begin{array}{c}Returnonequity=\frac{NetIncome}{Stockholdersequity}\times 100\\ =\frac{\$58,333}{\$176,413}\times 100\\ =33.06\%\end{array}$

(3) Debt to assets ratio

$\begin{array}{c}Debttoassetsratio=\frac{\text{Total\hspace{0.17em}Debts}}{\text{Total\hspace{0.17em}Assets}}\\ =\frac{\$1,228,313}{\$176,413+\$1,228,313}\times 100\\ =\frac{\$1,228,313}{\$1,404,726}\times 100\\ =87.44\%\end{array}$

Operating performance of the company

1. According to the industry average return on assets, the business entity is performing well because the actual ratio of the business entity is more than the industry average.

2.The industry average return on common stock equity is 16%, and the actual return on the common stock company is generating equals 33.06%. It means that the company generates more profit for stockholders than industry averages.

3.The company's debt to asset ratio is 87.44%, which is more than the industry average of 75%, which means that the company is not in a good financial position as most of its assets are financed through debt.

Even if the company is performing well, the debt to the asset is very high, reflecting that investing in the company’s bonds is riskier. But the investors might be attracted to the convertible bonds because the return on equity is higher than might increase the price of the shares, and investors can generate gain from such an increase in the prices.

Adjustments in the financial ratios

Under IFRS, the convertible bonds' equity and debt components of the convertible bonds are recorded separately. While under GAAP, these are not reported separately; therefore, the equity component of convertible bonds will be reported separately, which will affect the ratios.

	2017 (000)
Current liabilities	$554,114
Convertible subordinated debts $(\$648,020-\$150,000)$	498,020
Total liabilities $(\$1,228,313-\$150,000)$	1,078,313
Stockholder’s equity $(\$176,413+\$150,000)$	326,413
Net income	58,333

(1) Return on assets

$\begin{array}{c}Returnonassets=\frac{NetIncome}{TotalAssets}\times 100\\ =\frac{\$58,333}{\$176,413+\$1,228,313}\times 100\\ =\frac{\$58,333}{\$1,404,726}\times 100\\ =4.15\%\end{array}$

(2) Return on common stock equity

$\begin{array}{c}Returnonequity=\frac{NetIncome}{Stockholdersequity}\times 100\\ =\frac{\$58,333}{\$326,413}\times 100\\ =17.87\%\end{array}$

(3) Debt to assets ratio

$\begin{array}{c}Debttoassetsratio=\frac{\text{Total\hspace{0.17em}Debts}}{\text{Total\hspace{0.17em}Assets}}\\ =\frac{\$1,078,313}{\$176,413+\$1,228,313}\times 100\\ =\frac{\$1,078,313}{\$1,404,726}\times 100\\ =76.76\%\end{array}$