Teaching Note 4

Financial Ratio Analyisis

Common Financial Ratios:
An Illustration using the Pharmaceutical Industry, 1981

Squibb's History: Edward Squibb was a Navy doctor who developed techniques for making pure ether and chloroform, early anesthetics. In 1858 Squibb started one our oldest drug firms in New York City. He turned over control of Squibb to his sons in 1891. One of Merck's investors, Theodore Weicker, acquired a major interest in Squibb in 1905. Squibb became a major supplier of penicillin and morphine during WWII. By the 1950's sales were over $100 million. In 1952 Squibb was acquired by Mathieson Chemical, and then by Olin Industries in 1953. In 1968 Squibb became an independent, public company, and merged with Beech-Nut. Squibb-Beech Nut became Squibb Corporation in 1971. By 1975 sales were $1 billion. In the 1970's Squibb introduced two, new major cardiovascular drugs. When Bristol-Myers bought out Squibb in 1989 to form Bristol-Myers Squibb Company, Fortune rated the $12.7 billion purchase as the second biggest "Deal of the Year" (after $25 billion RJR/Nabisco).

Smith-Kline's History: Founded in 1830 in Philadelphia, SmithKline became a major pharmaceutical company, developing Benzedrine inhaler (1936), Dexedrine (1944), and Tagamet (1976). The cold remedy Contac and the ulcer drug Tagamet greatly increased revenues in the 1980's. SmithKline diversified and invested heavily in R&D. With investments not successful, R&D not productive, and a rival's (Glaxo) Zantac outselling Tagamet two to one, SmithKline agreed to merge with Beecham in 1989.

Bristol-Meyers' History: Clinton Pharmaceutical of Clinton, NY was founded by William Bristol in 1887, but was renamed Bristol-Meyers in 1900. The firm sold bulk pharmaceuticals to doctors and druggists. In 1943 the company bought Cheplin Biological Labs and began manufacturing tetracycline, penicillin, and other antibiotics. In the 1950's Bristol-Myers acquired drug companies in England and Germany. In 1959 Clairol was acquired and in the 1960's, and 1970's consumer products (Drano, Windex), nutritional products (Enfamil, Gerber), and orthopedic implants were added. After Merck, Bristol-Meyers Squibb is the second largest drug company with pharmaceuticals for cancer, AIDS, blood pressure, cholesterol and patent drugs (Bufferin, Comtrex, Excedrin, Nuprin).

Abbott Laboratories' History: Dr. Wallace Abbott, a family doctor, founded the Abbott Alkaloidal Company in a Chicago suburb in 1888. He had improved a pill that supplied a uniform amount of a drug. In early days, Abbott was criticized by the AMA for his aggressive selling tactics. During WWI Abbott Labs synthesized anesthetics and sedatives. A strong R&D was established in 1922 by acquisition. In 1928 a strong sales force was acquired when Abbott bought John T. Milliken and Company. In 1929 the company went public and continued its acquisitions. In WWII Abbott introduced different types of penicillin, leading to Erythrocin in 1952. In the 1960's consumer goods were added (Selsun, Murine, Similac) and hospital products in the 1970's (monitors, IV equipment, drug testing).

Market to Book Analysis: Below is an illustration of an application of stock market valuation and balance sheet valuation ratios to detect strategic issues.

Examine Squibb's and Smith Kline's M/B ratio, 1977-1981:

These ratios reveal underlying dynamics:

1. 1981 Squibb introduced a new product - M/B goes up.
2. Smith-Kline's ratio is declining- maybe because the patent for Tagamet is expiring
(this drug accounts for most of sales).
3. Average for industry is high - a good business to be in.
N.B.: Squibb's performance consistently lagged the industry average. In the late 1980's Squibb was acquired by Bristol-Myers in a non-hostile takeover.

Liquidity Ratios:

Before the firm can focus on a strategy, it must be able to meet its current financial obligations. Liquidity is the ability of the company to convert short-term assets to cash. Liquidity measures the degree to which liquid assets are available to meet current obligations.

Current Ratio. Current assets (cash, marketable securities, account s receivable, and inventory) and current liabilities are the firm's "working capital". Current assets are the assets from which cash is most likely to be realized in a reasonable time. The higher the current ratio, the more liquid the company.

Quick Ratio: This "acid test" measure of liquidity excludes inventory to capture "quickly" convertible assets available to pay current liabilities. Inventories that cannot be sold can inflate the current ratio and overestimate a firm's liquidity.

Leverage-Capital Ratios:

Leverage ratios measure the relative amount of debt employed and the ability of the firm to meet its financial obligations.

Long-Term Debt/Equity Ratio. This measures the relationship between the sources of capital for a business: long-term debt and equity. These are the permanent funding sources. To assess the capital structure, or the relative contribution of debt and equity, this ratio is helpful.

Total Debt/Equity. This ratio compares the two sources of business financing: debt and equity. Debt financing has been cheaper then equity financing. Tax laws permit the "write off" of some interest payments. A 14% interest debt can cost only 7% because of tax laws. Also, when equity is used, ownership and control is diluted. Therefore, many firms avoid use of equity financing.

Times Interest Earned: Periodic interest payments must be made to pay for debt. Interest expenses must be considered by looking at a firm's earnings before taxes are paid. Income taxes are usually assessed only if there are net earnings (profits) after interest is paid to debtors. So, the ratio uses the pre-tax earnings.

A high multiple indicates that the firms has a high ability to pay debt interest. Profits could fall some and the company could meet its debt service. A high multiple also indicates that the firm can borrow funds.