CH-3 Cash Flows and Financial Analysis – Practical Financial Management : Book Guide

CHAPTER 3 CASH FLOWS AND FINANCIAL ANALYSIS FOCUS The first half of the chapter is focused on cash flow in business. The emphasis is on understanding where cash comes from, what it's used for, and how to get that information out of financial statements. The second half of the chapter deals with financial analysis. A series of ratios are presented along with discussions of the kinds of problems they're designed to illuminate. Practical issues like the interpretation of a long collection period are considered in detail. PEDAGOGY Cash Flows: Students often find cash flow confusing, so extra care is taken to develop the ideas carefully starting with examples from personal life. After mastering the basic concepts, we move into business applications. Ratio Analysis: It's difficult to get students without business experience to appreciate ratio analysis. They calculate ratios readily enough, but have a hard time imagining what a particular comparison or trend implies about operations. For this reason we've spent extra time on the interpretation and implications of ratios. The comprehensive problem at the end of the chapter (problem 15) is designed to drive the interpretation ideas home. We suggest that you lecture on the material and assign the problem to be gone over in class after students have wrestled with it themselves. The numbers are straightforward, but you can get a lot of mileage out of having the students role play the analyst and propose possible reasons for the numerical results. The solution in this manual will give you a lot to work with. The problem and solution are drawn from the author's experience in doing just this kind of analysis in business. TEACHING OBJECTIVES Students should gain a thorough understanding of cash flow principles and the mechanics of constructing cash flows from the balance sheet and income statement. They should also develop an appreciation of financial analysis. Special emphasis should be given to the interpretation of ratios. Students tend to compute ratios, state whether they're higher or lower than a comparative figure and stop. They should be forced to think of operational reasons why the ratios are as they are. OUTLINE I. FINANCIAL INFORMATION - WHERE DOES IT COME FROM, WHO USES IT, AND WHAT ARE WE LOOKING FOR? A. Users of Financial Information Users include investors, vendors, and management. What each looks for B. Sources of Financial Information Annual Report and its biases, other sources. C. The Orientation of the Analyst The analyst is critical and investigative, looking for current and potential problems. II. THE STATEMENT OF CASH FLOWS A. How the Statement of Cash Flows Works - Preliminary Examples Introductory examples using personal assets and liabilities to ease into cash flow concepts. B. Business Cash Flows Overview and diagrams of cash flow ideas. Rules for analyzing changes in balance sheet accounts. C. Constructing the Statement of Cash Flows The mechanics of creating the statement from beginning and ending balance sheets and an income statement. D. Free Cash Flows The cash available for distribution to investors after reinvestment needs are satisfied. III. RATIO ANALYSIS Description of the idea and process. A. Comparisons Ratios give the best information when compared with history, competitors, or budgeted figures. B. Common Size Statements The income statement stated as percents of revenue facilitates comparisons over time and between firms. C. Ratios The general concept of ratio analysis, average or ending values for balance sheet numbers, and ratio categories. D. Liquidity Ratios Will the firm be able to pay its bills in the short run? The Current and Quick Ratios. E. Asset Management Ratios How well does the firm manage receivables, inventory, and fixed assets. A brief discussion of the pitfalls of receivables and inventory. F. Debt Management Ratios The benefit and risk of leverage. Measurements to determine whether the firm has too much debt. Coverage and Leverage Ratios. G. Profitability Ratios Assessing the bottom line. Returns on sales - how well are costs and expenses controlled, return on assets - includes a grade on asset management, return on equity - adds the effect of using borrowed money. H. Market Value Ratios What does the market think of the firm. The price earnings ratio, and the market to book value ratio. I. Du Pont Equations The relationships between ratios and their implications for running the business. Development of the equations. J. Using the Du Pont Equations The equations used in comparisons give insights into where to put management attention to improve performance. K. Sources of Comparative Information Where to get information on competitors and industry averages: D&B, Robert Morris Associates, Value Line. L. Limitations and Weaknesses of Ratio Analysis The things that make ratio analysis less than perfect. Diversified companies, window dressing, etc. QUESTIONS 1. List the main user groups of financial information. What are the reasons for their interest? Answer: There are three primary groups of users of financial information: Investors use the information to assess whether or not they want to put money into the company. Equity investors look for an indication of stability and the potential for long term growth. Debt investors are concerned with the firm's ability to generate cash to make interest and principal payments. Vendors who supply the firm on credit look for its ability to pay its bills (liquidity) in the short term. Management uses financial information to pinpoint problem areas for improvement in operations. 2. Where do analysts get financial information about companies? What are their concerns about the information? Answer: Financial information about companies comes mainly from the companies themselves. The primary source is the annual report. Since the annual report is essentially a report on the performance of management written by management, it tends to be favorably biased. The numerical information is usually correct, but the accompanying verbiage can be deceptively positive in tone and implication, especially with respect to prospects for the future. 3. Financial analysts are generally optimists who believe what they're told. Right or wrong? Explain. Answer: Wrong. The whole idea behind financial analysis is to be investigative and critical. The analyst is always looking for potential problems that may make the future less attractive than the past. 4. If a company's cash account increases from the beginning to the end of the year, there's more cash on hand so that must be a source of cash. Yet the cash account is an asset and the first cash flow rule says that an asset increase is a use of cash. Explain this apparent conflict. Answer: Cash in the bank is an asset that had to be put there. Putting it there uses cash that then can't be used anywhere else until it's withdrawn. In a sense, the firm "buys" a balance in its checking account with cash deposits. Therefore, increasing the cash balance uses cash. 5. Why don't we calculate the total difference in the equity accounts between the beginning and end of the year and consider that difference as a source or use of cash? Why do we similarly exclude the cash account? Answer: Changes in the equity accounts come from three sources, net income, dividends and the sale of new stock. Net income is included in operating activities, while dividends and new stock sales are part of financing activities. Since the items are included in the cash statement format, there is no need to consider changes in equity as a difference. The change in the cash balance is treated as a reconciling item in the cash flow format. Essentially the cash statement "proves" the cash balance. 6. What are free cash flows? Who is likely to be most interested in them? Why? Answer: Free cash flow is a firm's gross cash flow less necessary reinvestments. It's essentially cash available for distribution as interest, dividends, or debt reduction. When one company acquires another, the acquirer is interested in the future free cash flow of the company being acquired as an indication of whether the parent firm will have to provide more cash after the acquisition from equity investment or borrowing or will be able to reduce debt or take cash out for use elsewhere. 7. Outline the thinking behind ratio analysis in brief, general terms (a few lines; don't go into each ratio individually). Answer: Ratios are formed by dividing sets (usually pairs) of numbers drawn from financial statements. The magnitude of each ratio serves as a measure of the firm's performance with respect to some aspect of its business. Taken together, ratios can give an overall picture of how effectively a firm is being managed. 8. Financial ratios don't do you much good by themselves. Explain. Answer: Performance on particular ratios differs a great deal between types of business. Therefore, a ratio value doesn't mean much without a comparison to some standard that indicates whether performance is good or bad. The common comparisons are with the competition, history, and budget. 9. What is the reasoning behind using the current ratio as a measure of liquidity? Answer: The money flowing into and out of a firm due to normal business operations passes respectively through current assets and current liabilities that are defined to become or require cash within a year. Hence, at a point in time, anything coming in within a year is in current assets while anything going out in a year is in current liabilities. This suggests comparing the two through a ratio as a measure of liquidity. 10. Why do we need the quick ratio when we have the current ratio? Answer: Inventory is particularly subject to overstatement and may be difficult to convert to cash. Therefore, a measure of liquidity that does not depend on inventory is appropriate. 11. A company's terms are net 30 and the ACP is 35 days. Is that cause for alarm? Why or why not? Answer: Probably not, since customers routinely stretch payables, and an ACP of five days over terms isn't unusual. It could, however, indicate a substantial long overdue account among a majority of customers paying on time. If that's the case, the account may be uncollectible and require a write off. 12. Discuss the different definitions of debt in ratio analysis. Answer: Debt is sometimes taken to mean interest bearing, long-term bonds or loans only. Another definition includes short-term interest bearing notes and loans. A third approach includes current liabilities, which generally don't bear interest. Academics tend to view any obligation to pay money in the future as debt while practitioners favor the narrower definitions. When dealing with debt management ratios it is important to define exactly what is meant. 13. Why do people view having too much debt as risky? If you were interested in determining whether a company had too much debt, what measure would you use? Why? How much debt do you think would generally be considered too much? Answer: Debt is risky because it burdens the income statement with interest that must be paid regardless of profitability. Hence a leveraged company will fail more easily in bad times than one without debt. Too much debt depends to some extent on industry practice. The TIE ratio is a good indicator of whether the interest burden is excessive relative to the firm's ability to generate earnings. The debt ratio and the debt to equity ratio are good measures relative to other firms. There's no exact amount of debt that's too much, however, most financial analysts feel that debt in excess of 60% of capital (long term debt + equity) is becoming excessive. 14. It can be argued that the TIE ratio doesn't make much sense. Why? How would you change the measure to be more meaningful? (Hint: Think in terms of cash flows.) Answer: TIE measures the number of times EBIT covers interest. However, interest is a cash expense while EBIT does not represent cash flow. Therefore situations can exist in which TIE appears high but there isn't much cash to cover interest payments. A modification of the ratio that adjusts EBIT to more closely reflect cash flow would help. 15. Can managers affect market value ratios? Answer: Only indirectly. Market value ratios depend on the perceptions of investors as reflected in the price of a firm's stock. That price is influenced by the things managers do and by a number of other factors outside of management's control. Hence the ability of managers to influence market prices and therefore market value ratios is limited and imprecise. 16. Can A competent financial analyst always correctly assess a firm’s financial health from publicly available information? Explain. Answer: No. Managements have the ability to manipulate financial information to make a company’s performance look better than it is, and many do just that. The severity of this practice varies from interpreting accounting rules as favorably as possible to outright fraud. Auditors are supposed to prevent this kind of deception, which leads to misstated financial results, but often miss it. In extreme cases auditors have been known to participate in deceiving the investing public in order to curry favor with a client firm’s management which historically controlled approval and payment of audit fees. BUSINESS ANALYSIS 1. The present format for the statement of cash flows is organized according to operating activities, investing activities, and financing activities. That format has only been in use since the late 1980s. The previous format first listed all sources and then all uses of cash, giving a subtotal for each. Cash flow was then the difference between the two subtotals. What advantages or disadvantages do you see of the current format in relation to the old one? Which would you prefer if you had a choice? Answer: The new format highlights the different kinds of things a company does. It's a step in the direction of presenting a broad picture of businesses in the sense we described as an objective of accounting in Chapter 2. In that respect it is better for financially unsophisticated readers, because the format itself contains a certain amount of analysis. The old format is a more "nuts and bolts" treatment of where money came from and where it's gone. It's probably a little easier for people in the Treasury Department to use. Professionals, however, can easily get the same information from either presentation. 2. A company has been growing rapidly for the last three years. It was profitable before the growth spurt started. Although this year's revenues are almost three times those of three years ago, the firm is now losing money. What's the first thing you would do to try to pinpoint where the problem(s) may be? Answer: Construct a set of common size income statements to cover the past three years to see which costs and expenses are growing faster than revenue. 3. The term "liquidity" is used in several ways. What does it mean in the context of an asset or liability such as those on the balance sheet? What does it mean when applied to an operating company? What does the similar term "liquidate" mean when applied to a company? Answer: The liquidity of a balance sheet item refers to how readily it can be converted into cash without a substantial loss (asset) or how soon it will require cash (liability). An operating company's liquidity refers to its ability to meet its short term financial obligations (pay its bills). To liquidate a company means to sell its assets to pay off its liabilities. 4. The industry average inventory turnover ratio is 7 and your company's is 15. This could be good or bad news. Explain each possibility. How would you find out whether or not it is bad news? Answer: Your firm is running with a lot less inventory than the average. That's good news if it's due to efficient management. It's bad news if you're operating with insufficient inventory. Check to see if there are a lot of unfilled orders and lost sales due to stockouts. Also look for frequent stops in production operations due to running out of inventory. If these exist, the news is probably bad; if not, it's good. 5. You invested $20,000 in the stock of Hi Fly Inc two years ago. Since then the stock has done very well more than doubling in value. You tried analyze Hi Fly’s financial statements twice in the last two years, but were confused by several of the detailed notes to those statements. You haven’t worried about it though, because the statements show a steady growth in revenue and earnings along with an unqualified opinion by the firm’s auditors that they were prepared using generally accepted accounting principles (GAAP). While checking your investments online this morning you were shocked to see that Hi Fly’s stock price had declined by 30% since you last checked it a week ago. What may have happened? Answer: Hi Fly’s management may have been caught holding the company’s stock price up by manipulating its financial statements to look better than they have actually been. This may have been done without the auditors’ noticing the misstatements or with their cooperation. In an extreme case, the revelation and the resulting loss of investor confidence could lead to an even further decline in the stock’s price which may never recover. PROBLEMS A Business Statement of Cash Flows – Current Account Detail – Example 3-1 (page 76) 1. The Waterford Wax Company had the following current account activity last year. a. Calculate and display the current account detail required for the Cash From Operating Activities section of the Statement of Cash Flows. b. If you also knew that Waterford’s revenues had risen by 20% last year, would you be concerned about the firm’s financial health? Why? (Words only.) Solution: a. Waterford’s current account detail is: b. We should be very concerned about Waterford’s financial health. The percentage increases in receivables and inventory far outstrip the gain in sales revenue. This indicates that the firm may be having trouble collecting its receivables and has likely invested in inventory it can’t sell. The fact that payables have also risen dramatically indicates Waterford may be having trouble paying its bills on time. The magnitude of these increases makes it look like failure may be just around the corner. A Business Statement of Cash Flows – Operating Activities – Example 3-1, (page 77) 2. Timberline Inc. has the following current accounts last year. ($000) In addition, the company had sales revenues of $9,453,000 and costs and expenses (including interest and tax) of $7,580,000. Depreciation of $1,462,000 is included in the cost and expense figures. Construct a statement showing Timberline’s Cash From Operating Activities including a detail of changes in balance sheet accounts. Solution: A Business Statement of Cash Flows – Example 3-1 (page 76) 3. Latigoe Inc. has the following financial statements for 20X8. In addition the company paid stockholders dividends of $2.9 million and received $4.8 from the sale of new stock. No fixed assets were retired during the year. (Hint: That implies fixed asset purchases and depreciation are the changes in the gross fixed asset and accumulated depreciation accounts.) Latigoe Inc. Balance Sheet For the period ended 12/31/X8 ($000) ASSETS 12/31/X7 12/31/X8 Cash $3,245 $2,647 Accounts Receivable 7,943 5,614 INCOME STATEMENT Inventory 12,408 13,653 Period ended 12/31/X8 CURRENT ASSETS $23,596 $21,914 Sales $67,916 Fixed Assets COGS 35,281 Gross Mrgn $32,635 Gross $66,098 $72,166 Depreciation $4,268 Accum. Depreciation (47,040) (51,308) Expense $18,004 Net $19,058 $20,858 EBIT $10,363 Interest 1,096 TOTAL ASSETS $42,654 $42,772 EBT $9,267 Tax 3,707 Net Income $5,560 LIABILITIES Accounts Payable $1,699 $2,208 Accruals 950 754 CURRENT LIABILITIES $2,649 $2,962 Long-Term Debt $ 9,007 $1,352 Equity 30,998 38,458 TOTAL CAPITAL $40,005 $39,810 TOTAL LIABILITIES AND EQUITY $42,654 $42,772 Construct Latigoe’s Statement of Cash Flows for 20X8. Solution: First summarize the changes in working capital as follows. The Statement of Cash Flows follows. 4. Fitch Inc’s financial statements are as follows: FITCH INC Balance Sheet For the period ended 12/31/X1 ($000) ASSETS 12/31/X0 12/31/X1 Cash $2,165 $2,647 Accounts Receivable 4,832 5,614 INCOME STATEMENT Inventory 3,217 2,843 Period ended 12/31/X1 CURRENT ASSETS $10,214 $11,104 Sales $40,506 Fixed Assets COGS 14,177 Gross $35,183 $39,456 Gross Mrgn $26,329 Accum. Depreciation (22,640) (24,852) Expense $19,487 Net $12,543 $14,604 EBIT $6,842 Interest 180 TOTAL ASSETS $22,757 $25,708 EBT $6,662 Tax 2,265 Net Income $4,397 LIABILITIES Accounts Payable $1,642 $1,420 Accruals 438 1,228 CURRENT LIABILITIES $2,080 $2,648 Long-Term Debt $ 1,823 $ 409 Equity 18,854 22,651 TOTAL CAPITAL $20,677 $23,060 TOTAL LIABILITIES AND EQUITY $22,757 $25,708 Fitch also sold stock for $2.5 million and paid dividends of $3.1 million. No fixed assets were retired during the year. (Hint: That implies fixed asset purchases and depreciation are the changes in gross and accumulated depreciation accounts.) Construct Fitch’s Statement of Cash Flows for 20X1. Solution: First summarize the changes in working capital as follows. The Statement of Cash Flows follows. 5. Axtel Company has the following financial statements: AXTEL COMPANY Balance Sheet For the period ended 12/31/X1 ($000) ASSETS 12/31/X0 12/31/X1 Cash $3,514 $2,875 AXTEL COMPANY Accounts Receivable 6,742 5,583 Balance Sheet Inventory 2,573 3,220 For the period end 12/31/X1 CURRENT ASSETS $12,829 $11,678 Sales $36,227 Fixed Assets COGS 19,925 Gross $22,478 $24,360 Gross Margin $16,302 Accum. Depreciation (12,147) (13,313) Expense $10,868 Net $10,331 $11,047 EBIT $5,434 Interest 713 TOTAL ASSETS $23,160 $22,725 EBT $4,721 Tax 1,605 Net Income $3,116 LIABILITIES Accounts Payable $1,556 $1,702 Accruals 268 408 CURRENT LIABILITIES $1,824 $2,110 Long-Term Debt $ 7,112 $ 6,002 Equity 14,224 14,613 TOTAL CAPITAL $21,336 $20,615 TOTAL LIABILITIES AND EQUITY $23,160 $22,725 In addition, Axtel retired stock for $1,000,000 and paid a dividend of $1,727,000. Depreciation for the year was $1,166,000. Construct a Statement of Cash Flows for Axtel for 2001. (Hint: Retiring stock means buying it back from shareholders. Assume the purchase was made at book value, and treat it like a negative sale of stock.) Solution: First summarize the changes in working capital as follows. The Statement of Cash Flows then follows directly. 6. Fred Klein started his own business recently. He began by depositing $5,000 of his own money (equity) in a business account. Once he’d done that his balance sheet was as follows: During the next month, his first month of business, he completed the following transactions: (All payments were made with checks out of the bank account.) • Purchased $2,500 worth of inventory, paying $1,500 down and owing the vendor the remainder. • Used $500 of the inventory in making product • Paid employees’ wages on the last day of the month of $1,100. • Sold all the product made in the first month on credit for $3,000. • Paid rent of $1,200. a. Construct a balance sheet for Fred’s business at the end of its first month. (Hint: Fred’s business has only current assets, current liabilities and an equity account. Calculate the ending balance in each of the current accounts from the information given. The ending equity account balance will be the difference between the current assets and liabilities at month end.) b. Construct Fred’s income statement. (Hint: Fred’s revenue is the credit sale. His costs/expenses consist of the inventory used in product sold plus the things other than inventory for which he wrote checks. Ignore taxes.) c. Construct a statement of Fred’s Cash Flow From Operating Activities during the month. (Hint: Fred’s beginning balance sheet has only two accounts, cash and equity, each with a $5,000 balance. All other accounts open with zero balances.) d. Is Fred’s business profitable in an accounting sense? In a cash flow sense? (Words only.) e. Can the business fail while making a profit? How might that happen in the next month or so? (Words only.) Solution: a. Fred wrote checks for the following: Hence his ending cash account was $5,000  $3,800 = $1,200. The business made a $3,000 credit sale without collecting anything, so ending receivables are $3,000. Fred bought $2,500 of inventory of which $500 was sold off in product, so ending inventory is $2,000. He has one Account Payable to the inventory vendor for $1,000. There are no wage accruals, since employees were paid at the end of the month. Hence Fred’s balance sheet is as follows: b. Fred’s income statement has revenue of the $3,000 sale and cost/expense of the inventory used in product, the wages paid and the rent paid. d. Fred’s business is profitable in an accounting sense because net income is positive. But things don’t look so good from a cash flow perspective, because he’s running out of money to pay his bills. The main problem is that he hasn’t collected his receivables. Secondarily, he may have purchased too much inventory to start out. e. The business can easily fail while making an accounting profit. Indeed, that’s quite likely if the receivables aren’t collected soon, because then Fred won’t have the money to pay his employees or the rent. He could stave off failure by putting more of his own money into equity or getting a loan. However, a loan would be hard to get because of the business’s condition. 7. The Blandings Home Construction Company purchased a new crane for $350,000 this year. They sold the old crane for $80,000. At the time it had a net book value of $20,000. Assume any profit on the sale of old equipment is taxed at 25%. These were the only transactions that affected Investing Activities this year. Construct the Cash Flow From Investing Activities section of the Statement of Cash Flows to concisely convey the maximum information to readers of the company’s financial statements. Solution: First calculate the profit and cash flow effects of the sale of the old crane. Now note that the profit figure is irrelevant for cash flow purposes, because the cost of the sale, the undepreciated book value of the asset, isn’t an out of pocket expense. Hence the relevant cash flow from selling the old crane is simply $65,000, the difference between the $80,000 received and the $15,000 paid in tax. The Statement of Cash Flows should include the following. Cash From Investing Activities 8. Lansing Inc., a profitable food products manufacturer, has undertaken a major expansion that will be financed by new debt and equity issues as well as earnings. During the last year the company borrowed $5 million for a term of 30 years to finance a new building to house the expanded operations. It also sold 60,000 shares of $4 par value stock at $51 per share to pay for new equipment. It also paid off short term loans that support inventory and receivables totaling $700,000 as they came due and took out new short-term debt for the same purpose of $850,000, which was outstanding at year end. Lansing also made a scheduled payment of $500,000 on an old long-term loan with which it had acquired production equipment several years ago. The payment included interest of $425,000. Finally the firm paid dividends of $2.50 per share on 700,000 shares of outstanding common stock. Calculate and display the Cash From Financing Activities section of Lansing’s Statement of Cash Flows. Solution: First calculate the entries: 9. The Seymour Corp attempted to increase sales rapidly in 20X1 by offering a new, low cost product line designed to appeal to credit customers in relatively poor financial condition. The company sold no new stock during the year but paid dividends of $3,000,000. Depreciation for the year was $7,851,000, and no fixed assets were retired or sold. The firm had the following financial statements for 20X1. a. Without preparing a statement of cash flows, examine the changes in each balance sheet account and summarize in rough terms where Seymour got its cash and what it spent the money on. Include the sum of net income and depreciation as a source of cash. b. Construct a statement of cash flows for Seymour Corp. How does the information available from the statement compare with the results of your analysis in part a? c. Does it look like Seymour may be headed for financial trouble? Explain the possible implications of the new product and credit strategy on individual accounts. (Hint: Consider the implications of two extreme scenarios, the new product is doing very well or very poorly.) Solution: a. Seymour got over $14 million in cash from earnings (net income plus depreciation). It also borrowed almost $12 million formally, and effectively increased its borrowing from suppliers (payables) by about $3 million. All these totaled just under $29 million. The statement of cash flows by itself lacks the current account information necessary to fully analyze Seymour's condition. If that supporting detail is included, however, all of the information collected in part a is conveniently available in the statement. c. Two extreme scenarios are possible that would explain Seymour’s present situation. The difference between them hinges on whether the new product introduction was successful or unsuccessful. If the product was successful, the cash flows detailed in part a are unlikely to be a problem. If it was unsuccessful, however, those cash flows are likely to signal a crisis in the near future. In either case, it’s likely that the increase in fixed assets reflects spending on equipment to get ready to produce the new line. If the new product is successful that would have been a good investment, if not it may have been a waste of money. If the product was successful and sales increased substantially, the increase in receivables may be due to that jump in revenues, which would be good news. On the other hand, the receivables increase may be due to the financial weakness of the new customers. That is, many may not be paying their bills. That could be very bad news because such accounts may never be collected. The inventory increase is also likely to be due to the new product. If sales increased a lot, a higher inventory level would be appropriate to support the higher level of production – good news. But the inventory buildup may have been in anticipation of a sales increase that never materialized. If that’s the case, Seymour may be overstocked with materials it will never sell, which implies a big write off (loss) in the future. Payables are subject to similar reasoning. If sales increased significantly, higher payables probably imply a higher level of inventory purchases consistent with increased volume. But if things aren’t going well, higher payables probably mean Seymour isn’t paying its bills on time because it doesn’t have the cash. Generous dividends are usually paid to stockholders when a firm is doing well, which could be the case if the new product is a success. But sometimes managements pay high dividends in bad times to create an illusion of success and confidence in the future. Such a move often has an element of desperation which might be the case if the new venture was a failure. More analysis is necessary to determine what’s going on starting with an examination of last year’s income statement. A Free Cash Flow Business Analysis – Example 3-2 (page 82) 10. A group of investors is considering buying the Wheelwright Corporation, but does not want to contribute to the company’s financial support after the purchase. Wheelwright’s management has offered the following financial statements covering last year ($M omitted): Wheelwright paid no dividends and sold no new stock during the year. The firm’s tax rate is 30%. a. Develop Wheelwright’s free cash flow and make a recommendation as to whether it seems to be an appropriate acquisition for the investors. b. Assume that the investors will purchase the company subject to its existing debt ($59M). Does that change your recommendation? Solution: a. First calculate Wheelwright’s net operating profit and operating cash flow NOPAT = EBIT(1-T) = $35 (1-.3) = $24.5 and Operating Cash Flow = NOPAT + Depreciation = $24.5 + $6 = $30.5 Then subtract increases in gross fixed assets and current accounts for free cash flow, FCF = Operating Cash Flow – Increase in Fixed Assets - Increase in Current Accounts = $30.5 - $15 + $1 = $16.5 (Notice that the effect of the change in current accounts is positive because net current assets actually decreased.) Since free cash flow is substantially positive and the potential buyers are not interested in further investment, it seems that Wheelwright is an appropriate acquisition candidate. b. Consideration of servicing Wheelwright’s debt leads to a concept known as free cash flow to equity (FCFE). This is what remains for stockholders after the firm uses cash to pay interest and make any payments required to reduce principal. Since interest is deductible, we can consider its cash flow implications after tax by multiplying by (1-T). Interest after tax = Interest (1-T) = $7 (1-.3) = $4.9 Subtracting that from free cash flow implies that Wheelwright generates almost $12M per year that’s available to pay off debt and/or distribute to shareholders. Unless the debt requires unusually large principal payments in the short run, the firm still appears to meet the investor’s requirements. 11. Slattery Industries reported the following financial information for 20X2: The firm expects revenues costs, expenses (excluding depreciation), and working capital to grow at 10% per year for the next three years. It also expects to invest $2 million per year in fixed assets, which includes replacing worn out equipment and purchasing enough new equipment to support the projected growth and maintain a competitive position. Assume depreciation is 5% of the gross fixed asset account, the tax rate is 40%, and that Slattery has no debt and therefore pays no interest. a. Make a rough projection of cash flows for 20X3, 20X4 and 20X5 assuming no new debt or equity is raised. Simply compute an income statement in each year, add depreciation and subtract increases in working capital and fixed asset purchases. Don’t assume any new debt or equity. b. Are your projections free cash flows? c. What do your projections imply for Slattery’s owners/managers? b. How would you evaluate Slattery’s ability to achieve this level of growth (as measured by the increase in fixed assets)? Solution: b. Yes. These are free cash flows because they include the new investment necessary to replace worn out equipment, provide for forecast growth, and maintain a competitive position. c. The negative free cash flows imply that Slattery can’t support its projected growth without outside financing. That means it will have to either borrow or sell new stock. Common Size Statements – Example 3-3 (page 86) 12. Linden Corp. has a 10% market share in its industry. Below are income statements ($M) for Linden and for the industry. a. Develop common sized income statements for Linden and the industry as a whole. b. What areas should management focus on to improve performance, and what kind of issues should be examined or looked for in each area? Solution: b. The first thing to notice about the % columns is that Linden is significantly less profitable that the industry norm. The difference is 1.5% of revenues, which is significant. However the operating shortfall is far worse. Focusing on EBIT we can see that Linden is a very significant 5.2% of revenue less profitable than the industry standard. That’s enough to make the company’s long-term survival questionable. The difference between net income and EBIT is largely accounted for by interest. Linden spends only 3.8% of revenue on interest while the industry spends 7.0%. That could be because Linden has a very favorable interest rate, but more likely it’s borrowing a lot less. In the long run, that could be a missed opportunity in terms of leveraging the return on equity, but for the time being it’s just obscuring how bad operating results are (exclusive of the effects of financing). To figure out what’s going on we look into problems areas and think about the kind of issues management should search for. Keep in mind, however, that differences in cost and expense percentages are only indicators of areas for investigation, not confirmation of management problems. First notice that cost of goods sold is high. This could be due to higher than average labor rates, material costs, or poorly controlled factory overhead. All should be investigated. Sales and marketing expenses account for a large portion of the variance, which is very common. Look for a commission structure that’s paying too much, under productive sales people, ineffective advertising, too many sales support personnel, padded expense accounts, luxurious field sales offices, and excessive payments to outside sales consultants. The variance in Engineering (Research and Development) is favorable, but it raises a different kind of question. Will the firm be able to keep up with its competitors if it spends proportionately less on developing new product. Administration costs, often lumped in with the finance department, are another area in which management should search for inefficiencies. Look for excessive executive salaries and bonuses, lavish travel and entertainment expenses, money spent on acquiring other companies, and any other expenditures that aren’t strictly necessary to run the business. RATIO ANALYSIS Fifteen ratios are presented, explained, and numerically illustrated on pages 87 – 98 and summarized in Table 3-2 on page 98. Problem 13 just asks you to calculate the ratios for a set of financial statements. The remaining problems ask you to explore the ratios’ meanings and the relationships between them. For most you’ll write a ratio definition as an equation, substitute values for known or targeted variables, and solve for an unknown. Some of the problems contain hints to help you get started. 13. Calculate all of the ratios discussed in the chapter for the Axtel Company of problem 5. Assume Axtel had leasing costs of $7,267,000 and amortization of $1,416,000 in 20X1, and had 1,268,000 shares of stock outstanding that were valued at $28.75 per share at year end. The firm also must make principal repayments of $1,012,000 on its debt this year. Solution: Current Ratio Curr Assets / Curr Liabilities = $11,678 / $2,110 = 5.5 Quick Ratio [Curr Assets  Inv] / Curr Liabs = ($11,678  $3,220) / $2,110 = 4.0 Average Collection Period (ACP) [Accts Rec / Sales]  360 = [($5,583 / $36,227)  360] = 55.5 days Inventory Turnover COGS / Inventory = $19,925 / $3,220 = 6.2 OR Sales / Inventory = $36,227 / $3,220 = 11.3 Fixed Asset Turnover Sales / Fixed Assets = $36,227 / $11,047 = 3.3 Total Asset Turnover Sales / Total Assets = $36,227 / $22,725 = 1.6 Debt Ratio [Long Term Debt + Curr Liab] / Total Assets = ($6,002 + $2,110) / $22,725 = 35.7% Debt to Equity Ratio Long Term Debt : Equity = $6,002 : $14,613 = .41:1 Times Interest Earned (TIE) EBIT / Interest = $5,434 / $713 = 7.6 Cash Coverage [EBIT + Deprec] / Interest = ($5,434 + $1,166) / $713 = 9.3 Fixed Charge Coverage [EBIT + Lease Pmts] / [Interest + Lease Pmts] = ($5,434 + $7,267) / ($713 + $7,267) = 1.6 EBITDA Coverage [EBIT + Depreciation + Amortization + Lease Pmts] / [Interest + Lease Pmts + Principal Repayment] = ($5,434 + $1,166 + $1,416 + $7,267) / ($713 + $7,267 + $1,012) = $15,283 / $8,992 = 1.70 Return on Sales Net Income / Sales = $3,116 / $36,227 = 8.6% Return on Assets Net Income / Total Assets = $3,116 / $22,725 = 13.7% Return on Equity Net Income / Equity = $3,116 / $14,613 = 21.3% Price Earnings Ratio (P/E) First calculate the Earnings per Share (EPS) EPS = Net Income / # shares outstanding = $3,116 / 1.268 million = $2.46 Then P/E = Stock Price / EPS = $28.75 / $2.46 = 11.7 Market to Book Value Ratio First calculate the Book Value per Share BV per Shr = Equity / # shares outstanding = $14,613 / 1.268 million = $11.52 Then Mkt to Bk Value = Stock Price / BV per shr = $28.75 / $11.52 = 2.5 14. Norton Industries recorded total cost of goods sold for 20X2 of $6.5 million. Norton had the following inventory balances for the months indicated (end of period balances): a. Compute inventory turnover for Norton using the following methods to calculate the inventory figure: 1. End of year 2. Average of the beginning and end of year 3. Average of the ends of quarters (use the five quarter ends) 4. Average of the ends of months (use the 13 month ends) b. Which method provides the most accurate picture of Norton’s inventory management? Why? c. Which method do you think Norton is currently using? Why? Solution: a. (1) $6.5 / $1.19 = 5.46x (2) $6.5 / $1.195 = 5.44x (3) $6.5 / $1.288 = 5.05x (4) $6.5 / $1.555 = 4.18x b. There is quite a bit of fluctuation in the inventory balances from month to month. This is really only captured by using end-of-month balances. c. We can’t be sure, but there is a rationale that supports a guess that Norton is using the end-of-quarter approach. The end-of-quarter balances are significantly lower than those in the intervening months. That might mean management is only paying attention to the inventory levels when they are being measured for performance. This is called window dressing. There are other explanations for this kind of pattern (e.g. seasonality) but it would be worth looking into. 15. Partridge Inc. sells about $45 million a year on credit. Good credit and collections performance in the industry results in a 35 day ACP. a. What is the maximum receivables balance Partridge can tolerate and still receive a good rating with respect to credit and collections? (Hint: Write the equation defining ACP, treat the A/R balance as the unknown, substitute given or target values and solve). b. If Partridge is now collecting an average receivable in 40 days, by how much will it have to lower the receivables balance to achieve a good rating? Solution: a. Write the definition of ACP, substitute, and solve for the A/R balance. b. Substitute 40 days in the equation and solve for A/R as before. Then take the difference in the two solutions. 16. Epsom Co. manufactures furniture and sells about $40 million a year at a gross margin of 45%. a. What is the maximum inventory level the firm can carry to maintain an inventory turnover (based on COGS) of 8.0? b. If the inventory contains $1.2 million of obsolete and damaged goods which doesn't turn over at all, how fast would the active inventory have to turn over to achieve an overall turnover rate of 8.0? Solution: Notice how dramatically the presence of dead inventory changes the actual turnover performance required to make a reasonably good showing in the overall turnover number. 17. The Nelson Sheet Metal Company has current assets of $2.5 million and current liabilities of $1.0 million. The firm is in need of additional inventory and has an opportunity to borrow money on a short-term note with which it can buy the needed material. However, a previous financing agreement prohibits the company from operating with a current ratio below 1.8. What is the maximum amount of inventory Nelson can obtain in this manner. (Hint: The note will be a current liability and the purchased inventory will be a current asset of the same size, X. Form the limiting current ratio in terms of X and solve .) Solution: Let the amount of borrowed money and purchased inventory be X. Then after the purchase, both current assets and current liabilities will be increased by X, and the current ratio restriction can be stated as follows: 18. Sweet Tooth Cookies, Inc. has the following ratios What percentage of its assets are financed by equity? (Hint: Substitute into the Extended DuPont Equation.) Solution: Write the extended Du Pont Equation expressing the equity multiplier as total assets divided by equity substitute and rewrite. 19. The Paragon Company has sales of $2,000 with a cost ratio of 60%, current ratio of 1.5, inventory turnover ratio (based on cost) of 3.0, and average collection period (ACP) of 45 days. Complete the following current section of the firm's balance sheet. Solution: First, get the current asset total from the current ratio and the current liabilities total. 20. You are given the following selected financial information for The Blatz Corporation. Calculate accounts receivable, inventory, current assets, current liabilities, long-term debt, equity, ROA, and ROE. Solution: 21. Companies often use ratios as a basis for planning. The technique is to assume the business being planned will achieve targeted levels of certain ratios and then calculate the financial statement amounts that will result in those ratios. The process always starts with a dollar assumption about sales revenue. Forecast the balance sheet for Lambert Co., using the following projected information ($000). Round all projections to the nearest thousand dollars. Solution: A gross margin of 45% implies a cost ratio of 55% which leads to a cost of $5,500 if revenue is $10,000. Then Inventory Turnover = COGS / Inventory 7.0 = $5,500 / Inventory Inventory = $786 ACP = [Accts Rec / Sales]  360 42 = [Accts Rec / $10,000]  360 Accts Rec = $1,167 Current Assets / Current Liabilities = Current Ratio $2,453 / Current Liabilities = 2.0 Current Liabilities = $1,227 Total Asset Turnover = Sales / Total Assets 1.25 = $10,000 / Total Assets Total Assets = $8,000 Capital = Total Assets - Current Liabilities = $8,000  $1,227 = $6,773 Then Debt: Equity = 1: 3 implies capital is one quarter debt, hence LT Debt = $6,773 / 4 = $1,693 Then fill in the projected Balance Sheet as follows. 22. Tribke Enterprises collected the following data from their financial reports for 20X3: Complete the following abbreviated financial statements and calculate per share ratios indicated. (Hint: Start by subtracting the formula for the quick ratio from that for the current ratio and equating that to the numerical difference.) Solution: Step 1 – The inventory balance of $300,000 represents the difference between the Current Ratio and the Quick Ratio. Therefore, $300,000/x = .75, where x equals Total Current Liabilities. Total Current Liabilities = $300,000/.75 = $400,000. Step 2 – Since the Current Ratio is 1.5, x/$400,000 = 1.5, where x equals Total Current Assets. Total Current Assets = 1.5 x $400,000 = $600,000 Step 3 – Inventory Turnover = Cost of Goods Sold/Inventory, so 12 = x/300,000. Therefore, Cost of Goods Sold is $3,600,000. Step 4 – If the Gross Margin % is 40%, the Cost of Goods Sold must be 60% of Revenues. Therefore, Revenues x 60% = $3,600,000. Revenues = $6,000,000. Step 5 – Gross Margin = $6,000,000 - $3,600,000 = $2,400,000 Step 6 – Gross Margin minus Operating Expenses = EBIT. $2,400,000 - $1,120,000 = $1,280,000 = EBIT. Step 7 – TIE = EBIT/Interest Expense. 8 = $1,280,000/Interest Expense. Interest Expense = $160,000 Step 8 – Long Term Debt x Interest Rate = Interest Expense. Therefore, Long Term Debt x 8% = $160,000. $160,000/.08 = $2,000,000 = Long Term Debt Step 9 – Fixed Asset Turnover = Revenues/Fixed Assets. Therefore, 1.5 = $6,000,000/Fixed Assets. Fixed Assets = $6,000,000/1.5 = $4,000,000. Step 10 – Total Assets = Current Assets + Fixed Assets = $600,000 + $4,000,000 = $4,600,000. Step 11 – Paid-In Capital (Common Stock plus Paid-In Excess) = Number of Shares x Average Issue Price Per Share. Paid-In Capital = 290,000 shares x $5/share = $1,450,000. Step 12 – Since Assets = Liabilities + Equity and the only piece that is missing is Retained Earnings, Retained Earnings = Total Assets – Current Liabilities – Long Term Debt – Paid-In Capital = $4,600,000 - $400,000 - $2,000,000 - $1,450,000 = $750,000. Step 13 – Book Value/Share = (Paid-In Capital + Retained Earnings)/# of Shares = ($1,450,000 + $750,000)/290,000 = $7.59/share. Step 14 – Market/Book Ratio = $18.37/$7.59 = 2.42 EVA® AND MVA – Example 3-4 (page 103) 23. Milford Inc. has the following summarized financial statements ($000): Milford’s equity investors have typically demanded an expected return of at least 25% before they will buy the company’s stock Evaluate Milford’s performance using both ROE and EVA® approaches. Comment on the impact each analysis is likely to have on investors. Solution: Calculate Milford’s cost of capital. Its percentages of debt and equity are z Then calculate the cost of capital as a weighted average Calculate traditional ROE as follows: ROE = Net Income / Equity = $4,928 / $14,735 = 33.4% Next calculate EVA as follows: EVA® = EBIT(1 - T) - (debt + equity)(cost of capital %) = $9,002 (1-.35) – ($32,117)(.1581) = $5,851 - $5,078 = $773 Milford is doing well by either measure. However, the ROE approach may overstate the good news. A 33% ROE is considered extremely good in most businesses. On the other hand, although any positive EVA® implies the firm is exceeding investors’ expectations, the relatively small positive result here might imply that performance only modestly exceeds those expectations. 24. Prahm & Associates had EBIT of $5M last year. The firm carried an average debt of $15M during the year on which it paid 8% interest. The company paid no dividends and sold no new stock. At the beginning of the year it had equity of $17M. The tax rate is 40%, and Prahm’s cost of capital is 11%. Calculate Prahm’s EVA during the year and comment on that performance relative to ROE. Make your calculations using average balances in the capital accounts. Solution: Prahm clearly had a substandard performance in terms of EVA losing its stockholders a total of $645,000. On the other hand it looked pretty good in terms of ROE as a 12.6% return is usually considered fairly healthy. EVA is clearly the tougher measure 25. The Hardigree Hamburger chain is a closely held corporation with 400,000 shares of common stock outstanding. The owners would like to take the company public by issuing another 600,000 shares and selling them to the general public in an initial public offering (IPO). (IPOs are discussed briefly in Chapter 5 and in detail in chapter 8.) Benson’s Burgers is a similar chain that operates in another part of the country. Its stock is publicly traded at a price earnings (P/E) ratio of 25. Hardigree had net income of $2,500,000 in 2006. a. How much is Hardigree likely to raise with its public offering? b. What will the public offering imply about the wealth of the current owners? Solution: a. After the IPO there will be 1,000,000 shares of Hardigree stock outstanding. If the firm’s earnings remain at $2,500,000, its EPS will be EPS = $2,500,000 / 1,000,000 = $2.50 If Hardigree commands the same P/E ratio as Benson’s the new shares should sell for approximately P = EPS × P/E = $2.50 × 25 = $62.50 Which implies that selling 400,000 shares will raise $62.50 × 400,000 = $25,000,000 b. The IPO also establishes a price of $62.50 for the shares in the current owners’ hands. Hence their share of the company after the IPO (60%) will be worth about $62.50 × 600,000 = $37,500,000 26. Comprehensive Problem. The Protek Company is a large manufacturer and distributor of electronic components. Because of some successful new products marketed to manufacturers of personal computers, the firm has recently undergone a period of explosive growth, more than doubling its revenues over the last two years. However, the growth has been accompanied by a marked decline in profitability and a precipitous drop in the company's stock price. You are a financial consultant who has been retained to analyze the company's performance and find out what's going wrong. Your investigative plan involves conducting a series of in-depth interviews with management and doing some independent research on the industry. However, before starting, you want to focus your thinking to make sure you can ask the right questions. You'll begin by analyzing the firm's financial statements over the last three years. The following additional information is provided with the financial statements. Depreciation for 20X1, 20X2, and 20X3 was $200, $250, and $275 million respectively. No stock was sold or repurchased, and like many fast growing companies, Protek paid no dividends. Assume the tax rate is a flat 34% and the firm pays 10% interest on its debt. a. Construct Common Size Income Statements for 20X1, 20X2, and 20X3. Analyze the trend in each line. What appears to be happening? (Hints: Think in terms of both dollars and percentages. As the company grows, the absolute dollars of cost and expense spending go up. What does it mean if the percentage of revenue represented by the expenditure increases as well? How much of an increase in spending do you think a department could manage efficiently? Could pricing of Protek's products have any effect?) b. Construct Statements of Cash Flows for 20X2 and 20X3. Where is the company's money going to and coming from? Make a comment about their free cash flows during the period. Is it likely to have positive or negative free cash flows in the future? c. Calculate the indicated ratios for all three years. Analyze trends in each ratio and compare each with the industry average. What can you infer from this information? Make specific statements about liquidity, asset management, especially receivables and inventories, debt management, and profitability. Do not simply say that ratios are higher or lower than the average or that they are going up or down. Think about what might be going on in the company and propose reasons why the ratios are acting as they are. Use only ending balance sheet figures to calculate your ratios. Do certain specific problems tend to affect more than one ratio? Which ones? d. Construct both Du Pont Equations for Protek and the industry. What, if anything, do they tell us? e. One hundred million shares of stock have been outstanding for the entire period. The price of Protek stock in 20X1, 20X2, and 20X3 was $39.27, $26.10, and $11.55 respectively. Calculate the firm's Earnings Per Share (EPS), and its Price Earnings Ratio (P/E). What's happening to the P/E? To what things are investors likely to be reacting? How would a slowdown in personal computer sales affect your reasoning? f. Would you recommend Protek stock as an investment? Why might it be a very bad investment in the near future? Why might it be a very good one? Solution: a. The common size statements give us a hint that spending may have gotten out of control during the period of heady growth. This isn't at all uncommon. People become focused on growth, and spend money too aggressively. The problem is that current spending tends to raise the expense level, which carries into the future. E.g. people hired this year are on the payroll next year unless they're let go. Protek seems to have fallen into the spending trap. Notice that marketing expense is growing faster than revenue. We can see this because Marketing is an increasing percent of revenue over the three-year period. The same is true of Administration, but to a lesser extent. This kind of a pattern is dangerous because the firm is establishing a spending base that will be difficult to reduce if sales level off or decrease. R&D appears to be flat as a percent of revenue, but that too may be excessive, since we would generally expect that function to decrease somewhat as a percent as sales rise due to the non-current nature of the work. The Marketing increase is particularly troubling, because it's possible that the revenue increase is partially driven by an intense marketing and/or sales effort. In other words, it's usually possible to pump up sales by spending more on advertising or sales personnel. However, if the practice is carried too far, the incremental revenue costs more than it's worth and profit declines. Cost is also increasing as a percent of revenue. This can be due to several things. The first possibility is excessive spending leading to the kind of inefficiency we just discussed in the expense areas. In addition, however, the factory could be suffering from an externally driven increase in the cost of raw materials. Further, a cost ratio increase can come from a decrease in the price received for the product. That's a sales rather than a manufacturing issue, but it shows up on the cost ratio line. Price decreases can happen in two ways. In the first, competition drives list prices down with the knowledge of management. That happens in hi-tech business a lot as technology advances. A more insidious phenomenon comes about through discounting. In some companies, the sales force has a great deal of latitude in giving customers price breaks. When generous discounts are offered consistently the effective price received for product declines and sales volume increases. However, profitability suffers. Still another phenomenon involves the mix of product sold. In most companies, high end products carry the best profit margins. If Protek's sales growth has been in low-end, low margin product, profitability can be expected to decline. That means the firm can't afford to spend as much to support the new sales as it did to support the older high-end sales. Companies often don't recognize this and get caught in spending binds. Another observation is relevant. Notice how large the increase in spending in the marketing area is in absolute dollars. In a three-year period the budget has gone from $316M to $882M, a growth of 279%. As a rule it's very difficult to manage that much growth efficiently. Most managements just can't hire, train, and equip that many people that fast without a good deal of waste. Overall the common size analysis has given us a great deal to work with. Notice that it hasn't answered the question of why profits are shrinking, but it has focused our thinking and aimed us in the right direction for further analysis. Protek's Statement of Cash Flows tells us several very significant things. First, the cash generated by operations is declining fast. If things continue in the direction they have been going, that source will dry up altogether. The firm's money is going into Fixed Assets and Working Capital. Both of these should grow with the company, but they often grow faster causing cash shortages. We'll get an insight into whether or not Protek's asset growth is under control when we look at its ratios. Protek's money is coming from borrowing. That is, increases in debt. This is probably increasing the firm's risk, especially as profitability is declining. Free cash flows are clearly negative because of the firm's rapid growth. They aren't likely to be positive unless growth slows down substantially. c. Protek's ratios are as follows. We'll begin with the working capital situation. Notice that the ACP is increasing dramatically. This is bad news. It probably means the firm is selling to a lower class of customer on credit. That could be another factor behind the revenue growth. Easier credit pumps sales, but may be bad for profitability. There's a good chance the receivables balance contains some old and likely uncollectible accounts. Inventory turnover is declining. That's another bad sign. In times of rapid growth factories tend to use material inefficiently in an effort to get product shipped. Obsolete and unbalanced inventory tends to pile up and rapidly becomes valueless. This may be happening to Protek. The liquidity situation appears to be good, because the current and Quick Ratios are increasing. However, this may be a false indication. If receivables and inventories are overstated, current assets will also be overstated giving an incorrectly high value to the Current and Quick Ratios. Fixed Asset Turnover appears to be improving slightly. This allays our earlier fears that too many Fixed Assets may have been purchased. That area looks ok. Total Asset Turnover looks ok even considering a possible overstatement in some current assets. The trend in the Debt Ratio and the Debt to Equity Ratios could be trouble. The company is funding its growth by borrowing rather than through internally generated cash or new equity. The increase in these debt management ratios indicates Protek is borrowing faster than it's growing. That means risk is increasing rapidly along with interest expense. It's likely that lenders will stop advancing money soon, as capital is now more than two-thirds debt which is generally considered quite risky. An equity infusion is appropriate, but the depressed stock price makes that a tough pill to swallow. The decrease in TIE shows the leverage problem in a more alarming light. Here the effect of increased debt and interest is compounded by the fall off in operating profits. The increase in the equity multiplier is another way to look at the same increase in leverage. Remember that leverage works to the firm's advantage when results are good, but hurts when they're bad. Protek's results are bad now and getting worse, so the high level of leverage (borrowing) is a significant problem. The trend that the three profitability ratios reflect is the net result of everything we've said. Notice that ROE is still in the neighborhood of 10%. That may seem like an acceptable return, but it isn't because of the high level of risk inherent in the industry in general and in this company in particular. I.e. the industry average ROE is about 23%. d. The Du Pont Equation This indicates that at ROA the problem is in the revenue cost and expense areas associated with the income statement rather than in overall asset management which appears reasonably good. The extended Du Pont Equation says that at the moment leverage is still helping Protek's performance, since its ROE is only 44% of the industry average while its ROA is 28% of the industry average. However, that doesn't account for the increased risk of the higher leverage position. If ROA falls much lower, the effect of the leverage will be negative. Protek's stock price is dropping. Notice that EPSfundamentally what an investor is buying with a share of stockis falling, but the stock's price is falling faster. That's because the P/E ratio is also falling and the price is the product of EPS and P/E: Stock Price = EPS  P/E. The firm's performance establishes EPS, but the market pins a P/E on a stock. The P/E is essentially a statement of what the market will pay for a dollar of earnings. Higher "quality" earnings get higher P/E's. Quality is associated with growth and stability. In that respect, Protek is sending the market mixed signals. The revenue growth is good, but it isn't translating into earnings growth. In fact earnings are shrinking rapidly. Further, leverage is increasing which tends to decrease stability. So Protek’s P/E is falling on top of the decline in EPS, which causes the price to drop faster than profitability. A drop in sales could hurt badly because of the interest burden. f. Probably not, because of the risk. However, if the market is overreacting, it could be a speculative opportunity. COMPUTER PROBLEMS 27. At the close of 20X3, the financial statements of Northern Manufacturing were as follows. In addition, Northern paid dividends of $1.2M and sold new stock valued at $1.0M during 20X3. Use the CASHFLO program to produce Northern's statement of cash flows for 20X3. Solution: Excel Output: 28. Comparative historical financial statements for Northern Manufacturing of the preceding problem are as follows. a. Use the ANALYS program to prepare common size statements and a set of financial ratios for each of the last three years. Notice that ANALYS calculates ratios using average balance sheet figures where appropriate. b. Analyze the results of ANALYS for Northern Manufacturing. The firm has been quite successful in terms of revenue and profit growth so far. Do the ratios reveal any disturbing trends that might indicate future problems? Solution: a. ANALYS output: b. The steady increases in sales and profits look good, however, there appear to be some problems in current assets. The ACP has gone from 67 days (poor to begin with) to 108 days. That implies there may be some large uncollectible receivables. Inventory turns have also deteriorated indicating a possible overstatement. Liquidity ratios are improving, but in the light of the receivables and inventory, that may be a deceptive result. The company also seems to be running on very little cash. That could imply an effective cash management system or a shortage in spite of the high current assets. Debt is very high, but the trend is improving. Overall EPS is increasing but the P/E ratio and the stock's price are dropping a lot. That implies investors are concerned about something outside the ratio analysis. Perhaps people forecast bad times for the industry or the firm has a major threat hanging over it, like a lawsuit. This should be investigated. DEVELOPING SOFTWARE 29. Write a program to generate a Statement of Cash Flows yourself. It isn't as hard as you might think. First set up the Income Statement and two Balance Sheets on the spreadsheet just as they appear in Problem 27. Let the amounts in individual accounts such as cash, A/R, revenue, COGS, interest, and tax be input items, and let the program calculate all the totals and subtotals such as current assets, total assets, gross margin and net income. Next take a different area of the spreadsheet and set up the changes in the current accounts and the statement of cash flows as follows. Take all of the items shown in lower case xxx's from the statements in the first part of your spreadsheet. Some will be single items like Net Income and depreciation, but most will be differences between beginning and ending balances like the increase or decrease in long-term debt or the change in receivables. Finally, program the spreadsheet to add up the subtotals where the upper case XXX's appear and display the reconciliation. The trickiest part is keeping the signs straight in your subtractions for sources and uses. Once you have your program written, test it with the inputs to the CASHFLO program and see if you get the same results. 30. Write your own analysis program to calculate a common size income statement and the ratios introduced in this chapter. To keep the exercise reasonably simple, just provide for one year of ratios and one common size statement. Construct an input area in your spreadsheet in the form of an income statement and a balance sheet. Input the accounts and have the program calculate all totals and subtotals. Define your common size income statement alongside the input income statement by dividing each input line item by revenue. Define your ratios in another area drawing the numerators and denominators from the input statements. Test your program using the 20X3 statements for Northern Manufacturing from Problem 28. Compare your results with those of the ANALYS program. Solution Manual for Practical Financial Management William R. Lasher 9781305637542