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  • 1. CHAPTER 4 – Analysis of Financial Statements: MINI CASE ( Corresponds to PPTs & Class) (10-3) THE FIRST PART OF THE CASE, PRESENTED IN CHAPTER 3, DISCUSSED THE SITUATION THAT COMPUTRON INDUSTRIES WAS IN AFTER AN EXPANSION PROGRAM. THUS FAR, SALES HAVE NOT BEEN UP TO THE FORECASTED LEVEL, COSTS HAVE BEEN HIGHER THAN WERE PROJECTED, AND A LARGE LOSS OCCURRED IN 2001, RATHER THAN THE EXPECTED PROFIT. AS A RESULT, ITS MANAGERS, DIRECTORS, AND INVESTORS ARE CONCERNED ABOUT THE FIRM’S SURVIVAL. DONNA JAMISON WAS BROUGHT IN AS ASSISTANT TO FRED CAMPO, COMPUTRON’S CHAIRMAN, WHO HAD THE TASK OF GETTING THE COMPANY BACK INTO A SOUND FINANCIAL POSITION. COMPUTRON’S 2000 AND 2001 BALANCE SHEETS AND INCOME STATEMENTS, TOGETHER WITH PROJECTIONS FOR 2002, ARE SHOWN IN THE FOLLOWING TABLES. ALSO, THE TABLES SHOW THE 2000 AND 2001 FINANCIAL RATIOS, ALONG WITH INDUSTRY AVERAGE DATA. THE 2002 PROJECTED FINANCIAL STATEMENT DATA REPRESENT JAMISON’S AND CAMPO’S BEST GUESS FOR 2002 RESULTS, ASSUMING THAT SOME NEW FINANCING IS ARRANGED TO GET THE COMPANY “OVER THE HUMP.” JAMISON EXAMINED MONTHLY DATA FOR 2001 (NOT GIVEN IN THE CASE), AND SHE DETECTED AN IMPROVING PATTERN DURING THE YEAR. MONTHLY SALES WERE RISING, COSTS WERE FALLING, AND LARGE LOSSES IN THE EARLY MONTHS HAD TURNED TO A SMALL PROFIT BY DECEMBER. THUS, THE ANNUAL DATA LOOKED SOMEWHAT WORSE THAN FINAL MONTHLY DATA. ALSO, IT APPEARS TO BE TAKING LONGER FOR THE ADVERTISING PROGRAM TO GET THE MESSAGE ACROSS, FOR THE NEW SALES OFFICES TO GENERATE SALES, AND FOR THE NEW MANUFACTURING FACILITIES TO OPERATE EFFICIENTLY. IN OTHER WORDS, THE LAGS BETWEEN SPENDING MONEY AND DERIVING BENEFITS WERE LONGER THAN COMPUTRON’S MANAGERS HAD ANTICIPATED. FOR THESE REASONS, JAMISON AND CAMPO SEE HOPE FOR THE COMPANY--PROVIDED IT CAN SURVIVE IN THE SHORT RUN. JAMISON MUST PREPARE AN ANALYSIS OF WHERE THE COMPANY IS NOW, WHAT IT MUST DO TO REGAIN ITS FINANCIAL HEALTH, AND WHAT ACTIONS SHOULD BE TAKEN. YOUR ASSIGNMENT IS TO HELP HER ANSWER THE FOLLOWING QUESTIONS. PROVIDE CLEAR EXPLANATIONS, NOT YES OR NO ANSWERS. Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 3 - 1
  • 2. BALANCE SHEETS 2002E 2001 2000___ ASSETS CASH $ 14,000 $ 7,282 $ 9,000 SHORT-TERM INVESTMENTS 71,632 0 48,600 ACCOUNTS RECEIVABLE 878,000 632,160 351,200 INVENTORIES 1,716,480 1,287,360 715,200 TOTAL CURRENT ASSETS $2,680,112 $1,926,802 $1,124,000 GROSS FIXED ASSETS 1,197,160 1,202,950 491,000 LESS ACCUMULATED DEPRECIATION 380,120 263,160 146,200 NET FIXED ASSETS $ 817,040 $ 939,790 $ 344,800 TOTAL ASSETS $3,497,152 $2,866,592 $1,468,800 LIABILITIES AND EQUITY ACCOUNTS PAYABLE $ 436,800 $ 524,160 $ 145,600 NOTES PAYABLE 600,000 720,000 200,000 ACCRUALS 408,000 489,600 136,000 TOTAL CURRENT LIABILITIES $1,444,800 $1,733,760 $ 481,600 LONG-TERM DEBT 500,000 1,000,000 323,432 COMMON STOCK 1,680,936 460,000 460,000 RETAINED EARNINGS (128,584) (327,168) 203,768 TOTAL EQUITY $1,552,352 $ 132,832 $ 663,768 TOTAL LIABILITIES AND EQUITY $3,497,152 $2,866,592 $1,468,800 NOTE: “E” INDICATES ESTIMATED. THE 2002 DATA ARE FORECASTS. INCOME STATEMENTS 2002E 2001 2000___ SALES $7,035,600 $5,834,400 $3,432,000 COST OF GOODS SOLD 6,100,000 5,728,000 2,864,000 OTHER EXPENSES 312,960 680,000 340,000 DEPRECIATION 120,000 116,960 18,900 TOTAL OPERATING COSTS $6,532,960 $6,524,960 $3,222,900 EBIT $ 502,640 ($ 690,560) $ 209,100 INTEREST EXPENSE 80,000 176,000 62,500 EBT $ 422,640 ($ 866,560) $ 146,600 TAXES (40%) 169,056 (346,624) 58,640 NET INCOME $ 253,584 ($ 519,936) $ 87,960 EPS $1.014 ($5.199) $0.880 DPS $0.220 $0.110 $0.220 BOOK VALUE PER SHARE $6.209 $1.328 $6.638 STOCK PRICE $12.17 $2.25 $8.50 SHARES OUTSTANDING 250,000 100,000 100,000 TAX RATE 40.00% 40.00% 40.00% LEASE PAYMENTS 40,000 40,000 40,000 SINKING FUND PAYMENTS 0 0 0 NOTE: “E” INDICATES ESTIMATED. THE 2002 DATA ARE FORECASTS. Mini Case: 3 - 2 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc.
  • 3. RATIO ANALYSIS INDUSTRY 2002E 2001 2000 AVERAGE CURRENT 1.1× 2.3× 2.7× QUICK 0.4× 0.8× 1.0× INVENTORY TURNOVER 4.5× 4.8× 6.1× DAYS SALES OUTSTANDING (DSO) 39.0 36.8 32.0 FIXED ASSETS TURNOVER 6.2× 10.0× 7.0× TOTAL ASSETS TURNOVER 2.0× 2.3× 2.5× DEBT RATIO 95.4% 54.8% 50.0% TIE -3.9× 3.3× 6.2× EBITDA COVERAGE -2.5× 2.6× 8.0× PROFIT MARGIN -8.9% 2.6% 3.6% BASIC EARNING POWER -24.1% 14.2% 17.8% ROA -18.1% 6.0% 9.0% ROE -391.4% 13.3% 18.0% PRICE/EARNINGS -0.4× 9.7× 14.2× PRICE/CASH FLOW -0.6× 8.0× 7.6× MARKET/BOOK 1.7× 1.3× 2.9× BOOK VALUE PER SHARE $1.33 $6.64 N.A. NOTE: “E” INDICATES ESTIMATED. THE 2002 DATA ARE FORECASTS. Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 3 - 3
  • 4. A. WHY ARE RATIOS USEFUL? WHAT ARE THE FIVE MAJOR CATEGORIES OF RATIOS? ANSWER: RATIOS ARE USED BY MANAGERS TO HELP IMPROVE THE FIRM’S PERFORMANCE, BY LENDERS TO HELP EVALUATE THE FIRM’S LIKELIHOOD OF REPAYING DEBTS, AND BY STOCKHOLDERS TO HELP FORECAST FUTURE EARNINGS AND DIVIDENDS. THE FIVE MAJOR CATEGORIES OF RATIOS ARE: LIQUIDITY, ASSET MANAGEMENT, DEBT MANAGEMENT, PROFITABILITY, AND MARKET VALUE. B. CALCULATE THE 2002 CURRENT AND QUICK RATIOS BASED ON THE PROJECTED BALANCE SHEET AND INCOME STATEMENT DATA. WHAT CAN YOU SAY ABOUT THE COMPANY’S LIQUIDITY POSITION IN 2000, 2001, AND AS PROJECTED FOR 2002? WE OFTEN THINK OF RATIOS AS BEING USEFUL (1) TO MANAGERS TO HELP RUN THE BUSINESS, (2) TO BANKERS FOR CREDIT ANALYSIS, AND (3) TO STOCKHOLDERS FOR STOCK VALUATION. WOULD THESE DIFFERENT TYPES OF ANALYSTS HAVE AN EQUAL INTEREST IN THE LIQUIDITY RATIOS? ANSWER: CURRENT RATIO02 = CURRENT ASSETS/CURRENT LIABILITIES = $2,680,112/$1,444,800 = 1.86×. QUICK RATIO02 = (CURRENT ASSETS – INVENTORY)/CURRENT LIABILITIES = ($2,680,112 - $1,716,480)/$1,444,800 = 0.667×. THE COMPANY’S CURRENT AND QUICK RATIOS ARE LOW RELATIVE TO ITS 2000 CURRENT AND QUICK RATIOS; HOWEVER, THEY HAVE IMPROVED FROM THEIR 2001 LEVELS. BOTH RATIOS ARE WELL BELOW THE INDUSTRY AVERAGE, HOWEVER. C. CALCULATE THE 2002 INVENTORY TURNOVER, DAYS SALES OUTSTANDING (DSO), FIXED ASSETS TURNOVER, AND TOTAL ASSETS TURNOVER. HOW DOES COMPUTRON’S UTILIZATION OF ASSETS STACK UP AGAINST OTHER FIRMS IN ITS INDUSTRY? ANSWER: INVENTORY TURNOVER02 = SALES/INVENTORY = $7,035,600/$1,716,480 = 4.10×. DSO02 = RECEIVABLES/(SALES/360) Mini Case: 3 - 4 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc.
  • 5. = $878,000/($7,035,600/360) = 44.9 DAYS. Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 3 - 5
  • 6. FIXED ASSETS TURNOVER02 = SALES/NET FIXED ASSETS = $7,035,600/$817,040 = 8.61×. TOTAL ASSETS TURNOVER99 = SALES/TOTAL ASSETS = $7,035,600/$3,497,152 = 2.01×. THE FIRM’S INVENTORY TURNOVER RATIO HAS BEEN STEADILY DECLINING, WHILE ITS DAYS SALES OUTSTANDING HAS BEEN STEADILY INCREASING. WHILE THE FIRM’S FIXED ASSETS TURNOVER RATIO IS BELOW ITS 2000 LEVEL, IT IS ABOVE THE 2001 LEVEL. THE FIRM’S TOTAL ASSETS TURNOVER RATIO IS BELOW ITS 2000 LEVEL AND JUST SLIGHTLY BELOW ITS 2001 LEVEL. THE FIRM’S INVENTORY TURNOVER AND TOTAL ASSETS TURNOVER ARE BELOW THE INDUSTRY AVERAGE. THE FIRM’S DAYS SALES OUTSTANDING IS ABOVE THE INDUSTRY AVERAGE (WHICH IS BAD); HOWEVER, THE FIRM’S FIXED ASSETS TURNOVER IS ABOVE THE INDUSTRY AVERAGE. (THIS MIGHT BE DUE TO THE FACT THAT COMPUTRON IS AN OLDER FIRM THAN MOST OTHER FIRMS IN THE INDUSTRY, IN WHICH CASE, ITS FIXED ASSETS ARE OLDER AND THUS HAVE BEEN DEPRECIATED MORE, OR THAT COMPUTRON’S COST OF FIXED ASSETS WERE LOWER THAN MOST FIRMS IN THE INDUSTRY.) THE FIRM’S OPERATING CAPITAL REQUIREMENT RATIO IS HIGHER THAN THE INDUSTRY AVERAGE, INDICATING THAT COMPUTRON REQUIRES MORE DOLLARS OF CAPITAL TO GENERATE A DOLLAR OF SALES THAN THE AVERAGE FIRM IN THE INDUSTRY. D. CALCULATE THE 2002 DEBT, TIMES-INTEREST-EARNED, AND EBITDA COVERAGE RATIOS. HOW DOES COMPUTRON COMPARE WITH THE INDUSTRY WITH RESPECT TO FINANCIAL LEVERAGE? WHAT CAN YOU CONCLUDE FROM THESE RATIOS? ANSWER: DEBT RATIO02 = TOTAL DEBT/TOTAL ASSETS = ($1,444,800 + $500,000)/$3,497,152 = 55.61%. TIE02 = EBIT/INTEREST = $502,640/$80,000 = 6.3×.  EBITDA + LEASE  / EBITDA COVERAGE01 =  PAYMENTS   INTEREST + LOAN LEASE    REPAYMENTS + PAYMENTS  = ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5×. THE FIRM’S DEBT RATIO IS MUCH IMPROVED FROM 2001, BUT IT IS STILL Mini Case: 3 - 6 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc.
  • 7. ABOVE ITS 2000 LEVEL AND THE INDUSTRY AVERAGE. THE FIRM’S TIE AND EBITDA COVERAGE RATIOS ARE MUCH IMPROVED FROM THEIR 2000 AND 2001 LEVELS, BUT THEY ARE STILL BELOW THE INDUSTRY AVERAGE. E. CALCULATE THE 2002 PROFIT MARGIN, BASIC EARNING POWER (BEP), RETURN ON ASSETS (ROA), AND RETURN ON EQUITY (ROE). WHAT CAN YOU SAY ABOUT THESE RATIOS? ANSWER: PROFIT MARGIN02 = NET INCOME/SALES = $253,584/$7,035,600 = 3.6%. BASIC EARNING POWER02 = EBIT/TOTAL ASSETS = $502,640/$3,497,152 = 14.4%. ROA02 = NET INCOME/TOTAL ASSETS = $253,584/$3,497,152 = 7.25%. ROE02 = NET INCOME/COMMON EQUITY = $253,584/$1,552,352 = 16.34%. THE FIRM’S PROFIT MARGIN IS ABOVE 2000 AND 2001 LEVELS AND IS AT THE INDUSTRY AVERAGE. THE BASIC EARNING POWER, ROA, AND ROE RATIOS ARE ABOVE BOTH 2000 AND 2001 LEVELS, BUT BELOW THE INDUSTRY AVERAGE DUE TO POOR ASSET UTILIZATION. F. CALCULATE THE 2002 PRICE/EARNINGS RATIO, PRICE/CASH FLOW RATIOS, AND MARKET/BOOK RATIO. DO THESE RATIOS INDICATE THAT INVESTORS ARE EXPECTED TO HAVE A HIGH OR LOW OPINION OF THE COMPANY? ANSWER: EPS = NET INCOME/SHARES OUTSTANDING = $253,584/250,000 = $1.0143. PRICE/EARNINGS99 = PRICE PER SHARE/EARNINGS PER SHARE = $12.17/$1.0143 = 12.0×. CHECK: PRICE = EPS × P/E = $1.0143(12) = $12.17. CASH FLOW/SHARE02 = (NI + DEP)/SHARES = ($253,584 + $120,000)/250,000 = $1.49. PRICE/CASH FLOW = $12.17/$1.49 = 8.2×. BVPS = COMMON EQUITY/SHARES OUTSTANDING = $1,552,352/250,000 = $6.21. Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 3 - 7
  • 8. MARKET/BOOK = MARKET PRICE PER SHARE/BOOK VALUE PER SHARE = $12.17/$6.21 = 1.96X. BOTH THE P/E RATIO AND BVPS ARE ABOVE THE 2000 AND 2001 LEVELS BUT BELOW THE INDUSTRY AVERAGE. F. PERFORM A COMMON SIZE ANALYSIS AND PERCENT CHANGE ANALYSIS. WHAT DO THESE ANALYSES TELL YOU ABOUT COMPUTRON? ANSWER: FOR THE COMMON SIZE BALANCE SHEETS, DIVIDE ALL ITEMS IN A YEAR BY THE TOTAL ASSETS FOR THAT YEAR. FOR THE COMMON SIZE INCOME STATEMENTS, DIVIDE ALL ITEMS IN A YEAR BY THE SALES IN THAT YEAR. Common Size Balance Sheets Assets 2000 2001 2002E Ind. Cash 0.6% 0.3% 0.4% 0.3% ST Invest. 3.3% 0.0% 2.0% 0.3% AR 23.9% 22.1% 25.1% 22.4% Invent. 48.7% 44.9% 49.1% 41.2% Total CA 76.5% 67.2% 76.6% 64.1% Net FA 23.5% 32.8% 23.4% 35.9% TA 100.0% 100.0% 100.0% 100.0% Liabilities and Equity 2000 2001 2002E Ind. AP 9.9% 18.3% 12.5% 11.9% Notes pay. 13.6% 25.1% 17.2% 2.4% Accruals 9.3% 17.1% 11.7% 9.5% Total CL 32.8% 60.5% 41.3% 23.7% LT Debt 22.0% 34.9% 14.3% 26.3% Com. Stock 31.3% 16.0% 48.1% 20.0% Ret. Earnings 13.9% -11.4% -3.7% 30.0% Total equity 45.2% 4.6% 44.4% 50.0% Total L&E 100.0% 100.0% 100.0% 100.0% Common Size Income statement 2000 2001 2002E Ind. Sales 100.0% 100.0% 100.0% 100.0% COGS 83.4% 98.2% 86.7% 84.5% Other exp. 9.9% 11.7% 4.4% 4.4% Depr. 0.6% 2.0% 1.7% 4.0% EBIT 6.1% -11.8% 7.1% 7.1% Mini Case: 3 - 8 Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc.
  • 9. Int. Exp. 1.8% 3.0% 1.1% 1.1% EBT 4.3% -14.9% 6.0% 5.9% Taxes 1.7% -5.9% 2.4% 2.4% NI 2.6% -8.9% 3.6% 3.6% COMPUTRON HAS HIGHER PROPORTION OF CURRENT ASSETS (49.1%) THAN INDUSTRY (41.2%). COMPUTRON HAS SLIGHTLY LESS EQUITY (WHICH MEANS MORE DEBT) THAN INDUSTRY. COMPUTRON HAS MORE SHORT-TERM DEBT THAN INDUSTRY, BUT LESS LONG-TERM DEBT THAN INDUSTRY. COMPUTRON HAS HIGHER COGS (86.7) THAN INDUSTRY (84.5), BUT LOWER DEPRECIATION. RESULT IS THAT COMPUTRON HAS SIMILAR EBIT (7.1) AS INDUSTRY. FOR THE PERCENT CHANGE ANALYSIS, DIVIDE ALL ITEMS IN A ROW BY THE VALUE IN THE FIRST YEAR OF THE ANALYSIS. Percent Change Balance Sheets Assets 2000 2001 2002E Cash 0.0% -19.1% 55.6% ST Invest. 0.0% -100.0% 47.4% AR 0.0% 80.0% 150.0% Invent. 0.0% 80.0% 140.0% Total CA 0.0% 71.4% 138.4% Net FA 0.0% 172.6% 137.0% TA 0.0% 95.2% 138.1% Liabilities and Equity 2000 2001 2002E AP 0.0% 260.0% 200.0% Notes pay. 0.0% 260.0% 200.0% Accruals 0.0% 260.0% 200.0% Total CL 0.0% 260.0% 200.0% LT Debt 0.0% 209.2% 54.6% Com. Stock 0.0% 0.0% 265.4% Ret. Earnings 0.0% -260.6% -163.1% Total equity 0.0% -80.0% 133.9% Total L&E 0.0% 95.2% 138.1% Harcourt, Inc. items and derived items copyright © 2002 by Harcourt, Inc. Mini Case: 3 - 9
  • 10. Percent Change Income statement 2000 2001 2002E Sales 0.0% 70.0% 105.0% COGS 0.0% 100.0% 113.0% Other exp. 0.0% 100.0% -8.0% Depr. 0.0% 518.8% 534.9% EBIT 0.0% -430.3% 140.4% Int. Exp. 0.0% 181.6% 28.0% EBT 0.0% -691.1% 188.3% Taxes 0.0% -691.1% 188.3% NI 0.0% -691.1% 188.3% WE SEE THAT 2002 SALES GROW 105% FROM 2000, AND THAT NI GROWS 188% FROM 2000. SO COMPUTRON HAS BECOME MORE PROFITABLE. WE SEE THAT TOTAL ASSETS GROW AT A RATE OF 138%, WHILE SALES GROW AT A RATE OF ONLY 105%. SO ASSET UTILIZATION REMAINS A PROBLEM. H. USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW OF COMPUTRON’S FINANCIAL CONDITION AS PROJECTED FOR 2002. WHAT ARE THE FIRM’S MAJOR STRENGTHS AND WEAKNESSES? PROFIT TOTAL ASSETS EQUITY ANSWER: DU PONT EQUATION = MARGIN × TURNOVER × MULTIPLIER = 3.6% × 2.01 × 1/(1 - 0.5561) = 16.3%. STRENGTHS: THE FIRM’S FIXED ASSETS TURNOVER WAS ABOVE THE INDUSTRY AVERAGE. HOWEVER, IF THE FIRM’S ASSETS WERE OLDER THAN OTHER FIRMS IN ITS INDUSTRY THIS COULD POSSIBLY ACCOUNT FOR THE HIGHER RATIO. (COMPUTRON’S FIXED ASSETS WOULD HAVE A LOWER HISTORICAL COST AND WOULD HAVE BEEN DEPRECIATED FOR LONGER PERIODS OF TIME.) THE FIRM’S PROFIT MARGIN IS SLIGHTLY ABOVE THE INDUSTRY AVERAGE, DESPITE ITS HIGHER DEBT RATIO. THIS WOULD INDICATE THAT THE FIRM HAS KEPT COSTS DOWN, BUT, AGAIN, THIS COULD BE RELATED TO LOWER DEPRECIATION COSTS. WEAKNESSES: THE FIRM’S LIQUIDITY RATIOS ARE LOW; MOST OF ITS ASSET MANAGEMENT RATIOS ARE POOR (EXCEPT FIXED ASSETS TURNOVER); ITS DEBT MANAGEMENT RATIOS ARE POOR, MOST OF ITS PROFITABILITY RATIOS ARE LOW (EXCEPT PROFIT MARGIN); AND ITS MARKET VALUE RATIOS ARE LOW.
  • 11. I. USE THE FOLLOWING SIMPLIFIED 2002 BALANCE SHEET TO SHOW, IN GENERAL TERMS, HOW AN IMPROVEMENT IN THE DSO WOULD TEND TO AFFECT THE STOCK PRICE. FOR EXAMPLE, IF THE COMPANY COULD IMPROVE ITS COLLECTION PROCEDURES AND THEREBY LOWER ITS DSO FROM 44.9 DAYS TO THE 32-DAY INDUSTRY AVERAGE WITHOUT AFFECTING SALES, HOW WOULD THAT CHANGE “RIPPLE THROUGH” THE FINANCIAL STATEMENTS (SHOWN IN THOUSANDS BELOW) AND INFLUENCE THE STOCK PRICE? ACCOUNTS RECEIVABLE $ 878 DEBT $1,945 OTHER CURRENT ASSETS 1,802 NET FIXED ASSETS 817 EQUITY 1,552 LIABILITIES TOTAL ASSETS $3,497 PLUS EQUITY $3,497 ANSWER: SALES PER DAY = $7,035,600/360 = $19,543. ACCOUNTS RECEIVABLE UNDER NEW POLICY = $19,543 × 32 DAYS = $625,376. FREED CASH = OLD A/R - NEW A/R = $878,000 - $625,376 = $252,624. J. DOES IT APPEAR THAT INVENTORIES COULD BE REDUCED, AND, IF SO, HOW SHOULD THAT ADJUSTMENT AFFECT COMPUTRON’S PROFITABILITY AND STOCK PRICE. ANSWER: THE INVENTORY TURNOVER RATIO IS LOW. IT APPEARS THAT THE FIRM EITHER HAS EXCESSIVE INVENTORY OR SOME OF THE INVENTORY IS OBSOLETE. IF INVENTORY WERE REDUCED, THIS WOULD IMPROVE THE LIQUIDITY RATIOS, THE INVENTORY AND TOTAL ASSETS TURNOVER, AND THE DEBT RATIO, WHICH SHOULD IMPROVE THE FIRM’S STOCK PRICE AND PROFITABILITY.
  • 12. K. IN 2001, THE COMPANY PAID ITS SUPPLIERS MUCH LATER THAN THE DUE DATES, AND IT WAS NOT MAINTAINING FINANCIAL RATIOS AT LEVELS CALLED FOR IN ITS BANK LOAN AGREEMENTS. THEREFORE, SUPPLIERS COULD CUT THE COMPANY OFF, AND ITS BANK COULD REFUSE TO RENEW THE LOAN WHEN IT COMES DUE IN 90 DAYS. ON THE BASIS OF DATA PROVIDED, WOULD YOU, AS A CREDIT MANAGER, CONTINUE TO SELL TO COMPUTRON ON CREDIT? (YOU COULD DEMAND CASH ON DELIVERY, THAT IS, SELL ON TERMS OF COD, BUT THAT MIGHT CAUSE COMPUTRON TO STOP BUYING FROM YOUR COMPANY.) SIMILARLY, IF YOU WERE THE BANK LOAN OFFICER, WOULD YOU RECOMMEND RENEWING THE LOAN OR DEMAND ITS REPAYMENT? WOULD YOUR ACTIONS BE INFLUENCED IF, IN EARLY 2002, COMPUTRON SHOWED YOU ITS 2002 PROJECTIONS PLUS PROOF THAT IT WAS GOING TO RAISE OVER $1.2 MILLION OF NEW EQUITY CAPITAL? ANSWER: WHILE THE FIRM’S RATIOS BASED ON THE PROJECTED DATA APPEAR TO BE IMPROVING, THE FIRM’S LIQUIDITY RATIOS ARE LOW. AS A CREDIT MANAGER, I WOULD NOT CONTINUE TO EXTEND CREDIT TO THE FIRM UNDER ITS CURRENT ARRANGEMENT, PARTICULARLY IF I DIDN’T HAVE ANY EXCESS CAPACITY. TERMS OF COD MIGHT BE A LITTLE HARSH AND MIGHT PUSH THE FIRM INTO BANKRUPTCY. LIKEWISE, IF THE BANK DEMANDED REPAYMENT THIS COULD ALSO FORCE THE FIRM INTO BANKRUPTCY. CREDITORS’ ACTIONS WOULD DEFINITELY BE INFLUENCED BY AN INFUSION OF EQUITY CAPITAL IN THE FIRM. THIS WOULD LOWER THE FIRM’S DEBT RATIO AND CREDITORS’ RISK EXPOSURE. L. IN HINDSIGHT, WHAT SHOULD COMPUTRON HAVE DONE BACK IN 2000? ANSWER: BEFORE THE COMPANY TOOK ON ITS EXPANSION PLANS, IT SHOULD HAVE DONE AN EXTENSIVE RATIO ANALYSIS TO DETERMINE THE EFFECTS OF ITS PROPOSED EXPANSION ON THE FIRM’S OPERATIONS. HAD THE RATIO ANALYSIS BEEN CONDUCTED, THE COMPANY WOULD HAVE “GOTTEN ITS HOUSE IN ORDER” BEFORE UNDERGOING THE EXPANSION. M. WHAT ARE SOME POTENTIAL PROBLEMS AND LIMITATIONS OF FINANCIAL RATIO ANALYSIS? ANSWER: SOME POTENTIAL PROBLEMS ARE LISTED BELOW:
  • 13. 1. COMPARISON WITH INDUSTRY AVERAGES IS DIFFICULT IF THE FIRM OPERATES MANY DIFFERENT DIVISIONS. 2. DIFFERENT OPERATING AND ACCOUNTING PRACTICES DISTORT COMPARISONS. 3. SOMETIMES HARD TO TELL IF A RATIO IS “GOOD” OR “BAD.” 4. DIFFICULT TO TELL WHETHER COMPANY IS, ON BALANCE, IN A STRONG OR WEAK POSITION. 5. “AVERAGE” PERFORMANCE IS NOT NECESSARILY GOOD. 6. SEASONAL FACTORS CAN DISTORT RATIOS. 7. “WINDOW DRESSING” TECHNIQUES CAN MAKE STATEMENTS AND RATIOS LOOK BETTER. N. WHAT ARE SOME QUALITATIVE FACTORS ANALYSTS SHOULD CONSIDER WHEN EVALUATING A COMPANY’S LIKELY FUTURE FINANCIAL PERFORMANCE? ANSWER: TOP ANALYSTS RECOGNIZE THAT CERTAIN QUALITATIVE FACTORS MUST BE CONSIDERED WHEN EVALUATING A COMPANY. THESE FACTORS, AS SUMMARIZED BY THE AMERICAN ASSOCIATION OF INDIVIDUAL INVESTORS (AAII), ARE AS FOLLOWS: 1. ARE THE COMPANY’S REVENUES TIED TO ONE KEY CUSTOMER? 2. TO WHAT EXTENT ARE THE COMPANY’S REVENUES TIED TO ONE KEY PRODUCT? 3. TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER? 4. WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS GENERATED OVERSEAS? 5. COMPETITION 6. FUTURE PROSPECTS 7. LEGAL AND REGULATORY ENVIRONMENT

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