Asset Turnover Ratios and ROE: Impact of Asset Utilization and Debt, Assignments of Corporate Finance

Download Asset Turnover Ratios and ROE: Impact of Asset Utilization and Debt and more Assignments Corporate Finance in PDF only on Docsity! After reading this chapter, students should be able to:  Explain why ratio analysis is usually the first step in the analysis of a company’s financial statements.  List the five groups of ratios, specify which ratios belong in each group, and explain what information each group gives us about the firm’s financial position.  State what trend analysis is, and why it is important.  Describe how the Du Pont equation is used, and how it may be modified to include the effect of financial leverage.  Explain “benchmarking” and its purpose.  List several limitations of ratio analysis.  Identify some of the problems with ROE that can arise when firms use it as a sole measure of performance.  Identify some of the qualitative factors that must be considered when evaluating a company’s financial performance. Learning Objectives: 3 - 1 Chapter 3Analysis of Financial Statements LEARNING OBJECTIVES Chapter 3 shows how financial statements are analyzed to determine firms’ strengths and weaknesses. On the basis of this information, management can take actions to exploit strengths and correct weaknesses. At Florida, we find a significant difference in preparation between our accounting and non-accounting students. The accountants are relatively familiar with financial statements, and they have covered in depth in their financial accounting course many of the ratios dealt with in Chapter 3. We pitch our lectures to the non-accountants, which means concentrating on the use of statements and ratios, and the “big picture,” rather than on details such as seasonal adjustments and the effects of different accounting procedures. Details are important, but so are general principles, and there are courses other than the introductory finance course where details can be addressed. What we cover, and the way we cover it, can be seen by scanning Blueprints, Chapter 3. For other suggestions about the lecture, please see the “Lecture Suggestions” in Chapter 2, where we describe how we conduct our classes. DAYS ON CHAPTER: 3 OF 58 DAYS (50-minute periods) Lecture Suggestions: 3 - 2 LECTURE SUGGESTIONS book value. + + - Answers and Solutions: 3 - 5 Total Effect Current Current on Net Assets Ratio Income e. A fixed asset is sold for more than book value. + + + f. Merchandise is sold on credit. + + + g. Payment is made to trade creditors for previous purchases. - + 0 h. A cash dividend is declared and paid. - - 0 i. Cash is obtained through short-term bank loans. + - 0 j. Short-term notes receivable are sold at a discount. - - - k. Marketable securities are sold below cost. - - - l. Advances are made to employees. 0 0 0 m. Current operating expenses are paid. - - - n. Short-term promissory notes are issued to trade creditors in exchange for past due accounts payable. 0 0 0 o. 10-year notes are issued to pay off accounts payable. 0 + 0 p. A fully depreciated asset is retired. 0 0 0 q. Accounts receivable are collected. 0 0 0 r. Equipment is purchased with short-term notes. 0 - 0 s. Merchandise is purchased on credit. + - 0 t. The estimated taxes payable are increased. 0 - - 3-10 EVA is calculated as EBIT(1 - T) - (WACC)(Total Investor-Supplied Operating Capital). ROE is calculated as NI/Equity. As long as a company invests in projects with returns greater than their costs of capital, the projects are profitable and should be accepted. Likewise, EVA will be increased. Consequently, the firm’s projects this year may have lower ROEs, but the costs of capital could be lower too. Also, ROE doesn’t consider the size of an investment. A very small investment with a high ROE will not add much to shareholder wealth, as will a more substantial investment with an ROE that’s still greater than the project’s cost of capital. Answers and Solutions: 3 - 6 3-1 DSO = 40 days; S = $7,300,000; AR = ? DSO = 365 S AR 40 = /365000,300,7$ AR 40 = AR/$20,000 AR = $800,000. 3-2 A/E = 2.4; D/A = ? 58.33%. = 0.5833 = A D 2.4 1 - 1 = A D E A 1 - 1 = A D                 3-3 ROA = 10%; PM = 2%; ROE = 15%; S/TA = ?; TA/E = ? ROA = NI/A; PM = NI/S; ROE = NI/E. ROA = PM  S/TA NI/A = NI/S  S/TA 10% = 2%  S/TA S/TA = 5. ROE = PM  S/TA  TA/E NI/E = NI/S  S/TA  TA/E 15% = 2%  5  TA/E 15% = 10%  TA/E TA/E = 1.5. 3-4 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE = $6,000,000,000; Shares outstanding = 800,000,000; P0 = $32; M/B = ? Book value = 000,000,800 000,000,000,6$ = $7.50. SOLUTIONS TO END-OF-CHAPTER PROBLEMS . 8 = EBIT/INT 8 = $6,000,000,000/INT INT = $750,000,000. EBITDA = EBIT + DA = $6,000,000,000 + $3,200,000,000 = $9,200,000,000. EBITDA coverage ratio = pmts Lease pmts Princ. INT payments Lease EBITDA   = 000,000,000,2$000,000,000,1$000,000,750$ 000,000,000,2$000,000,200,9$   = 000,000,750,3$ 000,000,200,11$ = 2.9867. 3-10 ROE = Profit margin  TA turnover  Equity multiplier = NI/Sales  Sales/TA  TA/Equity. Now we need to determine the inputs for the equation from the data that were given. On the left we set up an income statement, and we put numbers in it on the right: Sales (given) $10,000,000 - Cost na EBIT (given) $ 1,000,000 - INT (given) 300,000 EBT $ 700,000 - Taxes (34%) 238,000 NI $ 462,000 Now we can use some ratios to get some more data: Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 = $5,000,000. D/A = 60%; so E/A = 40%; and, therefore, Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5. Now we can complete the Du Pont equation to determine ROE: ROE = $462,000/$10,000,000  $10,000,000/$5,000,000  2.5 = 0.231 = 23.1%. 3-11 Known data: TA = $1,000,000; kd = 8%; T = 40%; BEP = 0.2 = EBIT/Total assets, so EBIT = 0.2($1,000,000) = $200,000; D/A = 0.5 = 50%, so Equity = $500,000. D/A = 0% D/A = 50% EBIT $200,000 $200,000 Interest 0 40,000* EBT $200,000 $160,000 Tax (40%) 80,000 64,000 NI $120,000 $ 96,000 ROE = Equity NI = $1,000,000 $120,000 = 12% $500,000 $96,000 = 19.2% Difference in ROE = 19.2% - 12.0% = 7.2%. *If D/A = 50%, then half of the assets are financed by debt, so Debt = $500,000. At an 8 percent interest rate, INT = $40,000. 3-12 Statement a is correct. Refer to the solution setup for Problem 3-11 and think about it this way: (1) Adding assets will not affect common equity if the assets are financed with debt. (2) Adding assets will cause expected EBIT to increase by the amount EBIT = BEP(added assets). (3) Interest expense will increase by the amount kd(added assets). (4) Pre-tax income will rise by the amount (added assets)(BEP - kd). Assuming BEP > kd, if pre-tax income increases so will net income. (5) If expected net income increases but common equity is held constant, then the expected ROE will also increase. Note that if kd > BEP, then adding assets financed by debt would lower net income and thus the ROE. Therefore, Statement a is true--if assets financed by debt are added, and if the expected BEP on those assets exceeds the cost of debt, then the firm’s ROE will increase. Statements b, c, and d are false, because the BEP ratio uses EBIT, which is calculated before the effects of taxes or interest charges are felt. Of course, Statement e is also false. 3-13 a. Currently, ROE is ROE1 = $15,000/$200,000 = 7.5%. The current ratio will be set such that 2.5 = CA/CL. CL is $50,000, and it will not change, so we can solve to find the new level of current assets: CA = 2.5(CL) = 2.5($50,000) = $125,000. This is the level of current assets that will produce a current ratio of 2.5. At present, current assets amount to $210,000, so they can be reduced by $210,000 - $125,000 = $85,000. If the $85,000 generated is used to retire common equity, then the new common equity balance will be $200,000 - $85,000 = $115,000. Assuming that net income is unchanged, the new ROE will be ROE2 = $15,000/$115,000 = 13.04%. Therefore, ROE will increase by 13.04% - 7.50% = 5.54%. b. 1. Doubling the dollar amounts would not affect the answer; it would still be 5.54%. 2. Common equity would increase by $25,000 from the Part a scenario, which would mean a new ROE of $15,000/$140,000 = 10.71%, which would mean a difference of 10.71% - 7.50% = 3.21%. 3. An inventory turnover of 2 would mean inventories of $100,000, down $50,000 from the current level. That would mean an ROE of $15,000/$150,000 = 10.00%, so the change in ROE would be 10.00% - 7.5% = 2.5%. 4. If the company had 10,000 shares outstanding, then its EPS would be $15,000/10,000 = $1.50. The stock has a book value of $200,000/10,000 = $20, so the shares retired would be $85,000/$20 = 4,250, leaving 10,000 - 4,250 = 5,750 shares. The new EPS would be $15,000/5,750 = $2.6087, so the increase in EPS would be $2.6087 - $1.50 = $1.1087, which is a 73.91 percent increase, the same as the increase in ROE. 5. If the stock was selling for twice book value, or 2  $20 = $40, then only half as many shares could be retired ($85,000/$40 = 2,125), so the remaining shares would be 10,000 - 2,125 = 7,875, and the new EPS would be $15,000/7,875 = $1.9048, for an increase of $1.9048 - $1.5000 = $0.4048. c. We could have started with lower inventory and higher accounts receivable, then had you calculate the DSO, then move to a lower DSO that would require a reduction in receivables, and then determine the effects on ROE and EPS under different conditions. Similarly, we could have focused on fixed assets and the FA turnover ratio. In any of these cases, we could have had you use the funds generated to retire debt, which would have lowered interest charges and consequently increased net income and EPS. If we had to increase assets, then we would have had to finance this increase by adding either debt or equity, which would have lowered ROE and EPS, other things held constant. Finally, note that we could have asked some conceptual questions about the problem, either as a part of the problem or without any reference to the problem. For example, “If funds are generated by reducing assets, and if those funds are used to retire common stock, will EPS and/or ROE be affected by whether or not the stock sells above, at, or below book value?” 3-14 TA = $7,500,000,000; EBIT/TA = 10%; TIE = 2.5; DA = $1,250,000,000; Lease payments = $775,000,000; Principal payments = $500,000,000; EBITDA coverage = ? EBIT/$7,500,000,000 = 0.10 EBIT = $750,000,000. 2.5 = EBIT/INT 2.5 = $750,000,000/INT Step 2: If sales fall by 15%, the new sales level will be $4,977,272.73(0.85) = $4,230,681.82. Again, using the DSO equation, solve for the new accounts receivable figure as follows: 35 = AR/($4,230,681.82/365) 35 = AR/$11,590.91 AR = $405,681.82  $405,682. 3-18 The current EPS is $2,000,000/500,000 shares or $4.00. The current P/E ratio is then $40/$4 = 10.00. The new number of shares outstanding will be 650,000. Thus, the new EPS = $3,250,000/650,000 = $5.00. If the shares are selling for 10 times EPS, then they must be selling for $5.00(10) = $50. 3-19 Step 1: Calculate total assets from information given. Sales = $6 million. 3.2 = Sales/TA 3.2 = Assets 000,000,6$ Assets = $1,875,000. Step 2: Calculate net income. There is 50% debt and 50% equity, so Equity = $1,875,000  0.5 = $937,500. ROE = NI/S  S/TA  TA/E 0.12 = NI/$6,000,000  3.2  $1,875,000/$937,500 0.12 = 000,000,6$ NI4.6 $720,000 = 6.4NI $112,500 = NI. 3-20 Given ROA = 8% and net income of $600,000, total assets must be $7,500,000. ROA = TA NI 8% = TA $600,000 TA = $7,500,000. To calculate BEP, we still need EBIT. To calculate EBIT construct a partial income statement: EBIT $1,148,077 ($225,000 + $923,077) Interest 225,000 (Given) EBT $ 923,077 $600,000/0.65 Taxes (35%) 323,077 NI $ 600,000 BEP = TA EBIT = $7,500,000 $1,148,077 = 0.1531 = 15.31%. 3-21 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000. 2. Accounts payable = Debt – Long-term debt = $150,000 - $60,000 = $90,000. 3. Common stock = equity and sliabilitie Total - Debt - Retained earnings = $300,000 - $150,000 - $97,500 = $52,500. 4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000. 5. Inventories = Sales/5 = $450,000/5 = $90,000. 6. Accounts receivable = (Sales/365)(DSO) = ($450,000/365)(36.5) = $45,000. 7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable) Cash + $45,000 + $90,000 = (1.8)($90,000) Cash + $135,000 = $162,000 Cash = $27,000. 8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories) Fixed assets = $300,000 - ($27,000 + $45,000 + $90,000) Fixed assets = $138,000. 9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500. 3-22 a. (Dollar amounts in thousands.) Industry Firm Average sliabilitie Current assets Current = $330,000 $655,000 = 1.98 2.0 DSO = 365Sales/ receivable Accounts = 11.04$4,4 $336,000 = 76.3 days 35 days sInventorie Sales = $241,500 $1,607,500 = 6.66 6.7 assets Total Sales = $947,500 $1,607,500 = 1.70 3.0 Sales income Net = $1,607,500 $27,300 = 1.7% 1.2% assets Total income Net = $947,500 $27,300 = 2.9% 3.6% equity Common income Net = $361,000 $27,300 = 7.6% 9.0% assets Total debt Total = $947,500 $586,500 = 61.9% 60.0% b. For the firm, ROE = PM  T.A. turnover  EM = 1.7%  1.7  $361,000 $947,500 = 7.6%. For the industry, ROE = 1.2%  3  2.5 = 9%. Note: To find the industry ratio of assets to common equity, recognize that 1 - (total debt/total assets) = common equity/total assets. So, common equity/total assets = 40%, and 1/0.40 = 2.5 = total assets/common equity. c. The firm’s days sales outstanding is more than twice as long as the industry average, indicating that the firm should tighten credit or enforce a more stringent collection policy. The total assets turnover ratio is well below the industry average so sales should be increased, assets decreased, or both. While the company’s profit margin is higher than the industry average, its other profitability ratios are low compared to the industry--net income should be higher given the amount of equity and assets. However, the company seems to be in an average liquidity position and financial leverage is similar to others in the industry. b. ROE = Profit margin  Total assets turnover  Equity multiplier = Sales income Net  assets Total Sales  equity Common assets Total = $795 $27  $450 $795  $315 $450 = 3.4%  1.77  1.4286 = 8.6%. Firm Industry Comment Profit margin 3.4% 3.0% Good Total assets turnover 1.77 3.0 Poor Equity multiplier 1.4286 1.43* O.K. * 1 - TA D = TA E 1 – 0.30 = 0.7 EM = E TA = 7.0 1 = 1.43. Alternatively, EM = ROE/ROA = 12.9%/9% = 1.43. c. Analysis of the Du Pont equation and the set of ratios shows that the turnover ratio of sales to assets is quite low. Either sales should be increased at the present level of assets, or the current level of assets should be decreased to be more in line with current sales. d. The comparison of inventory turnover ratios shows that other firms in the industry seem to be getting along with about half as much inventory per unit of sales as the firm. If the company’s inventory could be reduced, this would generate funds that could be used to retire debt, thus reducing interest charges and improving profits, and strengthening the debt position. There might also be some excess investment in fixed assets, perhaps indicative of excess capacity, as shown by a slightly lower-than-average fixed assets turnover ratio. However, this is not nearly as clear-cut as the overinvestment in inventory. e. If the firm had a sharp seasonal sales pattern, or if it grew rapidly during the year, many ratios might be distorted. Ratios involving cash, receivables, inventories, and current liabilities, as well as those based on sales, profits, and common equity, could be biased. It is possible to correct for such problems by using average rather than end-of-period figures. 3-24 a. Here are the firm’s base case ratios and other data as compared to the industry: Firm Industry Comment Current 2.3 2.7 Weak Inventory turnover 4.8 7.0 Poor Days sales outstanding 37.4 days 32.0 days Poor Fixed assets turnover 10.0 13.0 Poor Total assets turnover 2.3 2.6 Poor Return on assets 5.9% 9.1% Bad Return on equity 13.1 18.2 Bad Debt ratio 54.8 50.0 High Profit margin on sales 2.5 3.5 Bad EPS $4.71 n.a. -- Stock Price $23.57 n.a. -- P/E ratio 5.0 6.0 Poor P/CF ratio 2.0 3.5 Poor M/B ratio 0.65 n.a. -- The firm appears to be badly managed--all of its ratios are worse than the industry averages, and the result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The company needs to do something to improve. b. A decrease in the inventory level would improve the inventory turnover, total assets turnover, and ROA, all of which are too low. It would have some impact on the current ratio, but it is difficult to say precisely how that ratio would be affected. If the lower inventory level allowed the company to reduce its current liabilities, then the current ratio would improve. The lower cost of goods sold would improve all of the profitability ratios and, if dividends were not increased, would lower the debt ratio through increased retained earnings. All of this should lead to a higher market/book ratio, a higher stock price, a higher price/earnings ratio, and a higher price/cash flow ratio. 3-25 The detailed solution for the spreadsheet problem is available both on the instructor’s resource CD-ROM and on the instructor’s side of South- Western’s web site, http://brigham.swlearning.com. Computer/Internet Applications: 3 - 22 South-Western SPREADSHEET PROBLEM TABLE IC3-2. INCOME STATEMENTS 2003E 2002 2001 SALES $7,035,600 $6,034,000 $3,432,000 COST OF GOODS SOLD 5,875,992 5,528,000 2,864,000 OTHER EXPENSES 550,000 519,988 358,672 TOTAL OPERATING COSTS EXCLUDING DEPRECIATION $6,425,992 $6,047,988 $3,222,672 EBITDA $ 609,608 ($ 13,988) $ 209,328 DEPRECIATION 116,960 116,960 18,900 EBIT $ 492,648 ($ 130,948) $ 190,428 INTEREST EXPENSE 70,008 136,012 43,828 EBT $ 422,640 ($ 266,960) $ 146,600 TAXES (40%) 169,056 (106,784)a 58,640 NET INCOME $ 253,584 ($ 160,176) $ 87,960 EPS $1.014 ($1.602) $0.880 DPS $0.220 $0.110 $0.220 BOOK VALUE PER SHARE $7.809 $4.926 $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 2003 DATA ARE FORECASTS. aTHE FIRM HAD SUFFICIENT TAXABLE INCOME IN 2000 AND 2001 TO OBTAIN ITS FULL TAX REFUND IN 2002. Integrated Case: 3 - 25 TABLE IC3-3. RATIO ANALYSIS INDUSTRY 2003E 2002 2001 AVERAGE CURRENT 1.2 2.3 2.7 INVENTORY TURNOVER 4.7 4.8 6.1 DAYS SALES OUTSTANDING (DSO)a 38.2 37.4 32.0 FIXED ASSETS TURNOVER 6.4 10.0 7.0 TOTAL ASSETS TURNOVER 2.1 2.3 2.6 DEBT RATIO 82.8% 54.8% 50.0% TIE -1.0 4.3 6.2 EBITDA COVERAGE 0.1 3.0 8.0 PROFIT MARGIN -2.7% 2.6% 3.5% BASIC EARNING POWER -4.6% 13.0% 19.1% ROA -5.6% 6.0% 9.1% ROE -32.5% 13.3% 18.2% PRICE/EARNINGS -1.4 9.7 14.2 PRICE/CASH FLOW -5.2 8.0 11.0 MARKET/BOOK 0.5 1.3 2.4 BOOK VALUE PER SHARE $4.93 $6.64 n.a. NOTE: “E” INDICATES ESTIMATED. THE 2003 DATA ARE FORECASTS. aCALCULATION IS BASED ON A 365-DAY YEAR. A. WHY ARE RATIOS USEFUL? WHAT ARE THE FIVE MAJOR CATEGORIES OF RATIOS? ANSWER: [S3-1 THROUGH S3-5 PROVIDE BACKGROUND INFORMATION. THEN, SHOW S3-6 AND S3-7 HERE.] 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 D’LEON’S 2003 CURRENT RATIO BASED ON THE PROJECTED BALANCE SHEET AND INCOME STATEMENT DATA. WHAT CAN YOU SAY ABOUT THE COMPANY’S LIQUIDITY POSITION IN 2001, 2002, AND AS PROJECTED FOR 2003? 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 THIS LIQUIDITY RATIO? Integrated Case: 3 - 26 ANSWER: [SHOW S3-8 AND S3-9 HERE.] CURRENT RATIO03 = CURRENT ASSETS/CURRENT LIABILITIES = $2,680,112/$1,144,800 = 2.34. THE COMPANY’S CURRENT RATIO IS IDENTICAL TO ITS 2001 CURRENT RATIO, AND IT HAS IMPROVED FROM ITS 2002 LEVEL. HOWEVER, THE CURRENT RATIO IS WELL BELOW THE INDUSTRY AVERAGE. C. CALCULATE THE 2003 INVENTORY TURNOVER, DAYS SALES OUTSTANDING (DSO), FIXED ASSETS TURNOVER, AND TOTAL ASSETS TURNOVER. HOW DOES D’LEON’S UTILIZATION OF ASSETS STACK UP AGAINST OTHER FIRMS IN ITS INDUSTRY? ANSWER: [SHOW S3-10 THROUGH S3-15 HERE.] INVENTORY TURNOVER03 = SALES/INVENTORY = $7,035,600/$1,716,480 = 4.10. DSO03 = RECEIVABLES/(SALES/365) = $878,000/($7,035,600/365) = 45.55 DAYS. FIXED ASSETS TURNOVER03 = SALES/NET FIXED ASSETS = $7,035,600/$817,040 = 8.61. TOTAL ASSETS TURNOVER03 = SALES/TOTAL ASSETS = $7,035,600/$3,497,152 = 2.01. THE FIRM’S INVENTORY TURNOVER AND TOTAL ASSETS TURNOVER RATIOS HAVE BEEN STEADILY DECLINING, WHILE ITS DAYS SALES OUTSTANDING HAS BEEN STEADILY INCREASING (WHICH IS BAD). HOWEVER, THE FIRM’S 2003 TOTAL ASSETS TURNOVER RATIO IS ONLY SLIGHTLY BELOW THE 2002 LEVEL. THE FIRM’S FIXED ASSETS TURNOVER RATIO IS BELOW ITS 2001 LEVEL; HOWEVER, IT IS ABOVE THE 2002 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 D’LEON IS AN OLDER FIRM THAN MOST OTHER FIRMS IN THE INDUSTRY, IN WHICH CASE, ITS FIXED ASSETS ARE OLDER AND THUS HAVE Integrated Case: 3 - 27 G. USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW OF D’LEON’S FINANCIAL CONDITION AS PROJECTED FOR 2003. WHAT ARE THE FIRM’S MAJOR STRENGTHS AND WEAKNESSES? Integrated Case: 3 - 30 ANSWER: [SHOW S3-28 THROUGH S3-30 HERE.] DU PONT EQUATION = MARGIN PROFIT  TURNOVER ASSETS TOTAL  MULTIPLIER EQUITY = 3.60%  2.01  1/(1 - 0.4417) = 12.96%  13.0%. 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. (D’LEON’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, AND ITS DEBT RATIO HAS BEEN GREATLY REDUCED, SO IT IS NOW BELOW THE INDUSTRY AVERAGE (WHICH IS GOOD). THIS IMPROVED PROFIT MARGIN COULD INDICATE THAT THE FIRM HAS KEPT OPERATING COSTS DOWN AS WELL AS INTEREST EXPENSE (AS SHOWN FROM THE REDUCED DEBT RATIO). INTEREST EXPENSE IS LOWER BECAUSE THE FIRM’S DEBT RATIO HAS BEEN REDUCED, WHICH HAS IMPROVED THE FIRM’S TIE RATIO SO THAT IT IS NOW ABOVE THE INDUSTRY AVERAGE. WEAKNESSES: THE FIRM’S CURRENT ASSET RATIO IS LOW; MOST OF ITS ASSET MANAGEMENT RATIOS ARE POOR (EXCEPT FIXED ASSETS TURNOVER); ITS EBITDA COVERAGE RATIO IS LOW; MOST OF ITS PROFITABILITY RATIOS ARE LOW (EXCEPT PROFIT MARGIN); AND ITS MARKET VALUE RATIOS ARE LOW. H. USE THE FOLLOWING SIMPLIFIED 2003 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 45.6 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 $1,545 OTHER CURRENT ASSETS 1,802 EQUITY 1,952 NET FIXED ASSETS 817 LIABILITIES PLUS TOTAL ASSETS $3,497 EQUITY $3,497 Integrated Case: 3 - 31 ANSWER: [SHOW S3-31 THROUGH S3-34 HERE.] SALES PER DAY = $7,035,600/365 = $19,275.62. ACCOUNTS RECEIVABLE UNDER NEW POLICY = $19,275.62  32 DAYS = $616,820. FREED CASH = OLD A/R - NEW A/R = $878,000 - $616,820 = $261,180. I. DOES IT APPEAR THAT INVENTORIES COULD BE ADJUSTED, AND, IF SO, HOW SHOULD THAT ADJUSTMENT AFFECT D’LEON’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 CURRENT ASSET RATIO, THE INVENTORY AND TOTAL ASSETS TURNOVER, AND REDUCE THE DEBT RATIO EVEN FURTHER, WHICH SHOULD IMPROVE THE FIRM’S STOCK PRICE AND PROFITABILITY. J. IN 2002, 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 D’LEON ON CREDIT? (YOU COULD DEMAND CASH ON DELIVERY, THAT IS, SELL ON TERMS OF COD, BUT THAT MIGHT CAUSE D’LEON 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 2003, D’LEON SHOWED YOU ITS 2003 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 CURRENT ASSET RATIO IS 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 Integrated Case: 3 - 32