FINANCIAL MANAGEMENT 1

ASSIGNMENT

EDITHA G. MARTIN
MBA 2

A. Why are ratios useful? What are the five major categories of ratios?

ANSWER:
Knowing how to calculate and use financial ratios is important for not only analysts, but for investors, lenders and
more. Ratios allow analysts to compare a various aspect of a company's financial statements against others in its
industry, to determine a company's ability to pay dividends, and more.
Comparison
Financial ratios establish benchmarks and standards for separate businesses. Categorize individual businesses by sector
and time frame to differentiate patterns that are attributable to a singular enterprise from those that are related to the
world economy, at-large.
Management Decisions
Management reviews financial ratios to determine the success of particular sales, marketing and financing strategies.
Executives can also use these accounting statistics as guides to expose and work to change weaknesses within the
firm.
Lenders
Lenders review financial ratios to determine the credit worthiness of the business and its ability to repay debt. Credit
rating agencies also analyze this data to help rate and describe bondholder risks.
Investor Behavior
Prospective investors choose to purchase ownership stakes within companies that show good financial standing relative
to share price value per financial ratios. Current shareholders may use these ratios as confirmation that the company is
not operating efficiently, prior to voting to unseat the board of directors or liquidating stock.

The five major categories of ratios are:
Liquidity,asset management, debt management, profitability, and market value.

B. Calculate De Leons 2003 current and quick ratios based on the projected balance sheet and income
statement data. What can you say about thecompanys 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 the liquidity ratios?

ANSWER:
Current ratio = current assets/current liabilities = $2,680,112/$1,144,800 = 2.3x.

The companys 2003 current ratio has improved from 2002 current ratio; however, both ratios are well
below the industry average.

C. Calculate the 2003 inventory turnover, days sales outstanding (dso), fixed assets turnover, and total assets
turnover. How does dleons utilization of assets stack up against other firms in its industry?

ANSWER:
Inventory turnover = sales/inventory = $7,035,600/$1,716,480 = 4.10x.

DSO = receivables/(sales/360) = $878,000/($7,035,600/365) = 45.5 days.

Fixed assets turnover = sales/net fixed assets = $7,035,600/$817,040 = 8.61x.

Total assets turnover = sales/total assets = $7,035,600/$3,497,152 = 2.01x.

De Leons inventory turnover ratio has been declining steadily. The inventory turnover of De Leon in 2003 compared
to industry average is halfway below i.e. 3.42 against 6.1. This also means that the turnover of the industry is faster
than De Leons.

DSO is a measure of time it takes a company to collect its accounts receivable from credit sales. The days sales
outstanding has been steadily increasing. The firms days sales outstanding is above the Industry average which is not
good. De Leons DSO means that it would take the company 45 days or so to collect its AR while the industry average
is 32 days.

Fixed asset turnover indicates the amount of sales generated by each dollar spent on fixed assets. Along this line, the
fixed asset turnover of De Leon is 8.6 against the 7.0 x of the industry. Though the firms fixed assets turnover ratio
has recovered from its 2002 level, but slightly lower than the 2001 level. The firms inventory turnover for 2003 is
higher than the industry average.

Total Asset turnover measures a companys ability to generate sales given its investment in total assets. De Leons
total asset turnover means that for every dollar invested in total assets, the firm will generate $2. The firms 2003
total assets turnover ratio is below the 2001 level and just slightly below its 2001 level. The firms total assets turnover
is below the industry average.

D. Calculate the 2003 debt, times-interest-earned, and EBITDA Coverage Ratios. How does De Leon compare
with the industry with respect to Financial leverage? What can you conclude from these ratios?

ANSWER:

Debt ratio = total debt/total assets = ($1,144,800 + $400,000)/$3,497,152 = 44 %.

TIE= EBIT/interest = $422,640/$70,008 = 6.04.

EBITDA Coverage = EBITDA/Interest Payments = 609,608/70,008 = 8.7

The firms debt ratio had dropped down to 44% from 82.8 %, and it is below the industry average. Debt ratio is a
ratio that indicates what proportion of debt a company has relative to its assets.

The firms TIE and EBITDA coverage ratios are much improved from their 2001 and 2002 levels, and they are
above the industry average.

Times Interest Earned measures the companys ability to meet its debt obligation. De Leons 6.04 means that it
could cover its interest charges 6x. A high ratio can indicate that a company has an undesirable lack of debt.

EBITDA Coverage is used to assess a companys financial durability by examining whether it is at least profitably
enough to pay off its interest expenses. A ratio greater than 1 indicates that the company has more than enough
interest coverage to pay off its interest expense. The ratio of De Leon is 8.7, it is more than 1.


E. Calculate the 2003 profit margin, Basic Earning Power (BEP), Return On Assets (ROA), And
Return On Equity (ROE). What can you say about these ratios?

ANSWER:
Profit Margin= Net Income/Sales = $253,584/$7,035,600 = 3.6%.

Basic Earning Power = EBIT/Total Assets = $492,648/$3,497,152 = 14.1%.

ROA = Net Income/Total Assets = $253,584/$3,497,152 = 7.25%.

ROE= Net Income/Common Equity = $253,584/$1,952,352 = 13 %.

The firms profit margin is above 2001 and 2002 levels and is just slightly above the industry average. The Basic
Earning Power, ROA, and ROE ratios are above both 2001 and 2002 levels, but below the industry average.

The Profit Margin, BEP, ROA and ROE belong to a class of financial ratios that are used to assess a firms ability to
generate earnings as compared to its expenses and other relevant costs incurred during a specific period of time.
for most of these ratios having a higher value relative to competitors ratio or the same ratio from a previous
period is indicative that the company is doing well.

F. Calculate the 2003 Price/Earnings Ratio, Price/Cash Flow Ratio, And Market/Book Ratio. Do these ratios
indicate that investors are expected to have a high or low opinion of the company?

ANSWER:

Price/Earnings Ratio = Price Per Share/Earnings Per Share = $12.17/$1.0143 = 12.0.

Price Cash Flow= Price of Stock/Cash flow per Share = $12.17/(253,584 + 116,960)/ 250,000
= 12.17/1.482 = 8.21

Book Value per Share = Total Common Equity/ No. of common Shares Outstanding
= 1,952,352/250,000 shares = 7.8

Market/Book = price of Stock/ BV per Share =12.17/7.8 = 1.56

The Price Earnings is sometimes referred to as the multiple because it shows how much investors are
willing to pay per dollar of earnings. In general a high P/E suggests that investors are expecting higher
earnings growth in the future compared with companies with a lower P/E.

The Price Cash Flow Ratio is used by investors to evaluate the investment attractiveness from a value
standpoint of a companys stock.

Market Value Ratio is used to compare a stock market value to its book value. A lower P/B ratio could
mean that the stock is undervalued. However, it could also mean that something is fundamentally wrong
with the company. The P/E, P/CF, AND M/B ratios are above the 2001and 2002 levels but below the industry
average.

G. Use the extended Du Pont equation to provide a summary and overview of Dleons financial condition as
projected for 2001. What are the firms major strengths and weaknesses?

ANSWER:

DU PONT EQUATION = MARGIN PROFIT x TURNOVER TOTAL ASSETS x MULTIPLIER EQUITY
= 3.6% x 2.01 x 2.03 = 14.68%.

STRENGTHS:
The firms fixed assets turnover was above the industry average.
The firms Profit Margin is slightly above the industry average.

WEAKNESSES:
De Leons liquidity ratios are low;
Asset Management ratios are poor;
Debt Management ratios are poor;
Profitability ratios are low;
Market value ratios are low

H. Use the following simplified 2001 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 $1,545
Other current assets 1,802 Equity 1,952
Net fixed assets 817 Liabilities plus equity $3,497
Total assets $3,497

ANSWER:

Sales Per Day = $7,035,600/365 = $19,273.97
Accounts Receivable (New) = $19,273.97 x 32 DAYS = $616,767
Free Cash = Old A/R - New A/R = $878,000 - $632,160 = $245,840.

I. Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect De Leons
profitability and stock price?

ANSWER:

Since the inventory turnover ratio is low, it might be that the firm either has excessive inventory or some of the
inventory is obsolete. If inventory were this would improve the liquidity ratios, the inventory and total assets turnover,
and the debt ratio, thereby improve the firms stock price and profitability.

J. In 2000, 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 dleon on credit? (you could demand cash on delivery, that is,
sell on terms of cod, but that might cause dleon 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, dleon showed you its 2003 projections plus proof that it was going
to raise over $1.2 million of new equity capital?

ANSWER:

While the firms ratios based on the projected data appear to be improving, the firms 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 didnt 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 firms debt ratio and creditors risk exposure.

K. In hindsight, what should De Leon have done back in 2001?

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 firms operations. Had the ratio analysis been conducted, the company would have gotten its house
in order before undergoing the expansion.

L. What are some potential problems and limitations of financial ratio analysis?

ANSWER:

Potential problems:
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.

M. What are some qualitative factors analysts should consider when evaluating a companys likely future
financial performance?

ANSWER:

Qualitative factors analysts should consider when evaluating a company:

1. Are the companys revenues tied to one key customer?
2. To what extent are the companys revenues tied to one key product?
3. To what extent does the company rely on a single supplier?
4. What percentage of the companys business is generated overseas?
5. Competition
6. Future prospects
7. Legal and regulatory environment