Case 1: Cash flow analysis (Signal Cable Company)

1. Why has the stock price fallen despite the fact that the net income has increase?
The stock price for Signal Cable Company has fallen from $7 to $5.50 per share although the
income statement stated that the net income has been increased from $124,700.3 in year 2003 to
$143,100 in year 2004. Basically, the increase and decrease in stock price is not directly affected
by the net income of a company but affected by the supply and demand of the investors. As we
can observe, Signal Cable Company had established two additional manufacturing facilities, and
that significantly increased its inventory but at the same time, these two additional investments
have increased the debts and liabilities of the company in year 2004. From the investors point of
view, they belief that high amount of debts and liabilities will result in the risk of getting lower
future net income and thus, their demand for the stock is decreasing and this affect the stock
price to decline.
2. How liquid would you say that this company is? Calculate the absolute liquidity of the
firm. How does it compare with the previous years liquidity position?
Liquidity is refer to a measure of the extent to which a person or organization has cash to meet
immediate and short-term obligations, or assets that can be quickly converted to do this. While
absolute liquidity is represented by the cash and near cash items such as cash, bank and
marketable securities.

Cash ratio

2004
= 5000 / 895,000

2003
= 40,000 / 355,000

= cash / current liabilities

Current ratio

= 0.0056
= 1,845,450 / 895,000

= 0.113
= 890,000 / 355,000

= current assets / current = 2.06

liabilities
Quick ratio

= 2.51

= (1,845,450 1,300,450) / = (890,000 650,000) /

= (current assets inventory) / 895,000

355,000

current liabilities

= 0.68

= 0.61

Net working capital to total = 950,450 / 2,913,450

= 535,000 / 1.247,000

asset

= 0.43

= 0.33

= NWC / total asset

Interval ratio

= [(1,537,500 + 40,000)/365] / = [(1,343,115 + 32,945)/365] /

= [(cost of goods sold + 1,845,450

890,000

expenses)/365] / total current = 426.9979398

= 236.072555

assets
Absolute liquidity

= 535,000

= 950,450

= NWC

From the table above, we notices that the absolute liquidity (Net working capital) has increased
in 2004 but the relative liquidity has decline. Besides, the current ratio also in declining stage but
the liquidity condition of this company still not yet considered as critical because from the
interval measures, it estimates that the company still can continue its operation for at least for
another 427 days if its cash inflows began to dry up. This interval coverage has increased
significantly from its level in 2003. Therefore, we can conclude that although the relative
liquidity of this company has decline since 2003, but it is not consider as critically low.
3. How does the market value of the stock compare with its book value? Is the book value
accurately reflecting the true condition of the company?
Market value refers to the market capitalization of a publicly-traded company where it is
obtained by multiplying the number of its outstanding shares by the current share price. Book
value refers to the net asset value of a company where it is calculated by taking total assets minus
intangible assets (patents, goodwill) and liabilities. In order to identify whether the book value
are accurately reflecting the true condition of the company, we need to find Signals book value
per share for both years.

Signals market value = current stock price X 200,000 shares

Signals book value in 2003 = [(total assets-total liabilities) = shareholders equity]

= $1,247,000 ($355,000 + $200,000)

= $692,000
Signals book value per share in 2003 = $692,000 / 200,000 shares
= $3.46
Signals book value in 2004 = [(total assets-total liabilities) = shareholders equity]
= $2,913,450 ($895,000 + $1,226,280)
= $792,170
Signals book value per share in 2004 = $792,170 / 200,000 shares = $3.96
From the equation above, we can observe that the stock price is higher than its book value as
Signal Cable Company had enjoyed a run up in profits over the past few years. However, during
the account statement preparation, the result shows that there is a drop in price for the current
year and this indicate there will be an increase in risk due to high debt level and low level of
liquidity. Therefore, although its shows that the book value per share which increases for $0.50
from year 2003 ($3.46) to year 2004 ($3.96), but it is still the market value that reflects the true
condition of the Signal Cable Company.
4. The board of directors is not clear as to why the cash balance has dropped so much in
spite of the increase in sales and the gross profit margin. What should Jay tell the board?
In order to know why the cash balance has dropped so much although the sales and gross profit
margin are increasing, Jay should do a Statement of Cash Flows for the year 2004.

Signal Cable Company

2004 Statement of Cash Flows

Cash at the beginning of year 2004

$40,000

Operating activity
Net income

143,000

Depreciation

79,000

Increase in accounts payable

90,000

Plus:

Less:
Increase in accounts receivable

(340,000)

Increase in inventory

(650,450)

Net cash from operating activity

(678,350)

Investment activity
Fixed asset acquisition
Net cash from investment activity

(790,000)
(790,000)

Financing activity
Increase in notes payable
Increase in long-term debt
Dividends paid
Increase in common stock
Net cash from financing activity
Net decrease in cash
Cash, end of year

450,000
1,026,280
(42,930)
1,433,350
(35,000)
$5,000

From the above statement of cash flows for the year 2004, we can observe that Signal Cable
Company has heavily invested in inventories, fixed assets and accounts payable. However, these
investments are only partially funded by the increase in payables and retained earnings available.
Therefore, Signal Cable Company has to borrow from short-term debt and drew down on its cash
reserves to fund the balance. From here, we can conclude that the acquisition of assets and

expansion of business activities is the main reason that led to the reduction in cash balance
although the sales have increase.
5. Measure the free cash flow of the firm. What does it indicate?
Free cash flow refers to the cash that a company is able to generate after laying out the money
required to maintain or expand its asset base.
Free cash flow = Operating cash flow net capital spending change in net working capital
Operating cash flow = earnings before interest and taxes (EBIT) + depreciation taxes
= $393,500 + $79,000 - $95,400
= $377,100
Net capital spending = ending net fixed assets beginning net fixed assets + depreciation
= $1,068,000 - $357,000 + $79,000
= $790,000
Change in net working capital = change in current asset change in current liabilities
= ($1,845,450 - $890,000) ($895,000 - $355,000)
= $415,450
Thus,
Free cash flow = $377,100 - $790,000 - $415,450
= ($828,350)
From the calculation shown above, Signal Cable Company had a negative free cash flow in 2004
which due to the increase in net capital spending and net working capital and this indicates that
there is an increase in net new borrowing and equity.

Net increase in long-term debt = $1,226,280 - $200,000

= $1,026,280

Dividends and interest paid = $42,930 + $155,000

= $197,930
Net amount of additional capital raised = $1,026,280 - $197,930 = $828,350
Form the checking calculation above, its shows that Signal Cable Company has raised additional
long-term debt to fund the increase in net fixed assets and net working capital.
6. Calculate the net working capital of the company for each of the two years. What can
you conclude about the firms net working capital?
Net working capital (NWC) = current assets current liabilities
NWC 2003 = $890,000 - $355,000
= $535,000
NWC 2004 = $1,845,450 - $895,000
= $950,450
The Signal Cable Company net working capital (NWC) has increases for $415,450 or 78% from
year 2003 to year 2004. This positive increases shows that the creditors and investors of Signal
Cable Company are able to generate enough from the operations to pay for the current
obligations with current assets.
7. Should the shareholders be concerned about the drop in cash flow or should they be
happy that the earnings per share have increased? Explain your answer.
The shareholders of Signal Cable Company should be concerned about the drop in cash flow. It
is because when the cash flow started to drop, it means that something is going wrong with the
company. Thus, the company should be aware of it and plan some moves to reduce the liquidity
risk.