Ch 3 Analysis of Financial Statements MINI CASE

The first part of the case, presented in Chapter 3, discussed the situation of Computron
Industries after an expansion program. A large loss occurred in 2013, rather than the
expected profit. As a result, its managers, directors, and investors are concerned about the
firm’s survival.
Jenny Cochran was brought in as assistant to Gary Meissner, Computron’s chairman,
who had the task of getting the company back into a sound financial position. Computron’s
2012 and 2013 balance sheets and income statements, together with projections for 2014, are
shown in the following tables. The tables also show the 2012 and 2013 financial ratios, along
with industry average data. The 2014 projected financial statement data represent
Cochran’s and Meissner’s best guess for 2014 results, assuming that some new financing is
arranged to get the company “over the hump.”
Cochrane 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.

Mini Case: 3 - 1
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Balance Sheets

Assets 2012 2013 2014e

Cash $ 9,000 $ 7,282 $ 14,000
Short-Term Investments. 48,600 20,000 71,632
Accounts Receivable 351,200 632,160 878,000
Inventories 715,200 1,287,360 1,716,480
Total Current Assets $ 1,124,000 $ 1,946,802 $ 2,680,112
Gross Fixed Assets 491,000 1,202,950 1,220,000
Less: Accumulated Depreciation 146,200 263,160 383,160
Net Fixed Assets $ 344,800 $ 939,790 $ 836,840
Total Assets $ 1,468,800 $ 2,886,592 $ 3,516,952

Liabilities And Equity 2011 2012 2013e

Accounts Payable $ 145,600 $ 324,000 $ 359,800
Notes Payable 200,000 720,000 300,000
Accruals 136,000 284,960 380,000
Total Current Liabilities $ 481,600 $ 1,328,960 $ 1,039,800
Long-Term Debt 323,432 1,000,000 500,000
Common Stock (100,000 Shares) 460,000 460,000 1,680,936
Retained Earnings 203,768 97,632 296,216
Total Equity $ 663,768 $ 557,632 $ 1,977,152
Total Liabilities And Equity $ 1,468,800 $ 2,886,592 $ 3,516,952

Mini Case: 3 - 2
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Income Statements
2012 2013 2014e
Sales $ 3,432,000 $ 5,834,400 $ 7,035,600
COGS except depr. 2,864,000 4,980,000 5,800,000
Depreciation 18,900 116,960 120,000
Other Expenses 340,000 720,000 612,960
Total Operating Costs $ 3,222,900 $ 5,816,960 $ 6,532,960
EBIT $ 209,100 $ 17,440 $ 502,640
Interest Expense 62,500 176,000 80,000
EBT $ 146,600 $ (158,560) $ 422,640
Taxes (40%) 58,640 (63,424) 169,056
Net Income $ 87,960 $ (95,136) $ 253,584

Other Data 2012 2013 2014e

Stock Price $ 8.50 $ 6.00 $ 12.17
Shares Outstanding 100,000 100,000 250,000
EPS $ 0.880 $ (0.951) $ 1.014
DPS $ 0.220 $ 0.110 $ 0.220
Tax Rate 40% 40% 40%
Book Value Per Share $ 6.638 $ 5.576 $ 7.909
Lease Payments $ 40,000 $ 40,000 $ 40,000

Ratio Analysis 2012 2013 2014e Industry Average

Current 2.3 1.5 2.58 2.7
Quick 0.8 0.5 0.93 1.0
Inventory Turnover 4.0 4.0 3.45 6.1
Days Sales Outstanding 37.4 39.5 45.5 32.0
Fixed Assets Turnover 10.0 6.2 8.41 7.0
Total Assets Turnover 2.3 2.0 2.00 2.5
Debt Ratio 35.6% 59.6% 22.7% 32.0%
Liabilities/Assets Ratio 54.8% 80.7% 43.8% 50.0%
TIE 3.3 0.1 6.3 6.2
EBITDA Coverage 2.6 0.8 5.5 8.0
Profit Margin 2.6% -1.6% 3.6% 3.6%
Basic Earning Power 14.2% 0.6% 14.3% 17.8%
ROA 6.0% -3.3% 7.2% 9.0%
ROE 13.3% -17.1% 12.8% 17.9%
Price/Earnings (P/E) 9.7 -6.3 12.0 16.2
Price/Cash Flow 8.0 27.5 8.1 7.6
Market/Book 1.3 1.1 1.5 2.9

Mini Case: 3 - 3
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website, in whole or in part.
a. Why are ratios useful? What three groups use ratio analysis and for what
reasons?

Answer: Ratios facilitate comparison of (1) one company over time and (2) one company versus
other companies. 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 cash flows.

b. Calculate the 2014 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 2012, 2013, and as projected for 2014? 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 Ratio14 = Current Assets/Current Liabilities

= $2,680,112/$1,039,800 = 2.58.

Quick Ratio14 = (Current Assets – Inventory)/Current Liabilities

= ($2,680,112 - $1,716,480)/$1,039,800 = 0.93.

The company’s current and quick ratios are higher relative to its 2012 current and
quick ratios; they have improved from their 2013 levels. Both ratios are below the
industry average, however.

Mini Case: 3 - 4
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website, in whole or in part.
c. Calculate the 2014 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 Turnover14 = COGS/Inventory

= ($5,800,000 + $120,000)/$1,716,480= 3.45.

DSO14 = Receivables/(Sales/365)
= $878,000/($7,035,600/365) = 45.5 Days.

Fixed Assets Turnover14 = Sales/Net Fixed Assets

= $7,035,600/$836,840 = 8.41.

Total Assets Turnover14 = Sales/Total Assets

= $7,035,600/$3,516,952 = 2.0.

The firm’s inventory turnover ratio has declined, while its days sales outstanding
has been steadily increasing. While the firm’s fixed assets turnover ratio is below its
2012 level, it is above the 2013 level. The firm’s total assets turnover ratio is below its
2012 level and equal to its 2013 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.)

Mini Case: 3 - 5
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website, in whole or in part.
d. Calculate the 2014 debt ratio, liabilities-to-assets ratio, 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 Ratio14 = Total Debt/Total Assets

= ($300,000+ $500,000)/$3,516,952 = 22.7%.
Liabilities-to-Assets Ratio14 = Total Liabilities/Total Assets
= ($1,039,800 + $500,000)/$3,516,952 = 43.8%.
TIE14 = EBIT/Interest = $502,640/$80,000 = 6.3.

 Lease   Loan Lease 

EBITDA Coverage14 =  EBITDA   /  Interest   
 Payments   Repayments Payments 
= ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5.

The firm’s debt ratio is much improved from 2013, and is still lower than its 2012
level and the industry average. The firm’s TIE and EBITDA coverage ratios are much
improved from their 2012 and 2013 levels. The firm’s TIE is better than the industry
average, but the EBITDA coverage is lower, reflecting the firm’s higher lease
obligations.

e. Calculate the 2014 profit margin, basic earning power (BEP), return on assets
(ROA), and return on equity (ROE). What can you say about these ratios?

Answer: Profit Margin14 = Net Income/Sales = $253,584/$7,035,600 = 3.6%.

Basic Earning Power14 = EBIT/Total Assets = $502,640/$3,516,952

= 14.3%.

ROA14 = Net Income/Total Assets = $253,584/$3,516,952 = 7.2%.

ROE14 = Net Income/Common Equity = $253,584/$1,977,152 = 12.8%.

The firm’s profit margin is above 2012 and 2013 levels and is at the industry
average. The basic earning power, ROA, and ROE ratios are above both 2012 and
2013 levels, but below the industry average due to poor asset utilization.

Mini Case: 3 - 6
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f. Calculate the 2014 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/Earnings14 = Price Per Share/Earnings Per Share

= $12.17/$1.0143 = 12.0.

Check: Price = EPS  P/E = $1.0143(12) = $12.17.

Cash Flow/Share14 = (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

= $1,977,152/250,000 = $7.91.

Market/Book = Market Price Per Share/Book Value Per Share

= $12.17/$7.91 = 1.54x.

Both the P/E ratio and BVPS are above the 2012 and 2013 levels but below the
industry average.

g. 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.

Mini Case: 3 - 7
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website, in whole or in part.
 Common Size Balance Sheets
Assets
Cash
Short Term Investments
Accounts Receivable
Inventories
Total Current Assets
Gross Fixed Assets
Less Accumulated Depreciation 10.0%
Net Fixed Assets
Total Assets
2012 2013 2014e Ind.
0.6% 0.3% 0.4% 0.3%
3.3% 0.7% 2.0% 0.3%
23.9% 21.9% 25.0% 22.4%
48.7% 44.6% 48.8% 41.2%
76.5% 67.4% 76.2% 64.1%
33.4% 41.7% 34.7% 53.9%
9.1% 10.9% 18.0%
23.5% 32.6% 23.8% 35.9%
100.0% 100.0% 100.0% 100.0%

Liabilities And Equity 2012 2013 2014e Ind.

Accounts Payable 9.9% 11.2% 10.2% 11.9%
Notes Payable 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total Current Liabilities 32.8% 46.0% 29.6% 23.7%
Long-Term Debt 22.0% 34.6% 14.2% 26.3%
Common Stock (100,000 Shares) 31.3% 15.9% 47.8% 20.0%
Retained Earnings 13.9% 3.4% 8.4% 30.0%
Total Equity 45.2% 19.3% 56.2% 50.0%
Total Liabilities And Equity 100.0% 100.0% 100.0% 100.0%

Common Size Income Statement 2012 2013 2014e Ind.

Sales 100.0% 100.0% 100.0% 100.0%
Cost Of Goods Sold 83.4% 85.4% 82.4% 84.5%
Depreciation 0.6% 2.0% 1.7% 4.0%
Other Expenses 9.9% 12.3% 8.7% 4.4%
Total Operating Costs 93.9% 99.7% 92.9% 92.9%
EBIT 6.1% 0.3% 7.1% 7.1%
Interest Expense 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes (40%) 1.7% -1.1% 2.4% 2.4%
Net Income 2.6% -1.6% 3.6% 3.6%

Computron has higher proportion of inventory and current assets than industry.
Computron has slightly more equity (which means less debt) than industry. Computron
has more short-term debt than industry, but less long-term debt than industry.
Computron has lower COGS than industry, but higher other expenses. Result is that
Computron has similar EBIT as industry.

Mini Case: 3 - 8
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website, in whole or in part.
 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
2012 2013 2014e
Cash 0.0% -19.1% 55.6%
Short Term Investments 0.0% -58.8% 47.4%
Accounts Receivable 0.0% 80.0% 150.0%
Inventories 0.0% 80.0% 140.0%
Total Current Assets 0.0% 73.2% 138.4%
Gross Fixed Assets 0.0% 145.0% 148.5%
Less Accumulated Depreciation 0.0% 80.0% 162.1%
Net Fixed Assets 0.0% 172.6% 142.7%
Total Assets 0.0% 96.5% 139.4%

Liabilities And Equity 2012 2013 2014e

Accounts Payable 0.0% 122.5% 147.1%
Notes Payable 0.0% 260.0% 50.0%
Accruals 0.0% 109.5% 179.4%
Total Current Liabilities 0.0% 175.9% 115.9%
Long-Term Debt 0.0% 209.2% 54.6%
Common Stock (100,000 Shares) 0.0% 0.0% 265.4%
Retained Earnings 0.0% -52.1% 45.4%
Total Equity 0.0% -16.0% 197.9%
Total Liabilities And Equity 0.0% 96.5% 139.4%

Percent Change Income Statement 2011 2012 2013e

Sales 0.0% 70.0% 105.0%
Depreciation 0.0% 518.8% 534.9%
Cost Of Goods Sold 0.0% 73.9% 102.5%
Other Expenses 0.0% 111.8% 80.3%
Total Operating Costs 0.0% 80.5% 102.7%
EBIT 0.0% -91.7% 140.4%
Interest Expense 0.0% 181.6% 28.0%
EBT 0.0% -208.2% 188.3%
Taxes (40%) 0.0% -208.2% 188.3%
Net Income 0.0% -208.2% 188.3%

We see that 2014 sales grew 105% from 2012, and that NI grew 188% from 2013.
So Computron has become more profitable. We see that total assets grew at a rate of
139%, while sales grew at a rate of only 105%. So asset utilization remains a
problem.

Mini Case: 3 - 9
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website, in whole or in part.
h. Use the extended Du Pont equation to provide a summary and overview of
Computron’s financial condition as projected for 2014. What are the firm’s major
strengths and weaknesses?

Profit Total Assets Equity

Answer: Du Pont Equation =  
Margin Turnover Multiplier
= 3.6%  2.0  ($3,516,952/$1,977,152)
= 3.6%  2.0  1.8 = 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. (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.

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

Answer: Some potential problems are listed below:

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.

Mini Case: 3 - 10
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website, in whole or in part.
j. 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

Mini Case: 3 - 11
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website, in whole or in part.