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Professor Anu Vuorikoski Bus 173A – Intermediate Financial Management Chapter 8: mini case a. Why are ratios useful? What are the five major categories of ratios? Ratios are useful to evaluate a firm’s financial statements and one can also compare their performance with other firms, or the industry average. The five major categories for ratios are as follow: i. Liquidity Ratios: measures the liquidity of the firm’s current assets to their current liabilities (or obligations to creditors). ii. Asset Management Ratios: measures how effectively the firm is handling and managing their assets. ii. Debt Management Ratios: measure their debt financing, or financial leverage; how much is the firm depended on debt. iv. Profitability Ratios: these ratios demonstrate the effects of liquidity, asset management, and debt combined together on operating results. v. Market Value Ratios: these are ratios that help managers know what investors think of the company’s past performance and future prospects. b. Calculate the 2007 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 2005, 2006, and as projected for 2007?

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? Current Ratio = Current Assets / Current Liabilities Current Ratio = $2,680,112 / $1,039,800 Current Ratio = 2. 58 times Quick Asset Ratio = (Current Assets – Inventory) / Current Liabilities Quick Asset Ratio = ($2,680,112 – $1,716,480) / $1,039,800 Quick Asset Ratio = 0. 93 times

The firm is has improved their in reducing their current liabilities and increasing their current asset; however, they are still below industrial avg. | |2005 |2006 |2007E |Industrial Avg. | |Current Ratio |2. 3x |1. 5x |2. 58x |2. 7x | |Quick Acid Ratio |0. 8x |0. 5x |0. 93x |1. 0x | Table 1 – from minicase (pg 281) Not all type of analyst would have an equal interest in the liquidity ratios. For instance, creditors might be interested more than managers.

If they are going to lend the firm some funds, they want to be sure they can be recovered their capital fast incase the firms goes bankrupt. c. Calculate the 2007 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Computron’s utilization of assets stack up against that of other firms in its industry? Inventory Turnover = Sales / Inventory Inventory Turnover = $7,035,600 / $1,716,480 Inventory Turnover = 4. 10 times Industry turn over is 6. 1 times while the firms inventory turnover is 4. 10.

The firm’s inventory is being stored longer than the industry average; hence it is taking up space, which is costing them money. They need to improve their inventory management system. Days Sales Outstanding = Receivables / (Annual Sales/365) Days Sales Outstanding = $878,000 / ($7,035,600/365) Days Sales Outstanding = 45. 55 Industry DSO is 32 days while the firm’s DSO is 45. 55 days to collect money from sales (or collect money from their accounts receivable). If they have a 30 days term, they are not doing to a good job and should change or enforce new policies.

Fixed Assets Turnover = Sales / Fixed Assets Fixed Assets Turnover = $7,035,600 / $836,840 Fixed Assets Turnover = 8. 41 times The industry fixed asset turnover is 7 times while the firm’s is expected to be a little bit over 8. 41. Meaning, they are being a bit more efficient than the industry average in using their assets to generate sales. Total Assets Turnover = Sales / Total Assets Turnover Total Assets Turnover = $7,035,600 / $3,516,952 Total Assets Turnover = 2. 00 times The industry total asset turnover is 2. 5 times while the firm’s is expected to be a 2. 0 times.

The firm is below the industry average due the increase in inventories and accounts receivables. d. Calculate the 2007 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? Debt Ratio = total liabilities / total assets Debt Ratio = $ 1,539,800/ $3,516,952 Debt Ratio = 0. 44 = 44% The industry average is 50%, which means creditors have supplied 50% (half) of their financing. The firm’s debt ratio is lower than the industry average, 44%, which is a good sign.

They should try to minimize it a bit more or not let it increase. Times-Interest-Earned (TIE) = EBIT / Interest Charges TIE = $502,640/ $80,000 TIE = 6. 28 times The industry and the firm’s TIE are almost the same (firm’s is 6. 28 and the industry average is 6. 2). They are both covering interest charges on their debt in the same length of time. EBITDA Coverage ratio = (EBIT + Depr. + Amort. + Lease payments) / (Interest + Lease payments) EBITDA Coverage Ratio = ($502,640 + $120,000)/ ($80,000 + $40,000+0) EBITDA Coverage Ratio = 5. 5 times e.

Calculate the 2007 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? Profit Margin = Net Income / Sales PM = $253,548/ $7,035,600 PM = 3. 6% | |2005 |2006 |2007E |Industrial Avg. | |Profit Margin |2. 6% |-1. 6% |3. 6% |3. 6% | Table 2 – from minicase (pg 281) The firm did horrible in 2006, but it’s now meeting the industrial average. Basic Earning Power = EBIT / Total Assets BEP = $502,640 / $3,516,952

BEP = 0. 142 = 14% | |2005 |2006 |2007E |Industrial Avg. | |Basic Earning Power |14. 2% |0. 6% |14% |17. 8% | Table 3 – from minicase (pg 281) Basic Earning Power eliminates the effect of taxes and financial leverage. The projected is below average compared to the industrial average. Return on Total Assets = ROA = Net Income/ Total Assets ROA = $253,548 / $3,516,952 ROA = 7. 2% ROA is lowered by debt–interest expense lowers net income, which also lowers ROA. |2005 |2006 |2007E |Industrial Avg. | |ROA |6. 0% |-3. 3% |7. 2% |9% | Table 4 – from minicase (pg 281) Return on Common Equity = ROE = Net Income/ Common Equity ROE = $253,548 / $1,977,152 ROE = 12. 8% The use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. | |2005 |2006 |2007E |Industrial Avg. | |ROE |13. 3% |-17. 1% |12. % |17. 9% | Table 5 – from minicase (pg 281) f. Calculate the 2007 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? Price/Earning Ratio = Price per share / Earning per Share Earnings per Share = Income / Number of outstanding shares P/E ratio = $12. 17 / ($253,548 / $250,000) P/E ratio = 11. 99x = 12x | |2005 |2006 |2007E |Industrial Avg. | |P/E ratio |9. x |-6. 3x |12x |16. 2x |

Table 6 – from minicase (pg 281) Price/Cash Flow Ratio = Price per Share / Cash Flow per Share Cash Flow per Share = (Net Income + Depr. ) / Shares Outstanding Price/Cash Flow Ratio = $12. 17/ (($253,548+$120,000)/250,000) Price/Cash Flow Ratio = $12. 17/ (($373,548)/250,000) Price/Cash Flow Ratio = $12. 17/ $1. 494192 Price/Cash Flow Ratio = 8. 15x | |2005 |2006 |2007E |Industrial Avg. | |Price/Cash Flow Ratio |8. x |27. 5x |8. 15x |7. 6x | Table 7 – from minicase (pg 281) Market/Book Ratio 1st Book Value per Share = Common Equity / Shares Outstanding Book Value per Share = $1,977,152 / 250,000 Book Value per Share = $7. 91 2nd Market/Book ratio = Market Price per Share / Book Value per Share M/B ratio = $12. 17 / $7. 91 M/B ratio = 1. 54 x | |2005 |2006 |2007E |Industrial Avg. | |Market/Book ratio |1. 3x |1. 1x |1. 54x |2. x | Table 8 – from minicase (pg 281) The price earning ratio is still below industrial average. The firm is considered riskier. However, investors are willing to pay a more for the estimated 2007 year than they did for the year of 2006. They do expect both revenue and earning to grow. g. Perform a common size analysis and percent change analysis. What do these analyses tell you about Computron? Common Size analysis for Income Statement (86. 7) than industry (84. 5), but higher other expenses. Result is that net, net the company has similar EBIT % (7. 1) as industry.

To increase EBIT and bottom line to create shareholder wealth (by increasing NOPAT), company needs to cut costs or grow costs slower than sales [pic] Common Size analysis for Balance Sheet The firm has higher proportion of inventory and current assets than Industry. The firm now has more equity than the industry average. The firm has more short-term debt than industry, but less long-term debt than industry. [pic] Common Size analysis for Balance Sheet (cont. ) [pic] Percent Change Analysis for Income Statement Sales grew 105% from 2004, and Net Income grew 188% from 2004. pic] h. Use the extended Du Pont equation to provide a summary and overview of Computron’s financial condition as projected for 2007. What are the firm’s strengths and weaknesses? Extended Du Pont Equation = ROE = = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Common Equity) = ($253,548 / $7,035,600) x ($7,035,600 / $3,516,952) x ($3,516,952 / $1,977,152) = 0. 036038 x 2. 000482 x 1. 778797 = 0. 128239 OR = Net Income / Comment Equity = 0. 128239 i. What are some potential problems and limitations of financial ratio analyses?

Average performance is not the best position a firm would like to be in. You want to aim higher. There are some firms that are seasonal and this can throw off some of the ratios for those firms when comparing them with others. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is “good” or “bad. ” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition. 1] j. What are some qualitative factors analysts should consider when evaluating a company? Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment? [2] ———————– [1] From the professors power point slide [2] From the professors power point slide

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