Tutorial 3 (Topic 2)

Financial Statements and Ratio Analysis

Question 1 – J.B. Chavez Corporation
Answer
a) .
Industry
RATIO 2008 2009 Norm
Liquidity:
Current Ratio 5.00 5.35 5.00
Acid-test (Quick) Ratio 2.70 2.63 3.00
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20

Operating profitability:
Operating Income Return on Investment 12.24% 12.97% 15.00%
Operating Profit Margin 24.00% 22.76% 20.00%
Total Asset Turnover .51 .57 .75
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20
Fixed Asset Turnover 1.04 1.12 1.00

Financing:
Debt Ratio 34.69% 32.81% 33.00%
Times Interest Earned 6.00 5.50 7.00

Rate of return on common stockholders’ investment:

Return on Common Equity 9.38% 9.53% 13.43%

b) The firm’s liquidity, the acid-test (quick) ratios are below the industry average
and have decreased from the prior year. Also, the average collection period and
inventory turnover are well below the industry averages, which suggests that
inventories of the firm are not selling. Since the current ratio is satisfactory, the
problem lies in the management of inventories and receivables. So, we may
reasonably conclude that Chavez is less liquid when compared with firms in the
industry.

c) In evaluating Chavez’s operating profitability relative to the average firm in the

industry, we must first analyse the operating income return on investment both
for Chavez and the industry. From the information given, this computation may
be made as follows:

= X

2008 2009 Industry

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 Industry (20.00% X 0.75)
15.00%
Chavez (24.00% X 0.51) 12.24%
(22.76% X 0.57 ) 12.97%

Thus, given the low operating income return on investment for Chavez relative to
the industry, we can conclude that management is not doing an adequate job of
generating operating profits on the firm’s assets. However, they did improve
between 2008 and 2009. The problem lies not with the operating profit margin,
instead, the problem arises from Chavez’s management not using the firm’s
assets efficiently, as indicated by the low asset turnover ratios. Here, the
problem occurs in managing accounts receivable and inventories, where we see
the low turnover ratios. The firm is using the fixed assets reasonably well i.e.
note the fixed assets turnover same with industry.
Management need to investigate pricing of their product relative to the industry.

d) Financing decisions
A balance-sheet perspective:
The debt ratio for Chavez in 2009 is around 32.81%, a decrease from 34.69% in
2008; that is, they finance about one-third of their assets with debt. The average
firm in the industry used about the same amount of debt per dollar of assets.

An income-statement perspective:
Chavez’s Times Interest Earned , 6.0 in 2008 and 5.50 in 2009 is below industry
norm of 7.0. A company’s times interest earned is affected by (1) the level of the
firm’s operating profitability (EBIT), (2) the amount of debt used, and (3) the
interest rate. Items 2 and 3 determine the amount of interest paid by the firm.
Based on the information provided , we can commend as follows:-
1. The firm’s operating profitability is below average, but improving. Thus,
we would expect this fact to contribute to a lower operating income return on
investment.
2. Chavez uses about the same amount of debt as the average firm, which
mean that its times interest earned would be about the same for the average
firm. Thus, Chavez’s low times interest earned is not the consequence of
using more debt.
3. We do not have any information about Chavez’s interest rate. But we know if
Chavez is paying a higher interest rate than its competitors, such a situation
would also be contributing to the problem.

e) Chavez has improved its return on common equity from 9.38% in 2008 to
9.53% in 2009, but is low when compared to an industry norm of 13.43%. The
improvement has come from an increase in the firm’s operating income return on
investment, despite a slight decrease in the use of debt financing. Thus, Chavez
has enhanced the returns to its owners, and with a small decline of financial
risk (slightly lower debt ratio) in the process.

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Question 2
Answer
(a) Salco’s total asset turnover, operating profit margin, and operating income return
on investment.
Sales
Total Asset Turnover =
Total Assets
$4,500,000
= $2,000,000

= 2.25 times
Operating Income
Operating Profit Margin =
Sales
$500,000
= $4,500,000

= 11.11%
Operating Income Operating Income
Return on Investment =
Total Assets
$500,000
= $2,000,000

= 25%
Operating Income Sales
or = x
Sales Total Assets
= .1111 X 2.25 = 25%

(b) The new operating income return on investment for Salco after the plant
renovation:
Operating Income Operating Income Sales
Return on Investment = x
Sales Total Assets
$4,500,000
= .13 x
$3,000,000

= .13 x 1.5 = 19.5%

(c) Return earned on the common stockholders’ investment:

Post-Renovation Analysis:
Net Income Available
Return on common
= to Common Stockholders
equity
Common Equity
$217,500
= $1,000,000  $500,000

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 = 14.5%
Net income Available to common stockholders following the renovation
was calculated as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 + $50,000) (150,000)
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500)
Net Income Available to Common Stockholders $ 217,500

Pre-renovation Analysis:
The pre-renovation rate of return on common equity is calculated as
follows:
$200,000
Return on Common Equity = $1,000,000
= 20%

Comparative Analysis:
A comparison of the two rates of return would argue that the renovation not be
undertaken. However, since investments in fixed assets generally produce cash
flows over many years, it is not appropriate to base decisions about their
acquisition on a single year’s ratios. There are additional problems with this
approach to fixed asset decision making which we will discover when we discuss
capital budgeting in a later chapter.

Question 3
Bluegrass Natural Foods Inc.
Answer
(a) Bluegrass appears to be holding excess inventory relative to the industry. This
fact is supported by the low inventory turnover and the low quick ratio, even
though the current ratio is above the industry average. This excess inventory
could be due to slow sales relative to production or possibly from carrying
obsolete inventory.

(b) The accounts receivable of Bluegrass appears to be high due to the large number
of days of sales outstanding (73 versus the industry average of 52 days). An
important question for internal management is whether the company's credit
policy is too lenient or customers are just paying slowly – or potentially not
paying at all.

(c) Since the firm is paying its accounts payable in 31 days versus the industry norm
of 40 days, Bluegrass may not be taking full advantage of credit terms extended

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 to them by their suppliers. By having the receivables collection period over
twice as long as the payables payment period, the firm is financing a significant
amount of current assets, possibly from long-term sources.

(d) The desire is that management will be able to curtail the level of inventory either
by reducing production or encouraging additional sales through a stronger sales
program or discounts. Getting rid of obsolete inventory will lead to gain in
income tax benefit. The firm must also push to try to get their customers to pay
earlier. Shorten credit terms by providing a discount for earlier payment will
improve cash collection from trade debtors. Paying suppliers later would also
reduce financing costs.
Carrying out these recommendations may be difficult because of the potential loss
of customers due to stricter credit terms. Delay in settlement of suppliers’ account
may lead costs of purchases to increase as we shall loose the discounts associated
with paying suppliers within stipulated credit term.

Question 4
Robert Arias
Answer
(a) The four companies are in very different industries. The operating characteristics of
firms across different industries vary significantly resulting in very different ratio
values.
(b) The explanation for the lower current and quick ratios most likely rests on the fact
that these two industries operate primarily on a cash basis. Their accounts
receivable balances are going to be much lower than for the other two companies.
(c) High level of debt can be maintained if the firm has a large, predictable, and steady
cash flow. Utilities tend to meet these cash flow requirements. The software firm
will have very uncertain and changing cash flow. The software industry is subject
to greater competition resulting in more volatile cash flow.
(d) Although the software industry has potentially high profits and investment return
performance, it also has a large amount of uncertainty associated with the profits.
Also, by placing all of the money in one stock, the benefits of reduced risk
associated with diversification are lost.

Question 5

Answer
Grenoble Enterprises Cash Budget (May – July)
March April May June July
Sales $50,000 $60,000 $70,000 $80,000 $100,000
Cash sales (0.20) $10,000 $12,000 $14,000 $16,000 $ 20,000

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  Lag 1 month (0.60) 36,000 42,000 48,000
 Lag 2 months (0.20) 10,000 12,000 14,000
Other income 2,000 2,000 2,000
 Total cash receipts $62,000 $72,000 $ 84,000
Disbursements
Purchases $50,000 $70,000 $ 80,000
Rent 3,000 3,000 3,000
Wages & salaries 6,000 7,000 8,000
Dividends 3,000
Principal & interest 4,000
Purchase of new 6,000
equipment
Taxes due 6,000
 Total cash $59,000 $93,000 $97,000
disbursements

Total cash receipts $62,000 $72,000 $84,000

Total cash disbursements 59,000 93,000 97,000
 Net cash flow $ 3,000 ($21,000) ($13,000)
Add: Beginning cash 5,000 8,000 (13,000)
Ending cash $ 8,000 ($13,000) ($26,000)
Minimum cash 5,000 5,000 5,000
Required total financing
(notes payable) $18,000 $31,000
Excess cash balance
(marketable securities) $ 3,000 0 0
The firm should establish a credit line of at least $31,000.

Question 7
What is net working capital? How is it different from gross working capital? What is
interest-bearing debt and non-interest-bearing debt?

Answer
Net working capital is the firm’s liquid assets (current assets) less its short-term debt.
Accountants include all short-term debt when computing net working capital; however, in
computing free cash flows, we only subtract the noninterest-bearing debt, such as accounts
payables and accruals. With this latter method, we are only considering the assets and
liabilities that are changing as a result of the normal operating cycle of the business—
beginning with the time inventory is purchased on credit to the time the firm collects the
cash from its customer.
Gross working capital is the sum of current assets, while net working capital is the
difference between current assets and current liabilities.

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As already suggested, we have both interest-bearing debt and noninterest-bearing debt.
The former is debt where the lender is paid interest for providing us the money.
Noninterest-bearing debt charges no interest because the “lender” is really a supplier or
an employee to whom we owe money, but they are not requiring the firm to pay interest.

Question 8
Discuss the reasons why one firm could have positive cash flows and be headed for
financial trouble, and another firm with negative cash flows could actually be in a good
financial position.

Answer
A firm could have positive cash flows but still be in trouble because it has negative cash
flows from operations. The positive cash flows would then be the result of the firm
reducing its investments in working capital or long-term assets. Such a situation means
that the company is not earning a satisfactory rate of return on its investments.
Another company could have very attractive rates of return on its assets, but be growing
so fast that the large investments in working capital and long-term assets result in
negative cash flows. In this latter case, management is simply investing in the future. As
the rate of growth slows, positive cash flows will occur.