Logistics1 --
Let's start with the current balance sheet. You probably have
resources of your own but one of the finest descriptions of financial
reports and how to use them was produced by Merrill Lynch years ago.
I've kept one in my library for decades but it's available on the web
too:
Merrill Lynch
"How to Read a Financial Report" (undated)
http://philanthropy.ml.com/ipo/resources/financial.html
The best way to start this problem is to create the balance sheet
categories, then plug in what's known -- using the quick ratios and
math to fill out the lines possible. We know at the start that the
company's total assets are $100 million, so at the bottom line of the
balance sheet both TOTAL ASSETS and TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY will be the same.
This exercise is probably better done in a spreadsheet because you can
make your balance sheet actually balance (and make it look cooler),
but I've done it here so that comments can be put in more clearly.
There is a * next to all of the assumptions below the balance sheet,
so you'll know what they are. There are even more assumptions made
than in my original clarification requests, as you'll see.
---
GEORGIA, INC.
Balance sheet
March 1, 2004
ASSETS
=======
Cash: $4,862,000
Marketable securities: $10,000,000
Accounts receivable: $8,219,000
Inventories: $4,931,000
Prepaid expenses: $0
TOTAL CURRENT ASSETS = $28,012, 000
Land: $20,000,000
Buildings: $10,000,000
Equipment, machinery: $45,000,000
TOTAL FIXED ASSETS = $75,000,000
Less accumulated depreciation: ($5,012,000)
NET FIXED ASSETS = $69,988,000
Intangibles (goodwill, patents): $2,000,000
=========================
TOTAL ASSETS = $100,000,000
=========================
LIABILITIES
Accounts payable: $20,169,000
Notes payable: $63,000
Accrued expenses payable: $1,250,000
Federal income taxes payable: $300,000
TOTAL CURRENT LIABILITIES = $21,782,000
Deferred income taxes: $48,218,000
5% Bonds due 2014: $5,000,000
TOTAL LONG-TERM LIABILITIES: $53,218,000
TOTAL LIABILITIES: $75,000,000
SHAREHOLDERS' EQUITY
Stock, par value $1: $1,000,000
Capital surplus: $1,000,000
Accumulated retained earnings: $23,000,000
TOTAL SHAREHOLDERS' EQUITY = $25,000,000
======================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY = $100,000,000
======================================================
ASSUMPTIONS:
? Nothing's really said about A/R. Normal terms are 30 days -- though
you'll find public companies with numbers between 5 days and 60 days,
depending on types of contracts written with customers. I've used 30
days for A/R -- and matched it with 30 days for A/P, as matching cash
flows is generally a good thing.
? With $8.2 million in sales per month we need to create some
inventory. A good number for a profitable firm is a gross margin of
40%, though some firms like Dell (NASDAQ: DELL) can operate profitably
on gross margins as low as 20%. We'll give the company a month's
worth of inventory so that it gets 12 turns per year.
? How much cash do we need to run a $100,000,000 company? Myself, I
like more cash -- at least enough to cover several months' operations.
So let's put some cash in for 2 months inventories/salaries/other
expenses. And let's give the company expenses of about $30 million
for all of its staff, so that it still takes 10% of sales to operating
income. But why keep all of that $14.8 million in cash, when we can
put some of it in overnight investments (marketable securities)?
? We've got TOTAL CURRENT ASSETS now, so the CA/CL ratio is 1.286 and
that gives us TOTAL CURRENT LIABILITIES too: $21.782 million.
? Let's go back and fill out the assets side so that everything totals
$100,000,000. Recognize that these are arbitrary numbers, put there
so that we can get something on every line (but based a bit on
experience):
-- Land: $20,000,000
-- buildings: $10,000,000
-- equipment: $45,000,000
-- accumulated depreciation: ($5,012,000)
-- intangibles: $2,000,000
? Now let's work on the liabilities side -- knowing that it has to
balance. We know the debt is $5 million; we also know TOTAL CURRENT
LIABILITIES. Debt/equity gives the long-term liabilities for
everything except deferred income taxes -- so we're going to have a
whopping $48.2 million there to make everything balance. Companies
can have large numbers here if they're in capital-intense businesses
that allow accelerated depreciation -- while the company may
straight-line the expenses for a more accurate product cost.
? Just so we're complete, we'll plug in some numbers for the CURRENT LIABILITIES:
-- Accounts payable: $20,169,000
-- Notes payable (3 months worth): $63,000
-- Accrued expenses (primarily salaries): $1,250,000
-- Federal income taxes payable (1 month): $300,000
---
THE INVESTMENT DECISIONS: 1
Let's dispense with the acquisition first: it will cost $10,000,000 to
finance and return $1,000,000 in net after-tax cash flow, which is
10%. Your hurdle rate is 15%. It's a no-go.
In reality, if you felt your cost-of-equity was 15%, you might pursue
the following argument:
? cost of equity = 15%
? cost of debt = 5%
? let's make the acquisition with 75% debt and 25% equity, then have a
weighted-average cost of capital (WACC) = 7.5%. Under these
conditions the investment would be a "go."
THE INVESTMENT DECISIONS: 2
This company isn't overstuffed with cash: it has enough to run its
operations. However, in the next year it will generate about $10
million in profits; $6.5 million after taxes (35% statutory rate).
Plus, depreciation could well add another $1 million in cash-flow.
Now that money isn't going to pay for an acquisition in March, but
it's there over the next six months to fund the $2 million in new
projects. And it will generate $5.5 million of the cash for the new
plant -- which presumably takes a year to design and build. So, the
company really only needs finance $2.5 million, if only the plant and
projects are funded.
Which gets us to the balance sheet for a year from now.
---
Here's what changes with the $10M in investment:
? Total fixed assets rise by $10 million.
? Depreciation of $2,857,000 generated an additional $1 million in
cash (at a 35% tax rate).
? Cash from operations generated $6.5 million -- and what wasn't spent
on projects we just stuffed in the bank.
On the liabilities side we will have an additional $6.5 million from
operations during the year, plus $2.5 million in borrowing. And,
remember that we've garnered $1 million in savings from accelerated
depreciation to help fund the projects -- so that goes in the
"deferred income tax" line:
GEORGIA, INC.
Balance sheet
March 1, 2005
ASSETS
=======
Cash: $4,862,000
Marketable securities: $12,857,000
Accounts receivable: $8,219,000
Inventories: $4,931,000
Prepaid expenses: $0
TOTAL CURRENT ASSETS = $30,869, 000
Land: $22,000,000
Buildings: $12,000,000
Equipment, machinery: $44,000,000
TOTAL FIXED ASSETS = $85,000,000
Less accumulated depreciation: ($7,869,000)
NET FIXED ASSETS = $77,131,000
Intangibles (goodwill, patents): $2,000,000
=========================
TOTAL ASSETS = $110,000,000
=========================
LIABILITIES
Accounts payable: $20,169,000
Notes payable: $63,000
Accrued expenses payable: $1,250,000
Federal income taxes payable: $300,000
TOTAL CURRENT LIABILITIES = $21,782,000
Deferred income taxes: $49,218,000
5% Bonds due 2014: $5,000,000
5% Bonds due 2009: $2,500,000
TOTAL LONG-TERM LIABILITIES: $56,718,000
TOTAL LIABILITIES: $78,500,000
SHAREHOLDERS' EQUITY
Stock, par value $1: $1,000,000
Capital surplus: $1,000,000
Accumulated retained earnings: $29,500,000
TOTAL SHAREHOLDERS' EQUITY = $31,500,000
======================================================
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY = $110,000,000
======================================================
The final comments on this for the board might reflect the structure
of this financing:
? it improves the current ratio and allows the company to build cash
for future expansion
? while it reduces the debt-to-equity, another year's operation (even
at a stable $100M level) will put the ratio back over 5:1. Any
increases in sales (or decreases in cost) with the new plant will put
that ratio even lower.
Google search strategy:
"how to read a financial report"
If any part of this answer is unclear -- or if you find an error in
math in these accounts -- please request a clarification before rating
the answer.
Best regards,
Omnivorous-GA |
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