Martin Smith  was recently hired as a financial analyst by company X,
a manufacturer of electronic components. His first task was to conduct
a financial analysis of the firm covering the last two years. To begin
he gathered the following financial statements and  other data.
Balance Sheets                             2005                     2004
------------------------------------------------------------------------
Assets

Cash 				52,000                  57,600
Accounts receivable                402,000               351,200
Inventories                       836,000                715,200
   Total current ass              1,290,000            1,124,000
Gross fixed assets                  527,000                491,000   
Less accumulated                    166,200                146,200  
depreciation                   
                                     
    Net fixed assets                360,800                344,800
Total assets                       1,650,800             1,468,800

Liabilities and Equity                               
 Accounts payable                    175,200               145,600        
 Notes payable                       225,000               200,000
Accruals                             140,000               136,000
    Total current liabilities        540,200              481,600          
Long term debt                    424,612              323,432                 
Common stock(100,000 share        460,000              460,000
Retained earnings                 225,988              203,768   
     Total equity                 685,988               663,768 
Total liabilities               1,650,800          1,468,800
and equity     

                       

Income Statements                 2005                            2004
------------------------------------------------------------------------
Sales  			  3,850,000	        3,432,000
Cost of goods sold	   3,250,000	       2,864,000
Other expenses 		      430.300	          340,000
Depreciation		       20,000	            18,900
     Total operating costs      3,700,300	    3,222,900
     EBIT		       149,700	            209,100
Interest expense	     76,000	          62,500
    EBT		              73,700	        146,600
Taxes(40%)		     29,480	        58,640
Net Income	               44,200	        87,960
EPS                          0.442 	        0.880

     
Statement of Cash Flows(2005):
-------------------------------------------------------------------------
Operating activities						
Net income					44,200
Other additions(sources of cash):
        Depreciation				20,000
        Increase in accounts payable		29,600
        Increase in accruals			 4,000
Subtractions (uses of cash)
        Increase in account receivable	         50,800
        Increase in inventories		        120,800
Net cash flow from operations			73,780
Long-Term Investing Activities						
Investment in fixed assets		        36,000
Financing Activities
     Increase in notes payable			25,000
     Increase in long-term debt			101,180
     Payment of cash dividends			 22,000
Net cash flow from financing 			104,180
Net reduction in cash account			  5,600
Cash at beginning of the year			  57,600
Cash at end of year				  52,000

Other Data                          	2005		2004
--------------------------------------------------------------------------
December 31 stock price		  6.00		   8.50
Number of shares		100,000		100,000
Dividends per share		   0.22		   0.22
Lease payment			 40,000		 40,000

Industry average data for 2005:

Ratio                         		Industry Average
--------------------------------------------------------------------
Current					2.7x
Quick					1.0x
Inventory turnover			6.0x
Days sales outstanding(DSO)		32.0 days
Fixed assets turnover			10.7x
Total assets turnover			2.6x
Debt ratio				50.0%
TIE					2.5x
Fixed charge coverage			2.1x
Profit margin				3.5%
ROA					9.1%
ROE					18.2%
Price/earnings				14.2x
Market/book				1.4x

You need to evaluate the company?s financial condition. Answer this questions:
    A. What can you conclude about the company?s financial condition
from its statement of cash flows?
    B. What is the purpose of  financial ratio analysis, and what are
the five major categories of ratios?
    C. What are the company?s current and quick ratios? What do they
tell you about the company?s  liquidity position?
    D.  What are the company?s  inventory turnover, days sales
outstanding, fixed assets turnover, and total assets turnover ratios?
How does the firm?s utilization of assets stack up against that of the
industry?
    E. What are the firm?s debt, times-interest-earned, and fixed
coverage ratios? How does the company compare to the industry with
respect to financial leverage? What conclusion can you draw from these
ratios?
   F. Calculate and discuss the firm?s profitability ratios- that is,
its profit margin, return on assets (ROA), and return on equity (REO).
   G. Calculate the company?s   market value ratios- that is, its
price/earnings ratio and its market/book ratio. What do these ratios
tell you about investors? opinions of the company?
   H. Use the DuPont equation to provide a summary and overview of the
company?s financial condition. What are the firm?s major strengths and
weaknesses?
Compare the company?s performance to the industry averages provided.

I will need all the formulas!!!

A. The company is burning a lot of cash in operations.  It appears to
be experiencing a sales slowdown manifesting itself through a marked
increase in inventories.  It may also be experiencing problems
collecting payments from customers given that its accounts receivable
have increased more than its sales.  It has taken on significant debt
to cover the cash flow shortfall, making the firm riskier for
investors.

B. "Financial Statement Analysis is used by: a) managers to evaluate
and improve performance, b) lenders (banks and bondholders) and bond
rating analysts (SP and Moody's) to evaluate the creditworthiness of a
company, and c) stockholders (current or prospective) and stock
analysts, to forecast earnings, DIV and stock price."  The five types
of ratios are liquidity, asset management, debt management,
profitability, and market value ratios.

C.  "Current Ratio: CA (Cash + AR + INV) / CL (AP + NP)"

2005: $1,290,000/$540,200 = 2.39.  2004: $1,124,000/$481,600 = 2.33.

Quick Ratio: "The formula: Current assets minus inventories, divided
by current liabilities"

"Quick or acid test ratio calculator" Bankrate.com
http://www.bankrate.com/brm/news/biz/bizcalcs/ratioquick.asp

2005: ($1,290,000 - $836,000)/$540,200 = 0.84.  2004: ($1,124,000 -
$715,200)/$481,600 = 0.85.

The liquidity position is not very good considering that most of its
current assets are inventory, which typically cannot be liquidated
quickly or at book value.

D.  Inventory Turnover: Sales/Inventory 2005: 4.6 times.  2004: 4.8
times.  The company is not turning over its inventory as fast as the
industry.

Days Sales Outstanding: Accounts Receivable/Sales per day 2005: 38
days.  2004: 37 days.  The company is not collecting as fast as the
industry.

Fixed Assets Turnover: Sales/Fixed Assets 2005: 10.67.  2004: 9.95. 
The company is not achieving as much productivity from its fixed
assets as its competitors.

Total Assets Turnover: Sales/Total Assets 2005: 2.33.  2004: 2.33. 
The company is not achieving as much productivity from its total
assets as its competitors.

E. Debt Ratio: Debt/Total Assets 2005: 0.26.  2004: 0.29

Times-Interest-Earned: Earnings Before Interest and Taxes/Interest
2005: 1.97.  2004: 3.35.

Fixed Coverage: "For example, since leases are a fixed charge, the
calculation determining a company's ability leases would be (EBIT +
Lease Expenses) / (Lease Expenses + Interest)."

"Fixed-Charge Coverage Ratio" Investopedia.com (2005)
http://www.investopedia.com/terms/f/fixed-chargecoverageratio.asp

2005: ($149,700 + $40,000)/($76,000 + $40,000) = 1.64.  2004: $209,100
+ $40,000)/($62,500 + $40,000) = 2.43 .  Was better than the industry
but now is worse.

F. Profit Margin: Net Income After Taxes/Sales 2005:1.15%.  2004:
2.56%.  Much less profitable than the industry and declining.

Return On Assets: Net Income After Taxes/Total Assets 2005: 2.68%. 
2004: 5.99%.  Much worse than the industry.

Return On Equity: Net Income After Taxes/Equity 2005: 6.44%.  2004:
13.25%.  Much worse than the industry.

G.  Price/Earnings: Price/Earnings Per Share 2005: 13.57.  2004: 9.66.
 Has increased to being approximately in line with the industry.

Market/Book: Price/(Equity/number of shares outstanding) 2005: 0.87. 
2004: 1.28.  Has decreased to being well below the industry.

H. Extended DuPont Equation: ROE = Profit Margin x Total Asset
Turnover x Total Assets/Equity 2005: 1.15% x 2.33 x
($1,650,800/$685,988) = 6.44%.  2004: 2.56% x 2.33 x
($1,468,800/$663,768) = 13.20%.

The company is currently achieving low productivity from its inventory
and fixed assets.  It is also not collecting from its customers as
quickly as the industry.  It needs to improve its sales and/or reduce
inventories and fixed assets to better match its competitors.

All other quotations taken from: "Chapter 3 - Analysis of Financial
Statements" http://spruce.flint.umich.edu/~mjperry/361-3.htm.  The
source also provided nearly all the formulas.

Sincerely,

Wonko

---

Request for Answer Clarification by bibby28-ga on 10 May 2005 10:15 PDT

For D.   Inventory turnover: Cost of godds sold/Inventories 2005:
3250000/836000=3.89 2004: 2864000/715200=4.00
I think this is the right formula

---

Request for Answer Clarification by bibby28-ga on 10 May 2005 10:26 PDT

For C. compare the company performance to the industry avarage.
 Thank you!

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Request for Answer Clarification by bibby28-ga on 10 May 2005 11:17 PDT

For E. The debt ratio doesn't seem right even if you compare with the industry.
Shouldn't it be  (long term debt+ common stock)/total assets
2005: 0.54
2004: 0.54

---

Clarification of Answer by wonko-ga on 10 May 2005 11:44 PDT

My apologies about the inventory turns calculation.  I overlooked the
COGS line somehow and assumed all sales resulted from inventory
reduction.  Inventory turns are considerably worse than the industry,
meaning that this company has increased carrying costs, may be
experiencing a slowdown in demand for its products, and/or is doing a
poor job of forecasting overall sales and/or product mix.

I did some additional research into the debt ratio.  It typically
includes short term and long term debt: "When calculating this ratio,
it is conventional to consider both current and non-current debt and
assets. " "debt ratio" investorwords.com
(2005)http://www.investorwords.com/1326/debt_ratio.html.  So,
2005:(540,200+424,612)/1650800 = .58 2004: (481,600+323,432)/1468800 =
.55. These are a bit higher than the industry, meaning the company is
more leveraged and therefore more risky.

C. The company has a lower quick ratio and current ratio than does the
industry, indicating its short-term obligations are riskier than those
of the industry as a whole.  Furthermore, since a large component is
inventory, which is potentially not all that liquid, especially at
book value, this makes its short-term obligations potentially more
risky relative to the industry than even the quick and current ratios
indicate.  As we see in part D., the company has more inventory as a %
of sales than does the industry, meaning that the industry has more
current assets in the form of more liquid assets.

Again, please accept my apology for my error in calculating inventory
turns and my apparently nonstandard interpretation of the debt ratio
formula in my initial response.  Thank you for requesting
clarification so that I could clear those up.  If you require
additional explanation of anything, please don't hesitate to ask.

Sincerely,

Wonko