I ntegrated Case 4-25 D’Leon I nc., Part I I Financial Statement Analysis Part I of this case, presented in Chapter 3, discussed the situation of D’Leon I nc., a regional snack foods producer, after an expansion program. D’Leon had increased plant capacity and undertaken a major marketing campaign in an attempt to “go national.” Thus far, sales have not been up to the forecasted level, costs have been higher than w ere projected, and a large loss occurred in 2008 rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival. Donna Jamison w as brought in as assistant to Fred Campo, D’Leon’s chairman, w ho had the task of getting the company back into a sound financial position. D’Leon’s 2007 and 2008 balance sheets and income statements, together w ith projections for 2009, are given in Tables I C 4-1 and I C 4-2. I n addition, Table I C 4-3 gives the company’s 2007 and 2008 financial ratios, together w ith industry average data. The 2009 projected financial statement data represent Jamison’s and Campo’s best guess for 2009 results, assuming that some new financing is arranged to get the company “over the hump.” Jamison examined monthly data for 2008 ( not given in the case) , and she detected an improving pattern during the year. Monthly sales w ere rising, costs w ere falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data look somew hat w orse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message out, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. I n other w ords, the lags betw een spending money and deriving benefits w ere longer than D’Leon’s managers had anticipated. For these reasons, Jamison and Campo see hope for the company—provided it can survive in the short run. Jamison must prepare an analysis of w here the company is now , w hat it must do to regain its financial health, and w hat actions should be taken. Your assignment is to help her answ er the follow ing questions. Provide clear explanations, not yes or no answ ers. Table I C 4-1. Balance Sheets 2009E 2008 2007 Assets Cash Accounts receivable I nventories Total current assets Gross fixed assets Less accumulated depreciation Net fixed assets Total assets $ 85,632 878,000 1,716,480 $ 2,680,112 1,197,160 380,120 $ 817,040 $ 3,497,152 $ 7,282 632,160 1,287,360 $ 1,926,802 1,202,950 263,160 $ 939,790 $ 2,866,592 $ 57,600 351,200 715,200 $ 1,124,000 491,000 146,200 $ 344,800 $ 1,468,800 $ $ $ Liabilities and Equity Accounts payable Notes payable Accruals Total current liabilities Long-term debt Common stock Retained earnings Total equity Total liabilities and equity 436,800 300,000 408,000 $ 1,144,800 400,000 1,721,176 231,176 $ 1,952,352 $ 3,497,152 Note: “E” indicates estimated. The 2009 data are forecasts. 524,160 636,808 489,600 $ 1,650,568 723,432 460,000 32,592 $ 492,592 $ 2,866,592 145,600 200,000 136,000 $ 481,600 323,432 460,000 203,768 $ 663,768 $ 1,468,800 Table I C 4-2. I ncome Statements Sales Cost of goods sold Other expenses Total operating costs excluding depreciation EBI TDA Depreciation EBI T I nterest expense EBT Taxes ( 40% ) Net income EPS DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments 2009E $ 7,035,600 5,875,992 550,000 2008 $ 6,034,000 5,528,000 519,988 2007 $ 3,432,000 2,864,000 358,672 $ 6,425,992 $ 609,608 116,960 $ 492,648 70,008 $ 422,640 169,056 $ 253,584 $ 6,047,988 ($ 13,988) 116,960 ( $ 130,948) 136,012 ( $ 266,960) ( 106,784) a ( $ 160,176) $ 3,222,672 $ 209,328 18,900 $ 190,428 43,828 $ 146,600 58,640 $ 87,960 $ $ $ $ ($ $ $ $ $ $ $ $ 1.014 0.220 7.809 12.17 250,000 40.00% 40,000 0 1.602) 0.110 4.926 2.25 100,000 40.00% 40,000 0 0.880 0.220 6.638 8.50 100,000 40.00% 40,000 0 Note: “E” indicates estimated. The 2009 data are forecasts. a The firm had sufficient taxable income in 2006 and 2007 to obtain its full tax refund in 2008. Table I C 4-3. Ratio Analysis 2009E Current Quick I nventory turnover Days sales outstanding ( DSO) a Fixed assets turnover Total assets turnover Debt ratio TI E Operating margin Profit margin Basic earning power ROA ROE Price/ earnings Market/ book Book value per share 2008 1.2 0.4 4.7 38.2 6.4 2.1 82.8% -1.0 -2.2% -2.7% -4.6% -5.6% -32.5% -1.4 0.5 $4.93 2007 2.3 0.8 4.8 37.4 10.0 2.3 54.8% 4.3 5.6% 2.6% 13.0% 6.0% 13.3% 9.7 1.3 $6.64 I ndustry Average 2.7 1.0 6.1 32.0 7.0 2.6 50.0% 6.2 7.3% 3.5% 19.1% 9.1% 18.2% 14.2 2.4 n.a. Note: “E indicates estimated. The 2009 data are forecasts. a Calculation is based on a 365-day year. A. Why are ratios useful? What are the five major categories of ratios? Answ er: [ S4-1 through S4-5 provide background information. Then, show S4-6 and S4-7 here.] 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 dividends. The five major categories of ratios are: liquidity, asset management, debt management, profitability, and market value. B. Calculate D’Leon’s 2009 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity positions in 2007, 2008, and as projected for 2009? 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 these liquidity ratios? Answ er: [ Show S4-8 and S4-9 here.] Current ratio09 = Current assets/ Current liabilities = $2,680,112/ $1,144,800 = 2.34. Quick ratio09 = ( Current assets – I nventories) / Current liabilities = ( $2,680,112 – $1,716,480) / $1,144,800 = $963,632/ $1,144,800 = 0.842. The company’s current and quick ratios are identical to its 2007 current and quick ratios, and they have improved from their 2008 levels. How ever, both the current and quick ratios are w ell below the industry averages. C. Calculate the 2009 inventory turnover, days sales outstanding ( DSO) , fixed assets turnover, and total assets turnover. How does D’Leon’s utilization of assets stack up against other firms in its industry? Answ er: [ Show S4-10 through S4-15 here.] I nventory turnover 09 = Sales/ I nventory = $7,035,600/ $1,716,480 = 4.10. DSO09 = Receivables/ ( Sales/ 365) = $878,000/ ( $7,035,600/ 365) = 45.55 days. Fixed assets turnover 09 = Sales/ Net fixed assets = $7,035,600/ $817,040 = 8.61. Total assets turnover 09 = Sales/ Total assets = $7,035,600/ $3,497,152 = 2.01. The firm’s inventory turnover and total assets turnover ratios have been steadily declining, w hile its days sales outstanding has been steadily increasing ( w hich is bad) . How ever, the firm’s 2009 total assets turnover ratio is only slightly below the 2008 level. The firm’s fixed assets turnover ratio is below its 2007 level; how ever, it is above the 2008 level. The firm’s inventory turnover and total assets turnover are below the industry average. The firm’s days sales outstanding ratio is above the industry average ( w hich is bad) ; how ever, the firm’s fixed assets turnover is above the industry average. ( This might be due to the fact that D’Leon is an older firm than most other firms in the industry, in w hich case, its fixed assets are older and thus have been depreciated more, or that D’Leon’s cost of fixed assets w ere low er than most firms in the industry.) D. Calculate the 2009 debt and times-interest-earned ratios. How does D’Leon compare w ith the industry w ith respect to financial leverage? What can you conclude from these ratios? Answ er: [ Show S4-16 and S4-17 here.] Debt ratio09 = Total debt/ Total assets = ( $1,144,800 + $400,000) / $3,497,152 = 44.17% . TI E09 = EBI T/ I nterest = $492,648/ $70,008 = 7.04. The firm’s debt ratio is much improved from 2008 and 2007, and it is below the industry average ( w hich is good) . The firm’s TI E ratio is also greatly improved from its 2007 and 2008 levels and is above the industry average. E. Calculate the 2009 operating margin, profit margin, basic earning pow er ( BEP) , return on assets ( ROA) , and return on equity ( ROE) . What can you say about these ratios? Answ er: [ Show S4-18 through S4-24 here.] Operating margin09 = EBI T/ Sales = $492,648/ $7,035,600 = 7.00% . Profit margin09 = Net income/ Sales = $253,584/ $7,035,600 = 3.60% . Basic earning pow er 09 = EBI T/ Total assets = $492,648/ $3,497,152 = 14.09% . ROA09 = Net income/ Total assets = $253,584/ $3,497,152 = 7.25% . ROE09 = Net income/ Common equity = $253,584/ $1,952,352 = 12.99%  13.0% . The firm’s operating margin is above 2007 and 2008 levels but slightly below the industry average. The firm’s profit margin is above 2007 and 2008 levels and slightly above the industry average. While the firm’s basic earning pow er and ROA ratios are above 2007 and 2008 levels, they are still below the industry averages. The firm’s ROE ratio is greatly improved over its 2008 level; how ever, it is slightly below its 2007 level and still w ell below the industry average. F. Calculate the 2009 price/ earnings ratio and market/ book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Answ er: [ Show S4-25 and S4-26 here.] EPS09 = Net income/ Shares outstanding = $253,584/ 250,000 = $1.0143. Price/ Earnings09 = Price per share/ Earnings per share = $12.17/ $1.0143 = 12.0. Check: Price = EPS  P/ E = $1.0143( 12.0) = $12.17. BVPS09 = Common equity/ Shares outstanding = $1,952,352/ 250,000 = $7.81. Market/ Book 09 = Market price per share/ Book value per share = $12.17/ $7.81 = 1.56. The P/ E and M/ B ratios are above the 2008 and 2007 levels but below the industry average. G. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2009. What are the firm’s major strengths and w eaknesses? Answ er: [ Show S4-27 and S4-28 here.] Equity DuPont equation = Profit  Total assets  margin turnover multiplier = 3.60%  2.01  1/ ( 1 – 0.4417) = 12.96%  13.0% . Strengths: The firm’s fixed assets turnover w as above the industry average. How ever, if the firm’s assets w ere older than other firms in its industry this could possibly account for the higher ratio. ( D’Leon’s fixed assets w ould have a low er historical cost and w ould have been depreciated for longer periods of time.) The firm’s profit margin is slightly above the industry average, and its debt ratio has been greatly reduced, so it is now below the industry average ( w hich is good) . This improved profit margin could indicate that the firm has kept operating costs dow n as w ell as interest expense ( as show n from the reduced debt ratio) . I nterest expense is low er because the firm’s debt ratio has been reduced, w hich has improved the firm’s TI E ratio so that it is now above the industry average. Weaknesses: The firm’s current asset ratio is low ; most of its asset management ratios are poor ( except fixed assets turnover) ; most of its profitability ratios are low ( except profit margin) ; and its market value ratios are low . H. Use the follow ing simplified 2009 balance sheet to show , in general terms, how an improvement in the DSO w ould tend to affect the stock price. For example, if the company could improve its collection procedures and thereby low er its DSO from 45.6 days to the 32-day industry average w ithout affecting sales, how w ould that change “ripple through” the financial statements ( show n in thousands below ) and influence the stock price? Accounts receivable Other current assets Net fixed assets Total assets $ 878 1,802 817 $3,497 Debt $1,545 Equity 1,952 Liabilities plus equity $3,497 Answ er: [ Show S4-29 through S4-32 here.] Sales per day = $7,035,600/ 365 = $19,275.62. Accounts receivable under new policy = $19,275.62  32 days = $616,820. Freed cash = old A/ R – new A/ R = $878,000 – $616,820 = $261,180. Reducing accounts receivable and its DSO w ill initially show up as an addition to cash. The freed up cash could be used to repurchase stock, expand the business, and reduce debt. All of these actions w ould likely improve the stock price. I. Does it appear that inventories could be adjusted? I f so, how should that adjustment affect D’Leon’s profitability and stock price? Answ er: The inventory turnover ratio is low . I t appears that the firm either has excessive inventory or some of the inventory is obsolete. I f inventory w ere reduced, this w ould improve the current asset ratio, the inventory and total assets turnover, and reduce the debt ratio even further, w hich should improve the firm’s stock price and profitability. J. I n 2008, the company paid its suppliers much later than the due dates; also it w as not maintaining financial ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off, and its bank could refuse to renew the loan w hen it comes due in 90 days. On the basis of data provided, w ould you, as a credit manager, continue to sell to D’Leon on credit? ( You could demand cash on delivery—that is, sell on terms of COD—but that might cause D’Leon to stop buying from your company.) Similarly, if you w ere the bank loan officer, w ould you recommend renew ing the loan or demand its repayment? Would your actions be influenced if in early 2009 D’Leon show ed you its 2009 projections along w ith proof that it w as going to raise more than $1.2 million of new equity? Answ er: While the firm’s ratios based on the projected data appear to be improving, the firm’s current asset ratio is low . As a credit manager, you w ould not continue to extend credit to the firm under its current arrangement, particularly if my firm didn’t have any excess capacity. Terms of COD might be a little harsh and might push the firm into bankruptcy. Likew ise, if the bank demanded repayment this could also force the firm into bankruptcy. Creditors’ actions w ould definitely be influenced by an infusion of equity capital in the firm. This w ould low er the firm’s debt ratio and creditors’ risk exposure. K. I n hindsight, w hat should D’Leon have done back in 2007? Answ er: Before the company took on its expansion plans, it should have done an extensive ratio analysis to determine the effects of its proposed expansion on the firm’s operations. Had the ratio analysis been conducted, the company w ould have “gotten its house in order” before undergoing the expansion. L. What are some potential problems and limitations of financial ratio analysis? Answ er: [ Show S4-33 and S4-34 here.] Some potential problems are listed below : 1. Comparison w ith 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 w hether company is, on balance, in a strong or w eak 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. 8. I nflation has badly distorted many firms’ balance sheets, so a ratio analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted w ith judgment. M. What are some qualitative factors analysts should consider w hen evaluating a company’s likely future financial performance? Answ er: [ Show S4-35 here.] Top analysts recognize that certain qualitative factors must be considered w hen evaluating a company. These factors, as summarized by the American Association of I ndividual I nvestors ( AAI I ) , are as follow s: 1. Are the company’s revenues tied to one key customer? 2. To w hat extent are the company’s revenues tied to one key product? 3. To w hat extent does the company rely on a single supplier? 4. What percentage of the company’s business is generated overseas? 5. How much competition does the firm face? 6. I s it necessary for the company to continually invest in research and development? 7. Are changes in law s and regulations likely to have important implications for the firm?