Ratios
Chapter 3 Mini Case
The first part of the case, presented in Chapter 2, discussed the situation of Computron Industries after an expansion program. A large loss occurred in 2016, rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival.
Jenny Cochran was brought in as assistant to Computron’s chairman, who had the task of getting the company back into a sound financial position. Cochran must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions to take. Your assignment is to help her answer the following questions, using the recent and projected financial information shown next. Provide clear explanations, not yes or no answers.
Input Data:
2015 2016 2017E
Bart Kreps: Projections
Year-end common stock price $8.50 $6.00 $12.17
Year-end shares outstanding 100,000 100,000 250,000
Tax rate 40% 40% 40%
Lease payments $40,000 $40,000 $40,000
Balance Sheets
Assets 2015 2016 2017E
Cash and equivalents $9,000 $7,282 $14,000
Short-term investments $48,600 $20,000 $71,632
Accounts receivable $351,200 $632,160 $878,000
Inventories $715,200 $1,287,360 $1,716,480
Total current assets $1,124,000 $1,946,802 $2,680,112
Gross Fixed Assets $491,000 $1,202,950 $1,220,000
Less Accumulated Dep. $146,200 $263,160 $383,160
Net Fixed Assets $344,800 $939,790 $836,840
Total Assets $1,468,800 $2,886,592 $3,516,952
Liabilities and equity
Accounts payable $145,600 $324,000 $359,800
Notes payable $200,000 $720,000 $300,000
Accruals $136,000 $284,960 $380,000
Total current liabilities $481,600 $1,328,960 $1,039,800
Long-term bonds $323,432 $1,000,000 $500,000
Total liabilities $805,032 $2,328,960 $1,539,800
Common stock (100,000 shares) $460,000 $460,000 $1,680,936
Retained earnings $203,768 $97,632 $296,216
Total common equity $663,768 $557,632 $1,977,152
Total liabilities and equity $1,468,800 $2,886,592 $3,516,952
Income Statements
2015 2016 2017E
Net sales $3,432,000 $5,834,400 $7,035,600
Costs of Goods Sold Except Depr. $2,864,000 $4,980,000 $5,800,000
Depreciation and amortization $18,900 $116,960 $120,000
Other Expenses $340,000 $720,000 $612,960
Total Operating Cost $3,222,900 $5,816,960 $6,532,960
Earnings before interest and taxes (EBIT) $209,100 $17,440 $502,640
Less interest $62,500 $176,000 $80,000
Pre-tax earnings $146,600 ($158,560) $422,640
Taxes (40%) $58,640 ($63,424) $169,056
Net Income before preferred dividends $87,960 ($95,136) $253,584
EPS $0.880 ($0.951) $1.014
DPS $0.220 $0.110 $0.220
Book Value Per Share $6.638 $5.576 $7.909
Cochran must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.
a. Why are ratios useful? What three groups use ratio analysis and for what reasons?
b. (1.) Calculate the current and quick ratios based on the projected balance sheet and income statement data.
Calculated Data: Ratios Industry
2015 2016 2017E Average
Liquidity ratios
Current Ratio
Bart Kreps: Current Assets divided by Current Liabilities.
Quick Ratio
Bart Kreps: Current Assets minus Inventories divided by Current Liabilities.
(2.) What can you say about the company’s liquidity position? 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?
c. Calculate the inventory turnover, days sales outstanding (DSO), fixed assets turnover, operating capital requirement, and total assets turnover. How does Computron’s utilization of assets stack up against other firms in its industry?
Industry
Asset Management ratios 2015 2016 2017E Average
Inventory Turnover
Bart Kreps: COGS divided by Inventories. 6.10
Days Sales Outstanding
Bart Kreps: Accounts Receivable divided by average daily sales. 32.00
Fixed Asset Turnover
Bart Kreps: Sales divided by Net Fixed Assets. 7.00
Total Asset Turnover
Bart Kreps: Sales divided by Total Assets. 2.50
d. Calculate the debt ratio, liabilities-to-assets ratio, 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?
Industry
Debt Management ratios 2015 2016 2017E Average
Debt Ratio 32.0%
Liabilities-to-assets Ratio
Bart Kreps: Total Debt divided by Total Assets. 50.0%
Times Interest Earned
Bart Kreps: EBIT divided by interest charges. 6.20
EBITDA Coverage Ratio
Bart Kreps: (EBITDA + Lease Payments) / (Interest + Loan Payments + Lease Payments) 8.00
e. Calculate the profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?
Industry
Profitability ratios 2015 2016 2017E Average
Net Profit Margin
Bart Kreps: Net Income divided by sales. 3.6%
Operating Margin
Bart Kreps: EBIT divided by sales. 7.1%
Gross Profit Margin
Bart Kreps: Net Income divided by (Sales – COGS). 15.5%
Basic Earning Power
Bart Kreps: EBIT divided by Total Assets. 17.8%
Return on Assets
Bart Kreps: Net Income divided by Total Assets. 9.0%
Return on Equity
Bart Kreps: Net Income divided by Common Equity. 18.0%
f. Calculate the 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?
Industry
Market Value ratios 2015 2016 2017E Average
Price-to Earnings Ratio
Bart Kreps: Price per share divided by Earnings Per Share. 14.20
Price-to-Cash Flow Ratio
Bart Kreps: P/CF ratio is calculated by dividing the price by the net cash flow per share. 7.60
Market-to-Book Ratio
Bart Kreps: Market Price per share divided by Book value per share. 2.90
Book Value Per Share
Bart Kreps: Common Equity divided by shares outstanding. na
g. Perform a common size analysis and percent change analysis. What do these analyses tell you about Computron?
See the worksheet with the TAB “Common Size and % Change”
h. Use the extended DuPont equation to provide a summary and overview of Computron’s projected financial condition. What are the firm’s major strengths and weaknesses?
DuPont Analysis ROE = P.M. X T.A.T.O. X Equity Multiplier
Computron 2015
Computron 2016
Computron 2017E
Industry Average 18.00% 0.0% 2.5 2.00
i. What are some potential problems and limitations of financial ratio analysis?
j. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?
Common Size and % Change
Common Size Statements
Balance Sheets 2015 2016 2017E Industry
Assets
Bart Kreps: Percentage of Total Assets.
Cash and equivalents 0.3%
Short-term investments 0.3%
Accounts receivable 22.4%
Inventories 41.2%
Total Current Assets 64.1%
Net Fixed Assets 35.9%
Total Assets 100.0% 100.0% 100.0% 100.0%
Liabilities and equity
Bart Kreps: Percentage of Total Liabilities and Equity.
Accounts payable 11.9%
Notes payable 2.4%
Accruals 9.5%
Total current liabilities 23.7%
Long-term bonds 26.3%
Total common equity 50.0%
Total liabilities and equity 100.0% 100.0% 100.0% 100.0%
Income Statements 2015 2016 2017E Industry
Net sales
Bart Kreps: Percentage of Net Sales. 100.0%
COGS except depr. 84.5%
Depreciation 4.0%
Other Expenses 4.4%
EBIT 7.1%
Less interest 1.1%
Pre-tax earnings 5.9%
Taxes (40%) 2.4%
Net Income before preferred dividends 3.6%
Percentage Change Analysis
Balance Sheets 2015 2016 2017E
Assets
Cash and equivalents 0%
Short-term investments 0%
Accounts receivable 0%
Inventories 0%
Total Current Assets 0%
Net Fixed Assets 0%
Total Assets 0%
Liabilities and equity
Accounts payable 0%
Notes payable 0%
Accruals 0%
Total current liabilities 0%
Long-term bonds 0%
Total common equity 0%
Total liabilities and equity 0%
Income Statements 2015 2016 2017E
Net sales 0%
Costs of Goods Sold 0%
Depreciation 0%
Other Expenses 0%
EBIT 0%
Less interest 0%
Pre-tax earnings 0%
Taxes (40%) 0%
Net Income before preferred dividends 0%

Common Size Analysis and Percent Change Analysis In common size analysis, all income statement items are divided by sales, and all balance sheet items are divided by total assets. In percent change analysis, all items are expressed as a percent change from the first year, called the base year, of the analysis.

 

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