In-Class Exercises

Financial Statement Analysis 1 Hint: Group industries into more general classes: Financial services Capital intensive Technology oriented Service Firms (basketball franchise is a partnership) Consumer Foods Retail

Financial Services Finance companies lend money, therefore carry large receivables –Firm 13 (General Motors Acceptance Company) Life Insurance companies must keep large reserves they pay to customers –Firm 11 (U.S. Life Corporation)

Capital Intensive Have large amounts of Property Plant & Equipt. Firms 9 and 12 Steel companies sell a commodity that has experienced intense global competition – low profit margins, #9 is Inland Steel #12 is Consolidated Edison

Consumer Foods Heavy advertisers (remember the Superbowl?) –Firms 4 and 7 –Distilled spirits tend to be aged longer than beer, resulting in a lower inventory turn Firm 4: inventory turn = 62/5.6 = 11.1 times/yr Firm 7: inventory turn = 46.5/21.7 = 2.1 times/yr –Firm 4 is the brewer (Anheuser Busch) and firm 7 is the distiller (Brown-Forman)

Technology- Oriented R&D expenses are higher –Firms 3, 5, and 8 –Pharmaceutical companies have typically had high margins – 8 (Merck) –Aerospace often receives advances on contracts, R&D cost is embedded in particular contracts (CGS). Firm 3 is Aerospace (Rockwell International) and firm 5 is Computer (Data General)

Service Firms Have few depreciable assets –Firms 2 and 10 –Firm 2 pays no income taxes as a partnership (Boston Celtics), firm 10 is the advertising agency (Ogilvy)

Retailers Department stores carry receivables and have a lower inventory turnover than grocery stores, so firm 6 is a department store (May Dept. Stores) and firm 1 is a grocery (Supermarkets General).

S-T Debt Paying Ability Working Capital This YearLast Year Current assets$2,060,000$1,470,000 Current liabilities 1,100, ,000 Working capital$ 960,000 $ 870,000

S-T Debt Paying Ability Current Ratio This YearLast Year Current assets $2,060,000$1,470,000 Current liabilities $1,100,000 $600,000 Current ratio 1.87 to to 1

S-T Debt Paying Ability Acid-test Ratio (Quick Ratio) This YearLast Year Quick assets $740,000$650,000 Current liabilities $1,100,000$600,000 Acid-test ratio 0.67 to to 1

Liquidity Activity Ratio Average Age of Receivables This YearLast Year Sales on account $7,000,000$6,000,000 Average receivables $525,000$375,000 Turnover of receivables 13.3 times16.0 times Avg age of receivables: 365 ÷ turnover 27.4 days22.8 days

Liquidity Activity Ratio Inventory Turnover This YearLast Year Cost of goods sold $5,400,000$4,800,000 Average inventory$1,050,000 $760,000 Inventory turnover 5.1 times 6.3 times Turnover in days: 365 ÷ turnover 71.6 days57.9 days

Ability to Meet L-T Obligations Debt-to-Equity Ratio This YearLast Year Total liabilities $1,850,000$1,350,000 Stockholders’ equity $2,150,000$1,950,000 Debt-to-equity ratio 0.86 to to 1

Ability to Meet L-T Obligations Times Interest Earned This YearLast Year Net income before interest and taxes $630,000$490,000 Interest expense $90,000 $90,000 Times interest earned 7.0 times5.4 times

Analysis of Liquidity Working capital has increased, however, its current position actually has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average, and both are trending downward.

Analysis of Profitability The company has improved its profit margin from last year. This is attributable to an increase in gross margin, which is offset somewhat by an increase in operating expenses. In both years the company’s net income as a percentage of sales equals or exceeds the industry average of 4%.

The inventory turned only 5 times this year as compared to over 6 times last year. It takes three weeks longer for the company to turn its inventory than the average for the industry (71 days as compared to 50 days for the industry). This suggests that inventory stocks are higher than they need to be.

The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. This is evident both from the common-size balance sheet and from the financial ratios.

Notice that the average age of the receivables has increased by 5 days since last year, and that it is now 9 days over the industry average. Many of the company’s customers are not taking their discounts, since the average collection period is 27 days and collection terms are 2/10, n/30. This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Perhaps the company has been too aggressive in expanding its sales.

Loan Approval Option The loan may be approved on the condition that the company take immediate steps to get its accounts receivable and inventory back under control. This would mean more rigorous checks of creditworthiness before sales are made and perhaps paring out of slow paying customers. It would also mean a sharp reduction of inventory levels to a more manageable size. If these steps are taken, it appears that sufficient funds could be generated to repay the loan in a reasonable period of time.