Chapter 8: MINI CASE

The first part of the case, presented in Chapter 7, discussed the situation that Computron
Industries was in after an expansion program. Thus far, sales have not been up to the
forecasted level, costs have been higher than were projected, and a large loss occurred in
2006, rather than the expected profit. As a result, its managers, directors, and investors
are concerned about the firm’s survival.
Donna Jamison was brought in as assistant to Fred Campo, Computron’s chairman,
who had the task of getting the company back into a sound financial position. Computron’s
2005 and 2006 balance sheets and income statements, together with projections for 2007,
are shown in the following tables. Also, the tables show the 2005 and 2006 financial ratios,
along with industry average data. The 2007 projected financial statement data represent
Jamison’s and Campo’s best guess for 2007 results, assuming that some new financing is
arranged to get the company “over the hump.”
Jamison examined monthly data for 2006 (not given in the case), and she detected an
improving pattern during the year. Monthly sales were rising, costs were falling, and large
losses in the early months had turned to a small profit by December. Thus, the annual data
looked somewhat worse than final monthly data. Also, it appears to be taking longer for
the advertising program to get the message across, for the new sales offices to generate
sales, and for the new manufacturing facilities to operate efficiently. In other words, the
lags between spending money and deriving benefits were longer than Computron’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 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.

Mini Case: 8 - 1
Balance Sheets

Assets 2005 2006 2007e

Cash $ 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 Depreciation 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 2005 2006 2007e

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 Debt 323,432 1,000,000 500,000
Common Stock (100,000 Shares) 460,000 460,000 1,680,936
Retained Earnings 203,768 97,632 296,216
Total Equity $ $ $
663,768 557,632 1,977,152
Total Liabilities And Equity $ $ $
1,468,800 2,886,592 3,516,952

Mini Case: 8 - 2
Income Statements
2005 2006 2007e
Sales $ $ 5,834,400 $
3,432,000 7,035,600
Cost Of Goods Sold 2,864,000 4,980,000 5,800,000
Other Expenses 340,000 720,000 612,960
Depreciation 18,900 116,960 120,000
Total Operating Costs $ $ 5,816,960 $
3,222,900 6,532,960
EBIT $ $ 17,440 $
209,100 502,640
Interest Expense 62,500 176,000 80,000
EBT $ $ $
146,600 (158,560) 422,640
Taxes (40%) 58,640 (63,424) 169,056
Net Income $ $ $
87,960 (95,136) 253,584

Other Data 2005 2006 2007e

Stock Price $ $ 6.00 $
8.50 12.17
Shares Outstanding 100,000 100,000 250,000
EPS $ $ $
0.880 (0.951) 1.014
DPS $ $ 0.110 $
0.220 0.220
Tax Rate 40% 40% 40%
Book Value Per Share $ $ 5.576 $
6.638 7.909
Lease Payments $ $ 40,000 $
40,000 40,000

Mini Case: 8 - 3
Ratio Analysis 2005 2006 2007e Industry Average
Current 2.3 1.5 2.58 2.7
Quick 0.8 0.5 0.93 1.0
Inventory Turnover 4.8 4.5 4.10 6.1
Days Sales Outstanding 37. 39. 45.5 32.0
4 5
Fixed Assets Turnover 10. 6. 8.4 7.0
0 2 1
Total Assets Turnover 2. 2. 2.0 2.5
3 0 0
Debt Ratio 54.8% 80.7% 43.8% 50.0%
TIE 3.3 0.1 6.3 6.2
EBITDA Coverage 2.6 0.8 5.5 8.0
Profit Margin 2.6% -1.6% 3.6% 3.6%
Basic Earning Power 14.2% 0.6% 14.3% 17.8%
ROA 6.0% -3.3% 7.2% 9.0%
ROE 13.3% -17.1% 12.8% 17.9%
Price/Earnings (P/E) 9.7 -6.3 12.0 16.2
Price/Cash Flow 8.0 27.5 8.1 7.6
Market/Book 1.3 1.1 1.5 2.9

a. Why are ratios useful? What are the five major categories of ratios?

Answer: 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.

Mini Case: 8 - 4
b. Calculate the 2007 current and quick ratios based on the projected balance sheet
and income statement data. What can you say about the company’s liquidity
position in 2005, 2006, and as projected for 2007? 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?

Answer: Current Ratio07 = Current Assets/Current Liabilities

= $2,680,112/$1,039,800 = 2.58× .

Quick Ratio07 = (Current Assets – Inventory)/Current Liabilities

= ($2,680,112 - $1,716,480)/$1,039,800 = 0.93× .

The company’s current and quick ratios are higher relative to its 2005 current and
quick ratios; they have improved from their 2006 levels. Both ratios are below the
industry average, however.

c. Calculate the 2007 inventory turnover, days sales outstanding (DSO), fixed
assets turnover, and total assets turnover. How does Computron’s utilization of
assets stack up against other firms in its industry?

Answer: Inventory Turnover07 = Sales/Inventory

= $7,035,600/$1,716,480 = 4.10× .

DSO07 = Receivables/(Sales/365)
= $878,000/($7,035,600/365) = 45.5 Days.

Fixed Assets Turnover07 = Sales/Net Fixed Assets

= $7,035,600/$836,840 = 8.41× .

Total Assets Turnover07 = Sales/Total Assets

= $7,035,600/$3,516,952 = 2.0× .

The firm’s inventory turnover ratio has been steadily declining, while its days
sales outstanding has been steadily increasing. While the firm’s fixed assets turnover
ratio is below its 2005 level, it is above the 2006 level. The firm’s total assets
turnover ratio is below its 2005 level and equal to its 2006 level.
The firm’s inventory turnover and total assets turnover are below the industry
average. The firm’s days sales outstanding is above the industry average (which is
bad); however, the firm’s fixed assets turnover is above the industry average. (This
might be due to the fact that Computron is an older firm than most other firms in the

Mini Case: 8 - 5
 industry, in which case, its fixed assets are older and thus have been depreciated
more, or that Computron’s cost of fixed assets were lower than most firms in the
industry.)

d. Calculate the 2007 debt, 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?

Answer: Debt Ratio07 = Total Liabilities/Total Assets

= ($1,039,800 + $500,000)/$3,516,952 = 43.8%.
Tie07 = EBIT/Interest = $502,640/$80,000 = 6.3× .

 Lease   Loan Lease 

EBITDA Coverage07 =  EBITDA +  /  Interest + + 
 Payments   Repayments Payments 
= ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5× .

The firm’s debt ratio is much improved from 2005, and is still lower than its 2004
level and the industry average. The firm’s TIE and EBITDA coverage ratios are
much improved from their 2005 and 2006 levels. The firm’s TIE is better than the
industry average, but the EBITDA coverage is lower, reflecting the firm’s higher
lease obligations.

e. Calculate the 2007 profit margin, basic earning power (BEP), return on assets
(ROA), and return on equity (ROE). What can you say about these ratios?

Answer: Profit Margin07 = Net Income/Sales = $253,584/$7,035,600 = 3.6%.

Basic Earning Power07 = EBIT/Total Assets = $502,640/$3,516,952

= 14.3%.

Mini Case: 8 - 6
 ROA07 = Net Income/Total Assets = $253,584/$3,516,952 = 7.2%.

ROE07 = Net Income/Common Equity = $253,584/$1,977,152 = 12.8%.

The firm’s profit margin is above 2005 and 2006 levels and is at the industry
average. The basic earning power, ROA, and ROE ratios are above both 2005 and
2006 levels, but below the industry average due to poor asset utilization.

f. Calculate the 2007 price/earnings ratio, price/cash flow ratios, and market/book
ratio. Do these ratios indicate that investors are expected to have a high or low
opinion of the company?

Answer: EPS = Net Income/Shares Outstanding = $253,584/250,000 = $1.0143.

Price/Earnings07 = Price Per Share/Earnings Per Share

= $12.17/$1.0143 = 12.0× .

Check: Price = EPS × P/E = $1.0143(12) = $12.17.

Cash Flow/Share07 = (NI + DEP)/Shares

= ($253,584 + $120,000)/250,000
= $1.49.

Price/Cash Flow = $12.17/$1.49 = 8.2× .

BVPS = Common Equity/Shares Outstanding

= $1,977,152/250,000 = $7.91.

Market/Book = Market Price Per Share/Book Value Per Share

= $12.17/$7.91 = 1.54x.

Both the P/E ratio and BVPS are above the 2005 and 2006 levels but below the
industry average.

g. Perform a common size analysis and percent change analysis. What do these
analyses tell you about Computron?

Answer: For the common size balance sheets, divide all items in a year by the total assets for
that year. For the common size income statements, divide all items in a year by the
sales in that year.

Mini Case: 8 - 7
 Common Size Balance Sheets
Assets
2005 2006 2007e Ind.
Cash 0.6% 0.3% 0.4% 0.3%
Short Term Investments 3.3% 0.7% 2.0% 0.3%
Accounts Receivable 23.9% 21.9% 25.0% 22.4%
Inventories 48.7% 44.6% 48.8% 41.2%
Total Current Assets 76.5% 67.4% 76.2% 64.1%
Gross Fixed Assets 33.4% 41.7% 34.7% 53.9%
Less Accumulated Depreciation 10.0% 9.1% 10.9% 18.0%
Net Fixed Assets 23.5% 32.6% 23.8% 35.9%
Total Assets 100.0 100.0 100.0 100.0
% % % %

Liabilities And Equity 2005 2006 2007e Ind.

Accounts Payable 9.9% 11.2% 10.2% 11.9%
Notes Payable 13.6% 24.9% 8.5% 2.4%
Accruals 9.3% 9.9% 10.8% 9.5%
Total Current Liabilities 32.8% 46.0% 29.6% 23.7%
Long-Term Debt 22.0% 34.6% 14.2% 26.3%
Common Stock (100,000 Shares) 31.3% 15.9% 47.8% 20.0%
Retained Earnings 13.9% 3.4% 8.4% 30.0%
Total Equity 45.2% 19.3% 56.2% 50.0%
Total Liabilities And Equity 100.0 100.0 100.0 100.0
% % % %

Common Size Income Statement 2005 2006 2007e Ind.

Sales 100.0 100.0 100.0 100.0
% % % %
Cost Of Goods Sold 83.4% 85.4% 82.4% 84.5%
Other Expenses 9.9% 12.3% 8.7% 4.4%
Depreciation 0.6% 2.0% 1.7% 4.0%
Total Operating Costs 93.9% 99.7% 92.9% 92.9%
EBIT 6.1% 0.3% 7.1% 7.1%
Interest Expense 1.8% 3.0% 1.1% 1.1%
EBT 4.3% -2.7% 6.0% 5.9%
Taxes (40%) 1.7% -1.1% 2.4% 2.4%
Net Income 2.6% -1.6% 3.6% 3.6%

Mini Case: 8 - 8
 Computron has higher proportion of inventory and current assets than
industry. Computron has slightly more equity (which means less debt) than industry.
Computron has more short-term debt than industry, but less long-term debt than
industry. Computron has lower COGS than industry, but higher other expenses.
Result is that Computron has similar EBIT as industry.

Mini Case: 8 - 9
 For the percent change analysis, divide all items in a row by the value in the first
year of the analysis.

Mini Case: 8 - 10
Percent Change Balance Sheets
Assets
2005 2006 2007e
Cash 0.0% -19.1% 55.6%
Short Term Investments 0.0% -58.8% 47.4%
Accounts Receivable 0.0% 80.0% 150.0
%
Inventories 0.0% 80.0% 140.0
%
Total Current Assets 0.0% 73.2% 138.4
%
Gross Fixed Assets 0.0% 145.0 148.5
% %
Less Accumulated Depreciation 0.0% 80.0% 162.1
%
Net Fixed Assets 0.0% 172.6 142.7
% %
Total Assets 0.0% 96.5% 139.4
%

Liabilities And Equity 2005 2006 2007e

Accounts Payable 0.0% 122.5 147.1
% %
Notes Payable 0.0% 260.0 50.0%
%
Accruals 0.0% 109.5 179.4
% %
Total Current Liabilities 0.0% 175.9 115.9
% %
Long-Term Debt 0.0% 209.2 54.6%
%
Common Stock (100,000 Shares) 0.0% 0.0% 265.4
%
Retained Earnings 0.0% -52.1% 45.4%
Total Equity 0.0% -16.0% 197.9
%

Mini Case: 8 - 11
 Total Liabilities And Equity 0.0% 96.5% 139.4
%

Percent Change Income 2005 2006 2007e

Statement
Sales 0.0% 70.0% 105.0
%
Cost Of Goods Sold 0.0% 73.9% 102.5
%
Other Expenses 0.0% 111.8% 80.3%
Depreciation 0.0% 518.8% 534.9
%
Total Operating Costs 0.0% 80.5% 102.7
%
EBIT 0.0% -91.7% 140.4
%
Interest Expense 0.0% 181.6% 28.0%
EBT 0.0% - 188.3
208.2% %
Taxes (40%) 0.0% - 188.3
208.2% %
Net Income 0.0% - 188.3
208.2% %

We see that 2007 sales grew 105% from 2005, and that NI grew 188% from 2005.
So Computron has become more profitable. We see that total assets grew at a rate of
139%, while sales grew at a rate of only 105%. So asset utilization remains a
problem.

Mini Case: 8 - 12
h. Use the extended Du Pont equation to provide a summary and overview of
Computron’s financial condition as projected for 2007. What are the firm’s
major strengths and weaknesses?

Profit Total Assets Equity

Answer: Du Pont Equation = Margin
× Turnover
× Multiplier
= 3.6% × 2.0 × ($3,516,952/$1,977,152)
= 3.6% × 2.0 × 1.8 = 13.0%.

Strengths: The firm’s fixed assets turnover was above the industry average.
However, if the firm’s assets were older than other firms in its industry this could
possibly account for the higher ratio. (Computron’s fixed assets would have a lower
historical cost and would have been depreciated for longer periods of time.) The
firm’s profit margin is slightly above the industry average, despite its higher debt
ratio. This would indicate that the firm has kept costs down, but, again, this could be
related to lower depreciation costs.

Weaknesses: The firm’s liquidity ratios are low; most of its asset management ratios
are poor (except fixed assets turnover); its debt management ratios are poor, most of
its profitability ratios are low (except profit margin); and its market value ratios are
low.

i. What are some potential problems and limitations of financial ratio analysis?

Answer: Some potential problems are listed below:

1. Comparison with 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 whether company is, on balance, in a strong or weak 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.

Mini Case: 8 - 13
j. What are some qualitative factors analysts should consider when evaluating a
company’s likely future financial performance?

Answer: Top analysts recognize that certain qualitative factors must be considered when
evaluating a company. These factors, as summarized by the American Association
Of Individual Investors (AAII), are as follows:

1. Are the company’s revenues tied to one key customer?

2. To what extent are the company’s revenues tied to one key product?

3. To what extent does the company rely on a single supplier?

4. What percentage of the company’s business is generated overseas?

5. Competition

6. Future prospects

7. Legal and regulatory environment

Mini Case: 8 - 14