Solution to Case 2

Financial Ratio Analysis

Bigger Isn’t Always Better!*

*Note to Instructor: Please note that the Balance sheet figures for 1997 have a few errors.
These are highlighted below.

Table I

Quickfix Autoparts

Balance Sheet

1997 1998 1999 2000 2001

ASSETS
Cash and marketable
securities $155,000 $309,099 $75,948 $28,826 $18,425
Accounts receivable 10,000 12,000 20,000 77,653 90,078
Inventory 250,000 270,000 500,000 520,000 560,000

Current assets $415,000 $591,099 $595,948 $626,480 $668,503

Land, buildings, plant,

and equipment $250,000 $250,000 $500,000 $500,000 $500,000
Accumulated depreciation (25,000) (50,000) (100,000) (150,00

Total assets $640,000 $791,099 $995,948 $976,480 $968,503

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 50,000
LIABILITIES AND EQUITIESShort-term bank loans
Accounts payable
Accruals

Current liabilities

Long-term bank loans

Mortgage

Long-term debt

Total liabilities

Common stock (100,000 shares)

Retained earnings
Total equity$150,000
10,000
5,000$145,000
10,506
5,100$140,000
19,998
7,331$148,000

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 Table II

Quickfix Autoparts

Income StatementNet sales

Cost of goods sold

Gross profit

Admin and selling exp

Depreciation
Miscellaneous expenses

Total operating exp

EBIT

Interest on ST loans
Interest on LT loans
Interest on mortgage

Total interest

Before-tax earnings
Taxes

Net income

Dividends on stock

Additions to
retained earnings

EPS (100,000 shares)19971998199920002001Net sales

Cost of goods sold

Gross profit

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1. How does Quickfix’s average compound growth rate in sales compare with its
earnings growth rate over the past five years?

Quickfix’s sales have increased by an average compound rate of 14% per year over the
period, 1997-2001. In comparison, its net income has declined from over $16,600 million
to a loss of $102 in 2001.

2. Which statements should Juan refer to and which one’s should he construct so as to
develop a fair assessment of the firm’s financial condition? Explain why?

Juan should refer to the income statement and the balance sheet over the past 3-5 year
period. In addition, he should prepare a cash flow statement, common size income
statement and common size balance sheet. The accounting statements provide the raw
data from which the other statements can be prepared. The cash flow statement helps
determine where the cash came from and where it was spent during a year. The common
size statements provide useful information regarding the relative trends of the various
assets, liabilities, revenue sources, and expense items. They also help the analyst make
meaningful comparisons between firms of varying sizes.

3. What calculations should Juan do in order to get a good grasp of what is going on
with Quickfix’s performance?

Juan should calculate the various liquidity, leverage, profitability, activity, and coverage
ratios for at least a three-year period. In addition, a Du Pont analysis of the return on
equity will help determine what has affected the profitability of the company.

4. Juan knows that he should compare Quickfix’s condition with an appropriate

benchmark. How should he go about obtaining the necessary comparison data?

Based on Quickfix’s industry classification code, Juan should collect industry averages of
the key financial ratios. Some useful sources for industry ratios include: Value Line,
Moody’s, Standard & Poor, And Dun & Bradstreet. In addition to the industry average,
the industry leader’s (within the size category) ratios could also be collected from the
Internet (e.g. Marketguide.com) and used for comparison.

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5. Besides comparison with the benchmark what other types of analyses could Juan
perform to comprehensively analyze the firm’s condition? Perform the suggested
analyses and comment on your findings.

Besides comparison with the benchmark, Juan could perform common size analyses of
the financial statements and a DuPont analysis of the return on assets and the return on
equity.

Quickfix Autoparts
Common Size Income Statement

1997 1997% 1998 1998% 1999 1999% 2000 2000% 2001

Net sales $600,000 100.0% $655,000 100.0% $780,000 100.0% $873,600 100.0% $1,013,376
Cost of goods 480,000 80.0% 537,100 82.0% 655,200 84.0% 742,560 85.0% 861,370
sold

Gross profit $120,000 20.0% $117,900 18.0% $124,800 16.0% $131,040 15.0% $152,006

Admin and $30,000 5.0% $15,345 2.3% $16,881 2.2% $43,680 5.0% $40,535
selling exp
Depreciation 25,000 4.2% 25,000 3.8% 50,000 6.4% 50,000 5.7% 50,000
Miscellaneous 2,027 0.3% 3,557 0.5% 5,725 0.7% 17,472 2.0% 15,201
expenses

Total $57,027 9.5% $43,902 6.7% $72,606 9.3% $111,152 12.7% $105,736
operating exp

EBIT $62,973 10.5% $73,998 11.3% $52,194 6.7% $19,888 2.3% $46,271

Interest on ST $15,000 2.5% $15,950 2.4% $14,000 1.8% $13,320 1.5% $13,320
loans
Interest on LT 8,000 1.3% 7,840 1.2% 15,680 2.0% 15,200 1.7% 14,640
loans
Interest on 12,250 2.0% 12,110 1.8% 18,970 2.4% 18,760 2.1% 18,480
mortgage

Total interest $35,250 5.9% $35,900 5.5% $48,650 6.2% $47,280 5.4% $46,440

Before-tax $27,723 4.6% $38,098 5.8% $3,544 0.5% ($27,392) -3.1% ($169)
earnings
Taxes 11,089 1.8% 15,239 2.3% 1,418 0.2% -10,957 -1.3% -68
Net income $16,634 2.8% $22,859 3.5% $2,126 0.3% ($16,435) -1.9%
($102)Quickfix Autoparts
Common Size Income Statement

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 The common size income statement indicates that the firm’s cost of goods sold has increased
quite a bit since 1997. Miscellaneous expenses have also increased from .3% of sales to 1.5% of
sales. On the other hand, selling and administrative expenses and interest charges have come
down a bit. The firm needs to look into its cost structure and try and reduce the overall costs of
doing business.

The common size balance sheet (shown below) shows that the firm’s inventory and accounts
receivables levels have gone up sharply, while its cash balance has significantly declined. Fixed
assets have increased over the past 5 years. The firm has taken on significantly larger amounts of
short and long-term debt relative to its total assets. Equity has not increased proportionately with
debt. As a result its capital structure has become more leveraged.

Quickfix Autoparts

Balance Sheet
1997 2000% 1998 1998% 1999 1999% 2000 2000% 2001 2001%
ASSETS
Cash and marketable
securities $155,000 24.22% $309,099 39.07% $75,948 7.63% $28,826 2.95% $18,425 1.90%
Accounts receivable 10,000 1.56% 12,000 1.52% 20,000 2.01% 77,653 7.95% 90,078 9.30%
Inventory 250,000 39.06% 270,000 34.13% 500,000 50.20% 520,000 53.25% 560,000 57.82%

Current assets $415,000 64.84% $591,099 74.72% $595,948 59.84% $626,480 64.16% $668,503 69.02%

Land, buildings, plant,

and equipment $250,000 39.06% $250,000 31.60% $500,000 50.20% $500,000 51.20% $500,000 51.63%
Accumulated depreciation -25,000 -3.91% -50,000 -6.32% -100,000 -10.04% -150,000 -15.36% -200,000 -20.65%

Net fixed assets $225,000 35.16% $200,000 25.28% $400,000 40.16% $350,000 35.84% $300,000 30.98%

Total assets $640,000 100.00% $791,099 100.00% $995,948 100.00% $976,480 100.00% $968,503 100.00%

LIABILITIES AND
EQUITIES
Short-term bank loans $50,000 7.81% $145,000 18.33% $140,000 14.06% $148,000 15.16% $148,000 15.28%

Accounts payable 10,000 1.56% 10,506 1.33% 19,998 2.01% 15,995 1.64% 16,795 1.73%
Accruals 5,000 0.78% 5,100 0.64% 7,331 0.74% 9,301 0.95% 11,626 1.20%

Current liabilities $65,000 10.16% $160,606 20.30% $167,329 16.80% $173,296 17.75% $176,421 18.22%

Long-term bank loans $63,366 9.90% $98,000 12.39% $196,000 19.68% $190,000 19.46% $183,000 18.90%
Mortgage 175,000 27.34% 173,000 21.87% 271,000 27.21% 268,000 27.45% 264,000 27.26%

Long-term debt $238,366 37.24% $271,000 34.26% $467,000 46.89% $458,000 46.90% $447,000 46.15%

Total liabilities $303,366 47.40% $431,606 54.56% $634,329 63.69% $631,296 64.65% $623,421 64.37%

Common stock (100,000 $320,000 50.00% $320,000 40.45% $320,000 32.13% $320,000 32.77% $320,000 33.04%
shares)
Retained earnings 16,634 2.60% 39,493 4.99% 41,619 4.18% 25,184 2.58% 25,082 2.59%

Total equity $336,634 52.60% $359,493 45.44% $361,619 36.31% $345,184 35.35% $345,082 35.63%

Total liabilities
and equity $640,000 100.00% $791,099 100.00% $995,948 100.00% $976,480 100.00% $968,503 100.00%

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 Du Pont Analysis

Net Profit Margin 2.77% 3.49% 0.27% -1.88% -0.01%

Total Asset
Turnover 0.9375 0.827962 0.7831734 0.894642 1.046332329
Equity Multiplier 1.901175 2.200596 2.7541363 2.828868 2.806587999

Return on Assets 2.60% 2.89% 0.21% -1.68% -0.01%

Return on Equity 4.94% 6.36% 0.59% -4.76% -0.03%

Quickfix Auto’s ROA has is currently negative but has improved since 2000. Most of the decrease has
come from the deteriorating profit situation. The firm’s total asset turnover has improved since 1999.

The firm’s ROE has suffered significantly since 1997. This has occurred largely due to the steep drop in
net profit margin. Had the firm not had such a high equity multiplier (from its high level of debt), the ROE
situation would have looked considerably worse.

6. Comment on Quickfix’s liquidity, asset utilization, long-term solvency, and

profitability ratios. What arguments would have to be made to convince the bank
that they should grant Quickfix the loan?

19971998199920002001Current Ratio6.383.683.563.623.79Quick
Ratio2.542.000.570.610.62Cash Ratio2.381.920.450.170.10Total Debt
Ratio0.470.550.640.650.64Debt-Equity Ratio0.901.201.751.831.81Equity
Multiplier1.902.202.752.832.81Times Interest Ratio1.792.061.070.421.00Cash Coverage
Ratio2.502.762.101.482.07Inventory Turnover ratio1.921.991.311.431.54Day's sales in
Inventory190.10183.49278.54255.60237.30Receivables
Turnover60.0054.5839.0011.2511.25ACP or Days' Sales in
Receivables6.086.699.3632.4432.44Total Asset Turnover0.940.830.780.891.05Capital
Intensity1.071.211.281.120.96Profit Margin2.77%3.49%0.27%-1.88%-
0.01%ROA2.60%2.89%0.21%-1.68%-0.01%ROE4.94%6.36%0.59%-4.76%-0.03%

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 Liquidity:
The firm’s overall liquidity is quite good with a current ratio of 3.79 and it has improved
quite a bit over the past three years. However, much of its current assets are tied in
inventory, since its quick ratio is only 0.62. The ability of the firm to pay off its current
liabilities from its cash reserves is not very good either and has deteriorated significantly
over the past five years.

Asset utilization:
The firm’s inventory turnover has declined considerably since 1997. There was some
improvement in 2001, but there is still a lot of room for further improvement. The
receivables turnover ratio has declined as well. An average collection period of 32 days is
pretty high for a retail business. The total asset turnover although not very high is at its
highest level in five years.

Long-term solvency:
Quickfix Auto’s debt ratio is 64% of total assets. It’s debt level has gone up by almost
37% since 1997. Since the firm’s coverage ratios are fairly low, the firm’s financial
structure can be considered to be fairly risky.

Profitability:
The firm’s profitability ratios have declined significantly in the past three years. The firm
is currently making losses.

Arguments that can be made to get the loan:

Improving liquidity (current ratio) and total asset turnover.

Improving cash coverage and interest coverage ratios.
Proof of better inventory management system (if possible)

7. If you were the commercial loan officer and were approached by Andre for a short
term loan of $25,000, what would your decision be?

Given the firm’s poor profitability and cash flow situation, I would not grant the loan.
However, I would tell him that if he can demonstrate improvement in inventory
management and better profitability over the next 2 quarters, we would reconsider.

8. What recommendations should Juan make for improvement, if any?

The firm needs to improve its inventory management, and credit collection policies.
Further, the cost of sales and miscellaneous costs should be looked into and brought
down more in line with its level in 1997. This will improve the liquidity and profitability
of the company.

9. What kinds of problems do you think Juan would have to cope with when doing a
comprehensive financial statement analysis of Quickfix Parts? What are the
limitations of financial statement analysis in general?
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General Problems
Selection of comparison benchmark
Accounting procedures differ.
Different fiscal year end
Seasonal businesses
Extraordinary gains/losses

Specific Problems
Selection of appropriate benchmark/ industry averages