Answers and Solutions: 3 - 1

Chapter 3
AnaIysis of FinanciaI Statements

Answers and Solutions:3 - 2



3-1 DSJ = 40 days; S = $7,300,000; AR = .

DSJ =
365
S
AR

40 =
/365 000 , 300 , 7 $
AR

40 = AR/$20,000
AR = $800,000.


3-2 A/E = 2.4; D/A = .

58.33%. = 0.5833 =
A
D
2.4
1
- 1 =
A
D
E
A
1
- 1 =
A
D

3-3 RJA = 10%; PM = 2%; RJE = 15%; S/TA = .; TA/E = .
RJA = NI/A; PM = NI/S; RJE = NI/E.

RJA = PM L S/TA
NI/A = NI/S L S/TA
10% = 2% L S/TA
S/TA = 5.

RJE = PM L S/TA L TA/E
NI/E = NI/S L S/TA L TA/E
15% = 2% L 5 L TA/E
15% = 10% L TA/E
TA/E = 1.5.


3-4 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE =
$6,000,000,000; Shares outstanding = 800,000,000; P
0
= $32; M/B = .

Book value =
000 , 000 , 800
000 , 000 , 000 , 6 $
= $7.50.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
.

Answers and Solutions: 3 - 3
M/B =
50 . 7 $
00 . 32 $
= 4.2667.


3-5 TA = $12,000,000,000; T = 40%; EBIT/TA = 15%; RJA = 5%; TIE = .

000 , 000 , 000 , 12 $
EBIT
= 0.15


EBIT = $1,800,000,000.

000 , 000 , 000 , 12 $
NI
= 0.05


NI = $600,000,000.

Now use the income statement format to determine interest so you can
calculate the firm's TIE ratio.

EBIT $1,800,000,000 See above.
INT 800,000,000
EBT $1,000,000,000 EBT = $600,000,000/0.6
Taxes (40%) 400,000,000
NI $ 600,000,000 See above.

TIE = EBIT/INT
= $1,800,000,000/$800,000,000
= 2.25.


3-6 We are given RJA = 3% and Sales/Total assets = 1.5L.

From Du Pont equation: RJA = Profit margin L Total assets turnover
3% = Profit margin(1.5)
Profit margin = 3%/1.5 = 2%.

We can also calculate the company's debt ratio in a similar manner, given
the facts of the problem. We are given RJA(NI/A) and RJE(NI/E); if we use
the reciprocal of RJE we have the following equation:

. 40% = 0.40 = 0.60 - 1 =
A
D
. 60% =
A
E
0.05
1
3% =
A
E
so ,
A
E
- 1 =
A
D
and
NI
E

A
NI
=
A
E
L
L


INT = EBIT - EBT
= $1,800,000,000 - $1,000,000,000

Answers and Solutions:3 - 4
Alternatively,

RJE = RJA L EM
5% = 3% L EM
EM = 5%/3% = 5/3 = TA/E.

Take reciprocal:

E/TA = 3/5 = 60%;

therefore, D/A = 1 - 0.60 = 0.40 = 40%.

Thus, the firm's profit margin = 2% and its debt ratio = 40%.


3-7 Present current ratio =
$525,000
$1,312,500
= 2.5.

Minimum current ratio =
NP + $525,000
NP + $1,312,500

= 2.0.

$1,312,500 + NP = $1,050,000 + 2NP
NP = $262,500.

Short-term debt can increase by a maximum of $262,500 without violating a
2 to 1 current ratio, assuming that the entire increase in notes payable
is used to increase current assets. Since we assumed that the additional
funds would be used to increase inventory, the inventory account will
increase to $637,500 and current assets will total $1,575,000.


3-8 TIE = EBIT/INT, so find EBIT and INT.
Interest = $500,000 L 0.1 = $50,000.

Net income = $2,000,000 L 0.05 = $100,000.
Pre-tax income (EBT) = $100,000/(1 - T) = $100,000/0.7 = $142,857.
EBIT = EBT + Interest = $142,857 + $50,000 = $192,857.

TIE = $192,857/$50,000 = 3.86L.


3-9 TA = $30,000,000,000; EBIT/TA = 20%; TIE = 8; DA = $3,200,000,000; Lease
payments = $2,000,000,000; Principal payments = $1,000,000,000; EBITDA
coverage = .

EBIT/$30,000,000,000 = 0.2
EBIT = $6,000,000,000.


Answers and Solutions: 3 - 5
8 = EBIT/INT
8 = $6,000,000,000/INT
INT = $750,000,000.

EBITDA = EBIT + DA
= $6,000,000,000 + $3,200,000,000
= $9,200,000,000.

EBITDA coverage ratio =
pmts Lease pmts Princ. INT
payments Lease EBITDA

=
000 , 000 , 000 , 2 $ 000 , 000 , 000 , 1 $ 000 , 000 , 750 $
000 , 000 , 000 , 2 $ 000 , 000 , 200 , 9 $

=
000 , 000 , 750 , 3 $
000 , 000 , 200 , 11 $
= 2.9867.


3-10 RJE = Profit margin L TA turnover L Equity multiplier
= NI/Sales L Sales/TA L TA/Equity.

Now we need to determine the inputs for the equation from the data that
were given. Jn the left we set up an income statement, and we put numbers
in it on the right:

Sales (given) $10,000,000
- Cost na
EBIT (given) $ 1,000,000
- INT (given) 300,000
EBT $ 700,000
- Taxes (34%) 238,000
NI $ 462,000

Now we can use some ratios to get some more data:
Total assets turnover = 2 = S/TA; TA = S/2 = $10,000,000/2 = $5,000,000.

D/A = 60%; so E/A = 40%; and, therefore,
Equity multiplier = TA/E = 1/(E/A) = 1/0.4 = 2.5.

Now we can complete the Du Pont equation to determine RJE:
RJE = $462,000/$10,000,000 L $10,000,000/$5,000,000 L 2.5 = 0.231 = 23.1%.



Answers and Solutions:3 - 6
3-11 Known data:

TA = $1,000,000; k
d
= 8%; T = 40%; BEP = 0.2 = EBIT/Total assets, so EBIT =
0.2($1,000,000) = $200,000; D/A = 0.5 = 50%, so Equity = $500,000.

D/A = 0% D/A = 50%
EBIT $200,000 $200,000
Interest 0 40,000
EBT $200,000 $160,000
Tax (40%) 80,000 64,000
NI $120,000 $ 96,000

RJE =
Equity
NI
=
$1,000,000
$120,000
= 12%
$500,000
$96,000
= 19.2%
Difference in RJE = 19.2% - 12.0% = 7.2%.

If D/A = 50%, then half of the assets are financed by debt, so Debt =
$500,000. At an 8 percent interest rate, INT = $40,000.


3-12 Statement a is correct. Refer to the solution setup for Problem 3-11 and
think about it this way: (1) Adding assets will not affect common equity
if the assets are financed with debt. (2) Adding assets will cause
expected EBIT to increase by the amount EBIT = BEP(added assets). (3)
Interest expense will increase by the amount k
d
(added assets). (4) Pre-tax
income will rise by the amount (added assets)(BEP - k
d
). Assuming BEP
k
d
, if pre-tax income increases so will net income. (5) If expected net
income increases but common equity is held constant, then the expected RJE
will also increase. Note that if k
d
BEP, then adding assets financed by
debt would lower net income and thus the RJE. Therefore, Statement a is
true--if assets financed by debt are added, and if the expected BEP on
those assets exceeds the cost of debt, then the firm's RJE will increase.
Statements b, c, and d are false, because the BEP ratio uses EBIT,
which is calculated before the effects of taxes or interest charges are
felt. Jf course, Statement e is also false.


3-13 a. Currently, RJE is RJE
1
= $15,000/$200,000 = 7.5%.
The current ratio will be set such that 2.5 = CA/CL. CL is $50,000,
and it will not change, so we can solve to find the new level of
current assets: CA = 2.5(CL) = 2.5($50,000) = $125,000. This is the
level of current assets that will produce a current ratio of 2.5L.
At present, current assets amount to $210,000, so they can be
reduced by $210,000 - $125,000 = $85,000. If the $85,000 generated is
used to retire common equity, then the new common equity balance will
be $200,000 - $85,000 = $115,000.
Assuming that net income is unchanged, the new RJE will be RJE
2
=
$15,000/$115,000 = 13.04%. Therefore, RJE will increase by 13.04% -
7.50% = 5.54%.

b. 1. Doubling the dollar amounts would not affect the answer; it would
still be 5.54%.

Answers and Solutions: 3 - 7
2. Common equity would increase by $25,000 from the Part a scenario,
which would mean a new RJE of $15,000/$140,000 = 10.71%, which would
mean a difference of 10.71% - 7.50% = 3.21%.

3. An inventory turnover of 2 would mean inventories of $100,000, down
$50,000 from the current level. That would mean an RJE of
$15,000/$150,000 = 10.00%, so the change in RJE would be 10.00% -
7.5% = 2.5%.

4. If the company had 10,000 shares outstanding, then its EPS would be
$15,000/10,000 = $1.50. The stock has a book value of $200,000/10,000
= $20, so the shares retired would be $85,000/$20 = 4,250, leaving
10,000 - 4,250 = 5,750 shares. The new EPS would be $15,000/5,750 =
$2.6087, so the increase in EPS would be $2.6087 - $1.50 = $1.1087,
which is a 73.91 percent increase, the same as the increase in RJE.

5. If the stock was selling for twice book value, or 2 L $20 = $40,
then only half as many shares could be retired ($85,000/$40 =
2,125), so the remaining shares would be 10,000 - 2,125 = 7,875, and
the new EPS would be $15,000/7,875 = $1.9048, for an increase of
$1.9048 - $1.5000 = $0.4048.

c. We could have started with lower inventory and higher accounts
receivable, then had you calculate the DSJ, then move to a lower DSJ
that would require a reduction in receivables, and then determine the
effects on RJE and EPS under different conditions. Similarly, we could
have focused on fixed assets and the FA turnover ratio. In any of
these cases, we could have had you use the funds generated to retire
debt, which would have lowered interest charges and consequently
increased net income and EPS.
If we had to increase assets, then we would have had to finance this
increase by adding either debt or equity, which would have lowered RJE
and EPS, other things held constant.
Finally, note that we could have asked some conceptual questions
about the problem, either as a part of the problem or without any
reference to the problem. For example, If funds are generated by
reducing assets, and if those funds are used to retire common stock,
will EPS and/or RJE be affected by whether or not the stock sells
above, at, or below book value.


3-14 TA = $7,500,000,000; EBIT/TA = 10%; TIE = 2.5; DA = $1,250,000,000; Lease
payments = $775,000,000; Principal payments = $500,000,000; EBITDA coverage = .

EBIT/$7,500,000,000 = 0.10
EBIT = $750,000,000.

2.5 = EBIT/INT
2.5 = $750,000,000/INT
INT = $300,000,000.


Answers and Solutions:3 - 8
EBITDA = EBIT + DA
= $750,000,000 + $1,250,000,000
= $2,000,000,000.

EBITDA coverage ratio =
pmts Lease pmts Princ. INT
payments Lease EBITDA

=
000 , 000 , 775 $ 000 , 000 , 500 $ 000 , 000 , 300 $
000 , 000 , 775 $ 000 , 000 , 000 , 2 $

=
000 , 000 , 575 , 1 $
000 , 000 , 775 , 2 $
= 1.7619 1.76.


3-15 TA = $5,000,000,000; T = 40%; EBIT/TA = 10%; RJA = 5%; TIE .

. 000 , 000 , 500 $ EBIT
10 . 0
,000 $5,000,000
EBIT

. 000 , 000 , 250 $ NI
05 . 0
,000 $5,000,000
NI

Now use the income statement format to determine interest so you can
calculate the firm's TIE ratio.

EBIT $500,000,000 See above.
INT 83,333,333
EBT $416,666,667 EBT = $250,000,000/0.6
Taxes (40%) 166,666,667
NI $250,000,000 See above.

TIE = EBIT/INT
= $500,000,000/$83,333,333
= 6.0.


3-16 Total market value = $3,750,000,000(1.9) = $7,125,000,000.
Market value per share = $7,125,000,000/50,000,000 = $142.50.

Alternative solution:
Book value per share = $3,750,000,000/50,000,000 = $75.
Market value per share = $75(1.9) = $142.50.


3-17 Step 1: Solve for current annual sales using the DSJ equation:
55 = $750,000/(Sales/365)
55Sales = $273,750,000
Sales = $4,977,272.73.

INT = EBIT - EBT
= $500,000,000 - $416,666,667

Answers and Solutions: 3 - 9
Step 2: If sales fall by 15%, the new sales level will be
$4,977,272.73(0.85) = $4,230,681.82. Again, using the DSJ
equation, solve for the new accounts receivable figure as
follows:
35 = AR/($4,230,681.82/365)
35 = AR/$11,590.91
AR = $405,681.82 $405,682.


3-18 The current EPS is $2,000,000/500,000 shares or $4.00. The current P/E ratio
is then $40/$4 = 10.00. The new number of shares outstanding will be
650,000. Thus, the new EPS = $3,250,000/650,000 = $5.00. If the shares are
selling for 10 times EPS, then they must be selling for $5.00(10) = $50.


3-19 Step 1: Calculate total assets from information given.
Sales = $6 million.

3.2L = Sales/TA
3.2L =
Assets
000 , 000 , 6 $

Assets = $1,875,000.

Step 2: Calculate net income.
There is 50% debt and 50% equity, so Equity = $1,875,000 L 0.5 =
$937,500.

RJE = NI/S L S/TA L TA/E
0.12 = NI/$6,000,000 L 3.2 L $1,875,000/$937,500
0.12 =
000 , 000 , 6 $
NI 4 . 6

$720,000 = 6.4NI
$112,500 = NI.


3-20 Given RJA = 8% and net income of $600,000, total assets must be $7,500,000.

RJA =
TA
NI

8% =
TA
$600,000

TA = $7,500,000.

To calculate BEP, we still need EBIT. To calculate EBIT construct a
partial income statement:

EBIT $1,148,077 ($225,000 + $923,077)
Interest 225,000 (Given)
EBT $ 923,077 $600,000/0.65
Taxes (35%) 323,077
NI $ 600,000

Answers and Solutions:3 - 10

BEP =
TA
EBIT

=
$7,500,000
$1,148,077

= 0.1531 = 15.31%.


3-21 1. Debt = (0.50)(Total assets) = (0.50)($300,000) = $150,000.

2. Accounts payable = Debt - Long-term debt = $150,000 - $60,000
= $90,000.

3. Common stock =
equity and
s liabilitie Total
- Debt - Retained earnings
= $300,000 - $150,000 - $97,500 = $52,500.

4. Sales = (1.5)(Total assets) = (1.5)($300,000) = $450,000.

5. Inventories = Sales/5 = $450,000/5 = $90,000.

6. Accounts receivable = (Sales/365)(DSJ) = ($450,000/365)(36.5)
= $45,000.

7. Cash + Accounts receivable + Inventories = (1.8)(Accounts payable)
Cash + $45,000 + $90,000 = (1.8)($90,000)
Cash + $135,000 = $162,000
Cash = $27,000.

8. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)
Fixed assets = $300,000 - ($27,000 + $45,000 + $90,000)
Fixed assets = $138,000.

9. Cost of goods sold = (Sales)(1 - 0.25) = ($450,000)(0.75) = $337,500.



Answers and Solutions: 3 - 11
3-22 a. (Dollar amounts in thousands.)
Industry
Firm Average


s liabilitie Current
assets Current
=
$330,000
$655,000
= 1.98L 2.0L

DSJ =
365 Sales/
receivable Accounts
=
11 . 04 $4,4
$336,000
= 76.3 days 35 days


s Inventorie
Sales
=
$241,500
$1,607,500
= 6.66L 6.7L


assets Total
Sales
=
$947,500
$1,607,500
= 1.70L 3.0L


Sales
income Net
=
$1,607,500
$27,300
= 1.7% 1.2%


assets Total
income Net
=
$947,500
$27,300
= 2.9% 3.6%


equity Common
income Net
=
$361,000
$27,300
= 7.6% 9.0%


assets Total
debt Total
=
$947,500
$586,500
= 61.9% 60.0%

b. For the firm,

RJE = PM L T.A. turnover L EM = 1.7% L 1.7 L
$361,000
$947,500
= 7.6%.
For the industry, RJE = 1.2% L 3 L 2.5 = 9%.

Note: To find the industry ratio of assets to common equity, recognize
that 1 - (total debt/total assets) = common equity/total assets. So,
common equity/total assets = 40%, and 1/0.40 = 2.5 = total
assets/common equity.

c. The firm's days sales outstanding is more than twice as long as the
industry average, indicating that the firm should tighten credit or
enforce a more stringent collection policy. The total assets turnover
ratio is well below the industry average so sales should be increased,
assets decreased, or both. While the company's profit margin is higher
than the industry average, its other profitability ratios are low compared
to the industry--net income should be higher given the amount of equity
and assets. However, the company seems to be in an average liquidity
position and financial leverage is similar to others in the industry.


Answers and Solutions:3 - 12
d. If 2002 represents a period of supernormal growth for the firm, ratios
based on this year will be distorted and a comparison between them and
industry averages will have little meaning. Potential investors who
look only at 2002 ratios will be misled, and a return to normal
conditions in 2003 could hurt the firm's stock price.


3-23 a. Industry
Firm Average

Current ratio =
s liabilitie Current
assets Current
=
$111
$303
= 2.73L 2L


assets total
to Debt
=
assets Total
Debt
=
$450
$135
= 30.00% 30.00%

earned
interest Times
=
Interest
EBIT
=
$4.5
$49.5
= 11L 7L


coverage
EBITDA
=
pymts
Lease

pymts
Princ.
INT
pymts Lease EBITDA

=
5 . 6 $
5 . 61 $
= 9.46L 9L


turnover
Inventory
=
s Inventorie
Sales
=
$159
$795
= 5L 10L

DSJ =
5 36 Sales/
receivable Accounts
=
$795/365
$66
= 30.3 days 24 days


Turnover
. A . F
=
assets fixed Net
Sales
=
$147
$795
= 5.41L 6L


Turnover
. A . T
=
assets Total
Sales
=
$450
$795
= 1.77L 3L

Profit margin =
Sales
income Net
=
$795
$27
= 3.40% 3.00%


assets total
on Return
=
assets Total
income Net
=
$450
$27
= 6.00% 9.00%


equity common
on Return
= RJA L EM = 6% L 1.4286 = 8.57% 12.90%

Alternatively,

RJE =
Equity
income Net
=
$315
$27
= 8.57% 8.6%.


Answers and Solutions: 3 - 13
b. RJE = Profit margin L Total assets turnover L Equity multiplier

=
Sales
income Net
L
assets Total
Sales
L
equity Common
assets Total


=
$795
$27
L
$450
$795
L
$315
$450
= 3.4% L 1.77 L 1.4286 = 8.6%.

Firm Industry Comment
Profit margin 3.4% 3.0% Good
Total assets turnover 1.77L 3.0L Poor
Equity multiplier 1.4286 1.43 J.K.

1 -
TA
D
=
TA
E

1 - 0.30 = 0.7
EM =
E
TA
=
7 . 0
1
= 1.43.

Alternatively, EM = RJE/RJA = 12.9%/9% = 1.43.

c. Analysis of the Du Pont equation and the set of ratios shows that the
turnover ratio of sales to assets is quite low. Either sales should be
increased at the present level of assets, or the current level of
assets should be decreased to be more in line with current sales.

d. The comparison of inventory turnover ratios shows that other firms in
the industry seem to be getting along with about half as much inventory
per unit of sales as the firm. If the company's inventory could be
reduced, this would generate funds that could be used to retire debt,
thus reducing interest charges and improving profits, and strengthening
the debt position. There might also be some excess investment in fixed
assets, perhaps indicative of excess capacity, as shown by a slightly
lower-than-average fixed assets turnover ratio. However, this is not
nearly as clear-cut as the overinvestment in inventory.

e. If the firm had a sharp seasonal sales pattern, or if it grew rapidly
during the year, many ratios might be distorted. Ratios involving
cash, receivables, inventories, and current liabilities, as well as
those based on sales, profits, and common equity, could be biased. It
is possible to correct for such problems by using average rather than
end-of-period figures.



Answers and Solutions:3 - 14
3-24 a. Here are the firm's base case ratios and other data as compared to the
industry:

Firm Industry Comment
Current 2.3 2.7 Weak
Inventory turnover 4.8 7.0 Poor
Days sales outstanding 37.4 days 32.0 days Poor
Fixed assets turnover 10.0L 13.0L Poor
Total assets turnover 2.3 2.6 Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.1 18.2 Bad
Debt ratio 54.8 50.0 High
Profit margin on sales 2.5 3.5 Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0L 6.0L Poor
P/CF ratio 2.0 3.5 Poor
M/B ratio 0.65 n.a. --

The firm appears to be badly managed--all of its ratios are worse than the
industry averages, and the result is low earnings, a low P/E, a low stock
price, and a low M/B ratio. The company needs to do something to improve.

b. A decrease in the inventory level would improve the inventory turnover,
total assets turnover, and RJA, all of which are too low. It would have
some impact on the current ratio, but it is difficult to say precisely how
that ratio would be affected. If the lower inventory level allowed the
company to reduce its current liabilities, then the current ratio would
improve. The lower cost of goods sold would improve all of the
profitability ratios and, if dividends were not increased, would lower the
debt ratio through increased retained earnings. All of this should lead
to a higher market/book ratio, a higher stock price, a higher
price/earnings ratio, and a higher price/cash flow ratio.

Spreadsheet Problem: 3 - 15



3-25 The detailed solution for the spreadsheet problem is available both on the
instructor's resource CD-RJM and on the instructor's side of South-
Western's web site, http://brigham.swlearning.com.






SPREADSHEET PROBLEM

ntegrated Case: 3 - 16



D'Leon Inc., Part II
inancial Statement Analysis

3-26 PART I OF THIS CASE, PRESENTED IN CHAPTER 2, DISCUSSED THE SITUATION
THAT D'LEON INC., A REGIONAL SNACK-FOODS PRODUCER, WAS IN 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 WERE PROJECTED, AND A LARGE LOSS OCCURRED IN 2002 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, D'LEON'S
CHAIRMAN, WHO HAD THE TASK OF GETTING THE COMPANY BACK INTO A SOUND
FINANCIAL POSITION. D'LEON'S 2001 AND 2002 BALANCE SHEETS AND INCOME
STATEMENTS, TOGETHER WITH PROJECTIONS FOR 2003, ARE GIVEN IN TABLES
IC3-1 AND IC3-2. IN ADDITION, TABLE IC3-3 GIVES THE COMPANY'S 2001 AND
2002 FINANCIAL RATIOS, TOGETHER WITH INDUSTRY AVERAGE DATA. THE 2003
PROJECTED FINANCIAL STATEMENT DATA REPRESENT JAMISON'S AND CAMPO'S BEST
GUESS FOR 2003 RESULTS, ASSUMING THAT SOME NEW FINANCING IS ARRANGED TO
GET THE COMPANY OVER THE HUMP.
JAMISON EXAMINED MONTHLY DATA FOR 2002 (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 LOOK
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 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 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.
INTEGRATED CASE

ntegrated Case:3 - 17
TABLE IC3-1. BALANCE SHEETS

2003E 2002 2001
ASSETS
CASH $ 85,632 $ 7,282 $ 57,600
ACCOUNTS RECEIVABLE 878,000 632,160 351,200
INVENTORIES 1,716,480 1,287,360 715,200
TOTAL CURRENT ASSETS $2,680,112 $1,926,802 $1,124,000
GROSS FIXED ASSETS 1,197,160 1,202,950 491,000
LESS ACCUMULATED DEPRECIATION 380,120 263,160 146,200
NET FIXED ASSETS $ 817,040 $ 939,790 $ 344,800
TOTAL ASSETS $3,497,152 $2,866,592 $1,468,800

LIABILITIES AND EQUITY
ACCOUNTS PAYABLE $ 436,800 $ 524,160 $ 145,600
NOTES PAYABLE 300,000 636,808 200,000
ACCRUALS 408,000 489,600 136,000
TOTAL CURRENT LIABILITIES $1,144,800 $1,650,568 $ 481,600
LONG-TERM DEBT 400,000 723,432 323,432
COMMON STOCK 1,721,176 460,000 460,000
RETAINED EARNINGS 231,176 32,592 203,768
TOTAL EQUITY $1,952,352 $ 492,592 $ 663,768
TOTAL LIABILITIES AND EQUITY $3,497,152 $2,866,592 $1,468,800

NOTE: E INDICATES ESTIMATED. THE 2003 DATA ARE FORECASTS.



ntegrated Case: 3 - 18
TABLE IC3-2. INCOME STATEMENTS

2003E 2002 2001
SALES $7,035,600 $6,034,000 $3,432,000
COST OF GOODS SOLD 5,875,992 5,528,000 2,864,000
OTHER EXPENSES 550,000 519,988 358,672
TOTAL OPERATING COSTS
EXCLUDING DEPRECIATION $6,425,992 $6,047,988 $3,222,672
EBITDA $ 609,608 ($ 13,988) $ 209,328
DEPRECIATION 116,960 116,960 18,900
EBIT $ 492,648 ($ 130,948) $ 190,428
INTEREST EXPENSE 70,008 136,012 43,828
EBT $ 422,640 ($ 266,960) $ 146,600
TAXES (40%) 169,056 (106,784)
a
58,640
NET INCOME $ 253,584 ($ 160,176) $ 87,960

EPS $1.014 ($1.602) $0.880
DPS $0.220 $0.110 $0.220
BOOK VALUE PER SHARE $7.809 $4.926 $6.638
STOCK PRICE $12.17 $2.25 $8.50
SHARES OUTSTANDING 250,000 100,000 100,000
TAX RATE 40.00% 40.00% 40.00%
LEASE PAYMENTS 40,000 40,000 40,000
SINKING FUND PAYMENTS 0 0 0

NOTE: E INDICATES ESTIMATED. THE 2003 DATA ARE FORECASTS.

a
THE FIRM HAD SUFFICIENT TAXABLE INCOME IN 2000 AND 2001 TO OBTAIN ITS FULL TAX
REFUND IN 2002.


ntegrated Case:3 - 19
TABLE IC3-3. RATIO ANALYSIS

INDUSTRY
2003E 2002 2001 AVERAGE
CURRENT 1.2L 2.3L 2.7L
INVENTORY TURNOVER 4.7L 4.8L 6.1L
DAYS SALES OUTSTANDING (DSO)
a
38.2 37.4 32.0
FIXED ASSETS TURNOVER 6.4L 10.0L 7.0L
TOTAL ASSETS TURNOVER 2.1L 2.3L 2.6L
DEBT RATIO 82.8% 54.8% 50.0%
TIE -1.0L 4.3L 6.2L
EBITDA COVERAGE 0.1L 3.0L 8.0L
PROFIT MARGIN -2.7% 2.6% 3.5%
BASIC EARNING POWER -4.6% 13.0% 19.1%
ROA -5.6% 6.0% 9.1%
ROE -32.5% 13.3% 18.2%
PRICE/EARNINGS -1.4L 9.7L 14.2L
PRICE/CASH FLOW -5.2L 8.0L 11.0L
MARKET/BOOK 0.5L 1.3L 2.4L
BOOK VALUE PER SHARE $4.93 $6.64 n.a.

NOTE: E INDICATES ESTIMATED. THE 2003 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?

ANSWER: S3-1 THRJUGH S3-5 PRJVIDE BACKGRJUND INFJRMATIJN. THEN, SHJW S3-6 AND
S3-7 HERE., RATIJS ARE USED BY MANAGERS TJ HELP IMPRJVE THE FIRM'S
PERFJRMANCE, BY LENDERS TJ HELP EVALUATE THE FIRM'S LIKELIHJJD JF
REPAYING DEBTS, AND BY STJCKHJLDERS TJ HELP FJRECAST FUTURE EARNINGS
AND DIVIDENDS. THE FIVE MAJJR CATEGJRIES JF RATIJS ARE: LIQUIDITY,
ASSET MANAGEMENT, DEBT MANAGEMENT, PRJFITABILITY, AND MARKET VALUE.


B. CALCULATE D'LEON'S 2003 CURRENT RATIO BASED ON THE PROJECTED BALANCE
SHEET AND INCOME STATEMENT DATA. WHAT CAN YOU SAY ABOUT THE COMPANY'S
LIQUIDITY POSITION IN 2001, 2002, AND AS PROJECTED FOR 2003? 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 THIS LIQUIDITY RATIO?


ntegrated Case: 3 - 20
ANSWER: SHJW S3-8 AND S3-9 HERE.,

CURRENT RATIJ
03
= CURRENT ASSETS/CURRENT LIABILITIES
= $2,680,112/$1,144,800 = 2.34L.

THE CJMPANY'S CURRENT RATIJ IS IDENTICAL TJ ITS 2001 CURRENT RATIJ,
AND IT HAS IMPRJVED FRJM ITS 2002 LEVEL. HJWEVER, THE CURRENT RATIJ IS
WELL BELJW THE INDUSTRY AVERAGE.


C. CALCULATE THE 2003 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?

ANSWER: SHJW S3-10 THRJUGH S3-15 HERE.,

INVENTJRY TURNJVER
03
= SALES/INVENTJRY
= $7,035,600/$1,716,480 = 4.10L.

DSJ
03
= RECEIVABLES/(SALES/365)
= $878,000/($7,035,600/365) = 45.55 DAYS.

FIXED ASSETS TURNJVER
03
= SALES/NET FIXED ASSETS
= $7,035,600/$817,040 = 8.61L.

TJTAL ASSETS TURNJVER
03
= SALES/TJTAL ASSETS
= $7,035,600/$3,497,152 = 2.01L.

THE FIRM'S INVENTJRY TURNJVER AND TJTAL ASSETS TURNJVER RATIJS HAVE
BEEN STEADILY DECLINING, WHILE ITS DAYS SALES JUTSTANDING HAS BEEN
STEADILY INCREASING (WHICH IS BAD). HJWEVER, THE FIRM'S 2003 TJTAL
ASSETS TURNJVER RATIJ IS JNLY SLIGHTLY BELJW THE 2002 LEVEL. THE
FIRM'S FIXED ASSETS TURNJVER RATIJ IS BELJW ITS 2001 LEVEL; HJWEVER, IT
IS ABJVE THE 2002 LEVEL.
THE FIRM'S INVENTJRY TURNJVER AND TJTAL ASSETS TURNJVER ARE BELJW
THE INDUSTRY AVERAGE. THE FIRM'S DAYS SALES JUTSTANDING IS ABJVE THE
INDUSTRY AVERAGE (WHICH IS BAD); HJWEVER, THE FIRM'S FIXED ASSETS
TURNJVER IS ABJVE THE INDUSTRY AVERAGE. (THIS MIGHT BE DUE TJ THE FACT
THAT D'LEJN IS AN JLDER FIRM THAN MJST JTHER FIRMS IN THE INDUSTRY, IN
WHICH CASE, ITS FIXED ASSETS ARE JLDER AND THUS HAVE BEEN DEPRECIATED

ntegrated Case:3 - 21
MJRE, JR THAT D'LEJN'S CJST JF FIXED ASSETS WERE LJWER THAN MJST FIRMS
IN THE INDUSTRY.)


D. CALCULATE THE 2003 DEBT, TIMES-INTEREST-EARNED, AND EBITDA COVERAGE
RATIOS. HOW DOES D'LEON COMPARE WITH THE INDUSTRY WITH RESPECT TO
FINANCIAL LEVERAGE? WHAT CAN YOU CONCLUDE FROM THESE RATIOS?

ANSWER: SHJW S3-16 THRJUGH S3-18 HERE.,

DEBT RATIJ
03
= TJTAL DEBT/TJTAL ASSETS
= ($1,144,800 + $400,000)/$3,497,152 = 44.17%.

TIE
03
= EBIT/INTEREST = $492,648/$70,008 = 7.04L.

EBITDA
03
=

PAYMENTS
LEASE
EBITDA /

PAYMENTS
LEASE
PAYMENTS
PRINCIPAL
INTEREST
= ($609,608 + $40,000)/($70,008 + $40,000)
= $649,608/$110,008 = 5.91L.

THE FIRM'S DEBT RATIJ IS MUCH IMPRJVED FRJM 2002 AND 2001, AND IT IS
BELJW THE INDUSTRY AVERAGE (WHICH IS GJJD). THE FIRM'S TIE RATIJ IS
ALSJ GREATLY IMPRJVED FRJM ITS 2001 AND 2002 LEVELS AND IS ABJVE THE
INDUSTRY AVERAGE. WHILE ITS EBITDA CJVERAGE RATIJ HAS IMPRJVED FRJM
ITS 2001 AND 2002 LEVELS, IT IS STILL BELJW THE INDUSTRY AVERAGE.


E. CALCULATE THE 2003 PROFIT MARGIN, BASIC EARNING POWER (BEP), RETURN ON
ASSETS (ROA), AND RETURN ON EQUITY (ROE). WHAT CAN YOU SAY ABOUT THESE
RATIOS?

ANSWER: SHJW S3-19 THRJUGH S3-24 HERE.,

PRJFIT MARGIN
03
= NET INCJME/SALES = $253,584/$7,035,600 = 3.60%.

BASIC EARNING PJWER
03
= EBIT/TJTAL ASSETS = $492,648/$3,497,152 =
14.09%.

RJA
03
= NET INCJME/TJTAL ASSETS = $253,584/$3,497,152 = 7.25%.

RJE
03
= NET INCJME/CJMMJN EQUITY = $253,584/$1,952,352 = 12.99% 13.0%.

ntegrated Case: 3 - 22

THE FIRM'S PRJFIT MARGIN IS ABJVE 2001 AND 2002 LEVELS AND SLIGHTLY
ABJVE THE INDUSTRY AVERAGE. WHILE THE FIRM'S BASIC EARNING PJWER AND
RJA RATIJS ARE BJTH ABJVE 2001 AND 2002 LEVELS, THEY ARE STILL BELJW
THE INDUSTRY AVERAGE. THE FIRM'S RJE RATIJ IS GREATLY IMPRJVED JVER
ITS 2002 LEVEL; HJWEVER, IT IS SLIGHTLY BELJW ITS 2001 LEVEL AND STILL
WELL BELJW THE INDUSTRY AVERAGE.


F. CALCULATE THE 2003 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?

ANSWER: SHJW S3-25 THRJUGH S3-27 HERE.,

EPS
03
= NET INCJME/SHARES JUTSTANDING = $253,584/250,000 = $1.0143.

PRICE/EARNINGS
03
= PRICE PER SHARE/EARNINGS PER SHARE
= $12.17/$1.0143 = 12.0L.

CHECK: PRICE = EPS L P/E = $1.0143(12.0) = $12.17.

CASH FLJW/SHARE
03
= (NI + DEP)/SHARES = ($253,584 + $116,960)/250,000
= $1.48.

PRICE/CASH FLJW
03
= $12.17/$1.48 = 8.2L.

BVPS
03
= CJMMJN EQUITY/SHARES JUTSTANDING = $1,952,352/250,000 = $7.81.

MARKET/BJJK
03
= MARKET PRICE PER SHARE/BJJK VALUE PER SHARE
= $12.17/$7.81 = 1.56L.

THE P/E, P/CF, AND M/B RATIJS ARE ABJVE THE 2002 AND 2001 LEVELS BUT
BELJW THE INDUSTRY AVERAGE.


G. USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW OF
D'LEON'S FINANCIAL CONDITION AS PROJECTED FOR 2003. WHAT ARE THE
FIRM'S MAJOR STRENGTHS AND WEAKNESSES?


ntegrated Case:3 - 23
ANSWER: SHJW S3-28 AND S3-30 HERE.,

DU PJNT EQUATIJN =
MARGIN
PRJFIT
L
TURNJVER
ASSETS TJTAL
L
MULTIPLIER
EQUITY

= 3.60% L 2.01 L 1/(1 - 0.4417) = 12.96% 13.0%.

STRENGTHS: THE FIRM'S FIXED ASSETS TURNJVER WAS ABJVE THE INDUSTRY
AVERAGE. HJWEVER, IF THE FIRM'S ASSETS WERE JLDER THAN JTHER FIRMS IN
ITS INDUSTRY THIS CJULD PJSSIBLY ACCJUNT FJR THE HIGHER RATIJ.
(D'LEJN'S FIXED ASSETS WJULD HAVE A LJWER HISTJRICAL CJST AND WJULD
HAVE BEEN DEPRECIATED FJR LJNGER PERIJDS JF TIME.) THE FIRM'S PRJFIT
MARGIN IS SLIGHTLY ABJVE THE INDUSTRY AVERAGE, AND ITS DEBT RATIJ HAS
BEEN GREATLY REDUCED, SJ IT IS NJW BELJW THE INDUSTRY AVERAGE (WHICH IS
GJJD). THIS IMPRJVED PRJFIT MARGIN CJULD INDICATE THAT THE FIRM HAS
KEPT JPERATING CJSTS DJWN AS WELL AS INTEREST EXPENSE (AS SHJWN FRJM
THE REDUCED DEBT RATIJ). INTEREST EXPENSE IS LJWER BECAUSE THE FIRM'S
DEBT RATIJ HAS BEEN REDUCED, WHICH HAS IMPRJVED THE FIRM'S TIE RATIJ SJ
THAT IT IS NJW ABJVE THE INDUSTRY AVERAGE.

WEAKNESSES: THE FIRM'S CURRENT ASSET RATIJ IS LJW; MJST JF ITS ASSET
MANAGEMENT RATIJS ARE PJJR (EXCEPT FIXED ASSETS TURNJVER); ITS EBITDA
CJVERAGE RATIJ IS LJW; MJST JF ITS PRJFITABILITY RATIJS ARE LJW (EXCEPT
PRJFIT MARGIN); AND ITS MARKET VALUE RATIJS ARE LJW.


H. USE THE FOLLOWING SIMPLIFIED 2003 BALANCE SHEET TO SHOW, IN GENERAL
TERMS, HOW AN IMPROVEMENT IN THE DSO WOULD TEND TO AFFECT THE STOCK
PRICE. FOR EXAMPLE, IF THE COMPANY COULD IMPROVE ITS COLLECTION
PROCEDURES AND THEREBY LOWER ITS DSO FROM 45.6 DAYS TO THE 32-DAY
INDUSTRY AVERAGE WITHOUT AFFECTING SALES, HOW WOULD THAT CHANGE RIPPLE
THROUGH THE FINANCIAL STATEMENTS (SHOWN IN THOUSANDS BELOW) AND
INFLUENCE THE STOCK PRICE?

ACCOUNTS RECEIVABLE $ 878 DEBT $1,545
OTHER CURRENT ASSETS 1,802 EQUITY 1,952
NET FIXED ASSETS 817 LIABILITIES PLUS
TOTAL ASSETS $3,497 EQUITY $3,497


ntegrated Case: 3 - 24
ANSWER: SHJW S3-31 THRJUGH S3-34 HERE.,

SALES PER DAY = $7,035,600/365 = $19,275.62.

ACCJUNTS RECEIVABLE UNDER NEW PJLICY = $19,275.62 L 32 DAYS
= $616,820.

FREED CASH = JLD A/R - NEW A/R = $878,000 - $616,820 = $261,180.


I. DOES IT APPEAR THAT INVENTORIES COULD BE ADJUSTED, AND, IF SO, HOW
SHOULD THAT ADJUSTMENT AFFECT D'LEON'S PROFITABILITY AND STOCK PRICE?

ANSWER: THE INVENTJRY TURNJVER RATIJ IS LJW. IT APPEARS THAT THE FIRM EITHER
HAS EXCESSIVE INVENTJRY JR SJME JF THE INVENTJRY IS JBSJLETE. IF
INVENTJRY WERE REDUCED, THIS WJULD IMPRJVE THE CURRENT ASSET RATIJ, THE
INVENTJRY AND TJTAL ASSETS TURNJVER, AND REDUCE THE DEBT RATIJ EVEN
FURTHER, WHICH SHJULD IMPRJVE THE FIRM'S STJCK PRICE AND PRJFITABILITY.


J. IN 2002, THE COMPANY PAID ITS SUPPLIERS MUCH LATER THAN THE DUE DATES,
AND IT WAS 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 WHEN IT COMES DUE IN
90 DAYS. ON THE BASIS OF DATA PROVIDED, WOULD 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 WERE THE BANK
LOAN OFFICER, WOULD YOU RECOMMEND RENEWING THE LOAN OR DEMAND ITS
REPAYMENT? WOULD YOUR ACTIONS BE INFLUENCED IF, IN EARLY 2003, D'LEON
SHOWED YOU ITS 2003 PROJECTIONS PLUS PROOF THAT IT WAS GOING TO RAISE
OVER $1.2 MILLION OF NEW EQUITY CAPITAL?

ANSWER: WHILE THE FIRM'S RATIJS BASED JN THE PRJJECTED DATA APPEAR TJ BE
IMPRJVING, THE FIRM'S CURRENT ASSET RATIJ IS LJW. AS A CREDIT MANAGER,
I WJULD NJT CJNTINUE TJ EXTEND CREDIT TJ THE FIRM UNDER ITS CURRENT
ARRANGEMENT, PARTICULARLY IF I DIDN'T HAVE ANY EXCESS CAPACITY. TERMS
JF CJD MIGHT BE A LITTLE HARSH AND MIGHT PUSH THE FIRM INTJ BANKRUPTCY.

ntegrated Case:3 - 25
LIKEWISE, IF THE BANK DEMANDED REPAYMENT THIS CJULD ALSJ FJRCE THE FIRM
INTJ BANKRUPTCY.
CREDITJRS' ACTIJNS WJULD DEFINITELY BE INFLUENCED BY AN INFUSIJN JF
EQUITY CAPITAL IN THE FIRM. THIS WJULD LJWER THE FIRM'S DEBT RATIJ AND
CREDITJRS' RISK EXPJSURE.


K. IN HINDSIGHT, WHAT SHOULD D'LEON HAVE DONE BACK IN 2001?

ANSWER: BEFJRE THE CJMPANY TJJK JN ITS EXPANSIJN PLANS, IT SHJULD HAVE DJNE AN
EXTENSIVE RATIJ ANALYSIS TJ DETERMINE THE EFFECTS JF ITS PRJPJSED
EXPANSIJN JN THE FIRM'S JPERATIJNS. HAD THE RATIJ ANALYSIS BEEN
CJNDUCTED, THE CJMPANY WJULD HAVE GJTTEN ITS HJUSE IN JRDER BEFJRE
UNDERGJING THE EXPANSIJN.


L. WHAT ARE SOME POTENTIAL PROBLEMS AND LIMITATIONS OF FINANCIAL RATIO
ANALYSIS?

ANSWER: SHJW S3-35 AND S3-36 HERE., SJME PJTENTIAL PRJBLEMS ARE LISTED BELJW:

1. CJMPARISJN WITH INDUSTRY AVERAGES IS DIFFICULT IF THE FIRM JPERATES
MANY DIFFERENT DIVISIJNS.

2. DIFFERENT JPERATING AND ACCJUNTING PRACTICES DISTJRT CJMPARISJNS.

3. SJMETIMES HARD TJ TELL IF A RATIJ IS GJJD JR BAD.

4. DIFFICULT TJ TELL WHETHER CJMPANY IS, JN BALANCE, IN A STRJNG JR
WEAK PJSITIJN.

5. AVERAGE PERFJRMANCE IS NJT NECESSARILY GJJD.

6. SEASJNAL FACTJRS CAN DISTJRT RATIJS.

7. WINDJW DRESSING TECHNIQUES CAN MAKE STATEMENTS AND RATIJS LJJK
BETTER.


M. WHAT ARE SOME QUALITATIVE FACTORS ANALYSTS SHOULD CONSIDER WHEN
EVALUATING A COMPANY'S LIKELY FUTURE FINANCIAL PERFORMANCE?

ntegrated Case: 3 - 26

ANSWER: SHJW S3-37 HERE., TJP ANALYSTS RECJGNIZE THAT CERTAIN QUALITATIVE
FACTJRS MUST BE CJNSIDERED WHEN EVALUATING A CJMPANY. THESE FACTJRS, AS
SUMMARIZED BY THE AMERICAN ASSJCIATIJN JF INDIVIDUAL INVESTJRS (AAII),
ARE AS FJLLJWS:

1. ARE THE CJMPANY'S REVENUES TIED TJ JNE KEY CUSTJMER.

2. TJ WHAT EXTENT ARE THE CJMPANY'S REVENUES TIED TJ JNE KEY PRJDUCT.

3. TJ WHAT EXTENT DJES THE CJMPANY RELY JN A SINGLE SUPPLIER.

4. WHAT PERCENTAGE JF THE CJMPANY'S BUSINESS IS GENERATED JVERSEAS.

5. CJMPETITIJN.

6. FUTURE PRJSPECTS.

7. LEGAL AND REGULATJRY ENVIRJNMENT.