Chapter 5 EVALUATING FINANCIAL PERFORMANCE

FOCUS
In this chapter, we focus on identifying and understanding the financial ratios used to evaluate the ventures financial performance over time. Venture performance and efficiency is important to a variety of constituencies including lenders and creditors, equity investors, and the entrepreneur. Lenders and creditors want to be repaid in full and on time; investors want a sufficient return on their investments as compensation for the risks they are taking; the entrepreneur initially wants to survive and then build value in the venture.

LEARNING OBJECTIVES
1. Describe how financial ratios are used to monitor a ventures performance 2. Identify specific cash burn rate measures and liquidity ratios and explain how they are calculated and used by the entrepreneur 3. Identify and describe the use and value of conversion period ratios to the entrepreneur 4. Identify specific leverage ratios and explain their usage by lenders and creditors 5. Identify and describe measures of profitability and efficiency that are important to the entrepreneur and equity investors 6. Describe limitations when using financial ratios

CHAPTER OUTLINE
5.1 5.2 USING FINANCIAL RATIOS CASH BURN RATES AND LIQUIDITY RATIOS A. Measuring Venture Cash Burn and Build Rates B. Beyond Burn: Traditional Measures of Liquidity C. Interpreting Cash-Related and Liquidity-Related Trends CONVERSION PERIOD RATIOS A. Measuring Conversion Times B. Interpreting Changes in Conversion Times LEVERAGE RATIOS A. Interpreting Changes in Financial Leverage PROFITABILITY AND EFFICIENCY RATIOS A. Income Statement Measures of Profitability B. Efficiency and Return Measures C. Operating Return on Assets D. Interpreting Changes in Profitability and Efficiency INDUSTRY COMPARABLE RATIO ANALYSIS A HITCHHIKERS GUIDE TO FINANCIAL ANALYSIS SUMMARY

5.3 5.4 5.5

5.6 5.7

57

DISCUSSION QUESTIONS AND ANSWERS

1. What are financial ratios and why are they useful? Financial ratios are measurements that show relationships between two or more financial variables. 2. What are the three types of comparisons that can be made when conducting ratio analyses? The three types of comparison that can be made with ratio analysis are trend analysis, cross-sectional analysis, and industry comparables (benchmark) analysis. 3. What is meaning of the terms cash build and cash burn? How do we calculate net cash burn rates? Cash build is the amount the firm receives on its sales calculated by net sales less the change in receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and on its investments in assets. 4. How is the current ratio calculated and what does it measure? How does the quick ratio differ from the current ratio? The firms current ratio is calculated by dividing the current assets by the current liabilities. This ratio measures the firms ability to pay off their short term debt in the near term. The quick ratio differs in that it leaves out inventory in calibrating current assets. 5. Describe how a firms net working capital (NWC) is measured and how the NWC-to-total- assets ratio is calculated. What does this ratio measure? Net working capital is measured by subtracting current liabilities from current assets. NWC-to-totalassets ratio is calculated by dividing NWC by the firms total assets (or average total assets). This calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity. 6. What is meant by a ventures operating cycle? Also, describe the cash conversion cycle. A ventures operating cycle is the time it takes to purchase raw materials, assemble a product, book a sale, and collect on it. The cash conversion cycle is the operating cycle less the days of short-term credit extended by suppliers, employees and government (the purchase-to-payment cycle). 7. What are the three components of the cash conversion cycle? How is each component calculated? The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-tocash conversion period, and purchase-to-payment conversion period. The inventory-to-sale conversion period is calculated by dividing average inventories by the ventures average daily cost of goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of average payables and accrued liabilities by the ventures cost of goods sold per day. 8. Briefly explain how changes in the conversion times of the components of the cash conversion cycle can be interpreted.

58

A lengthening of the inventory-to-sale conversion period indicates less efficient inventory management. A lengthening of the sale-to-cash conversion period indicates less efficient collections or management of receivables. A decrease in the purchase-to-payment period indicates a less efficient use of the credit provided by suppliers, employees and the government. 9. What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a ventures assets and/or its equity? Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equity-ratio, and the equity multiplier. 10. What is the importance of the relationship between a ventures current liabilities and its total debt? The portion of total debt that is current represents those liabilities that will come due within the next year. The percentage of debt held in current liabilities is a reasonable glimpse of the ventures reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely to need to restructure their liabilities in the near future. 11. Describe the two types of coverage ratios that are typically calculated when trying to assess a ventures ability to meet its interest payments and other financing-related obligations? The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage ratio. The interest coverage ratio measures the ventures ability to pay its annual interest liability and is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures the ventures ability to cover interest and fixed charges. It is calculated by dividing the sum of the

ventures EBITDA and lease payments divided by the sum of interest payments, rental or lease payments, and the before-tax cost of debt repayments.
12. What are four measures used to indicate how efficiently the venture is in generating profits on its sales? Describe how each measure is calculated. The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT margin. Gross profit margin is calculated by dividing the gross profit by the ventures net sales. Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the ventures net sales. Net profit margin is calculated by dividing net income by net sales. NOPAT margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.

13. Identify and describe four profitability/efficiency ratios that combine data from both the income
statement and the balance sheet. The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is EBIT divided by average total assets. Return on assets is net profit divided by average total assets. Return on equity is net profit divided by average owners equity. 14. Identify and describe the two components of the ROA model both in terms of what financial dimensions they measure and how they are calculated.

59

The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio. Net profit margin measures the amount of sales that become net profit and is calculated by dividing net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with one dollar of assets. It is calculated by dividing net sales by the firms average assets. 15. What are the three ratio components of the ROE model? How is each calculated and what financial dimensions do they measure? The three ratio components of the ROE model are the net profit margin (net income/sales), asset turnover (net sales/average total assets), and the equity multiplier (average total assets/average equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset are utilized in the production of sales. The equity multiplier measures how the firm scales its assets on a base of equity (through liabilities and debt). 16. Indicate some of the concerns or cautions that need to be considered when conducting ratio analysis . When conducting ratio analysis, it is important to compare apples to apples by consistent use of the same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand that certain ratios may simultaneously indicate undesirable and desirable aspects of the ventures strategy and risk position. For example, an efficient use of trade credit can be interpreted as advantageous use of inexpensive credit or as the assumption of a large amount of short-term financial risk (low current and quick ratios).

INTERNET ACTIVITIES 1. Go to the Hoovers business online Web site at www.hoovers.com and click on companies & industries. Identify a firm such as Google, Inc. (sticker symbol: GOOG) or Applebees International, Inc. (ticker symbol: APPB).

A.

Obtain the most recent three years of income statements and balance sheets. Analyze the changes in operating and financial performance, if any, by applying the ratio analyses covered in the chapter. Web-researched results vary due to constant updating of the related web sits.

B.

Estimate the length of the cash conversion over the two most recent years of available data. What changes have occurred, if any? Web-researched results vary due to constant updating of the related web sits.

C.

Identify the industry that firm being studied resides in and the major competitors. Obtain financial statement information for one or more competitors and conduct a ratios analysis of each competitor analyzed. Web-researched results vary due to constant updating of the related web sits.

60

EXERCISES/PROBLEMS AND ANSWERS 1. Bike-With-Us Corporation, a specialty bicycle parts replacement venture, was started last year by two former professional bicycle riders who had substantial competitive racing experience including competing in the Tour de France. The two entrepreneurs borrowed $50,000 from members of their families and each put up $30,000 in equity capital. Retail space was rented and $60,000 was spent for fixtures and store equipment. Following are the abbreviated income statement and balance sheet information for the Bike-With-Us Corporation after one complete year of operation. BIKE-WITH-US CORPORATION Sales $325,000 Operating Costs 285,000 Depreciation 10,000 Interest 5,000 Taxes 6,000 Cash Receivables Inventories Fixed Assets, Net Payables Accruals Long-Term Loan Common Equity $1,000 30,000 50,000 50,000 11,000 10,000 50,000 60,000

A. Prepare an income statement and a balance sheet for the Bike-With-Us Corporation using only the information provided above. Income Statement Sales $325,000 Less: Opr. Costs 285,000 EBITDA 40,000 Less: Depreciation 10,000 EBIT 30,000 Less: Interest 5,000 EBT 25,000 Less: Taxes 6,000 Net Income 19,000 Balance Sheet Cash Receivables Inventories Total Cur. Assets $1,000 30,000 50,000 81,000

61

Fixed Assets, Net Total Assets Payables Accruals Total Cur. Liab. Long-Term Loan Common Equity Total Liab. & Eq.

50,000 $131,000 11,000 10,000 21,000 50,000 60,000 $131,000

B. Calculate the current ratio, quick ratio, and NWC-to-total-assets ratio. Current Ratio = Current Asset/Current Liabilities = $81,000/$21,000 = 3.86 Quick Ratio = (CA - Inventories)/CL = ($81,000 - $50,000)/$21,000 = 1.48 NWC to Total Assets Ratio = (CA - CL)/Assets = ($81,000 - $21,000)/$131,000 = .458 C. Calculate the total-debt-to-total-assets ratio, debt-to-equity ratio, and interest coverage Total Debt to Total Assets Ratio = Debt/Assets = $71,000/$131,000 = .542 Debt to Equity Ratio = Debt/Equity = $71,000/$60,000 = 1.183 Interest Coverage Ratio = EBITDA/Interest = $40,000/$5,000 = 8.00 D. Calculate the net profit margin, sales-to-total-assets ratio, and the return on total assets. Net Profit Margin = Net Profit/Revenues = $19,000/$325,000 = 5.85% Sales to Total Assets Ratio = Sales/Assets = $325,000/$131,000 = 2.48 Return on Total Assets = Net Profit/Assets = $19,000/$131,000 = 14.50% E. Calculate the equity multiplier. Combine this calculation with the calculations in Part D to show the ROE model with its three components. Equity Multiplier = Assets/Equity = $131,000/$60,000 = 2.183 ROE = Net Profit Margin x Asset Turnover x Equity Multiplier = 5.85% x 2.48 x 2.183 = 31.67% 2. Use the financial statements data for the Bike-With-Us Corporation provided in Problem 1 to make the following calculations. A. Calculate the operating return on assets. Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90% B. Determine the effective interest rate paid on the long-term debt. Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00%

62

C.

Calculate the NOPAT margin. How does this compare with the results for the net profit margin? Did the owners benefit from the use of interest-bearing long-term debt? Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00% NOPAT Margin = [(EBIT)(1 tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 = $22,800/$325,000 = 7.02% The Net Profit Margin was lower at 5.85% Since the Operating Return on Assets (22.90%) was higher than the Effective Interest Rate (10.00%), the firm benefited from having interest-bearing long-term debt.

3. The C&B Castillo Company was started in 2003. The company manufactures components for personal decision assistant (PDA) products and for other hand-held electronic products. A difficult operating year 2004 was followed by a profitable 2005. However, the founders (Connie and Bob Castillo) are still concerned about the ventures liquidity position and the amount of cash being used to operate the firm. Following are income statements and balance sheets for the C&B Castillo Company for 2004 and 2005: A. Use year-end data to calculate the current ratio, the quick ratio, and the net working capital (NWC) to total assets ratio for 2004 and 2005 for the Castillo Company. What changes occurred? Current Ratio = Current Asset/Current Liabilities Year 2004: $650,000/$270,000 = 2.41 Year 2005: $800,000/$330,000 = 2.42 Quick Ratio = (CA - Inventories)/CL Year 2004: ($650,000 - $400,000)/$270,000 = 0.93 Year 2005: ($800,000 - $500,000)/$330,000 = 0.91 NWC to Total Assets Ratio = (CA - CL)/Assets Year 2004: ($650,000 - $270,000)/$1,000,000 = 0.38 Year 2005: ($800,000 - $330,000)/$1,000,000 = 0.47 B. Use Castillos complete income statement data and the changes in balance sheet items between 2004 and 2005 to determine the firms cash build and cash burn for 2005. Did Castillo have a net cash build or net cash burn for 2005? Cash Build = Sales Change in Accounts Receivable = $1,500,000 - $80,000 = $1,420,000 Cash Burn = Inventory-Related Purchases + Administrative Expenses + Marketing Expenses + Interest Expense - (Change in Accrued Liabilities + Change in Payables) + Capital Investments + Taxes = ($900,000 +$100,000) + $250,000 + $150,000 + $60,000 - ($20,000 + $30,000) + $90,000 + $25,000 = $1,525,000 Net Cash Burn or Build = Cash Build Cash Burn = $1,420,000 - $1,525,000

63

= -$105,000 = $105,000 Cash Burn C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly cash build and cash burn rates. Also indicate the amount of the net monthly cash build or cash burn rate. Monthly Cash Burn Rate Less: Monthly Cash Build Rate Monthly Net Cash Burn Rate C&B CASTILLO COMPANY
Net Sales

$1,525,000 12 -$1,420,000 12 $105,000 12

$127,083.33 -$118,333.33 $8,750.00

Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes Net Income (Loss)

2004 2005 $900,000 $1,500,000 540,000 900,000 360,000 600,000 90,000 150,000 250,000 250,000 40,000 40,000 (20,000) 160,000 45,000 60,000 (65,000) 100,000 0 25,000 ($65,000) $75,000 2005 $20,000 280,000 500,000 800,000 540,000 -140,000 400,000 $1,200,000 $160,000 70,000 100,000 330,000 400,000 150,000 200,000 120,000 $1,200,000

2004 Cash $50,000 Accounts Receivables 200,000 Inventories 400,000 Total Current Assets 650,000 Gross Fixed Assets 450,000 Accumulated Depreciation -100,000 Net Fixed Assets 350,000 Total Assets $1,000,000 Accounts Payable $130,000 Accruals 50,000 Bank Loan 90,000 Total Current Liabilities 270,000 Long-Term Debt 300,000 Common Stock 150,000 Paid-in-Capital 200,000 Retained Earnings 80,000 Total Liab. & Equity $1,000,000

64

4. The C&B Castillo Company described in Problem 3 improved its operations from a net loss in 2004 to a net profit in 2005. While the founders, Connie and Bob Castillo, are happy about these developments, they are concerned with trying to understand how long the firm takes to complete its cash conversion cycle in 2005. Use the financial statements from Problem 3 to make your calculations. Balance sheet items should reflect the averages of the 2004 and 2005 accounts. A. Calculate the inventory-to-sale conversion period for 2005. Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS = (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days B. Calculate the sale-to-cash conversion period for 2005. Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales = (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days C. Calculate the purchase-to-payment conversion period for 2005. Purchase-to-Payment Conversion Period = (Avg. Payables + Avg. Accruals)/Avg. Daily CGS = ((($130,000 + $160,000)/2) + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days D. Determine the length of the Castillo Companys cash conversion cycle for 2005. Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Salesto-cash Conversion Period) (Purchase-to-Payment Conversion Period) = 182.50 days + 58.40 days 83.14 days = 157.76 days 5. Use the financial statements data for the C&B Castillo Company presented in Problem 3. A. Calculate the net profit margin in 2004 and 2005 and the sales-to-total-assets ratio using yearend data for each of the two years. Net profit margin 2004: -$65,000/$900,000 = -7.22% Net profit margin 2005: $75,000/$1,500,000 = 5.00% Sales-to-total-assets 2004: $900,000/$1,000,000 = .900 Sales-to-total-assets 2005: $1,500,000/$1,200,000 = 1.250 B. Use your calculations from Part A to determine the rate of return on assets in each of the two years for the C&B Castillo Company. Rate of return on assets 2004: -7.22% x .900 = -6.50% Rate of return on assets 2005: 5.00% x 1.250 = 6.25%

65

C. Calculate the percentage growth in net sales from 2004 to 2005. Compare this with the percentage change in total assets for the same period. Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67% Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00% D. Express each expense item as a percentage of net sales for both 2004 and 2005. Describe what happened that allowed the C&B Castillo Company to move from a loss to a profit between the two years. Net sales Cost of goods sold Gross profit Marketing General & administrative Depreciation EBIT Interest Earnings before taxes Income taxes Net income (loss) 2004 100.00% 60.00 40.00 10.00 27.78 4.44 -2.22 5.00 -7.22 0.00 -7.22% 6.67 25.00 5.00% 2005 100.00% 60.00 40.00 10.00 16.67 2.67 10.67 4.00

The decline in general and administrative expenses as a percentage of sales (i.e., the spreading of fixed costs) was the major contributor to C&B Castillo becoming profitable. The decline in depreciation expenses and in interest expenses as percentages of sales also contributed to the move to profitability. However, increased taxes on profits reduced some of the profitability gains. 6. Safety-First, Inc. makes portable ladders that can be used to exit second floor levels of homes in the event of fire. Each ladder consists of fire resistant rope and high strength plastic steps. A lightweight fire resistant cape with a smoke filter is included with SafetyFirst ladder. Each ladder and cape, when not in use, are rolled up and stored in a pouch the size of a back pack and can easily be taken on trips and vacations. Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts college in the northwest three years ago. After struggling for the first year, the venture seemed to be growing and producing profits. Following are the two most recent years of financial statements, expressed in thousands of dollars, for the Safety-First Corporation. SAFETY-FIRST, INC. Income Statements (in $ Thousands) 2004 3,750 2,250 1,500 700 66 2005 4,500 2,700 1,800 900

Net sales Cost of goods sold Gross profit Operating expenses

Income before taxes Income taxes Net income Balance Sheets (in $ Thousands)

800 250 550

900 300 600

Cash Accounts receivable Inventories Total current assets Gross fixed assets Less accumulated depreciation Net fixed assets Total assets Accounts payable Bank loan Accrued liabilities Total current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

2004 400 500 1,450 2,350 2,000 (950) 1,050 3,400 300 150 100 550 150 850 1,850 3,400

2005 150 800 2,000 2,950 2,800 (1,250) 1,550 4,500 400 250 150 800 150 1,100 2,450 4,500

A. Using yearend data for, calculate the inventory to sales conversion period, the sales to cash conversion period, and the purchases to payments conversion period for 2004 and 2005. Inventory to Sale Conversion Period Sale to Cash Conversion Period 235.22 48.67 279.83 52.72

B. Determine the cash conversion cycle for each year and discuss the changes, if any that took place. Purchase to Payment Conversion Period Cash Conversion Cycle 64.89 219.00 74.35 258.20

MINI CASE: SCANDI HOME FURNISHINGS, INC.

67

Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2002. Sales during the first full year (2003) of operation reached $1.3 million. Sales increased by 15 percent in 2004 and another 20 percent in 2005. However, profits after increasing in 2004 over 2003 fell sharply in 2005 causing Kaj to wonder what was happening to his pride and joy business venture. After all, Kaj has continued to work as close as possible to a 24/7 pace beginning with the startup of Scandi and through the first three full years of operation. Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures, and sells to home furnishings retailers Scandinavian-designed furniture and accessories. The modern Scandinavian design has a streamlined and uncluttered look. While this furniture style is primarily associated with Denmark, both Norway and Sweden designers have contributed to the allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian design can be traced to the elegant curves of art nouveau from which designers were able to produce aesthetically pleasing, structurally strong modern furniture. Danish, and the home furnishings produced by the other Scandinavian countriesSweden, Norway, and Finland, are made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics. Kaj grew up in Copenhagen, Denmark and received a college degree from a technical university in Sweden. As is typically in Europe, Kaj began his business career as an apprentice at a major home furnishings manufacturer in Copenhagen. After learning the trade, he quickly moved into a management position in the firm. However, after a few years, Kaj realized that what he really wanted to do was to start and operate his own Scandinavian home furnishings business. At the same time, after traveling throughout the world including the U.S., he was sure that he wanted to be an entrepreneur in the United States. Thus, while it was hard to give up the Tivoli Gardens with its many entertainment and dining activities, as well as the other attractions in Copenhagen, Kaj moved to the U.S. in early 2002. With $140,000 of his personal assets, and $210,000 from venture investors, he began operations in mid-2002. Kaj, with a 40 percent ownership interest and industry-related management expertise, was allowed to operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure he did the right thing. Following are the three years of income statements and balance sheets for the Scandi Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive advantage that he would need to continue to expand sales. After first concentrating on selling Scandinavian home furnishings in the northeast in 2003 and 2004, he decided to enter the west coast market. An increase in expenses associated with identifying, contacting, and selling to home furnishings retailers in California, Oregon, and Washington. Kaj Rasmussen was hoping that you could help him better understand what has been happening to Scandi Home Furnishings both from operating and financial standpoints.

SCANDI HOME FURNISHINGS, INC. Income Statements 2003 2004 2005

68

Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrative Depreciation EBIT Interest Earnings Before Taxes Income Taxes (40%) Net Income

$1,300,000 780,000 520,000 130,000 150,000 40,000 200,000

$1,500,000 $1,800,000 900,000 1,260,000 600,000 540,000 150,000 200,000 150,000 200,000 53,000 60,000 247,000 80,000 45,000 57,000 70,000 155,000 190,000 10,000 62,000 76,000 4,000 $93,000 $114,000 $6,000

SCANDI HOME FURNISHINGS, INC. Balance Sheets 2003 Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets $50,000 200,000 450,000 700,000 300,000 $1,000,000 2004 $40,000 260,000 500,000 800,000 400,000 $1,200,000 $170,000 70,000 90,000 330,000 400,000 300,000 50,000 120,000 $1,200,000 2005 $10,000 360,000 600,000 970,000 500,000 $1,470,000 $180,000 80,000 184,000 444,000 550,000 300,000 50,000 126,000 $1,470,000

Accounts Payable $130,000 Accruals 50,000 Bank Loan 90,000 Total Current Liabilities 270,000 Long-Term Debt 300,000 Common Stock ($10 par)* 300,000 Capital Surplus 50,000 Retained Earnings 80,000 Total Liab. & Equity $1,000,000

Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture investors when Scandi Home Furnishings was incorporated in mid-2002. A. Kaj was particularly concerned by the drop in cash from $50,000 in 2003 to $10,000 in 2005. Calculate the average current ratio, the quick ratio, and the networking capital to total assets ratio for 2003-2004 and 2004-2005. What has happened to Scandis liquidity position? Note: ratio calculations involving asset items on the balance sheet are averages of the prior and current years. See calculations below in the spreadsheet output. All three

69

liquidity ratios (current ratio, quick ratio, and the NWC-to-Total-Assets ratio) all were trending downward. For example, the current ratio declined from 2.500 in 2004 to 2.287 in 2005. B. An analysis of the cash conversion cycle should also help Kaj understand what has been happening to the operations of Scandi. Prepare an analysis of the average conversion periods for the three components of the cash conversion cycle for 2003-2004 and 20042005. Explain was has happened in terms of each component of the cycle. Results for the cash conversion cycle and its components are shown below in the spreadsheet output. Ratios are based on the current years income statement amounts and average amounts (past year and current year) for balance sheet items. The cash conversion cycle declined from 163.44 days in 2004 to 149.77 days in 2005 due to a sharp decline in the inventory-to-sale conversion period which more than offset an increase in the sale-to-cash conversion period and a decrease in the purchase-to-payment conversion period. C. Kaj should be interested in knowing whether Scandi has been building or burning cash. Compare the cash build, cash burn, and the net cash build/burn positions for 2004 and 2005. What, if any, changes have occurred? The venture had a net cash build of 17,000 for 2004 and a net cash burn of -214,000 for 2005. See the spreadsheet output below for details. Operating and interest expenses increased resulting in lower cash from operations. The situation was made worse due to the increase in accounts receivable and in inventories. D. Creditors, as well as management, are also concerned about the ability of the venture to meet its debt obligations as they come due, the proportion of current liabilities to total debt, the availability of assets to meet debt obligations in the event of financial distress, and the relative size of equity investments to debt levels. Calculate average ratios in each of these areas for the 2003-2004 and 2004-2005 periods. Interpret your results and explain what has happened to Scandi. The spreadsheet output below shows that financial leverage (as measured by the totaldebt-to-total-assets ratio, the equity multiplier, and the debt-to-equity ratio) deteriorated or became worse in 2005 versus 2004. This indicates that the firm relied more heavily on debt funds to meet its financial needs (i.e., net cash burn position in 2005). The currentliabilities-to-total debt ratio improved indicating a more than proportional use of longterm debt relative to short-term debt to meet financing needs in 2005. E. Of importance to Kaj and the venture investors is the efficiency of the operations of the venture. Several profit margin ratios relating to the income statement are available to help analyze Scandis performance. Calculate average profit margin ratios for 20032004 and 2004-2005 and describe what is happening to the profitability of Scandi Home Furnishings.

70

All profitability ratios decreased in 2005 versus 2004. For example, the gross profit margin decreased from 40.00% to 35.00% and the net profit margin decreased from 7.38% to 3.97%. See the spreadsheet results below for the other profitability ratio calculations. F. Kaj and the venture investors are also interested in how efficiently Scandi is able to convert their equity investment, as well as the ventures total assets, into sales. Calculate several ratios that combine data from the income statements and balance sheets and compare what has happened between the 2003-2004 and 2004-2005 periods. The sales-to-total-assets ratio declined from 1.3636 in 2004 to 1.3483 in 2005. Decreases also occurred in the ROA results (from 10.36% to .45%) and in the ROE results (from 25.33% to 1.27%). See spreadsheet results below. G. A ROA model consisting of the product of two ratios provides an overview of a ventures efficiency and profitability at the same time. A ROE model consists of the product of three ratios and simultaneously shows an overview a ventures efficiency, profitability, and leverage performance. Calculate ROA and ROE models for the 2003-2004 and 2004-2005 periods. Provide an interpretation of your findings. ROA 2004: ROA 2005: ROE 2004: ROE 2005: 10.36% = 7.38% x 1.3636 1.27% = 3.97% x 1.3483 25.33% = 7.38% x 1.3636 x 2.444 1.27% = 3.97% x 1.3483 x 2.822

Both the ROA and ROE model results show declining performance due to a large decline in the net profit margin and a decline in the sales-to-assets ratio. Furthermore, the financial leverage (as measured by the equity multiplier) increased from 2004 to 2005 during this period of declining operating performance. H. Kaj has been able to obtain some industry ratio data from the home furnishings industry trade association of which he is a member. The industry association collects proprietary financial information from members of the association, compiles averages to protect the proprietary nature of the information, and provides averages for use by individual trade association members. Over the 2003-2004 and 2004-2005 periods, the inventory-to-sale conversion period has averaged 200 days, while the sale-to-cash conversion period (days of sales outstanding) for the industry has average 60 days. How did Scandis operations in terms of these two components of the cash conversion cycle compare with these industry averages? Scandis inventory-to-sale conversion period (192.64 days and 159.33 days) was lower (and thus better) relative to the 200 day average for the industry. Thus, the firm was turning over its inventories more quickly than the industry average. The firms sale-tocash conversion period decreased from being better than the 60-day industry average at 55.97 days to being worse than the industry average at 62.86 days.

71

I. Trade association data for the home furnishings industry shows an average net profit margin of 6.5 percent, a sales-to-assets ratio of 1.3 times, and a total-debt-to-total-assets ratio of 55 percent over the 2003-2004 and 2004-2005 time periods. Compare and contrast to the industry average in terms of the ROA and ROE models. Make sure you compare the components of each model as well as the product of the components. If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1 - . 55). If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for the industry of 2.222. Thus, the industry ROE model is: ROE Industry: 18.78% = 6.50% x 1.300 x 2.222 From Part G: ROA 2004: 10.36% = 7.38% x 1.3636 ROA 2005: 1.27% = 3.97% x 1.3483 ROE 2004: 25.33% = 7.38% x 1.3636 x 2.444 ROE 2005: 1.27% = 3.97% x 1.3483 x 2.822 Scandis ROE declined from above the industry average in 2004 to well below the industry average in 2005. The firms net profit margin also declined from above the industry average to below the industry average. Also, while the turnover of assets declined slightly for the firm, the ratio remained above the industry average. Scandis use of debt to finance its assets was above the industry average in 2004 and even more so in 2005.

72

Scandi Home Furn

Income Statements Net Sales Cost of Goods Sold Gross Profit Marketing General & Administrati Depreciation
73

Scandi Home Fu

Note: Ratio calculati sheet items. For exa sheet data for 2003 a Ratio Calculations Part A: Liquidity Ratios: Current Ratio
74