ACCT 002 Lecture Notes - Lecture 3: Headcount, Weighted Arithmetic Mean, Financial Statement
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This term you have learned to understand a companyâs financial story using the language of accounting. The recording and reporting of information is essential to decision makers and other users of financial information; numbers on the various financial statements are used to help further understand the financial condition of the business. This process is known as financial ratio analysis and allows us to analyze the companyâs financial position in relation to other organizations in the industry. In this final assignment, you will apply the concepts you have learned throughout the term to perform financial statement analysis and to offer some recommendations.
Assume that you are a health care consultant hired by the Dependable DME Company. DME is Durable Medical Equipment and includes all equipment that benefits patients who have certain medical conditions. The owner of the company, David Smith, is interested in applying for a loan to expand his business; he desires to open a second location in another city. He is preparing to apply to a local bank for a loan.
The bank will base its decision on the following averages for the DME industry:
| Ratio | Industry Average |
| Current ratio | 1.50 |
| Quick ratio | 0.80 |
| Receivables turnover ratio | 18.0 |
| Inventory turnover ratio | 20.0 |
| Debt to assets ratio | 0.56 |
| Profit margin | 10.25% |
The balance sheet data for Dependable DME Company follows:
| December 31, 2017 | December 31, 2016 | |
| Cash | $75,000 | $60,000 |
| Accounts receivable | 40,000 | 20,000 |
| Inventory | 30,000 | 20,000 |
| Prepaid insurance | 5,000 | 5,000 |
| Total current assets | 140,000 | 105,000 |
| Property and equipment | 600,000 | 550,000 |
| Accumulated depreciation | 140,000 | 110,000 |
| Total property and equipment | 460,000 | 440,000 |
| Total assets | $600,000 | $545,000 |
| Accounts payable | $60,000 | $60,000 |
| Other current liabilities | 40,000 | 45,000 |
| Total current liabilities | 100,000 | 105,000 |
| Bonds payable | 150,000 | 150,000 |
| Total liabilities | 250,000 | 255,000 |
| Common stock | 250,000 | 250,000 |
| Retained earnings | 100,000 | 40,000 |
| Total stockholdersâ equity | 350,000 | 290,000 |
| Total liabilities and stockholdersâ equity | $600,000 | $545,000 |
The income statement data for Dependable DME Company follows:
| Sales | $600,000 |
| Cost of goods sold | 350,000 |
| Gross profit | $250,000 |
| Operating expenses | 100,000 |
| Operating income | $150,000 |
| Interest expense | 25,000 |
| Income before taxes | $125,000 |
| Income tax expense | 65,000 |
| Net income | $60,000 |
Required:
Calculate the following six (6) ratios: Current Ratio, Quick Ratio, Receivables Turnover Ratio, Inventory Turnover Ratio, Profit Margin Ratio and Debt to Assets Ratio. Be sure to show the actual calculation as well as your final answer.
You are only required to calculate the ratios for 2017; however, for two of the ratios (Receivables Turnover Ratio and Inventory Turnover Ratio), you will need data from 2016 for the formula. When calculating the Quick Ratio, please note that Short-Term Investments are $0 in this scenario. (24 points; 4 points for each ratio calculation)
Below each ratio, comment on the interpretation of the ratio. In other words, what does the result tell you, specifically? (8 points)
Based upon the industry averages upon which the bank relies, should they approve the loan to Mr. Smith? Why or why not? (7 points)
In one-half page, comment on what financial aspect of Dependable DME Company looks good and where can Mr. Smith make some improvements. Specifically identify at least two recommendations to Mr. Smith that can be made to improve the financial position of his business. (8 points)
A large loss occurred in 2017 at Transpire Inc in Canterbury, rather than the expected profit. As a result, its stakeholders are concerned about the firmâs performance.
You are hired as the new Chief Financial Officer and are given the task of getting the company back into a sound financial position. Transpireâs 2016 and 2017 balance sheets and income statements, together with projections for 2018, are shown in the following tables. The tables also show the 2016 and 2017 financial ratios, along with industry average data. The 2018 projected financial statement data represent the best projection for 2018 results, assuming that some new financing is arranged to get the company âover the humpâ and back on track.
You must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken.
Table 1. Transpire Inc. Balance Sheets
| Assets | 2016 | 2017 | 2018e | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| ($â000) | ($â000) | ($â000) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Cash | 8,000 | 7,482 | 15,000 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Short-Term Investments | 48,600 | 20,000 | 71,632 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Accounts Receivable | 351,200 | 652,160 | 878,000 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Inventories | 715,200 | 1,287,360 | 1,816,480 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Total Current Assets | 1,123,000 | 1,967,002 | 2,781,112 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 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 | 1,467,800 | 2,906,792 | 3,617,952 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Table 2. Transpire Inc. Income Statements
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Table 3 Transpire Inc. other data
| Stock Price ($) | 85.00 | 60.00 | 78.00 | |
| Shares (units) | 100,000 | 100,000 | 250,000 | |
| Earnings per Share ($) | 6.88 | - | 1.59 | 3.41 |
| Dividend per Share ($) | 0.22 | - | 0.22 | |
| Tax Rate (%) | 40.00 | 40.00 | 40.00 | |
| Book Value per Share ($) | 6.638 | 5.960 | 7.909 | |
| Lease Payments ($) | 40,000 | 40,000 | 40,000 |
Table 4 Transpire Inc. Ratio Analysis
| 2016 | 2017 | 2018e | Industry | ||
| Average | |||||
| Current Ratio (X) | 2.34 | 1.50 | 2.67 | 2.00 | |
| Quick Ratio (X) | 0.85 | 0.52 | 0.93 | 1.00 | |
| Inventory Turnover (X) | 4.00 | 3.87 | 3.19 | 5.00 | |
| Average Age of Inventory (days) | 91.15 | 94.35 | 114.31 | 45.00 | |
| Average Collection Period (days) | 28.92 | 40.80 | 39.88 | 30.00 | |
| Average Payment Period (days) | 18.56 | 23.75 | 22.64 | 60.00 | |
| Fixed Asset Turnover (X) | 12.85 | 6.21 | 9.60 | 8.00 | |
| Total Asset Turnover (X) | 3.02 | 2.01 | 2.22 | 2.50 | |
| Debt Ratio (X) | 0.55 | 0.79 | 0.45 | 0.35 | |
| Debt to Equity Ratio (X) | 1.21 | 3.88 | 0.83 | 0.80 | |
| Times Interest Earned (X) | 19.35 | 0.10 | 18.78 | 25.00 | |
| Gross Profit Margin (%) | 35.38 | 14.64 | 27.82 | 28.00 | |
| Operating Profit Margin (%) | 27.28 | 0.30 | 18.70 | 17.00 | |
| Net Profit Margin (%) | 15.52 | - | 2.72 | 10.62 | 12.00 |
| Return on Total Assets (%) | 46.87 | - | 5.45 | 23.59 | 30.00 |
| Return on Equity (%) | 103.64 | - | 26.60 | 43.17 | 35.00 |
| Price/Earnings (P/E) Ratio (X) | 12.36 | - | 37.84 | 22.84 | 10.00 |
| Market/Book Value Ratio (X) | 12.81 | 10.07 | 9.86 | 7.00 |
Required:
Prepare a financial statement analysis of Transpire Inc. Your analysis should cover each of the following:
1. Why are ratios useful? Which three groups uses ratio analysis and for what reasons?
2.Transpireâs liquidity position (using current and quick ratios) in 2016, 2017, and projected for 2018. Compare it to the industry averages. What actions should be taken to improve its liquidity position?
3.Transpireâs operating and utilisation of assets projected (using inventory turnover, average age of inventory, average collection period, average payment period, fixed asset turnover, and total asset turnover) in 2016, 2017, and projected for 2018. Compare it to the industry averages. What actions should be taken to improve its operating and utilisation of assets position?
4.Transpireâs financial leverage (using debt ratio, debt to equity ratio, and times-interest-earned) in 2016, 2017, and projected for 2018. What actions should be taken to improve its financial leverage position?
5.Transpireâs profitability (using gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE)) in 2016, 2017, and projected for 2018. Compare it to the industry averages. What actions should be taken to improve its profitability position?
6.Analyse the projected 2018 price/earnings ratio and market/book value ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Explain your answers
7. Discuss the major strengths and weaknesses of the firm using the results of Du Pont analysis as projected for 2018
8.Perform a common size analysis and percent change analysis. What do these analyses tell you about Transpire? What actions should be taken to improve its overall financial position?
9.If one uses the industry average P/E ratio to estimate the firmâs share price in 2018, how much should it be? Comment on this method.
10.What are some potential problems and limitations of financial ratio analysis?
Tying the Ratios Together
The DuPont equation shows the relationships among asset management, debt management, and
-Select-liquiditymarketprofitabilityCorrect 1 of Item 1 ratios. Management can use the DuPont equation to analyze ways of improving the firm's performance. Its equation is:
Ratio analysis is important to understand and interpret financial statements; however, sound financial analysis involves more than just calculating and interpreting numbers. -Select-QuantitativeQualitativeForeignCorrect 2 of Item 1 factors also need to be considered.
Quantitative Problem: Rosnan Industries' 2014 and 2013 balance sheets and income statements are shown below.
| Balance Sheets: | |||
| 2014 | 2013 | ||
| Cash and equivalents | $60 | $45 | |
| Accounts receivable | 275 | 300 | |
| Inventories | 375 | 350 | |
| Total current assets | $710 | $695 | |
| Net plant and equipment | 2,000 | 1,490 | |
| Total assets | $2,710 | $2,185 | |
| Accounts payable | $150 | $85 | |
| Accruals | 75 | 50 | |
| Notes payable | 110 | 135 | |
| Total current liabilities | $335 | $270 | |
| Long-term debt | 450 | 290 | |
| Common stock | 1,225 | 1,225 | |
| Retained earnings | 700 | 400 | |
| Total liabilities and equity | $2,710 | $2,185 | |
| Income Statements: | |||
| 2014 | 2013 | ||
| Sales | $2,000 | $1,500 | |
| Operating costs excluding depreciation | 1,250 | 1,000 | |
| EBITDA | $750 | $500 | |
| Depreciation and amortization | 100 | 75 | |
| EBIT | $650 | $425 | |
| Interest | 62 | 45 | |
| EBT | $588 | $380 | |
| Taxes (40%) | 235 | 152 | |
| Net income | $353 | $228 | |
| Dividends paid | $53 | $48 | |
| Addition to retained earnings | $300 | $180 | |
| Shares outstanding | 100 | 100 | |
| Price | $25.00 | $22.50 | |
| WACC | 10.00% | ||
What is the firmâs 2014 current ratio? Round your answer to two decimal places.
The 2014 current ratio indicates that Rosnan has -Select-insufficientsufficientCorrect 1 of Item 3 current assets to meet its current obligations as they come due.
What is the firmâs 2014 total assets turnover ratio? Round your answer to four decimal places.
Given the 2014 current and total assets turnover ratios calculated above, if Rosnanâs 2014 quick ratio is 1.0 then an analyst might conclude that Rosnanâs fixed assets are managed -Select-efficientlyinefficientlyCorrect 1 of Item 4.
What is the firmâs 2014 debt-to-capital ratio? Round your answer to two decimal places.
%
If the industry average debt-to-capital ratio is 30%, then Rosnanâs creditors have a -Select-smallerbiggerCorrect 1 of Item 5 cushion than indicated by the industry average.
What is the firmâs 2014 profit margin? Round your answer to two decimal places.
%
If the industry average profit margin is 12%, then Rosnanâs lower than average debt-to-capital ratio might be one reason for its high profit margin.
-Select-TrueFalseCorrect 1 of Item 6
What is the firmâs 2014 price/earnings ratio? Round your answer to two decimal places.
Using the DuPont equation, what is the firmâs 2014 ROE? Round your answer to two decimal places.
%
