Zofia Szydlowski CHAPTER 3 Page 86 Question 3-1 What four financial statements are contained in most reports?

The four financial statements contained in most reports are: 1. Balance sheet 2. Income statement 3. Statement of stockholders equity 4. Statement of cash flow. Page 86 Question 3-2 Who are some of the basic users of financial statements, and how do they use them? The users of the basic financial statements are: stockholders, investors, financial institutions, government regulators, and managers. Financial statements show the financial performance of a company. They are used for both internal - and external purposes. When they are used internally, the management and sometimes the employees use them for their own information. Managers use them to plan ahead and set goals for upcoming periods. When they use the financial statements that were published, the management can compare them with their internally used financial statements. They can also use their own and other enterprises financial statements for comparison with macro-economic data and forecasts, as well as to the market and industry in which they operate in. Stockholders and managers use them to make business plans and decisions. Investors use them to review the return on their funds. They also review the statement of stockholders equity to assess changes in the companys shares outstanding. Financial institutions use them to make lending decisions to companies. The government uses them to ascertain the propriety and accuracy of taxes and duties paid by companies. CHAPTER 4 Page 126 Question 4-3 Du Point analysis. Doublewide Dealers has an ROA of 10 %, a 2% profit margin, and an ROE of 15%. What is its total assets turnover? What is its equity multiplier? ROE (Return on equity) = Profit margin x TAT (Total asset turnover) x EM (Equity multiplier) Total Asset turnover = sales revenue / total asset = 10% / 2% = 5 times Equity multiplier = total asset / total stockholder equity 15% / 10% = 1.5 times

ROA (return on assets) = Profit margin Total assets turnover.

Page 126 Question 4-5 Price/earnings ratio. A company has an EPS of $2, 00, a book value per share of $20, and a market/book ratio of 1.2x. What is its P/E ratio? Market Value = $20 X 1.2 = $24 per share P/E = $24 / $2 = 12.0 Page 127 Question 4-6 Dupont and Roe A firm has a profit margin of 2% and an equity multiplier of 2.0. Its sales are $100 million, and it has total assets of $50 million. What is its ROE? ROE (return on common equity) measures the rate of return on the stockholders investment. ROE = profit x total turnover x equity multiplier 0.08 (8%) = 0.02 (2%) x (100 mil / 50 mil) x 2 ROE = 0.08 (8%) Integrated Case Page 132: Dleon Inc., Part II a. Why are ratios useful? What are the five major categories of ratios? Five major categories of ratios are: - Liquidity - Asset management - Debt management - Profitability - Market value Ratios are used to analyze the statements to identify weaknesses that need to be strengthened to maximize stock price. The firms rations are compared with averages for its industry and with the leading firms in the industry (benchmarking), and these comparisons are used to help formulate policies that will lead to improved future performance. The firms own rations can be analyzed over time to see if its financial situation is getting better or worse.

b. Calculate DLeons2012 current and quick ratios based on the projected balance sheet and income statement data. What can you say about companys liquidity positions in 2011, in 2010, and as projected for 2012? We often think of ratios of being useful 1. To managers to help run the business 2. To bankers for credit analysis 3. To stockholders for stuck valuation Would these different types analysis have an equal interest in the companys liquidity ratios? Projected for 2012 Current ratio = current assets /current liabilities = $2,680,112 / $1,144,800 = 2.34 Quick ratio = (current assets inventories)/current liabilities = = ($2,680,112 - $1,716,480) / $1,144,800 = .8417 2011 Current ratio = current assets /current liabilities = $1,926,802 /$1,650,568 = 1.167 Quick ratio == (current assets inventories)/current liabilities = = ($1,926,802 - $1,287,360) / $1,650,568 = .387 2010 Current ratio = current assets /current liabilities = $1,124,000 / $481,600 = 2.305 Quick ratio == (current assets inventories)/current liabilities = = ($1,124,000 - $715,200 / $481,600 = .848 The current ratio for 2012 and 2010 are almost the same, which is the sign of the same liquidity position but when look closely at current assets and current liabilities for these two years we see that it there is a big increase in current assets in 2010 due to increased amount of inventories. There is also an increase in current liabilities in 2010, which leads to similar result in current ratios. In 2011 on the other hand, the increase of current liabilities was significantly bigger than the current assets, which lead to a smaller current ratio for 2011. The increase in current liabilities in 2010 was a result of increased amount of paid accounts payable and notes payable, which explains a significant decrease in cash in 2011. In 2010 and 2012, they have a substantial amount of money tied up in inventories. c. Calculate the 2012 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does DLeons utilization of assets sack up against other firms in the industry? Inventory turnover = Sales / Inventory = $7,035,600 / $1,716,480 = 4.10 DSO = Receivables / (Sales / 365) = $878,000 / ($7,035,600) = 45.55 days Fixed assets turnover = Sales / Net fixed assets = $7,035,600 / $817,040 = 8.61 Total assets turnover = Sales / Total assets = $7,035,600 / $3,497,152 = 2.01

The inventory turnover and total assets turnover ratios have been deteriorating, and the same time its day sales outstanding have been growing, which is not a good sign. The 2011 total assets turnover ratio is little lower than 2011. The companys fixed assets turnover ratio is below its 2010 level but it is higher than 2010 level. The firms inventory turnover and total assets turnover are below the industry average. The firms fixed assets turnover is above the industry average. d. Calculate the 2012 debt-to-assets and times interest-earn ratio. How does DLeon compare with the industry with respect to financial leverage? What can you conclude from these ratios? DDebt ratio = Total debt / Total assets = = ($1,144,800 + $400,000) / $3,497,152 = 44.17% TIE = EBIT / Interest = $492,648 / $70,008 = 7.04 The firms debt ratio is much improved from 2010 and 2011, and it is below the industry average (good). The firms TIE ratio is also improved from its 2010 and 2011 level and is above the industry average. e. Calculate the 2012 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? Operating margin = EBIT / Sales = $492,648 / $7,035,600 = 7.00%. Profit margin09 = Net income / Sales = $253,584 / $7,035,600 = 3.60%. Basic earning power = EBIT / Total assets = $492,648 / $3,497,152 = 14.09%. ROA = Net income / Total assets = $253,584 / $3,497,152 = 7.25%. ROE = Net income / Common equity = $253,584 / $1,952,352 = 12.99% = 13.0%. The companys operating margin is above 2010 and 1011 levels but lower than the industry average. The profit margin is above 2010 and 2011 levels and above the industry average. Basic earning power and ROA ratios are above 2010 and 2011 levels but are still below the industry averages. The ROE is improved over the 2011 level but lower than 2010 level and below the industry average.

f. Calculate 2012 price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? EPS = Net income / Shares outstanding = $253,584 / 250,000 = $1.0143. Price/Earnings = Price per share / Earnings per share = $12.17/$1.0143 = 12.0. Check: Price = EPS P / E = $1.0143(12.0) = $12.17. BVP = Common equity / Shares outstanding = $1,952,352 / 250,000 = $7.81. Market/Book = Market price per share / Book value per share = = $12.17 / $7.81 = 1.56 The P/E and M / B ratios are above the 2011 and 2010 levels but below the industry average. g. Use the DuPont equation to provide a summary and overview of DLeons financial condition as projected for 2012. What are the firms major strengths and weaknesses? Profit margin x total assets turnover x equity multiplier = 3. 60% x 2.01 x1(1 0.4417) = 12.96% = 13% Strengths: Fixed assets turnover is above the industry average. The profit margin is above the industry average, which means that the company kept operating costs down and interest rates expense low. Weaknesses: Current asset ratio is low. Most of its asset ratios are low excluding the fixed assets turnover. Most of its profitability ratios are low excluding the profit margin. h. Use the following simplified 2012 balance sheet to show, in general terms, how an improvement in the procedures and thereby lower its DSO from 45,6 days to the 32day industry average without affecting sale, how would that change ripple through the financial statements (show in thousands below) and influence the stock price? Accounts receivable Other current assets Net fixed assets Total assets $876 1,802 817 $3,497 Debt Equity Liability plus equity $1,545 1,952 $3,497

Sales per day = $7,035,600/365 = $19,275.62. Accounts receivable under new policy= $19,275.62 32 days = $616,820. Freed cash = old A/R new A/R = $878,000 $616,820 = $261,180. By reducing accounts receivable and DSO will bring addition to cash. The freed up cash can be used for expanding of the business and reducing debt, which would improve the stock price. i. Does it appear that inventories could be adjusted? If so, how should that adjustment affect DLeons profitability and stock price? The inventory turnover ratio is low, which suggests that it has huge inventory or some of it old. Reducing inventory would help improve the current ratio, the inventory and total assets turnover, reduce the debt ratio, which would improve the companys profitability. j. In 2011, the company paid its suppliers much later than the due dates; also, 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. In the basis of data provided, would you, as a credit manager, continue to sell to DLeon on credit? (You could demand cash on delivery that is, sell on terms of COD but that might cause DLeon to stop buying from your company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or demand it repayment? Would you actions be influenced if in early 2012 DLeon showed you its 2012 projections along with proof that it was going to raise more than $1,2 million of new equity? Although the companys ratios seem to be increasing, the current asset ratio is low. As a credit manager, I would not continue offering credit to DLeon. Terms of COD maybe too severe to he company and push it out of business. If the band demanded the repayment it could also result in bankruptcy of the firm. The creditors would be interesting in the 2012 projections since that would lower the firms debt ratio and lower creditors risks. k. In hindsight, what should DLeon have done in 2010? DLeon should have done far reaching ration analysis in 2010 to decide the effects of its proposed expansion on the companys operations. This analysis should have been done before the company decided to embark on the expansion plan.

l. What are some potential problems and limitations of financial ratio analysis? 1. Many ratios are calculated on the basis of the balance-sheet figures. 2. These figures are as on the balance-sheet date only and may not be indicative of the year-round position. 3. Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. 4. It gives current and past trends, but not future trends. 5. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. 6. There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. 7. Sometimes it is difficult to tell if a ratio is good or bad. 8. Seasonal factors can misrepresent ratios. 9. The ratios are only as good or bad as the underlying information used to calculate them. 10. Average performance is not inevitably good. m. What are some qualitative factors that analysts should consider when evaluating a companys likely future financial performance? There are some qualitative factors that analysts should consider while evaluating a company's future financial performance. The Qualitative Factors to be considered include analyzing: 1. The extent to which the Company's revenues depend upon on key customer or one key product. 2. To what extend the companys revenues are tied to one key product. 3. How much does the company rely on a single supplier. 4. How much of the companys business comes from overseas. 5. Number of competitors in the industry. 6. Should the company invest in R&D. 7. How much changes in regulations will affect the companys business.