Integrated Case Chapter 4

FINANCIAL STATEMENTS AND TAXES Part I of this case, presented in Chapter 3, discussed the situation of D’Leon Inc., a regional snack foods producer, 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 2011 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 2010 and 2011 balance sheets and income statements, together with the projections for 2012 are given in Tables IC 4.1 and IC 4.2. In addition, Table IC 4.3 gives the company’s 2010 and 2011 financial ratios, together, together with industry average data. The 2012 projected financial statement data represent Jamison’s and Campo’s best guess for 2012 results, assuming that some new financing is arranged to get the company “over the hump”

Jason examined monthly data for 2011 (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 looked somewhat worse than final monthly data. Also, it 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 year or not answers.

a. Why are the ratios useful? What are the five major categories of ratios?

b. Calculate D’Leon’s 2012 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity positions in 2010, in 2011, and as projected for 2012? We often thing that ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholder for stock valuation. Would these different types of analysts have an equal interest in the company’s liquidity ratios?

c. Calculate the 2012 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 the industry?

d. Calculate the 2012 debt to assets and times interest earned ratios. How does D’Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios?

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?

f. Calculate the 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?

g. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition and projected for 2012. What are the firm’s major strengths and weaknesses?

h. Use the following simplified 2012 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

Net fixed assets 817 Equity 1,952

Total assets $3,497 Liabilities plus equity $3,497

i. Does it appear that inventories could be adjusted? If so, how should that adjustment affect the D’Leon’s profitability and stock price?

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 loans 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 the 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 2012 D’Leon showed you its 2012 projections along with proof that is was going to raise more than $1.2 million of new equity?

k. In hindsight, what should D’Leon have done in 2010?

l. What are some potential problems and limitations of financial ratio analysis?

m. What are some qualitative factors that analysts should consider when evaluating a company’s likely future financial performance?

Table IC 4.1 Balance Sheets

2012E 2011 2010

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 $436,000 $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 2012 data are forecasts.

Table IC 4.2 Income Statements

2012E 2011E 2010E

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

and amortization $6,425,992 $6,047,988 $3,222,672

EBITDA $609,608 ($13,988) $209,328

Depreciation & Amortization 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 2012 data are forecasts.

The firm has sufficient taxable income in 2009 and 2010 to obtain its full tax refund in 2011

Table IC 4.3 Ratio Analysis

2012E 2011 2010 Industry Average

Current 1.2x 2.3x 2.7x

Quick 0.4x 0.8x 1.0x

Inventory turnover 4.7x 4.8x 6.1x

Days sales outstanding (DSO)a 38.2 37.4 32.0

Fixed assets turnover 6.4x 10.0x 7.0x

Total assets turnover 2.1x 2.3x 2.6x

Debt-to-asset- ratio 82.8% 54.8% 50.0%

TIE -1.0x 4.3x 6.2x

Operating margin -2.2% 5.6% 7.3%

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 -1.4x 9.7x 14.2x

Market/book 0.5x 1.3x 2.4x

Book value per share $4.93 $6.64 n.a.

Note: E indicates estimated. The 2012 data are forecasts.

Calculation is based on a 365-day year.