CHAPTER 4 Analysis of Financial Statements

CHAPTER 4–Analysis of Financial Statements:

MINI CASE ( Corresponds to PPTs & Class) (10-3)

THE FIRST PART OF THE CASE, PRESENTED IN CHAPTER 3, DISCUSSED THE SITUATION THAT COMPUTRON INDUSTRIES WAS IN AFTER AN EXPANSION PROGRAM. THUS FAR, SALES HAVE NOT BEEN UP TO THE FORECASTED LEVEL, COSTS HAVE BEEN HIGHER THAN WERE PROJECTED, AND A LARGE LOSS OCCURRED IN 2001, 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, COMPUTRON’S CHAIRMAN, WHO HAD THE TASK OF GETTING THE COMPANY BACK INTO A SOUND FINANCIAL POSITION. COMPUTRON’S 2000 AND 2001 BALANCE SHEETS AND INCOME STATEMENTS, TOGETHER WITH PROJECTIONS FOR 2002, ARE SHOWN IN THE FOLLOWING TABLES. ALSO, THE TABLES SHOW THE 2000 AND 2001 FINANCIAL RATIOS, ALONG WITH INDUSTRY AVERAGE DATA. THE 2002 PROJECTED FINANCIAL STATEMENT DATA REPRESENT JAMISON’S AND CAMPO’S BEST GUESS FOR 2002 RESULTS, ASSUMING THAT SOME NEW FINANCING IS ARRANGED TO GET THE COMPANY “OVER THE HUMP.”

JAMISON EXAMINED MONTHLY DATA FOR 2001 (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 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 COMPUTRON’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.

BALANCE SHEETS

2002E 2001 2000___

ASSETS

CASH $ 14,000 $ 7,282 $ 9,000

SHORT-TERM INVESTMENTS 71,632 0 48,600

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 600,000 720,000 200,000

ACCRUALS 408,000 489,600 136,000

TOTAL CURRENT LIABILITIES $1,444,800 $1,733,760 $ 481,600

LONG-TERM DEBT 500,000 1,000,000 323,432

COMMON STOCK 1,680,936 460,000 460,000

RETAINED EARNINGS (128,584) (327,168) 203,768

TOTAL EQUITY $1,552,352 $ 132,832 $ 663,768

TOTAL LIABILITIES AND EQUITY $3,497,152 $2,866,592 $1,468,800

NOTE: “E” INDICATES ESTIMATED. THE 2002 DATA ARE FORECASTS.

INCOME STATEMENTS

2002E 2001 2000___

SALES $7,035,600 $5,834,400 $3,432,000

COST OF GOODS SOLD 6,100,000 5,728,000 2,864,000

OTHER EXPENSES 312,960 680,000 340,000

DEPRECIATION 120,000 116,960 18,900

TOTAL OPERATING COSTS $6,532,960 $6,524,960 $3,222,900

EBIT $ 502,640 ($ 690,560) $ 209,100

INTEREST EXPENSE 80,000 176,000 62,500

EBT $ 422,640 ($ 866,560) $ 146,600

TAXES (40%) 169,056 (346,624) 58,640

NET INCOME $ 253,584 ($ 519,936) $ 87,960

EPS $1.014 ($5.199) $0.880

DPS $0.220 $0.110 $0.220

BOOK VALUE PER SHARE $6.209 $1.328 $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 2002 DATA ARE FORECASTS.

RATIO ANALYSIS

INDUSTRY

2002E 2001 2000 AVERAGE

CURRENT 1.1 2.3 2.7

QUICK 0.4 0.8 1.0

INVENTORY TURNOVER 4.5 4.8 6.1

DAYS SALES OUTSTANDING (DSO) 39.0 36.8 32.0

FIXED ASSETS TURNOVER 6.2 10.0 7.0

TOTAL ASSETS TURNOVER 2.0 2.3 2.5

DEBT RATIO 95.4% 54.8% 50.0%

TIE -3.9 3.3 6.2

EBITDA COVERAGE -2.5 2.6 8.0

PROFIT MARGIN -8.9% 2.6% 3.6%

BASIC EARNING POWER -24.1% 14.2% 17.8%

ROA -18.1% 6.0% 9.0%

ROE -391.4% 13.3% 18.0%

PRICE/EARNINGS -0.4 9.7 14.2

PRICE/CASH FLOW -0.6 8.0 7.6

MARKET/BOOK 1.7 1.3 2.9

BOOK VALUE PER SHARE $1.33 $6.64 N.A.

NOTE: “E” INDICATES ESTIMATED. THE 2002 DATA ARE FORECASTS.

A.WHY ARE RATIOS USEFUL? WHAT ARE THE FIVE MAJOR CATEGORIES OF RATIOS?

ANSWER:RATIOS ARE USED BY MANAGERS TO HELP IMPROVE THE FIRM’S PERFORMANCE, BY LENDERS TO HELP EVALUATE THE FIRM’S LIKELIHOOD OF REPAYING DEBTS, AND BY STOCKHOLDERS TO HELP FORECAST FUTURE EARNINGS AND DIVIDENDS. THE FIVE MAJOR CATEGORIES OF RATIOS ARE: LIQUIDITY, ASSET MANAGEMENT, DEBT MANAGEMENT, PROFITABILITY, AND MARKET VALUE.

B.CALCULATE THE 2002 CURRENT AND QUICK RATIOS BASED ON THE PROJECTED BALANCE SHEET AND INCOME STATEMENT DATA. WHAT CAN YOU SAY ABOUT THE COMPANY’S LIQUIDITY POSITION IN 2000, 2001, AND AS PROJECTED FOR 2002? 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 THE LIQUIDITY RATIOS?

ANSWER:CURRENT RATIO02= CURRENT ASSETS/CURRENT LIABILITIES

= $2,680,112/$1,444,800 = 1.86.

QUICK RATIO02= (CURRENT ASSETS – INVENTORY)/CURRENT LIABILITIES

= ($2,680,112 - $1,716,480)/$1,444,800 = 0.667.

THE COMPANY’S CURRENT AND QUICK RATIOS ARE LOW RELATIVE TO ITS 2000 CURRENT AND QUICK RATIOS; HOWEVER, THEY HAVE IMPROVED FROM THEIR 2001 LEVELS. BOTH RATIOS ARE WELL BELOW THE INDUSTRY AVERAGE, HOWEVER.

C.CALCULATE THE 2002 INVENTORY TURNOVER, DAYS SALES OUTSTANDING (DSO), FIXED ASSETS TURNOVER, AND TOTAL ASSETS TURNOVER. HOW DOES COMPUTRON’S UTILIZATION OF ASSETS STACK UP AGAINST OTHER FIRMS IN ITS INDUSTRY?

ANSWER:INVENTORY TURNOVER02=SALES/INVENTORY

=$7,035,600/$1,716,480 = 4.10.

DSO02= RECEIVABLES/(SALES/360)

= $878,000/($7,035,600/360) = 44.9 DAYS.

FIXED ASSETS TURNOVER02 = SALES/NET FIXED ASSETS

= $7,035,600/$817,040 = 8.61.

TOTAL ASSETS TURNOVER99 = SALES/TOTAL ASSETS

= $7,035,600/$3,497,152 = 2.01.

THE FIRM’S INVENTORY TURNOVER RATIO HAS BEEN STEADILY DECLINING, WHILE ITS DAYS SALES OUTSTANDING HAS BEEN STEADILY INCREASING. WHILE THE FIRM’S FIXED ASSETS TURNOVER RATIO IS BELOW ITS 2000 LEVEL, IT IS ABOVE THE 2001 LEVEL. THE FIRM’S TOTAL ASSETS TURNOVER RATIO IS BELOW ITS 2000 LEVEL AND JUST SLIGHTLY BELOW ITS 2001 LEVEL.

THE FIRM’S INVENTORY TURNOVER AND TOTAL ASSETS TURNOVER ARE BELOW THE INDUSTRY AVERAGE. THE FIRM’S DAYS SALES OUTSTANDING IS ABOVE THE INDUSTRY AVERAGE (WHICH IS BAD); HOWEVER, THE FIRM’S FIXED ASSETS TURNOVER IS ABOVE THE INDUSTRY AVERAGE. (THIS MIGHT BE DUE TO THE FACT THAT COMPUTRON IS AN OLDER FIRM THAN MOST OTHER FIRMS IN THE INDUSTRY, IN WHICH CASE, ITS FIXED ASSETS ARE OLDER AND THUS HAVE BEEN DEPRECIATED MORE, OR THAT COMPUTRON’S COST OF FIXED ASSETS WERE LOWER THAN MOST FIRMS IN THE INDUSTRY.) THE FIRM’S OPERATING CAPITAL REQUIREMENT RATIO IS HIGHER THAN THE INDUSTRY AVERAGE, INDICATING THAT COMPUTRON REQUIRES MORE DOLLARS OF CAPITAL TO GENERATE A DOLLAR OF SALES THAN THE AVERAGE FIRM IN THE INDUSTRY.

D.CALCULATE THE 2002 DEBT, TIMES-INTEREST-EARNED, AND EBITDA COVERAGE RATIOS. HOW DOES COMPUTRON COMPARE WITH THE INDUSTRY WITH RESPECT TO FINANCIAL LEVERAGE? WHAT CAN YOU CONCLUDE FROM THESE RATIOS?

ANSWER:DEBT RATIO02 = TOTAL DEBT/TOTAL ASSETS

= ($1,444,800 + $500,000)/$3,497,152 = 55.61%.

TIE02 = EBIT/INTEREST = $502,640/$80,000 = 6.3.

EBITDA COVERAGE01= /

= ($502,640 + $120,000 + $40,000)/($80,000 + $40,000) = 5.5.

THE FIRM’S DEBT RATIO IS MUCH IMPROVED FROM 2001, BUT IT IS STILL ABOVE ITS 2000 LEVEL AND THE INDUSTRY AVERAGE. THE FIRM’S TIE AND EBITDA COVERAGE RATIOS ARE MUCH IMPROVED FROM THEIR 2000 AND 2001 LEVELS, BUT THEY ARE STILL BELOW THE INDUSTRY AVERAGE.

E.CALCULATE THE 2002 PROFIT MARGIN, BASIC EARNING POWER (BEP), RETURN ON ASSETS (ROA), AND RETURN ON EQUITY (ROE). WHAT CAN YOU SAY ABOUT THESE RATIOS?

ANSWER:PROFIT MARGIN02 = NET INCOME/SALES = $253,584/$7,035,600 = 3.6%.

BASIC EARNING POWER02 = EBIT/TOTAL ASSETS = $502,640/$3,497,152 = 14.4%.

ROA02 = NET INCOME/TOTAL ASSETS = $253,584/$3,497,152 = 7.25%.

ROE02 = NET INCOME/COMMON EQUITY = $253,584/$1,552,352 = 16.34%.

THE FIRM’S PROFIT MARGIN IS ABOVE 2000 AND 2001 LEVELS AND IS AT THE INDUSTRY AVERAGE. THE BASIC EARNING POWER, ROA, AND ROE RATIOS ARE ABOVE BOTH 2000 AND 2001 LEVELS, BUT BELOW THE INDUSTRY AVERAGE DUE TO POOR ASSET UTILIZATION.

F.CALCULATE THE 2002 PRICE/EARNINGS RATIO, PRICE/CASH FLOW RATIOS, AND MARKET/BOOK RATIO. DO THESE RATIOS INDICATE THAT INVESTORS ARE EXPECTED TO HAVE A HIGH OR LOW OPINION OF THE COMPANY?

ANSWER:EPS = NET INCOME/SHARES OUTSTANDING = $253,584/250,000 = $1.0143.

PRICE/EARNINGS99 = PRICE PER SHARE/EARNINGS PER SHARE

= $12.17/$1.0143 = 12.0.

CHECK: PRICE = EPS  P/E = $1.0143(12) = $12.17.

CASH FLOW/SHARE02= (NI + DEP)/SHARES = ($253,584 + $120,000)/250,000

= $1.49.

PRICE/CASH FLOW = $12.17/$1.49 = 8.2.

BVPS = COMMON EQUITY/SHARES OUTSTANDING = $1,552,352/250,000 = $6.21.

MARKET/BOOK = MARKET PRICE PER SHARE/BOOK VALUE PER SHARE

= $12.17/$6.21 = 1.96X.

BOTH THE P/E RATIO AND BVPS ARE ABOVE THE 2000 AND 2001 LEVELS BUT BELOW THE INDUSTRY AVERAGE.

F.PERFORM A COMMON SIZE ANALYSIS AND PERCENT CHANGE ANALYSIS. WHAT DO THESE ANALYSES TELL YOU ABOUT COMPUTRON?

ANSWER:FOR THE COMMON SIZE BALANCE SHEETS, DIVIDE ALL ITEMS IN A YEAR BY THE TOTAL ASSETS FOR THAT YEAR. FOR THE COMMON SIZE INCOME STATEMENTS, DIVIDE ALL ITEMS IN A YEAR BY THE SALES IN THAT YEAR.

Common Size Balance Sheets
Assets
2000 / 2001 / 2002E / Ind.
Cash / 0.6% / 0.3% / 0.4% / 0.3%
ST Invest. / 3.3% / 0.0% / 2.0% / 0.3%
AR / 23.9% / 22.1% / 25.1% / 22.4%
Invent. / 48.7% / 44.9% / 49.1% / 41.2%
Total CA / 76.5% / 67.2% / 76.6% / 64.1%
Net FA / 23.5% / 32.8% / 23.4% / 35.9%
TA / 100.0% / 100.0% / 100.0% / 100.0%
Liabilities and Equity
2000 / 2001 / 2002E / Ind.
AP / 9.9% / 18.3% / 12.5% / 11.9%
Notes pay. / 13.6% / 25.1% / 17.2% / 2.4%
Accruals / 9.3% / 17.1% / 11.7% / 9.5%
Total CL / 32.8% / 60.5% / 41.3% / 23.7%
LT Debt / 22.0% / 34.9% / 14.3% / 26.3%
Com. Stock / 31.3% / 16.0% / 48.1% / 20.0%
Ret. Earnings / 13.9% / -11.4% / -3.7% / 30.0%
Total equity / 45.2% / 4.6% / 44.4% / 50.0%
Total L&E / 100.0% / 100.0% / 100.0% / 100.0%
Common Size Income statement
2000 / 2001 / 2002E / Ind.
Sales / 100.0% / 100.0% / 100.0% / 100.0%
COGS / 83.4% / 98.2% / 86.7% / 84.5%
Other exp. / 9.9% / 11.7% / 4.4% / 4.4%
Depr. / 0.6% / 2.0% / 1.7% / 4.0%
EBIT / 6.1% / -11.8% / 7.1% / 7.1%
Int. Exp. / 1.8% / 3.0% / 1.1% / 1.1%
EBT / 4.3% / -14.9% / 6.0% / 5.9%
Taxes / 1.7% / -5.9% / 2.4% / 2.4%
NI / 2.6% / -8.9% / 3.6% / 3.6%

COMPUTRON HAS HIGHER PROPORTION OF CURRENT ASSETS (49.1%) THAN INDUSTRY (41.2%). COMPUTRON HAS SLIGHTLY LESS EQUITY (WHICH MEANS MORE DEBT) THAN INDUSTRY. COMPUTRON HAS MORE SHORT-TERM DEBT THAN INDUSTRY, BUT LESS LONG-TERM DEBT THAN INDUSTRY. COMPUTRON HAS HIGHER COGS (86.7) THAN INDUSTRY (84.5), BUT LOWER DEPRECIATION. RESULT IS THAT COMPUTRON HAS SIMILAR EBIT (7.1) AS INDUSTRY.

FOR THE PERCENT CHANGE ANALYSIS, DIVIDE ALL ITEMS IN A ROW BY THE VALUE IN THE FIRST YEAR OF THE ANALYSIS.

Percent Change Balance Sheets
Assets
2000 / 2001 / 2002E
Cash / 0.0% / -19.1% / 55.6%
ST Invest. / 0.0% / -100.0% / 47.4%
AR / 0.0% / 80.0% / 150.0%
Invent. / 0.0% / 80.0% / 140.0%
Total CA / 0.0% / 71.4% / 138.4%
Net FA / 0.0% / 172.6% / 137.0%
TA / 0.0% / 95.2% / 138.1%
Liabilities and Equity
2000 / 2001 / 2002E
AP / 0.0% / 260.0% / 200.0%
Notes pay. / 0.0% / 260.0% / 200.0%
Accruals / 0.0% / 260.0% / 200.0%
Total CL / 0.0% / 260.0% / 200.0%
LT Debt / 0.0% / 209.2% / 54.6%
Com. Stock / 0.0% / 0.0% / 265.4%
Ret. Earnings / 0.0% / -260.6% / -163.1%
Total equity / 0.0% / -80.0% / 133.9%
Total L&E / 0.0% / 95.2% / 138.1%

Percent Change Income statement
2000 / 2001 / 2002E
Sales / 0.0% / 70.0% / 105.0%
COGS / 0.0% / 100.0% / 113.0%
Other exp. / 0.0% / 100.0% / -8.0%
Depr. / 0.0% / 518.8% / 534.9%
EBIT / 0.0% / -430.3% / 140.4%
Int. Exp. / 0.0% / 181.6% / 28.0%
EBT / 0.0% / -691.1% / 188.3%
Taxes / 0.0% / -691.1% / 188.3%
NI / 0.0% / -691.1% / 188.3%

WE SEE THAT 2002 SALES GROW 105% FROM 2000, AND THAT NI GROWS 188% FROM 2000. SO COMPUTRON HAS BECOME MORE PROFITABLE. WE SEE THAT TOTAL ASSETS GROW AT A RATE OF 138%, WHILE SALES GROW AT A RATE OF ONLY 105%. SO ASSET UTILIZATION REMAINS A PROBLEM.

H.USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW OF COMPUTRON’S FINANCIAL CONDITIONAS PROJECTED FOR 2002. WHAT ARE THE FIRM’S MAJOR STRENGTHS AND WEAKNESSES?

ANSWER:DU PONT EQUATION = 

= 3.6%  2.01  1/(1 - 0.5561) = 16.3%.

STRENGTHS: THE FIRM’S FIXED ASSETS TURNOVER WAS ABOVE THE INDUSTRY AVERAGE. HOWEVER, IF THE FIRM’S ASSETS WERE OLDER THAN OTHER FIRMS IN ITS INDUSTRY THIS COULD POSSIBLY ACCOUNT FOR THE HIGHER RATIO. (COMPUTRON’S FIXED ASSETS WOULD HAVE A LOWER HISTORICAL COST AND WOULD HAVE BEEN DEPRECIATED FOR LONGER PERIODS OF TIME.) THE FIRM’S PROFIT MARGIN IS SLIGHTLY ABOVE THE INDUSTRY AVERAGE, DESPITE ITS HIGHER DEBT RATIO. THIS WOULD INDICATE THAT THE FIRM HAS KEPT COSTS DOWN, BUT, AGAIN, THIS COULD BE RELATED TO LOWER DEPRECIATION COSTS.

WEAKNESSES: THE FIRM’S LIQUIDITY RATIOS ARE LOW; MOST OF ITS ASSET MANAGEMENT RATIOS ARE POOR (EXCEPT FIXED ASSETS TURNOVER); ITS DEBT MANAGEMENT RATIOS ARE POOR, MOST OF ITS PROFITABILITY RATIOS ARE LOW (EXCEPT PROFIT MARGIN); AND ITS MARKET VALUE RATIOS ARE LOW.

I.USE THE FOLLOWING SIMPLIFIED 2002 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 44.9 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 $1,945

OTHER CURRENT ASSETS 1,802

NET FIXED ASSETS 817 EQUITY 1,552

LIABILITIES

TOTAL ASSETS $3,497 PLUS EQUITY $3,497

ANSWER:SALES PER DAY = $7,035,600/360 = $19,543.

ACCOUNTS RECEIVABLE UNDER NEW POLICY= $19,543  32 DAYS

= $625,376.

FREED CASH = OLD A/R - NEW A/R = $878,000 - $625,376 = $252,624.

J.DOES IT APPEAR THAT INVENTORIES COULD BE REDUCED, AND, IF SO, HOW SHOULD THAT ADJUSTMENT AFFECT COMPUTRON’S PROFITABILITY AND STOCK PRICE.

ANSWER:THE INVENTORY TURNOVER RATIO IS LOW. IT APPEARS THAT THE FIRM EITHER HAS EXCESSIVE INVENTORY OR SOME OF THE INVENTORY IS OBSOLETE. IF INVENTORY WERE REDUCED, THIS WOULD IMPROVE THE LIQUIDITY RATIOS, THE INVENTORY AND TOTAL ASSETS TURNOVER, AND THE DEBT RATIO, WHICH SHOULD IMPROVE THE FIRM’S STOCK PRICE AND PROFITABILITY.

K.IN 2001, 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 COMPUTRON ON CREDIT? (YOU COULD DEMAND CASH ON DELIVERY, THAT IS, SELL ON TERMS OF COD, BUT THAT MIGHT CAUSE COMPUTRON 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 2002, COMPUTRON SHOWED YOU ITS 2002 PROJECTIONS PLUS PROOF THAT IT WAS GOING TO RAISE OVER $1.2 MILLION OF NEW EQUITY CAPITAL?

ANSWER:WHILE THE FIRM’S RATIOS BASED ON THE PROJECTED DATA APPEAR TO BE IMPROVING, THE FIRM’S LIQUIDITY RATIOS ARE LOW. AS A CREDIT MANAGER, I WOULD NOT CONTINUE TO EXTEND CREDIT TO THE FIRM UNDER ITS CURRENT ARRANGEMENT, PARTICULARLY IF I DIDN’T HAVE ANY EXCESS CAPACITY. TERMS OF COD MIGHT BE A LITTLE HARSH AND MIGHT PUSH THE FIRM INTO BANKRUPTCY. LIKEWISE, IF THE BANK DEMANDED REPAYMENT THIS COULD ALSO FORCE THE FIRM INTO BANKRUPTCY.

CREDITORS’ ACTIONS WOULD DEFINITELY BE INFLUENCED BY AN INFUSION OF EQUITY CAPITAL IN THE FIRM. THIS WOULD LOWER THE FIRM’S DEBT RATIO AND CREDITORS’ RISK EXPOSURE.

L.IN HINDSIGHT, WHAT SHOULD COMPUTRON HAVE DONE BACK IN 2000?

ANSWER:BEFORE THE COMPANY TOOK ON ITS EXPANSION PLANS, IT SHOULD HAVE DONE AN EXTENSIVE RATIO ANALYSIS TO DETERMINE THE EFFECTS OF ITS PROPOSED EXPANSIONON THE FIRM’S OPERATIONS. HAD THE RATIO ANALYSIS BEEN CONDUCTED, THE COMPANY WOULD HAVE “GOTTEN ITS HOUSE IN ORDER” BEFORE UNDERGOING THE EXPANSION.

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

ANSWER:SOME POTENTIAL PROBLEMS ARE LISTED BELOW:

1.COMPARISON WITH INDUSTRY AVERAGES IS DIFFICULT IF THE FIRM OPERATES MANY DIFFERENT DIVISIONS.

2.DIFFERENT OPERATING AND ACCOUNTING PRACTICES DISTORT COMPARISONS.

3.SOMETIMES HARD TO TELL IF A RATIO IS “GOOD” OR “BAD.”

4.DIFFICULT TO TELL WHETHER COMPANY IS, ON BALANCE, IN A STRONG OR WEAK POSITION.

5.“AVERAGE” PERFORMANCE IS NOT NECESSARILY GOOD.

6.SEASONAL FACTORS CAN DISTORT RATIOS.

7.“WINDOW DRESSING” TECHNIQUES CAN MAKE STATEMENTS AND RATIOS LOOK BETTER.

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

ANSWER:TOP ANALYSTS RECOGNIZE THAT CERTAIN QUALITATIVE FACTORS MUST BE CONSIDERED WHEN EVALUATING A COMPANY. THESE FACTORS, AS SUMMARIZED BY THE AMERICAN ASSOCIATION OF INDIVIDUAL INVESTORS (AAII), ARE AS FOLLOWS:

1.ARE THE COMPANY’S REVENUES TIED TO ONE KEY CUSTOMER?

2.TO WHAT EXTENT ARE THE COMPANY’S REVENUES TIED TO ONE KEY PRODUCT?

3.TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER?

4.WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS GENERATED OVERSEAS?

5.COMPETITION

6.FUTURE PROSPECTS

7.LEGAL AND REGULATORY ENVIRONMENT