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

Ratios is useful in such a way it helps managers/internal users in improving and assessing the firm s performance, lenders in evaluating the firm s likelihood of repaying debts, and shareholders in forecasting future earnings and dividends that can the firms be able to provide. It standardizes numbers, facilitates comparisons and used to highlight weaknesses and strengths.

Five Major Categories of Ratio a. Liquidity b. Asset Management c. Debt Management d. Profitability e. Market Value

Meaning
show the relationship of a firm s current assets to its current liabilities, and thus its ability to meet maturing debts. measure how effectively a firm is managing its assets. reveal (1) the extent to which the firm is financed with debt and (2) its likelihood of defaulting on its debt obligations. show the combined effects of liquidity, asset management, and debt management policies on operating results. relate the firm s stock price to its earnings, cash flow, and book value per share, thus giving management an indication investors think of the company s past performance and future prospects. of what

b. Calculate D Leon s 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?

2002 Current Ratio: Total Current assets Divided by Total current liabilities $2,680,112 $1,144,800 2.3

2001 $1,926,802 $1,650,568 1.2

2000 $1,124,000 $481,600 2.3

Industry

2.7

Acid Test (Quick) Ratio: Total Quick ssets Divided by Total Current Liabilities

As we can see at the current ratio and quick ratio, the company is expecting to improve but still below the industry average. It s only indicates that the company s controls over their current asset is not sufficient as in the industry, hence liquidity position is weak. These ratios are not good for the sake of the creditors; the current ratio showed that the company can pays their P1 liabilities by P2.3 of their current assets, the acid test ratio showed that the company can pays P1 for every liabilities they have from their quick asset, the cash flow liquidity ratio showed that the company can pays P0.84 from their Cash Resources for every P1 liability, but it s better than 2001 which has a sudden decrease on this two ratios. These numbers indicating that it may attract more investors to invest for their company, the reason is because the company has the ability to recover and eventually controls its current asset well and pay its current liabilities even if it become due. c. Calculate the 2002 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 its industry?

$963,632 $1,144,800 0.84

$639,442 $1,650,568 0.4

$408,800 $481,600 0.8

1.0

2002 ail Sales Outstanding: Receivables ivided by aily ales (Annual ales 365 days)

2001 $ 632,160 16,532 38.24 2001 $ 6,034,000 939,790 6.42 2001 $ 6,034,000 2,866,592 2.10 $

2000 351,200 9,403 37.35 2000 $ 3,432,000 344,800 9.95 2000 $ 3,432,000 1,468,800 2.34

Industr

878,000 19,276 45.55 2002

32.0
Industr

Fixed Assets Turnover ales ivided by Net Fixed Assets

$ 7,035,600 817,040 8.61 2002

7.00
Industr

Total Assets turnover ales ivided by Total Assets

$ 7,035,600 3,497,152 2.01

2.6

The inventory turnover of the company is decreasing which shows that there is no improvement currently forecasted, it might due to having of old inventory in large amount, or its control might be poor. The Daily Sales of Outstanding of the company is increasing which is not good because it s only means that the company collects too slowly, and situation is getting worse and its probability because of poor credit policy.

The fixed asset turnover of the company is higher than to its 2001 because of the increase in sales and decrease in net fixed asset as the depreciation is concerned. It only indicates that the management has generated sales from investments in fixed assets effectively.

Inventor Turnover ales ivided by Inventory

$ 7,0 5,600 1,716,480 4.10

$ 6,0 ,000 1,287,360 4.69

,432,000 715,200 4.80

6.1

2002

2001

2000

Industr

The firm s 2002 Total assets turnover ratio is lower than to its 2001 for about 0.09 and these is because total assets increase faster than to its sales particularly increase in accounts receivables and inventory (excessive current assets). As contrast to the company s industry, the inventory turnover and total asset turnover are below industry average while the fixed asset turnover and Daily sales outstanding is above the industry. In regards to the increase of DSO against to the industry, this shows unfavorable situation.

d. Calculate the 2002 debt, times-interest-earned, and EBITDA coverage ratios. How does D Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios?

Divi

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st x

ns + L s P

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@ @E @ @D@ C BA 9@9  8 &    734 1

EBIT verage ati EB T D i tion L s P nts Tot l

 24

2002

2001 ( 30,948) 116,960 40000 26,012 176,012 0.15

nts

492,648 116,960 40000 649,608 110,008 5.91

)$ $

 

Ti s Interest E rned EB T Divi t st Ex

ti

492, 48 70,008 7.04

0,948) ,0 2 -0.96

90,428 43,828 4.34 2000 90,428 18,900 40000 249,328 83,828 2.97

6.20 Industry

8.00

2002

2001

2000

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i Tot l Li iliti s Divi Tot l ss ts

,5 , 00 , 7, 5 . %

, 7 ,000 , ,5 . %

05,0 , , 00 5 . %

50.0% Indus y

2002

2001

2000

Indus y

'

3 21 & %% 1 0

& %%      6 5

The firm s debt ratio improved from 82.8% reduced to 44.2% in 2001 and 2002 respectively and below the industry average and this indicates a positive and favorable situation that the management had stop to rely heavy on borrowed capital and increased the potential benefits to the firm s owners. D Leon s time interest earned ratio is also improved as the debt of the company is also reduced and brings its ratio above the industry average which is good because it implies that the company can cover its annual interest expense from operating earnings is .04 times . The EBITDA coverage ratio of D Leon increased from 0.1 to .91; this is good because although it is still below the industry average, the company had improved it for almost 3840%.

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?

rofit argin Net Income ivided by ales

asic arning ower E IT ivided by Total assets

eturn on Assets ( OA) Net Income ivided by Total Assets

eturn on uit ( O ) Net Income ivided by ommon Equity

Profit margin increased from negative 2.6 % (very bad) to positive 3.60 which is also above the industry average , it is a favorable where it indicates that the company have the ability and give effort in controlling its operating expenses with sharply increasing it sales. Basic earnings power, return on assets and equity ratio are still below the industry average although they are seemly had increased and above 2001 and 2000. Basic earnings power is projected to be below average which needs room for improvement. The inancial leverage of the company in 2002 is greater than 1 indicating the ROE exceeds ROA; the firm is using debt effectively.

253,584 1,952,352 12.99

(160,176) 492,592 -32.52

87,960 663,768 13.25

18.20

2002

2001

2000

Industr

253,584 3,497,152 7.25

(160,176) 2,866,592 -5.59

87,960 1,468,800 5.99

9.10

2002

2001

2000

Industr

492,648 3,497,152 14.09

(130,948) 2,866,592 -4.57

190,428 1,468,800 12.96

19.10

2002

2001

2000

Industr

253,584 7,035,600 3.60

(160,176) 6,034,000 2.65

87,960 3,432,000 2.56

3.50

2002

2001

2000

Industr

` b R c`

U a Y

U U U

ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase.

f. Calculate the 2002 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

The Price/Earnings ratio of the company which measures how much investors will pay for 1 of earnings, is relatively high thus it s good and increased from negative to positive 12.00, but still below the industry average. This could be because the market is reacting favorably to the firm s good year. Market/Book Value Ratio which measures how much paid for 1 of book value, is relatively high thus it s good

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2001

2000

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g. Use the extended Du Pont equation to provide a summary and overview of D Leon s financial condition as projected for 2002. What are the firm s major strengths and weaknesses?

ROE ! Profit Margin v Total Asset Turnover v Equity Multiplier Net Income Sales Total Assets ! v v Sales Total Assets Common Equity

Strengths
average, 8.61)

Weaknesses
Current atio Asset Management atio EBITDA Coverage atio Pro itability atio Market Value atio

industry average, 7.04)

h. 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. or example, if the company could improve its collection procedures and thereby lower its DSO from 4 .6 days to the 32-day industry average without affecting sales, how would that change

Debt ratio (reduced from 82.8% to 44.2%) Times Interest earned ratio ( above

average, 3.60%)

Pro it Margin atio (slightly above industry

Fixed Asset Turnover ( above industry

Divided by sales

Divided by otal ssets

Divided by ommon quity

} } } 

}  } 

}  ~} }

et income

2 3, 4 ,03 ,600 0.04 x

Sales

,03 ,600 3,4 , 2 2.01 x

otal ssets

3,4 , 2 , 2,3 2 1.79 = 13.0%

ripple through the financial statements (shown in thousands below) and influence the stock price?

ales ivided by days aily ales ultiply by esirable (days) Accounts Receiva le under new policy Old R c iv bl L : n R c iv bl Cash Collections to be realized

i.

Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect D Leon s profitability and stock price? The company has a low inventory turnover; it is lower than the industry average of 6.0. It only means that the company won t able to manage its inventory efficiently wherein it carries too much inventory or it has obsolete, slow moving or inferior inventory stock. If inventory is adjusted and reduced, this will lead to an improvement in the current asset, the inventory and total asset ratio and reduce the debt ratio even further, which should improve the firm s stock price and profitability.

j.

In 2001, the company paid its suppliers much later than the due dates, and it was not maintaining financial ratio sat levels called for in its bank loan agreements. Therefore,

Total assets

3,49

7,035,600 365 19,275.62 32 616,819.73 878,000 616,819.73 261,180.27

et fixed assets

81

Liabilities plus equity

Other current assets

1,802

Equity

1,9 2 3,49

Accounts receivable

8 8

Debt

1, 4

suppliers could cut the company off, and its bank could refuse to renew the loan when it comes due in 90days. On the basis of 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 2002, D Leon showed you its 2002 projections plus proof that it was going to raise over 1.2 million of new equity capital? As a credit manager, I would not continue to sell on credit and extending credit to the customers because it cause shortage on cash and may the all assets will be vested only in receivables and the risks of uncollectible accounts will be also increase and the near fact that the company has any excess capacity to let it. But at the same time, pushing the term COD may not be also advisable because it also too risky on the part of the customer who doesn t have immediate money to pay and would stop buying from the company. So, it s manner of efficient and effective possible credit policy that would the collection of the firm will be improve that would not too restrictive and liberal on the part of the customer. Yes, because a projection of over 1.2 million of new equity capital would lower the firm s debt ratio which result a decrease also in creditor s risk exposure and gives a good capital relationship between the two.

k. In hindsight, what should D Leon have done back in 2000? It should done an Extensive ratio analysis to analyze, assess, and determine the effects of its proposed expansion on the firm as a whole especially on its operation.

l.

What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions.

Average performance is not necessarily good. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is good or bad. Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition. Influence of external factors i. General business conditions ii. Seasonal nature of business operations Impact of inflation

m. What are some qualitative factors analysts should consider when evaluating a company s likely future financial performance? Are the company s revenues tied to a single customer? To what extent are the company s revenues tied to a single product? To what extent does the company rely on a single supplier? What percentage of the company s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company s legal and regulatory environment?