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Financial Statement Analysis Example

Using the financial statements on the next three pages of this assignment, and using all the UBT standard ratios, work out the ratios for the financial accounts on all years shown. For each category, indicate what direction you would like the Year 4 number to move in. Up, the same, or down:

  • Assume a 0% VAT rate
  • The term “Creditors” in the Creditor payment period ratio, refers to “Accounts Payable”; the term “Credit Purchases” refers to “COGS.”
  • In the “Cash flow to Debt” ratio, use the “Total Cash Flows from Operating Activities” (Cash Flow Statement)
  • The “Number of Days in Period” is 365
  • Do not make adjustments for Owners’ Remuneration (there is no need to adjust for remuneration as the expense is already deducted and the salaries are at market rate)
  • Assume that the standard contract terms in the industry allow for a 60-day payment period

Income Statement

Year 3
(Current Year)		 Year 2 Year 1 Industry Averages
Sales
Category 1 4,500,000 29.03% 4,200,000 34.43% 4,200,000 34.43%
Category 2 6,500,000 41.94% 2,500,000 20.49% 2,000,000 16.39%
Category 3 4,500,000 29.03% 5,500,000 45.08% 6,000,000 49.18%
Total Sales 15,500,000 100.00% 12,200,000 100.00% 12,200,000 100.00% 100.00%
Cost of Goods Sold
Category 1 4,275,000 27.58% 4,060,000 33.28% 4,200,000 34.43%
Category 2 3,770,000 24.32% 1,450,000 11.89% 1,160,000 9.51%
Category 3 1,575,000 10.16% 2,170,000 17.79% 2,480,000 20.33%
Total Cost of Goods Sold 9,620,,000 62.06% 7,680,000 62.95% 7,840,000 64.26% 55.33%
Gross Profit 5,880,000 37.94% 4,520,000 37.05% 4,360,000 35.74% 44.67%
Expenses
Owners/Officers Compensation 300,000 1.94% 300.000 2.46% 300,000 2.46% 2.50%
Salary/Wages (incl. benefits) 2,200,000 14.19% 1,952,000 16.00% 1,800,000 14.75% 13.30%
Rent 380,000 2.45% 376,980 3.09% 366,000 3.00% 2.20%
Amortization & Depreciation 400,000 2.58% 400,000 3.28% 302,000 2.48% 3.70%
Advertising 300,000 1.94% 240,000 1.97% 200,000 1.64% 1.90%
Other SG&A Exp. 1,200,000 7.74% 800,000 6.56% 800,000 6.56% 7.00%
Total Expenses 4,780,000 30.84% 4,068,980 33.35% 3,768,000 30,89% 30.60%
Operating Profit 1,100,000 7.10% 451,020 3.70% 592,000 4.85% 14.07%
Interest Expense
Other Income (Such as :Interest)		 100,000 0.65% 100,000 0.82% 85,500 0.70% 2.80%
Net Profit Before Tax 1,000,000 6.45% 351,020 2.88% 506,500 4.15% 11.27%
Tax Provision 200,000 1.29% 70,204 0.58% 175,360 1.44% 2.00%
Net Profit 800,000 5.16% 280,816 2.30% 331,140 2.71% 8.20%
Owners Draws/Dividends 100,000 75,000 0
Retained Earnings 700,000 205,816 331,140

The Widget Company Balance Sheet

Assets Year 3 Year 2 year 1 Averages
Current Assets
Cash 528.956 5.61% 178,956 1.97% 707,140 8.64% 8.45%
Accounts Receivable 2,500,000 26.51% 2,400,000 26.43% 1,800,000 22.00% 15.47%
Inventory 1,600,000 16.97% 1,300,000 14.32% 1,200,000 14.67% 15.54%
Other Current Assets 0.00% 0.00% 0.00% 5.63%
Total Current Assets 4,628,956 49.09% 3,878,956 42.72% 3,707,140 45.31% 45.09%
Long-term Assets
Property, Plant & Equipment 5,902,000 5,902,000 4,776,000
Less: Accumulated depreciation 1,102,000 702,000 302,000
Net Fixed Assets 4,800,000 50.91% 5,200,000 57.28% 4,474,000 54.69% 54.91%
Total Long-term Assets 4,800,000 50.91% 5,200,000 4,474,000 54.69% 54.91%
Total Assets 9,428,956 100.00% 9,078,956 100.00% 8,181,140 100.00% 100.00%
Liabilities
Current Liabilities
Accounts Payable 2,200,000 23.33% 2,000,000 22.03% 2,200,000 26.89% 8.82%
Loans/Notes Payable 800,000 8.84% 0.00% 0.00%
Other Current Liabilities 800,000 0.00% 0.00% 0.00%
Total Current Liabilities 3,000,000 31.82% 2,000,000 22.03% 0.00%
Long-term Liabilities
Loans Payable 3,500,000 37.12% 3,850,000 42.41% 2,850,000 34.84%
Other Long Term Liabilities 0.00% 0.00% 0.00%
Total Long Term Liabilities 3,500,000 37.12% 3,850,000 42.41% 2,850,000 34.84% 40.23%
Total Liabilities 6,500,000 68.94% 5,850,000 64.43% 5,050,,000 61.73% 64.10%
Stockholder's Equity
Paid in Capital 1,692,000 17.94% 2,692,000 29.65% 2,800,000 34.23% 0.00%
Retained Earnings 1,236,956 13.12% 536,956 5.91% 331,140 4.05% 0.00%
Total Stockholder's Equity 2,928,956 31.06% 3,228,956 35.57% 3,131,140 38.27% 35.90%
Total Liabilities & Equity 9,428,956 100.00% 9,078,956 100.00% 8,181,140 100.00% 100.00%

The Widget Company

Cash Flow Statement Year 3 Year 2 Year 1
Cash Flows From Operating Activities
Net Profit 800,000 280,816 331,140
Accounts Receivable Increase(-) (100,000) (600,000) (1,800,000)
Inventory Increase(-) (300,000) (100,000) (1,200,000)
Other Current Assets Increase(-) 0 0 0
Depreciation Expense 400,000 400,000 302,000
Accounts Payable Increase 200,000 (200,000) 2,200,000
Total Cash Flows From Operating Activities 1,000,000 (219,184) (166,860)
Cash Flows From Inventory Activities
Purchases of property, plant and equipment(-) 0 (1,126,00) (4,776,000)
Total Cash Flows From Investing Activities 0 (1,126,00) (4,776,000)
Cash Flows From Financial Activities
Increase/Decrease in Short-term borrowings 800,000 0 0
Increase/Decrease in Long-term borrowings (350,000) 1,000,000 2,850,000
Increase/Decrease in Equity Accounts (1,000,000) 183,000 2,800,000
Total Cash Flows From Financial Activities (650,000) 817,000 5,650,000
Net Change in Cash During Year 350,000 (528,184) 707,140
Beginning Cash Balance 178,956 707,140 0
Ending Cash Balance (Beginning Cash Bal. + Net Change) 528,956 178,956 707,140
Financial Ratios Industry Averages
Year 1 Year 2 Year 3 Year 4
Profitability
Gross Margin 35.74% 37.05% 37.94% increase 43.5%
Net Operating Margin 4.85% 3.69% 7.09% increase 14.1%
Net Operating Margin 4.85% 3.69% 7.09% increase 14.1%
Return on Assets (ROA) 4.05% 3.09% 8.48% increase 8.9%
Return on Equity (ROE) 10.57% 8.69% 27.31% increase 24.7%
Efficiency
Productivity Factor (factor 4) 1.05 1.04 1.07 increase 2.8
Stock Turnover 6.53 6.144 6.63 decrease 5.3
Stock on Hand Period (days) 56 50 55 same 69
Debtor Collection Period (days) 54 63 58 decrease 40
Creditor Payment Period (days) 102 99 80 decrease 55
Working Capital Cycle (days) 45 56 38 same 54
Liquidity
Working Capital 18.42% 20.69% 17.27% same 14.8%
Over or Under Trading 2.04 1.72 2.41 increase 7
Current Ratio 1.68 1.94 1.54 increase 1.9
Quick Ratio 1.14 1.29 1.01 increase 1.2
Stability
Liabilities to Equity (Leverage) 1.61 1.81 2.22 decrease 1.79
Equity 38.27% 35.56% 31.06% same 36%
Interest Cover 6.92 4.51 11 same 11.0
Cash flow to Debt (3.304%) (3.74%) increase increase 19%

Name 4 ratios in the analysis that you find the most troubling.

  1. Net Operating Margin
  2. Over or under trading
  3. Cash flow to debt ratio
  4. Debtor collection period

Why did you choose these four ratios? Give at least two reasons for each ratio.

Net Operating Margin:

  • It is very low (almost half) as compared to the industry standard. This means low operational efficiency of the company
  • Since other companies in the industry earn almost double than this company, it would lead to poor investor reliance and thus poor investments in the company.

Over or under trading:

  • The firm is under trading. This is a troubling point as the company is not able to efficiently manage its resources towards efficient trading.
  • The firm is performing much below the industry average. This gives the competitors an edge over this company.

Cash flow to debt ratio

  • The cash flow history of the company is very disturbing as it has not been able to generate cash from operations consistently.
  • Since the cash flow to debt ratio is low, the company will not be able to easily arrange for further debt as it does not have an ability to pay back its debts.

Debtor collection period:

  • It has been consistently high as compared to industry standards, thus, the firms funds are tied up for long time duration with the credit customers.
  • Since funds are not readily available, the firm may face difficulty in meeting its day to day cash requirements.

For each ratio, give two possible reasons why the numbers look the way they do, good or bad. Give two actions you would want to take to improve the ratios.

Gross Margin Reasons:
  • The cost of sales(as a percentage of sales) is high. This reduces profits.
  • Category 1 and 2 have higher costs as compared to Category 3.
Actions
  • Improve production efficiency of category 2 and 3.
  • Improve overall production efficiency so as to at least meet the industry standards.
Net Operating Margin Reasons:
  • High operating expenses is the major cause of poor operating margin.
  • There may be operational inefficiencies such as overstaffing, poor cost control mechanism, lower productivity, etc.
Actions
  • Improve operational efficiency by minimizing wastages and maximising productivity.
  • Ensuring adequate cost control during production process.
Return on Assets Reasons:
  • The ratio is close to industry standard. This means that this company’s return on assets is almost similar to that of other companies in the industry.
  • This shows that the company is efficiently able to convert its investment in assets to profit.
Actions
  • The company can work on its efficiency to bring the ROA to the industry standard.
  • The company should aim at ROA higher than industry standards as this is a means for comparing different companies within the industry.
Return on Equity Reasons:
  • The company’s ROE is not stable over the 3 years. This may be due to inconsistent utilisation of shareholders’ funds by the company.
  • In the 3rd year, the company has performed better than the industry standard. This is due to efficient utilisation and management of shareholders’ funds.
Actions
  • Adopt a suitable strategy for ensuring a consistent management of the shareholders equity in order to eliminate such fluctuations in return.
  • The company should maintain progressive trend of profits so that investor confidence can be ensured. Also, the company can work on improving the return on shareholders’ investment.
Productivity Factor Reasons:
  • The productivity factor is low as the resources are inefficiently used.
  • The inputs are not able to generate outputs as per the industry standards.
Actions
  • The company should improve their operational efficiency and ensure better utilisation of inputs.
  • The company should try to minimise wastages and eliminate any inefficiency in operations as it is very important to improve this ratio.
Stock Turnover Reasons:
  • The consistent stock turnover shows that the firm has a stable and efficient stock management strategy.
  • Since the company is also under trading, high stock turnover may be due to inefficient buying and administering of inventory.
Actions
  • The company should ensure that it efficiently administers its inventory management.
  • It should try to improve sales efficient along with inventory management. Only the high inventory turnover will show positive signs for the company.
Stock on Hand Period Reasons:
  • This is lower than the industry average which shows that the company holds inventory for less number of days.
  • This period will show the sales and Inventory management efficiency of the company.
Actions
  • The company should try to maintain the current inventory period as it is a positive sign of efficiency.
  • The company also need to ensure that the short inventory period is also supplemented by efficient sales.
Debtor Collections Period Reasons:
  • It depicts the number of days in which the company receives payment from its customers. This is high showing that funds are locked up with customers for long time.
  • Due to poor sales efficiency, the firm may be forced to offer better credit term to attract customers.
Actions
  • The company should try to reduce this period on a priority basis as this adversely affects cash flows in the company.
  • The firm should offer credit terms as per the industry trend so that the firm does not dace paucity of liquid cash.
Creditor Payment Period Reasons:
  • The firm may be able to obtain good credit terms from its suppliers due to good market reputation.
  • On the other hand, high payment period could also be due to inability of the company to pay back in time.
Actions
  • The company should ensure sufficient cash flows so that it can pay back within the stipulated time.
  • The company should adhere to the industry norms of payment so that it can easily obtain credit in the future as well.
Working Capital Cycle Reasons:
  • Low working capital cycle may be due to efficient conversion of current assets and current liabilities into cash
  • This is a positive sign as it is lower than the industry standard.
Actions
  • The firm should maintain the current cycle as it is beneficial for the company.
  • The firm should continue with its current working cycle.
Working Capital Percent Reasons:
  • The recent fall in the ratio may be due to high current liabilities of the company.
  • The rise in the ratio during the 1st and 2nd year could be due to improved profitability during that period.
Actions
  • The firm should maintain the ratio at the current level.
  • The ratio being higher than the industry standard shows better relative working capital management by the company.
Over or Under Trading Reasons:
  • It may be due to large amount of current assets.
  • Under trading may also be due to large amount of idle and poorly managed funds.
Actions
  • The business should use surplus cash in other profitable ventures, such as through diversification.
  • The firm needs to efficiently manage current assets. This need to be done on a priority basis as under trading can be very harmful for the company and its goodwill.
Current Ratio Reasons:
  • Low current ratio may be due to high amount of current liabilities.
  • The ratio has decreased from the 2nd to the 3rd year. This may be due to inefficient assets management by the firm.
Actions
  • The company should try to achieve a better balance between the current assets and current liabilities so as to meet the industry standard for liquidity position.
  • The steep rise in current liabilities should be controlled. This can be done by reducing the creditor payment period as well.
Quick Ratio Reasons:
  • The worsening of the ratio during the 2nd to 3rd year may be due to the rise in current liabilities.
  • The ratio shows negative signs for this company as it has a poor liquidity as compared to the general level of liquidity maintained by the competitors.
Actions
  • The company should make payments on time to reduce current liabilities.
  • The cash flow should be improved as it is the most liquid asset that the company can possess.
Liabilities to Equity Reasons:
  • The ratio is very high in the 3rd year due to a fall in stakeholders’ equity along with a rise in the debt.
  • The proportion of debt to the equity is high showing that the firm has high borrowings which can lead to a fall in its further debt raising capacity.
Actions
  • Pay off some part of the debt so that the ratio at least confirms to the industry standard.
  • Ensure that the liabilities to equity ratio is not too high as it adversely affects the debt raising and loan servicing capacity of the company.
Equity Reasons:
  • Fall in equity ratio over the years may be due to increased reliance on debt and fall in the equity component.
  • The equity ratio lower than the industry standard means that the competitors of this company have a greater reliance in equity than this company.
Actions
  • The firm should increase the proportion of equity by raising more funds.
  • The company can also reduce its debt component in order to improve the ratio.
Interest Cover Reasons:
  • The company is making sufficient profits in order to cover its interest obligations.
  • The company has a comfortable position with respect to interest payments.
Actions
  • The company should maintain the current ratio as it also meets industry standards.
  • If the company borrows more, it should ensure that the profits also rise reasonably so that the interest coverage ratio can be maintained at a similar level.
Cash Flow to Debt Reasons:
  • The ratio has been negative in the first 2 years as the company has not been able to generate cash from operations.
  • The low ratio shows the difficulty of the firm to payback its obligations.
Actions
  • The company should improve its cash flow from operating activities so that it is able to generate enough cash for meeting day to day fund requirements.
  • The company should try to be more consistent with respect to managing cash from operating activities.

Cash Flow Impact

For each of the following scenarios, decide what the most likely effect on the cash flow on the Cash Flow Statement will be. Does the total cash flow on the Cash Flow Statement go up, down, stay the same, or is it unknown with the information given?

Cash Direction
1. Depreciation is recorded on the Income Statement as an expense down
2. Machinery is purchased for $500,000 with a $500,000 loan up
3. Accounts payable balance goes down down
4. An owner sells his shares at book value to a new owner for cash same
5. The LOC is drawn on for $10,000 same
6. A loan is repaid down
7. Accounts receivables balance goes down up
8. A sale is made up
9. A piece of equipment is sold for cash up
10. Inventory balance decreases up