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Bigger is not always better

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Financial Management

Case study-1
Bigger Isn’t Always Better!

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Overview
Andre Pires, with over 15 years experience in the automobile industry opened a automobile parts store, in mid-western region of United States. Business had picked up significantly well over the years and Andre had more than doubled the store size by the third year of operations. Andre’s knowledge of finance and accounting was limited and he decided to recruit Juan Plexo, a second semester MBA student ,who had an undergraduate degree in Accountancy and was interested in concentrating in finance.

Facts

Andre had learned the nuances of the fiercely competitive auto mobile servicing business. Andre had more than doubled the store size by the third year of operations. Most of his available funds were used up in expanding the business. For the past two years, the store’s net income figures had been negative and his cash flow situation had gotten pretty weak. Issues

The net income figures for the past two years was negative.


Andre needed to raise funds for future growth and was in need of a loan. The return on assets and return on equity had become negative in the last two years. The Earnings per share(EPS) also is negative in the last two years.

Q1. How does Quick fix’s average compound growth rate in sales compare with its earnings growth rate over the past five years? Ans. CAGR in sales= (Ending value/Beginning value) ^ (1/#of years)-1 = (1,013,376/600,000^1/5)-1

=.1105
Average compound growth rate in sale=CAGR/No of years=.1105/5=2.21% Average earnings growth rate=Net income/Sales
Particulars 2000 2001 2002 2003 2004 Net income
16634 22859 2126 -16435 -102 Net sales 600,000 655,000 780,000 873,600 1,013,376 Earnings growth rate 2.77 3.49 .27 -1.88 -0.01 Average earnings growth=Sum of earnings growth rate/5

=4.64/5
=0.9%

Q2. Which statements should Juan refer to and which ones should he construct so as to develop a fair assessment of the firm’s financial condition? Explain why? Ans. To develop a fair assessment of the firm’s financial condition, Juan should refer to the Balance Sheet and Income statement of Quickfix Autoparts. The Balance Sheet shows a snapshot of a company’s assets, liabilities and shareholder’s equity at the end of the reporting period. Assets are further classified as current assets and fixed assets. It also showcases the financial strength of the company at any point of time. Liabilities are amounts of money that a company owes to others. Shareholder’s equity(also known as capital or net worth).It’s the money that would be left if a company sold of all of its assets and paid of all of its liabilities. The leftover money belongs to the shareholders or the owners of the company. An income statement shows how much revenue a company earned over a specific period of time. It shows the costs and expenses associated with earning that revenue. The Earnings per share (EPS) in the Income Statement shows how much money shareholders would receive if the company decided to distribute all of the net earnings of the period. Juan should construct a statement of cash flows to know whether the company generated cash. The statements of cash flows are classified as operating activities, investing activities and financing activities. The cash flow from operating activities reconciles the net income to the actual cash the company received or used in its operating activities. The cash flow resulting from investing activities reports the aggregate change in a company’s cash position resulting from any gains or losses from investments in the financial markets and operating subsidiaries, and changes resulting from amounts spent on investments. Cash flows from financing activities include any activities
that involve the company’s owners or creditors.

Q3. What calculations should Juan do in order to get a good grasp of what is going on with Quick fix’s performance? Ans. Juan should calculate the following ratios to get a good picture of Quick fix’s performance: 1. Liquidity Ratios

Current ratio
Cash ratio
Quick ratio

2. Long term Solvency Ratios
Interest coverage ratio
Total Debt ratio
Debt Equity ratio
Equity Multiplier
Cash Coverage Ratio

3. Profitability ratios
Return on Equity
Return on Asset
Profit Margin

4. Activity Ratios
Asset Turnover Ratio
Inventory Turnover Ratio
Receivables Turnover
Fixed Asset Turnover
Total Asset Turnover
Q4. Juan knows that he should compare Quickfix’s condition with an appropriate benchmark. How should he go about obtaining the necessary comparison data? Ans. Juan should do the following:
Juan could also use Time Trend Analysis which compares the past years data to find out the changes i.e. the trends that the company is following. The peer group analysis is to identify firms similar in the sense that they compete
in the same markets, have similar assets and operate in similar ways. Juan could use the Standard Industrial Classification (SIC) codes. These are the four-digit codes established by the U.S government for statistical reporting. There are certain smaller peer companies in the same industry that have filled their return with security exchange commission. Juan could download their financial statements; read footnotes and Management Decision Analysis of those companies which would help him in decide where his company stands.

Q5. Besides comparison with the benchmark what other types of analyses could Juan perform to comprehensively analyze the firm’s condition? Perform the suggested analyses and comment on your findings. Ans. The company can analyze the ratios of the organization. Using ratios, the relative profitability, growth or debt levels, can be measured with ease. A business ratio report, takes the hard work out of financial performance analysis. Different ratios signify different things. For example, a Current ratio of 1 is considered good. The type of industry in which the operation is conducted also matters. It is necessary that one is aware of these standard ratios so as to see the position of your performance. Juan can prepare Common size income statement and balance sheet in order to understand the financial position of the company. This would assist Juan in better understanding of the company.

Common size income statement

2000
2001
2002
2003
2004
Net sales
100.0
100.0
100.0
100.0
100.0
Cost of goods sold
80.0
82.0
84.0
85.0
85.0
Gross profit
20.0
18.0
16.0
15.0
15.0
admin & selling expenses
5.0
2.3
2.2
5.0
4.0
depreciation
4.2
3.8
6.4
5.7
4.9
Misc. expenses
0.3
0.5
0.7
2.0
1.5
Total Operating expenses
9.5
6.7
9.3
12.7
10.4
EBIT
10.5
11.3
6.7
2.3
4.6
Interest on ST loans
2.5
2.4
1.8
1.5
1.3
Interest on Long term loans
1.3
1.2
2.0
1.7
1.4
Interest on mortgage
2.0
1.8
2.4
2.1
1.8
Total Interest
5.9
5.5
6.2
5.4
4.6
Before tax earnings
4.6
5.8
0.5
-3.1
-0.0
taxes
1.8
2.3
0.2
-1.3
-0.0
Net Income
2.8
3.5
0.3
-1.9
-0.0

COMMONSIZE BALANCE SHEET

ASSETS
2000
2001
2002
2003
2004
Cash and marketable securities
24.22
39.07
7.63
2.95
1.9
Accounts receivable
1.56
1.52
2.01
7.95
9.3
Inventory
39.06
34.13
50.2
53.25
57.82
Current asset
64.84
74.72
59.84
64.16
69.02
Land, building, plant and equipment
39.06
31.6
50.2
51.2
51.63
Accumulated depreciation
3.91
6.32
10.04
15.36
20.65
TOTAL ASSETS
100
100
100
100
100
Liabilities

Short term loans
7.81
18.33
14.06
15.16
15.28
Account payable
1.56
1.33
2.01
1.64
1.73
Accruals
0.78
0.64
0.74
0.95
1.2
Current liability
10.16
20.3
16.8
17.75
18.22
Long term bank loans
9.9
12.39
19.68
19.46
18.9
Mortgage
27.34
21.87
27.21
27.45
27.26
Long term debt
37.24
34.26
46.89
46.9
46.15
Total liability
47.4
54.56
63.69
64.65
64.37
Liability and equities

Common stock(100,000 Shares)
50
40.45
32.13
32.77
33.04
Retained earnings
2.6
4.99
4.18
2.58
2.59
Total equity
52.6
45.44
36.31
35.35
35.63
TOTAL LIABLITIES & EQUITY
100
100
100
100
100

Q6. Comment on Quickfix’s liquidity, asset utilization, long-term solvency, and profitability ratios. What arguments have to be made to convince the bank that they should grant Quickfix the loan? Ans. Liquidity ratios

2000
2001
2002
2003
2004
Current ratio
6.4
3.7
3.6
3.6
3.8
Quick ratio
2.5
2.0
0.6
0.6
0.6
Cash ratio
2.4
1.9
0.5
0.2
0.1

The current ratio of the firm is high (6.3) in the first year and then it falls and does not vary much in the remaining period. The high current ratio signifies that the firm may be tying up too much of their money in a form that is not earning them anything. The working capital to total assets measures a company’s ability to cover its short-term financial obligations. This ratio can provide an insight as to the liquidity of the company. Here, the net working capital to total assets is quite low and remains almost the same throughout the entire period. A low or decreasing ratio indicates the company may have too many current liabilities, reducing the amount of working capital available.

Asset-utilization ratios

2000
2001
2002
2003
2004
Inventory turnover
1.9
2.0
1.3
1.4
1.5
Day sales in inventory
190.1
183.5
278.5
255.6
237.3
Receivable turnover
60.0
54.6
39.0
11.3
11.2
Day sales in receivable turnover
6.1
6.7
9.4
32.4
32.4
Total asset turnover
0.9
0.8
0.8
0.9
1.0

Inventory turnover
Inventory turnover reflects how often a company sells off or turns off its entire inventory within a given financial reporting period. In this case, the inventory turnover ratio is around 1.92 and varies slightly over the 5 years. A low inventory turnover ratio signifies that the company needs more time to deplete the existing inventory. Receivables turnover

The receivables turnover showed a fair picture in the first year and then kept decreasing every year. In the first year, Quickfix collected its outstanding credit accounts 60 times. So is the case with the other years, the number of times they collected the credit accounts. Receivables turnover is a good way to gauge the effectiveness of your company’s payment terms. Total asset turnover

This ratio measures a firm’s efficiency at using its assets in generating sales or revenue. It also indicates pricing strategy-companies with low profit margin tend to have high asset turnover, while those with high profit
margins have low asset turnover. Here, the total asset turnover is low. This may be due to a potential problem in the firm’s long-term investments.

Financial Leverage ratios

2000
2001
2002
2003
2004
Total debt ratio
0.5
0.5
0.6
0.6
0.6
Debt-equity ratio
0.9
1.2
1.8
1.8
1.8
Long term debt ratio
0.4
0.4
0.6
0.6
0.6
Interest coverage ratio
1.8
2.1
1.1
0.4
1.0
Cash coverage ratio
1.1
0.7
-1.0
-2.8
-3.3

Debt-equity ratio
The debt-equity ratio measures how much money a company should safely be able to borrow over long periods of time. In the first year, the equity is higher than the debt which proves to be a fair deal. In the remaining years, the debt is higher. This has both advantages and disadvantages. Because of higher debt, the company owes more. Many companies use debt to finance a large portion of their business. Debt is also a cheaper source of financing than equity. Also, shareholders(those that provided the equity funding)are the first to lose their investment when the company goes bankrupt. Times-interest earned ratio

This ratio measures how well a company has its interest obligations covered. Here, the times interest earned ratio is 1.7 in the first year and then increases and then decreases from the third year. A lower times interest earned ratio means less earnings are available to meet interest payments and that the business is more vulnerable to increases in interest rates.

Profitability ratios

2000
2001
2002
2003
2004
Profit Margin
2.77%
3.49%
0.27%
-1.88%
-0.01%
ROA
2.60%
2.89%
0.21%
-1.68%
-0.01%
ROE
4.94%
6.36%
0.59%
-4.76%
-0.03%

Profit Margin
The profit margin ratio states how much profit the company makes for every dollar of sales. In the first three years, the profit margin ratio is low and its decreases even more and become negative in the last two years which is not a good sign. A low profit margin ratio indicates that low amount of earnings required to pay fixed costs and profits, are generated from revenues. It also indicates that the business is unable to control its production costs.

Return on Assets (ROA)

Return on assets is a measure of profit per dollar of assets. Like the profit margin ratio, the return on assets ratio is low in the first 3 years and then becomes negative in the last 2 years. A low return on assets ratio indicates that the earnings are low for the amount of assets.

Return on equity (ROE)
ROE is a measure of how the stockholders fared during the year. Because benefitting shareholders is our goal, ROE in an accounting sense, is the true bottom-line of performance.ROE is useful for comparing the profitability of a company to that of other firms in the industry. A
business that has high return on equity is more likely to be one that is capable of generating cash internally. Here, the ROE is significantly low in the first 3 years and shows a negative figure in the last 2 years which is a poor indicator of their performance.

Quickfix should be granted a loan since their current assets are fair enough. They have more current assets than current liabilities.

Q7. If you were the commercial loan officer and were approached by Andre for a short-term loan of $25,000, what would your decision be? Why? Ans. As a commercial loan officer, I would agree to provide Andre with a short-term loan of $25,000.Short-term loans is available in both secured and unsecured forms. To avail secured quick term loan, the borrower has to place a property or so as collateral with the lender. For unsecured short term loan, no collateral is required but the interest rate is higher. Since, Andre’s current ratio and quick ratio show a fair picture, it is advisable to provide him with a short-term loan. It may also be suggested that he goes for a short-term secured loan since he owns assets and he could keep it as collateral against the loan.

Q8. What recommendations should Juan make for improvement, if any? Ans. It is necessary that Juan works on the inventory turnover ratio since it is low here which means the company needs more time to deplete its assets. This may be due to overstocking of assets, obsolescence, or deficiencies in the product line or marketing effort. It is recommended that goods not be overstocked. The times interest ratio is also low in the last two years. This may be due to a lot of debt that the company has. Thus, it is recommended that the debt be reduced. Other sources of raising fund should be considered. The company should also work on its profitability ratios which are the key indicators of the organization’s financial performance which show a poor picture especially in the last two years. A little bit of sensible planning and proper decision making at the right time can definitely help overcome these issues the company is facing at the moment.
Q9. What kind of problems do you think Juan would have to cope with when
conducting a comprehensive financial statement analysis of Quickfix Auto parts? What are the limitations of financial statement analysis in general? Ans. Firstly, Juan would have to prepare a Statement of Cash flows and a Statement of Owner’s Equity. Financial statement analysis is a tool most credit mangers use in evaluating credit risk. Credit risk comes in two different forms: 1. The risk that a customer’s business will fail resulting in bad debt write-offs for its creditors, 2. The risk that the customer will pay slowly.

Limitations
* Past performance, good or bad is, not necessarily a good indicator of what will happen with a customer in the future. *The more, out-of-date a customer’s financial statements are, the less value they are to the credit department. *Without the notes to the financial statements, credit mangers cannot get a clear picture of the scope of the credit risk they are considering. *The financial statement analysis is limited by the fact that financial statements are “window dressed” by creative accountants. *The financial statement analysis just provides a snapshot of a business’ financial health but not the complete moving picture. *It is also difficult to say whether a company is healthy seeing its financial statements because that depends on the nature and size of the business.

Cite this Bigger is not always better

Bigger is not always better. (2016, May 12). Retrieved from https://graduateway.com/bigger-is-not-always-better/

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