a. Here are the firm's base case ratios and other data as compared to the industry:
Firm Industry Comment
Quick 0.85H 1.0H Weak
Current 2.33 2.7 Weak
Inventory turnover 4.8 7.0 Poor
Days sales outstanding 37 days 32 days Poor
Fixed assets turnover 10.0H 13.0H Poor
Total assets turnover 2.33 2.6 Poor
Return on assets 5.9% 9.1% Bad
Return on equity 13.07 18.2 Bad
Debt ratio 54.8 50.0 High
Profit margin on sales 2.5 3.5 Bad
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio 5.0H 6.0H Poor
M/B ratio 0.65 n.a. --
The firm appears to be badly managed--all of its ratios are worse than the industry averages, and the result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The company needs to do something to improve.
b. A decrease in the inventory level would improve the inventory turnover, total assets turnover, and ROA, all of which are too low. It would have some impact on the current ratio, but it is difficult to say precisely how that ratio would be affected. If the lower inventory level allowed the company to reduce its current liabilities, then the current ratio would improve. The lower cost of goods sold would improve all of the profitability ratios and, if dividends were not increased, would lower the debt ratio through increased retained earnings. All of this should lead to a higher market/book ratio and a higher stock price.
c. The revised data and ratios are shown below:
INPUT DATA: KEY OUTPUT:
1997 Firm Industry
Cash $ 84,527 Quick 1.2 1.0
A/R 395,000 Current 3.0 2.7
Inventories 700,000 Inv. turn. 6.1 7.0
Land and bldg. 238,000 DSO 33 32
Machinery 132,000 F.A.turn. 8.3 13.0
Other F.A. 150,000 T.A.turn. 2.5 2.6
ROA 10.5% 9.1%
Accts. & notes pay. $ 275,000 ROE 19.9% 18.2%
Accruals 120,000 TD/TA 47.0% 50.0%
Long-term debt 404,290 PM 4.2% 3.5%
Common stock 575,000 EPS $7.78 n.a.
Retained earnings 325,237 Stock Price $46.68 n.a.
__________ P/E ratio 6.0 6.0
Total assets $1,699,527 M/B 1.19 n.a.
Total claims $1,699,527
Income statement
Sales $4,290,000
Cost of G.S. 3,450,000
Adm. & sales exp. 248,775
Depreciation 159,000
Misc. 134,000
Net income $ 178,935
P/E ratio 6
No. of shares 23,000
Cash dividend $ 0.95
Under these new conditions, the company looks much better. Its turnover ratios are still low, but its ROA and ROE are above the industry average; its estimated P/E ratio is better, and its stock price is anticipated to double. There is still room for improvement, but the company is in much better shape.
d. The financial statements and ratios for the scenario in which the cost of goods sold decreases by an additional $125,000 are shown on the next page. As you can see, the profit ratios are quite high and the stock price has risen to $66.24.
INPUT DATA: KEY OUTPUT:
1997 Firm Industry
Cash $ 159,527 Quick 1.4 1.0
A/R 395,000 Current 3.2 2.7
Inventories 700,000 Inv. turn. 6.1 7.0
Land and bldg. 238,000 DSO 33 32
Machinery 132,000 F.A.turn. 8.3 13.0
Other F.A. 150,000 T.A.turn. 2.4 2.6
ROA 14.3% 9.1%
Accts. & notes pay. $ 275,000 ROE 26.0% 18.2%
Accruals 120,000 TD/TA 45.0% 50.0%
Long-term debt 404,290 PM 5.9% 3.5%
Common stock 575,000 EPS $11.04 n.a.
Retained earnings 400,237 Stock Price $66.24 n.a.
__________ P/E ratio 6.0 6.0
Total assets $1,774,527 M/B 1.56 n.a.
Total claims $1,774,527
Income statement
Sales $4,290,000
Cost of G.S. 3,325,000
Adm. & sales exp. 248,775
Depreciation 159,000
Misc. 134,000
__________
Net income $ 253,935
P/E ratio 6
No. of shares 23,000
Cash dividend $ 0.95
e. The financial statements and ratios for the scenario in which the cost of goods sold increases by $125,000 over the revised estimate are shown on the next page. As you can see, profits would decline sharply. The ROE would drop to 12.6%, EPS would fall to $4.52, the stock price would drop to $27.11, and the M/B ratio would be only 0.76.
INPUT DATA: KEY OUTPUT:
1997 Firm Industry
Cash $ 9,527 Quick 1.0 1.0
A/R 395,000 Current 2.8 2.7
Inventories 700,000 Inv. turn. 6.1 7.0
Land and bldg. 238,000 DSO 33 32
Machinery 132,000 F.A.turn. 8.3 13.0
Other F.A. 150,000 T.A.turn. 2.6 2.6
ROA 6.4% 9.1%
Accts. & notes pay. $ 275,000 ROE 12.6% 18.2%
Accruals 120,000 TD/TA 49.2% 50.0%
Long-term debt 404,290 PM 2.4% 3.5%
Common stock 575,000 EPS $4.52 n.a.
Retained earnings 250,237 Stock Price $27.11 n.a.
__________ P/E ratio 6.0 6.0
Total assets $1,624,527 M/B 0.76 n.a.
Total claims $1,624,527
Income statement
Sales $4,290,000
Cost of G.S. 3,575,000
Adm. & sales exp. 248,775
Depreciation 159,000
Misc. 134,000
__________
Net income $ 103,935
P/E ratio 6
No. of shares 23,000
Cash dividend $ 0.95
f. Computer models allow us to analyze quickly the impact of operating and financial decisions on the firm's overall performance. A firm can analyze its financial ratios under different scenarios to see what might happen if a decision, such as the purchase of a new asset, did not produce the expected results. This gives the managers some idea about what might happen under the best and worst cases and helps them to make better decisions.