Signal Cable Company
1. Why has the stock price fallen despite the fact that the net income has increased?
Although Signal has made a net profit that is higher than that of the previous year, its net
profit margin is lower (6.98% vs. 7.43%). Most of this decrease has been caused by the
significant increase in debt in 2004 resulting in much higher interest expenses ($111,000
higher than 2003). Higher debt is not necessarily bad, if profitability is proportionately
higher as well. However, the interest coverage ratio of this firm has dropped considerably
from 5.72 in 2003 to 2.54 in 2004. Stock prices are affected by earnings as well as by risk
expectations. The drop in price is an indication that investors are concerned about the
increased risk of high debt.
2. How liquid would you say that this company is? Calculate the absolute liquidity of
the firm. How does it compare with the previous year's liquidity position?
Liquidity is defined as the ability of converting an asset into cash without significant loss of
value. A firm’s liquidity refers to its ability to pay its short-term bills and current liabilities
by converting its current assets into cash. Liquidity is also referred to a firm’s short-term
solvency. There are various measures of liquidity such as the current ratio, the quick ratio,
the cash ratio, the ratio of net working capital to total assets, and the interval measure.
Cash Ratio
Current Ratio
Quick Ratio
NWC to TA
Interval Ratio
Absolute Liquidity = NWC
2004
2003
0.0056
0.113
2.06
2.51
0.61
0.68
0.33
0.43
426.99
236.07
950,450
535,000
The above ratios indicate that although the absolute liquidity (Net working Capital) of the
firm has increased in 2004, the relative liquidity of the firm has decreased. The current
ratio has significantly declined. However, the liquidity situation is not critical because, as
1
the interval measure indicates, the firm could continue operating for at least another 427
days if its cash inflows began to dry up. This interval coverage has increased
significantly from its level in 2003. Thus one can conclude that although the relative
liquidity condition of the company has deteriorated since 2003, it is not critically low.
3. How does the market value of the stock compare with its book value? Is the book
value accurately reflecting the true condition of the company?
Signal’s Market Value = Current Stock Price X 200,000 shares
Signal’s Book Value in 2003= (Total Assets – Total Liabilities) = Shareholders’
Equity
= $1,247,000-$555,000
= $692,000
Signal’s 2003 Book Value per share = $792,170/200,000 shares = $3.46
Signal’s Book Value in 2004 = (Total Assets – Total Liabilities) = Shareholders’
Equity
= $2,913,450-$2,121,280
= $792,170
Signal’s 2004 Book Value per share = $792,170/200,000 shares = $3.96
The book value per share rarely equals the market value per share. In the case of Signal,
the stock price is higher than its book value since it has been growing and has had a run
up of sales and profits over the past few years. The drop in price recently reflects the
increased risk due to higher debt levels and the lower relative liquidity position of the
company. Although the book value per share has increased slightly in 2004 ($3.96 vs.
$3.46), it is the market value that reflects the true condition of the company.
4. The board of directors is not clear as to why the cash balance has dropped so much
despite the increase in sales and the gross profit margin. What should Jay tell the
board?
In order to ascertain why the cash balance has dropped so much, it would be necessary to
do a Statement of Cash Flows for 2004.
Signal Cable Company
2
2004 Statement of Cash Flows
Cash at beginning of year 2004
$ 40,000
Operating activity
Net income
Plus:
Depreciation
Increase in accounts payable
143,100
79,000
90,000
Less:
Increase in accounts receivable
Increase in inventory
Net cash from operating activity
Investment activity
Fixed asset acquisitions
Net cash from
activity
(340,000)
(650,450)
(678,350)
(790,000)
investment
(790,000)
Financing activity
Increase in notes payable
450,000
Increase in long-term debt
1,026,280
Dividends paid
(42,930)
Increase in common stock
Net cash from financing activity 1,433,350
Net decrease in Cash
(35,000)
Cash, end of year
$
5,000
The statement of cash flows shows that the firm has invested heavily in accounts receivable,
inventories and fixed assets. These investments were only partially funded by an increase in payables
and retained earnings. Signal Cable borrowed $1.47million worth of short and long-term debt and
drew down on its cash reserves to fund the balance. Thus, although sales went up and cost of goods
sold declined, the acquisition of assets and business expansion activities led to a reduction in the cash
balance.
5. Measure the free cash flow of the firm. What does it indicate?
3
The free cash flow (FCF) of a firm (also known as cash flow from assets) indicates how much cash a
firm can freely distribute to its creditors and stockholders. It is cash that is not needed for working
capital or fixed asset investments. Free cash flow is measured as follows:
FCF = Operating cash flow – Net capital spending – Change in net working capital
Where:
Operating Cash flow (OCF) = Earnings before interest and taxes
+Depreciation
-Taxes
Net Capital Spending (NCS)= Ending Net Fixed Assets
-Beginning Net Fixed Assets
+Depreciation
Change in Net Working Capital = Ending NWC – Beginning NWC
OCF = $393,500 + $79,000 – $95,400 =
$377,100
NCS = $1,068,000 - $357000 + $79,000 = $790,000
Change in NWC = [($1,845,450- $895,000)- ($890,000-$355,000)]
=[$950,450 – $535,000]
=$415,450
Free Cash Flow = $377,100 -$790,000 – $415,450
= -$828,350
Signal Cable had a negative amount of free cash flow in 2004 primarily due to its increase in net
capital spending and net working capital. A negative free cash flow means that the amount of net new
borrowing and equity would have increased.
Let’s check…
Net increase in Long-term debt = $1,226,280 – $200,000 = $1,026,280
Dividends and interest paid = $42,930+$155,000 = $197,930
Net amount of additional capital raised = $1,026,280 – $197,930 = $828,350
The free cash flow calculation shows that Signal cable raised additional long-term debt to
fund its increase in net fixed assets and net working capital.
4
6. Calculate the net working capital of the company for each of the two years. What can you
conclude about the firm's net working capital?
2003
Current Assets
- Current Liabilities
= Net Working Capital
$890,000
355,000
535,000
2004
$1,845,450
895,000
950,450
Signal Cable has significantly increased its net working capital (almost 78% higher) in 2004.
7. Should the shareholders be concerned about the drop in cash flow or should they be
happy that the earnings per share have increased? Explain your answer.
The shareholders are rightly concerned about the drop in cash flow and net profit margin.
The decline in cash flow is usually an early warning signal and the managers should take the
necessary steps to alleviate the resulting deterioration of the firm’s liquidity.
5
Financial Analysis Ratio
Bigger Isn’t Always Better!
Table I
Quickfix Autoparts
Balance Sheet
2000
2001
2002
2003
2004
$155,000
10,000
250,000
$309,099
12,000
270,000
$75,948
20,000
500,000
$28,826
77,653
520,000
$18,425
90,078
560,000
$415,000
$591,099
$595,948
$626,480
$668,503
$250,000
(25,000)
$250,000
(50,000)
$500,000
(100,000)
$500,000
(150,000)
$500,000
(200,000)
$225,000
$200,000
$400,000
$350,000
$300,000
$640,000
$791,099
$995,948
$976,480
$968,503
$50, 000
10,000
5,000
$145,000
10,506
5,100
$140,000
19,998
7,331
$148,000
15,995
9,301
$148,000
16,795
11,626
$65,000
$160,606
$167,329
$173,296
$176,421
$63,366
175,000
$98,000
173,000
$196,000
271,000
$190,000
268,000
$183,000
264,000
Long-term debt
$238,366
$271,000
$467,000
$458,000
$447,000
Total liabilities
$303,366
$431,606
$634,329
$631,296
$623,421
Common stock (100,000 shares) $320,000
Retained earnings
16,634
$320,000
39,493
$320,000
41,619
$320,000
25,184
$320,000
25,082
ASSETS
Cash and marketable
securities
Accounts receivable
Inventory
Current assets
Land, buildings, plant,
and equipment
Accumulated depreciation
Net fixed assets
Total assets
LIABILITIES
EQUITIES
Short-term bank loans
Accounts payable
Accruals
Current liabilities
Long-term bank loans
Mortgage
AND
Total equity
$336,634
$359,493
$361,619
$345,184
$345,082
Total liabilities
and equity
$640,000
$791,099
$995,948
$976,480
$968,503
6
Table II
Quickfix Autoparts
Income Statement
2000
2001
2002
2003
2004
$600,000
480,000
$655,000
537,100
$780,000
655,200
$873,600
742,560
$1,013,376
861,370
$120,000
$117,900
$124,800
$131,040
$152,006
$30,000
25,000
2,027
$15,345
25,000
3,557
$16,881
50,000
5,725
$43,680
50,000
17,472
$40,535
50,000
15,201
$57,027
$43,902
$72,606
$111,152
$105,736
$62,973
$73,998
$52,194
$19,888
$46,271
$15,000
8,000
12,250
$15,950
7,840
12,110
$14,000
15,680
18,970
$13,320
15,200
18,760
$13,320
14,640
18,480
$35,250
$35,900
$48,650
$47,280
$46,440
Before-tax earnings
Taxes
$27,723
11,089
$38,098
15,239
$3,544
1,418
($27,392)
(10,957)
($169)
(68)
Net income
$16,634
$22,859
$2,126
($16,435)
($102)
Dividends on stock
0
0
0
0
0
Additions to
retained earnings
$16,634
$22,859
$2,126
($16,435)
($102)
EPS (100,000 shares)
$0.17
$0.23
$0.02
($0.16)
($0.00)
Net sales
Cost of goods sold
Gross profit
Admin and selling exp
Depreciation
Miscellaneous expenses
Total operating exp
EBIT
Interest on ST loans
Interest on LT loans
Interest on mortgage
Total interest
7
1. How does Quickfix’s average compound growth rate in sales compare with its
earnings growth rate over the past five years?
Quickfix’s sales have increased by an average compound rate of 14% per year over the
past five years. In comparison, its net income has declined from over $16,600 in 2000, to
a loss of $102 in 2004.
2. Which statements should Juan refer to and which should he construct so as to
develop a fair assessment of the firm’s financial condition? Explain why?
Juan should refer to the income statement and the balance sheet over the past 3-5 year
period. In addition, he should prepare a cash flow statement, common size income
statement and common size balance sheet. The accounting statements provide the raw
data from which the other statements can be prepared. The cash flow statement helps
determine where the cash came from and where it was spent during a year. The common
size statements provide useful information regarding the relative trends of the various
assets, liabilities, revenue sources, and expense items. They also help the analyst make
meaningful comparisons between firms of varying sizes.
3. What calculations should Juan do in order to get a good grasp of what is going on
with Quickfix’s performance?
Juan should calculate the various liquidity, leverage, profitability, activity, and coverage
ratios for at least a three-year period. In addition, a Du Pont analysis of the return on
equity will help determine what has affected the profitability of the company.
4. Juan knows that he should compare Quickfix’s condition with an appropriate
benchmark. How should he go about obtaining the necessary comparison data?
Based on Quickfix’s industry classification code, Juan should collect industry averages of
the key financial ratios. Some useful sources for industry ratios include: Value Line,
Moody’s, Standard & Poor, and Dun & Bradstreet. In addition to the industry average,
the industry leaders (within the size category) ratios could also be collected from the
Internet (e.g. Marketguide.com) and used for comparison.
5. 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.
8
Besides comparison with the benchmark, Juan could perform common size analyses of
the financial statements and a DuPont analysis of the return on assets and the return on
equity.
Quickfix Autoparts
Common Size Income Statement
2000
2000% 2001
2001% 2002
2002% 2003
2003% 2004
2004%
Net sales
$600,000 100.0% $655,000 100.0% $780,000 100.0% $873,600 100.0% $1,013,376 100.0%
Cost of goods 480,000 80.0% 537,100 82.0% 655,200 84.0% 742,560 85.0% 861,370 85.0%
sold
Gross profit $120,000 20.0%
$117,900 18.0%
$124,800 16.0%
$131,040 15.0%
$152,006 15.0%
Admin
and $30,000 5.0%
selling exp
Depreciation 25,000 4.2%
$15,345 2.3%
$16,881 2.2%
$43,680 5.0%
$40,535
4.0%
25,000
3.8%
50,000
6.4%
50,000
5.7%
50,000
4.9%
Miscellaneous 2,027
expenses
3,557
0.5%
5,725
0.7%
17,472
2.0%
15,201
1.5%
0.3%
Total
$57,027 9.5%
operating exp
$43,902 6.7%
$72,606 9.3%
$111,152 12.7%
$105,736 10.4%
$73,998 11.3%
$52,194 6.7%
$19,888 2.3%
$46,271
4.6%
Interest on ST $15,000 2.5%
loans
Interest on LT 8,000
1.3%
loans
Interest
on 12,250 2.0%
mortgage
$15,950 2.4%
$14,000 1.8%
$13,320 1.5%
$13,320
1.3%
7,840
1.2%
15,680
2.0%
15,200
1.7%
14,640
1.4%
12,110
1.8%
18,970
2.4%
18,760
2.1%
18,480
1.8%
Total interest $35,250 5.9%
$35,900 5.5%
$48,650 6.2%
$47,280 5.4%
$46,440
4.6%
Before-tax $27,723 4.6%
earnings
Taxes
11,089 1.8%
$38,098 5.8%
$3,544
0.5%
($27,392) -3.1%
($169)
-0.02%
15,239
1,418
0.2%
-10,957
-68
-0.01%
Net income
$22,859 3.5%
$2,126
0.3%
($16,435) -1.9%
($102)
-0.01%
EBIT
$62,973 10.5%
$16,634 2.8%
2.3%
9
-1.3%
The common size income statement indicates that the firm’s cost of goods sold has increased
quite a bit since 2000. Miscellaneous expenses have also increased from .3% of sales to 1.5% of
sales. On the other hand, selling and administrative expenses and interest charges have come
down a bit. The firm needs to look into its cost structure and try and reduce the overall costs of
doing business.
The common size balance sheet (shown below) shows that the firm’s inventory and accounts
receivables levels have gone up sharply, while its cash balance has significantly declined. Fixed
assets have increased over the past 5 years. The firm has taken on significantly larger amounts
of short and long-term debt relative to its total assets. Equity has not increased proportionately
with debt. As a result its capital structure has become more leveraged.
Quickfix Autoparts
Balance Sheet
2000
2000%
2001
2001%
2002
2002%
2003
2003%
2004
2004%
ASSETS
Cash and marketable
securities
$155,000
24.22%
$309,099
39.07%
$75,948
7.63%
$28,826
2.95%
$18,425
1.90%
Accounts receivable
10,000
1.56%
12,000
1.52%
20,000
2.01%
77,653
7.95%
90,078
9.30%
Inventory
250,000
39.06%
270,000
34.13%
500,000
50.20%
520,000
53.25%
560,000
57.82%
$415,000
64.84%
$591,099
74.72%
$595,948
59.84%
$626,480
64.16%
$668,503
69.02%
and equipment
$250,000
39.06%
$250,000
31.60%
$500,000
50.20%
$500,000
51.20%
$500,000
51.63%
Accumulated depreciation
-25,000
-3.91%
-50,000
-6.32%
-100,000
-10.04%
-150,000
-15.36%
-200,000
-20.65%
$225,000
35.16%
$200,000
25.28%
$400,000
40.16%
$350,000
35.84%
$300,000
30.98%
$640,000
100.00% $791,099
100.00% $995,948
100.00% $976,480
100.00% $968,503
100.00%
$50,000
7.81%
$145,000
18.33%
$140,000
14.06%
$148,000
15.16%
$148,000
15.28%
Accounts payable
10,000
1.56%
10,506
1.33%
19,998
2.01%
15,995
1.64%
16,795
1.73%
Accruals
5,000
0.78%
5,100
0.64%
7,331
0.74%
9,301
0.95%
11,626
1.20%
$65,000
10.16%
$160,606
20.30%
$167,329
16.80%
$173,296
17.75%
$176,421
18.22%
Long-term bank loans
$63,366
9.90%
$98,000
12.39%
$196,000
19.68%
$190,000
19.46%
$183,000
18.90%
Mortgage
175,000
27.34%
173,000
21.87%
271,000
27.21%
268,000
27.45%
264,000
27.26%
$238,366
37.24%
$271,000
34.26%
$467,000
46.89%
$458,000
46.90%
$447,000
46.15%
$303,366
47.40%
$431,606
54.56%
$634,329
63.69%
$631,296
64.65%
$623,421
64.37%
Current assets
Land, buildings, plant,
Net fixed assets
Total assets
LIABILITIES AND EQUITIES
Short-term bank loans
Current liabilities
Long-term debt
Total liabilities
10
Common stock (100,000 shares)
$320,000
50.00%
$320,000
40.45%
$320,000
32.13%
$320,000
32.77%
$320,000
33.04%
Retained earnings
16,634
2.60%
39,493
4.99%
41,619
4.18%
25,184
2.58%
25,082
2.59%
$336,634
52.60%
$359,493
45.44%
$361,619
36.31%
$345,184
35.35%
$345,082
35.63%
$640,000
100.00% $791,099
Total equity
Total liabilities
and equity
100.00% $995,948
11
100.00% $976,480
100.00% $968,503
100.00%
Du Pont Analysis
2000
2001
2002
0.27%
2003
-1.88%
2004
Net Profit Margin 2.77%
Total
Asset
Turnover
0.9375
Equity Multiplier 1.901175
3.49%
-0.01%
Return on Assets
2.60%
2.89%
0.21%
-1.68%
-0.01%
Return on Equity
4.94%
6.36%
0.59%
-4.76%
-0.03%
0.827962 0.7831734 0.894642 1.046332329
2.200596 2.7541363 2.828868 2.806587999
Quickfix Auto’s ROA is currently negative but has improved since 2003. Most of the decrease has come
from the deteriorating profit situation. The firm’s total asset turnover has improved consistently since
2002.
The firm’s ROE has suffered significantly since 2001. This has occurred largely due to the steep drop in
net profit margin. Had the firm not had such a high equity multiplier (from its high level of debt), the
ROE situation would have looked considerably worse.
6. Comment on Quickfix’s liquidity, asset utilization, long-term solvency, and
profitability ratios. What arguments would have to be made to convince the bank
that they should grant Quickfix the loan?
Current Ratio
Quick Ratio
Cash Ratio
Total Debt Ratio
Debt-Equity Ratio
Equity Multiplier
Times Interest Ratio
Cash Coverage Ratio
Inventory Turnover ratio
Days sales in Inventory
Receivables Turnover
ACP or Days' Sales in Receivables
Total Asset Turnover
Capital Intensity
Profit Margin
ROA
ROE
2000
2001
2002
2003
2004
6.38
2.54
2.38
0.47
0.90
1.90
1.79
2.50
1.92
190.10
60.00
6.08
0.94
1.07
2.77%
2.60%
4.94%
3.68
2.00
1.92
0.55
1.20
2.20
2.06
2.76
1.99
183.49
54.58
6.69
0.83
1.21
3.49%
2.89%
6.36%
3.56
0.57
0.45
0.64
1.75
2.75
1.07
2.10
1.31
278.54
39.00
9.36
0.78
1.28
0.27%
0.21%
0.59%
3.62
0.61
0.17
0.65
1.83
2.83
0.42
1.48
1.43
255.60
11.25
32.44
0.89
1.12
-1.88%
-1.68%
-4.76%
3.79
0.62
0.10
0.64
1.81
2.81
1.00
2.07
1.54
237.30
11.25
32.44
1.05
0.96
-0.01%
-0.01%
-0.03%
12
Liquidity:
The firm’s overall liquidity is quite good with a current ratio of 3.79 and it has improved
quite a bit over the past three years. However, much of its current assets are tied in
inventory, since its quick ratio is only 0.62. The ability of the firm to pay off its current
liabilities from its cash reserves is not very good either and has deteriorated significantly
over the past five years.
Asset utilization:
The firm’s inventory turnover has declined considerably since 2000. There was some
improvement in 2004, but there is still a lot of room for further improvement. The
receivables turnover ratio has declined as well. An average collection period of 32 days
is pretty high for a retail business. The total asset turnover although not very high is at its
highest level in five years.
Long-term solvency:
Quickfix Auto’s debt ratio is 64% of total assets. Its debt level has gone up by almost
37% since 2000. Since the firm’s coverage ratios are fairly low, the firm’s financial
structure can be considered to be fairly risky.
Profitability:
The firm’s profitability ratios have declined significantly in the past three
years. The firm is currently making losses.
Arguments that can be made to get the loan:
Improving liquidity (current ratio) and total asset turnover.
Improving cash coverage and interest coverage ratios.
Proof of better inventory management system (if possible)
7. 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?
Given the firm’s poor profitability and cash flow situation, I would not grant the loan.
However, I would tell him that if he can demonstrate improvement in inventory
management and better profitability over the next 2 quarters, we would reconsider.
8. What recommendations should Juan make for improvement, if any?
The firm needs to improve its inventory management, and credit collection policies.
Further, the cost of sales and miscellaneous costs should be looked into and brought
down more in line with its level in 2000. This will improve the liquidity and profitability
of the company.
13
9. What kinds of problems do you think Juan would have to cope with when doing a
comprehensive financial statement analysis of Quickfix Parts?
What are the
limitations of financial statement analysis in general?
General Problems
Selection of comparison benchmark
Accounting procedures differ.
Different fiscal year end
Seasonal businesses
Extraordinary gains/losses
Specific Problems
Selection of appropriate benchmark/ industry averages
14