Chapter 5
EVALUATING FINANCIAL PERFORMANCE
FOCUS
In this chapter, we focus on identifying and understanding the financial ratios used to evaluate the
venture’s financial performance over time. Venture performance and efficiency is important to a variety
of constituencies including lenders and creditors, equity investors, and the entrepreneur. Lenders and
creditors want to be repaid in full and on time; investors want a sufficient return on their investments as
compensation for the risks they are taking; the entrepreneur initially wants to survive and then build value
in the venture.
LEARNING OBJECTIVES
1. Describe how financial ratios are used to monitor a venture’s performance
2. Identify specific cash burn rate measures and liquidity ratios and explain how they are calculated and
used by the entrepreneur
3. Identify and describe the use and value of conversion period ratios to the entrepreneur
4. Identify specific leverage ratios and explain their usage by lenders and creditors
5. Identify and describe measures of profitability and efficiency that are important to the entrepreneur
and equity investors
6. Describe limitations when using financial ratios
CHAPTER OUTLINE
5.1
5.2
5.3
5.4
5.5
5.6
5.7
USING FINANCIAL RATIOS
CASH BURN RATES AND LIQUIDITY RATIOS
A. Measuring Venture Cash Burn and Build Rates
B. Beyond Burn: Traditional Measures of Liquidity
C. Interpreting Cash-Related and Liquidity-Related Trends
CONVERSION PERIOD RATIOS
A. Measuring Conversion Times
B. Interpreting Changes in Conversion Times
LEVERAGE RATIOS
A. Interpreting Changes in Financial Leverage
PROFITABILITY AND EFFICIENCY RATIOS
A. Income Statement Measures of Profitability
B. Efficiency and Return Measures
C. Operating Return on Assets
D. Interpreting Changes in Profitability and Efficiency
INDUSTRY COMPARABLE RATIO ANALYSIS
A HITCHHIKER’S GUIDE TO FINANCIAL ANALYSIS
SUMMARY
57
DISCUSSION QUESTIONS AND ANSWERS
1. What are financial ratios and why are they useful?
Financial ratios are measurements that show relationships between two or more financial variables.
2. What are the three types of comparisons that can be made when conducting ratio analyses?
The three types of comparison that can be made with ratio analysis are trend analysis, cross-sectional
analysis, and industry comparables (benchmark) analysis.
3. What is meaning of the terms cash build and cash burn? How do we calculate net cash burn rates?
Cash build is the amount the firm receives on its sales calculated by net sales less the change in
receivables. Cash burn is the amount of cash a firm uses on its operating and financing expenses and
on its investments in assets.
4. How is the current ratio calculated and what does it measure? How does the quick ratio differ from
the current ratio?
The firm’s current ratio is calculated by dividing the current assets by the current liabilities. This
ratio measures the firm’s ability to pay off their short term debt in the near term. The quick ratio
differs in that it leaves out inventory in calibrating current assets.
5. Describe how a firm’s net working capital (NWC) is measured and how the NWC-to-total- assets
ratio is calculated. What does this ratio measure?
Net working capital is measured by subtracting current liabilities from current assets. NWC-to-totalassets ratio is calculated by dividing NWC by the firm’s total assets (or average total assets). This
calculation measures liquidity of the firm with a higher percentage indicating a greater liquidity.
6. What is meant by a venture’s operating cycle? Also, describe the cash conversion cycle.
A venture’s operating cycle is the time it takes to purchase raw materials, assemble a product, book a
sale, and collect on it. The cash conversion cycle is the operating cycle less the days of short-term
credit extended by suppliers, employees and government (the purchase-to-payment cycle).
7. What are the three components of the cash conversion cycle? How is each component calculated?
The three components of the cash conversion cycle are inventory-to-sale conversion period, sales-tocash conversion period, and purchase-to-payment conversion period. The inventory-to-sale
conversion period is calculated by dividing average inventories by the venture’s average daily cost of
goods sold. The sale-to-cash conversion period is calculated by dividing the average receivables by
the net sales per day. The purchase-to-payment conversion period is calculated by dividing the sum of
average payables and accrued liabilities by the venture’s cost of goods sold per day.
8. Briefly explain how changes in the conversion times of the components of the cash conversion cycle
can be interpreted.
A lengthening of the inventory-to-sale conversion period indicates less efficient inventory
management. A lengthening of the sale-to-cash conversion period indicates less efficient collections
58
or management of receivables. A decrease in the purchase-to-payment period indicates a less
efficient use of the credit provided by suppliers, employees and the government.
9. What is the meaning of leverage ratios? What are typical ratios used for relating total debt to a
venture’s assets and/or its equity?
Leverage ratios indicate the extent to which the venture is in debt and its ability to repay its debt
obligations. Typical ratios used are the total-debt-to-total-assets-ratio, debt-to-equity-ratio, and the
equity multiplier.
10. What is the importance of the relationship between a venture’s current liabilities and its total debt?
The portion of total debt that is “current” represents those liabilities that will come due within the
next year. The percentage of debt held in current liabilities is a reasonable glimpse of the venture’s
reliance on debt soon requiring an outlay of cash. Ventures with higher percentages are more likely
to need to restructure their liabilities in the near future.
11. Describe the two types of “coverage” ratios that are typically calculated when trying to assess a
venture’s ability to meet its interest payments and other financing-related obligations?
The two types of coverage ratios used are the interest coverage ratio and the fixed charges coverage
ratio. The interest coverage ratio measures the venture’s ability to pay its annual interest liability and
is calculated by dividing EBITDA by the annual interest payment. The fixed charges ratio measures
the venture’s ability to cover interest and fixed charges. It is calculated by dividing the sum of the
venture’s EBITDA and lease payments divided by the sum of interest payments, rental or
lease payments, and the before-tax cost of debt repayments.
12. What are four measures used to indicate how efficiently the venture is in generating profits on its
sales? Describe how each measure is calculated.
The four ratios used are gross profit margin, operating profit margin, net profit margin, and NOPAT
margin. Gross profit margin is calculated by dividing the gross profit by the venture’s net sales.
Operating profit margin is calculated by dividing earnings before interest and taxes (EBIT), by the
venture’s net sales. Net profit margin is calculated by dividing net income by net sales. NOPAT
margin is calculated by: (EBIT x (1 minus the tax rate))/net sales.
13. Identify and describe four profitability/efficiency ratios that combine data from both the income
statement and the balance sheet.
The four ratios are sales-to-total-assets, operating return on assets, return on assets, and return on
equity. Sales-to-total-assets is net sales divided by average total assets. Operating return on assets is
EBIT divided by average total assets. Return on assets is net profit divided by average total assets.
Return on equity is net profit divided by average owners’ equity.
14. Identify and describe the two components of the ROA model both in terms of what financial
dimensions they measure and how they are calculated.
The two components of the ROA model are the net profit margin and the sales-to-total-assets ratio.
Net profit margin measures the amount of sales that become net profit and is calculated by dividing
59
net income by sales. Sales-to-total-assets measures the how much the firm generates in sales with one
dollar of assets. It is calculated by dividing net sales by the firm’s average assets.
15. What are the three ratio components of the ROE model? How is each calculated and what financial
dimensions do they measure?
The three ratio components of the ROE model are the net profit margin (net income/sales), asset
turnover (net sales/average total assets), and the equity multiplier (average total assets/average
equity). Net profit margin measures profitability of sales. Asset turnover measures how well asset
are utilized in the production of sales. The equity multiplier measures how the firm scales its assets
on a base of equity (through liabilities and debt).
16. Indicate some of the concerns or cautions that need to be considered when conducting ratio analysis
.
When conducting ratio analysis, it is important to compare “apples to apples” by consistent use of the
same inputs to the ratios (e.g. annual sales or quarterly sales). It is also important to understand that
certain ratios may simultaneously indicate undesirable and desirable aspects of the venture’s strategy
and risk position. For example, an efficient use of trade credit can be interpreted as advantageous use
of inexpensive credit or as the assumption of a large amount of short-term financial risk (low current
and quick ratios).
INTERNET ACTIVITIES
1.
Go to the Hoovers business online Web site at www.hoovers.com and click on “companies
& industries.” Identify a firm such as Google, Inc. (sticker symbol: GOOG) or Applebee’s
International, Inc. (ticker symbol: APPB).
A. Obtain the most recent three years of income statements and balance sheets. Analyze the
changes in operating and financial performance, if any, by applying the ratio analyses
covered in the chapter.
Web-researched results vary due to constant updating of the related web sits.
B. Estimate the length of the cash conversion over the two most recent years of available
data. What changes have occurred, if any?
Web-researched results vary due to constant updating of the related web sits.
C. Identify the industry that firm being studied resides in and the major competitors. Obtain
financial statement information for one or more competitors and conduct a ratios
analysis of each competitor analyzed.
Web-researched results vary due to constant updating of the related web sits.
60
EXERCISES/PROBLEMS AND ANSWERS
1.
Bike-With-Us Corporation, a specialty bicycle parts replacement venture, was started last
year by two former professional bicycle riders who had substantial competitive racing
experience including competing in the Tour de France. The two entrepreneurs borrowed
$50,000 from members of their families and each put up $30,000 in equity capital. Retail
space was rented and $60,000 was spent for fixtures and store equipment. Following are
the abbreviated income statement and balance sheet information for the Bike-With-Us
Corporation after one complete year of operation.
BIKE-WITH-US CORPORATION
Sales
$325,000
Operating Costs
285,000
Depreciation
10,000
Interest
5,000
Taxes
6,000
Cash
Receivables
Inventories
Fixed Assets, Net
Payables
Accruals
Long-Term Loan
Common Equity
$1,000
30,000
50,000
50,000
11,000
10,000
50,000
60,000
A. Prepare an income statement and a balance sheet for the Bike-With-Us Corporation
using only the information provided above.
Income Statement
Sales
$325,000
Less: Opr. Costs
285,000
EBITDA
40,000
Less: Depreciation
10,000
EBIT
30,000
Less: Interest
5,000
EBT
25,000
Less: Taxes
6,000
Net Income
19,000
Balance Sheet
Cash
Receivables
Inventories
Total Cur. Assets
Fixed Assets, Net
$1,000
30,000
50,000
81,000
50,000
61
Total Assets
$131,000
Payables
Accruals
Total Cur. Liab.
Long-Term Loan
Common Equity
Total Liab. & Eq.
11,000
10,000
21,000
50,000
60,000
$131,000
B. Calculate the current ratio, quick ratio, and NWC-to-total-assets ratio.
Current Ratio = Current Asset/Current Liabilities = $81,000/$21,000 = 3.86
Quick Ratio = (CA - Inventories)/CL = ($81,000 - $50,000)/$21,000 = 1.48
NWC to Total Assets Ratio = (CA - CL)/Assets = ($81,000 - $21,000)/$131,000 = .458
C. Calculate the total-debt-to-total-assets ratio, debt-to-equity ratio, and interest coverage
Total Debt to Total Assets Ratio = Debt/Assets = $71,000/$131,000 = .542
Debt to Equity Ratio = Debt/Equity = $71,000/$60,000 = 1.183
Interest Coverage Ratio = EBITDA/Interest = $40,000/$5,000 = 8.00
D. Calculate the net profit margin, sales-to-total-assets ratio, and the return on total assets.
Net Profit Margin = Net Profit/Revenues = $19,000/$325,000 = 5.85%
Sales to Total Assets Ratio = Sales/Assets = $325,000/$131,000 = 2.48
Return on Total Assets = Net Profit/Assets = $19,000/$131,000 = 14.50%
E. Calculate the equity multiplier. Combine this calculation with the calculations in Part D
to show the ROE model with its three components.
Equity Multiplier = Assets/Equity = $131,000/$60,000 = 2.183
ROE = Net Profit Margin x Asset Turnover x Equity Multiplier
= 5.85% x 2.48 x 2.183 = 31.67%
2. Use the financial statements data for the Bike-With-Us Corporation provided in Problem 1 to
make the following calculations.
A. Calculate the operating return on assets.
Operating return on assets = EBIT/Assets = $30,000/$131,000 = 22.90%
B. Determine the effective interest rate paid on the long-term debt.
Effective interest rate = Interest/Long-term debt = $5,000/$50,000 = 10.00%
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C. Calculate the NOPAT margin. How does this compare with the results for the net profit
margin? Did the owners benefit from the use of interest-bearing long-term debt?
Tax Rate = Taxes/EBT = $6,000/$25,000 = 24.00%
NOPAT Margin = [(EBIT)(1 – tax rate)]/Net Sales = [$30,000(1 - .24)]/$325,000 =
$22,800/$325,000 = 7.02%
The Net Profit Margin was lower at 5.85%
Since the Operating Return on Assets (22.90%) was higher than the Effective Interest
Rate (10.00%), the firm benefited from having interest-bearing long-term debt.
3. The C&B Castillo Company was started in 2003. The company manufactures components
for personal decision assistant (PDA) products and for other hand-held electronic products.
A difficult operating year 2004 was followed by a profitable 2005. However, the founders
(Connie and Bob Castillo) are still concerned about the venture’s liquidity position and the
amount of cash being used to operate the firm. Following are income statements and
balance sheets for the C&B Castillo Company for 2004 and 2005:
A. Use year-end data to calculate the current ratio, the quick ratio, and the net working
capital (NWC) to total assets ratio for 2004 and 2005 for the Castillo Company. What
changes occurred?
Current Ratio = Current Asset/Current Liabilities
Year 2004: $650,000/$270,000 = 2.41
Year 2005: $800,000/$330,000 = 2.42
Quick Ratio = (CA - Inventories)/CL
Year 2004: ($650,000 - $400,000)/$270,000 = 0.93
Year 2005: ($800,000 - $500,000)/$330,000 = 0.91
NWC to Total Assets Ratio = (CA - CL)/Assets
Year 2004: ($650,000 - $270,000)/$1,000,000 = 0.38
Year 2005: ($800,000 - $330,000)/$1,000,000 = 0.47
B. Use Castillo’s complete income statement data and the changes in balance sheet items
between 2004 and 2005 to determine the firm’s cash build and cash burn for 2005. Did
Castillo have a net cash build or net cash burn for 2005?
Cash Build = Sales – Change in Accounts Receivable
= $1,500,000 - $80,000 = $1,420,000
Cash Burn = Inventory-Related Purchases + Administrative Expenses + Marketing
Expenses + Interest Expense - (Change in Accrued Liabilities +
Change in Payables) + Capital Investments + Taxes
= ($900,000 +$100,000) + $250,000 + $150,000 + $60,000 - ($20,000
+ $30,000) + $90,000 + $25,000 = $1,525,000
Net Cash Burn or Build = Cash Build – Cash Burn
= $1,420,000 - $1,525,000
63
= -$105,000 = $105,000 Cash Burn
C. Convert the annual cash build and cash burn amounts calculated in Part B to monthly
cash build and cash burn rates. Also indicate the amount of the net monthly cash build
or cash burn rate.
Monthly Cash Burn Rate
Less: Monthly Cash Build Rate
Monthly Net Cash Burn Rate
$1,525,000 12 $127,083.33
-$1,420,000 12 -$118,333.33
$8,750.00
$105,000 12
C&B CASTILLO COMPANY
Net Sales
Cost of Goods Sold
Gross Profit
Marketing
General & Administrative
Depreciation
EBIT
Interest
Earnings Before Taxes
Income Taxes
Net Income (Loss)
2004
$900,000
540,000
360,000
90,000
250,000
40,000
(20,000)
45,000
(65,000)
0
($65,000)
2005
$1,500,000
900,000
600,000
150,000
250,000
40,000
160,000
60,000
100,000
25,000
$75,000
2004
Cash
$50,000
Accounts Receivables
200,000
Inventories
400,000
Total Current Assets
650,000
Gross Fixed Assets
450,000
Accumulated Depreciation -100,000
Net Fixed Assets
350,000
Total Assets
$1,000,000
2005
$20,000
280,000
500,000
800,000
540,000
-140,000
400,000
$1,200,000
Accounts Payable
$130,000
Accruals
50,000
Bank Loan
90,000
Total Current Liabilities
270,000
Long-Term Debt
300,000
Common Stock
150,000
Paid-in-Capital
200,000
Retained Earnings
80,000
Total Liab. & Equity
$1,000,000
$160,000
70,000
100,000
330,000
400,000
150,000
200,000
120,000
$1,200,000
64
4. The C&B Castillo Company described in Problem 3 improved its operations from a net loss
in 2004 to a net profit in 2005. While the founders, Connie and Bob Castillo, are happy
about these developments, they are concerned with trying to understand how long the firm
takes to complete its cash conversion cycle in 2005. Use the financial statements from
Problem 3 to make your calculations. Balance sheet items should reflect the averages of the
2004 and 2005 accounts.
A. Calculate the inventory-to-sale conversion period for 2005.
Inventory-to-Sale Conversion Period = Avg. Inventory/Avg. Daily COGS
= (($400,000 + $500,000)/2)/($900,000/365) = 182.50 days
B. Calculate the sale-to-cash conversion period for 2005.
Sale-to-Cash Conversion Period = Avg. Receivables/Avg. Daily Sales
= (($200,000 + $280,000)/2)/($1,500,000/365) = 58.40 days
C. Calculate the purchase-to-payment conversion period for 2005.
Purchase-to-Payment Conversion Period
= (Avg. Payables + Avg. Accruals)/Avg. Daily CGS
= ((($130,000 + $160,000)/2) + ($50,000 + $70,000)/2)/($900,000/365) = 83.14 days
D. Determine the length of the Castillo Company’s cash conversion cycle for 2005.
Length of the Cash Conversion Cycle = (Inventory-to-Sale Conversion Period) + (Salesto-cash Conversion Period) – (Purchase-to-Payment Conversion Period)
= 182.50 days + 58.40 days – 83.14 days = 157.76 days
5. Use the financial statements data for the C&B Castillo Company presented in Problem 3.
A. Calculate the net profit margin in 2004 and 2005 and the sales-to-total-assets ratio using
yearend data for each of the two years.
Net profit margin 2004: -$65,000/$900,000 = -7.22%
Net profit margin 2005: $75,000/$1,500,000 = 5.00%
Sales-to-total-assets 2004: $900,000/$1,000,000 = .900
Sales-to-total-assets 2005: $1,500,000/$1,200,000 = 1.250
B. Use your calculations from Part A to determine the rate of return on assets in each of the
two years for the C&B Castillo Company.
Rate of return on assets 2004: -7.22% x .900 = -6.50%
Rate of return on assets 2005: 5.00% x 1.250 = 6.25%
65
C. Calculate the percentage growth in net sales from 2004 to 2005. Compare this with the
percentage change in total assets for the same period.
Percentage growth in net sales: ($1,500,000 - $900,000)/$900,000 = 66.67%
Percentage change in total assets: ($1,200,000 - $1,000,000)/$1,000,000 = 20.00%
D. Express each expense item as a percentage of net sales for both 2004 and 2005. Describe
what happened that allowed the C&B Castillo Company to move from a loss to a profit
between the two years.
Net sales
Cost of goods sold
Gross profit
Marketing
General & administrative
Depreciation
EBIT
Interest
Earnings before taxes
Income taxes
Net income (loss)
2004
100.00%
60.00
40.00
10.00
27.78
4.44
-2.22
5.00
-7.22
0.00
-7.22%
2005
100.00%
60.00
40.00
10.00
16.67
2.67
10.67
4.00
6.67
25.00
5.00%
The decline in general and administrative expenses as a percentage of sales (i.e., the
spreading of fixed costs) was the major contributor to C&B Castillo becoming profitable.
The decline in depreciation expenses and in interest expenses as percentages of sales also
contributed to the move to profitability. However, increased taxes on profits reduced some
of the profitability gains.
6. Safety-First, Inc. makes portable ladders that can be used to exit second floor levels of homes
in the event of fire. Each ladder consists of fire resistant rope and high strength plastic
steps. A lightweight fire resistant cape with a smoke filter is included with Safety-First
ladder. Each ladder and cape, when not in use, are rolled up and stored in a pouch the size
of a back pack and can easily be taken on trips and vacations.
Jan Smithson founded Safety-First as soon as she graduated from a private liberal arts
college in the northwest three years ago. After struggling for the first year, the venture
seemed to be growing and producing profits. Following are the two most recent years of
financial statements, expressed in thousands of dollars, for the Safety-First Corporation.
SAFETY-FIRST, INC.
Income Statements (in $ Thousands)
2004
3,750
2,250
1,500
Net sales
Cost of goods sold
Gross profit
66
2005
4,500
2,700
1,800
Operating expenses
Income before taxes
Income taxes
Net income
700
800
250
550
900
900
300
600
Cash
Accounts receivable
Inventories
Total current assets
Gross fixed assets
Less accumulated depreciation
Net fixed assets
Total assets
2004
400
500
1,450
2,350
2,000
(950)
1,050
3,400
2005
150
800
2,000
2,950
2,800
(1,250)
1,550
4,500
Accounts payable
Bank loan
Accrued liabilities
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and equity
300
150
100
550
150
850
1,850
3,400
400
250
150
800
150
1,100
2,450
4,500
Balance Sheets (in $ Thousands)
A. Using yearend data for, calculate the inventory to sales conversion period, the sales to
cash conversion period, and the purchases to payments conversion period for 2004 and
2005.
Inventory to Sale Conversion Period
Sale to Cash Conversion Period
235.22
48.67
279.83
52.72
B. Determine the cash conversion cycle for each year and discuss the changes, if any that
took place.
Purchase to Payment Conversion
Period
Cash Conversion Cycle
64.89
219.00
67
74.35
258.20
MINI CASE: SCANDI HOME FURNISHINGS, INC.
Kaj Rasmussen founded Scandi Home Furnishings as a corporation during mid-2002. Sales
during the first full year (2003) of operation reached $1.3 million. Sales increased by 15 percent
in 2004 and another 20 percent in 2005. However, profits after increasing in 2004 over 2003
fell sharply in 2005 causing Kaj to wonder what was happening to his “pride and joy” business
venture. After all, Kaj has continued to work as close as possible to a 24/7 pace beginning with
the startup of Scandi and through the first three full years of operation.
Scandi Home Furnishings, located in eastern North Carolina, designs, manufactures, and
sells to home furnishings retailers Scandinavian-designed furniture and accessories. The
modern Scandinavian design has a streamlined and uncluttered look. While this furniture style
is primarily associated with Denmark, both Norway and Sweden designers have contributed to
the allure of Scandinavian home furnishings. Some say that the inspiration for the Scandinavian
design can be traced to the “elegant curves” of art nouveau from which designers were able to
produce aesthetically pleasing, structurally strong modern furniture. Danish, and the home
furnishings produced by the other Scandinavian countries—Sweden, Norway, and Finland, are
made using wood (primarily oak, maple, and ash), aluminum, steel, and high-grade plastics.
Kaj grew up in Copenhagen, Denmark and received a college degree from a technical
university in Sweden. As is typically in Europe, Kaj began his business career as an apprentice
at a major home furnishings manufacturer in Copenhagen. After “learning the trade,” he
quickly moved into a management position in the firm. However, after a few years, Kaj realized
that what he really wanted to do was to start and operate his own Scandinavian home
furnishings business. At the same time, after traveling throughout the world including the U.S.,
he was sure that he wanted to be an entrepreneur in the United States. Thus, while it was hard
to give up the Tivoli Gardens with its many entertainment and dining activities, as well as the
other attractions in Copenhagen, Kaj moved to the U.S. in early 2002. With $140,000 of his
personal assets, and $210,000 from venture investors, he began operations in mid-2002. Kaj,
with a 40 percent ownership interest and industry-related management expertise, was allowed to
operate the venture in a way that he thought was best for Scandi. Four years later, Kaj is sure
he did the right thing.
Following are the three years of income statements and balance sheets for the Scandi
Home Furnishings Corporation. Kaj has felt that in order to maintain a competitive advantage
that he would need to continue to expand sales. After first concentrating on selling Scandinavian
home furnishings in the northeast in 2003 and 2004, he decided to enter the west coast market.
An increase in expenses associated with identifying, contacting, and selling to home furnishings
retailers in California, Oregon, and Washington. Kaj Rasmussen was hoping that you could
help him better understand what has been happening to Scandi Home Furnishings both from
operating and financial standpoints.
68
SCANDI HOME FURNISHINGS, INC.
Income Statements
Net Sales
Cost of Goods Sold
Gross Profit
Marketing
General & Administrative
Depreciation
EBIT
Interest
Earnings Before Taxes
Income Taxes (40%)
Net Income
2003
2004
2005
$1,300,000
780,000
520,000
130,000
150,000
40,000
200,000
45,000
155,000
62,000
$93,000
$1,500,000
900,000
600,000
150,000
150,000
53,000
247,000
57,000
190,000
76,000
$114,000
$1,800,000
1,260,000
540,000
200,000
200,000
60,000
80,000
70,000
10,000
4,000
$6,000
SCANDI HOME FURNISHINGS, INC.
Balance Sheets
2003
2004
2005
$50,000
200,000
450,000
700,000
300,000
$1,000,000
$40,000
260,000
500,000
800,000
400,000
$1,200,000
$10,000
360,000
600,000
970,000
500,000
$1,470,000
Accounts Payable
$130,000
Accruals
50,000
Bank Loan
90,000
Total Current Liabilities
270,000
Long-Term Debt
300,000
Common Stock ($10 par)* 300,000
Capital Surplus
50,000
Retained Earnings
80,000
Total Liab. & Equity
$1,000,000
$170,000
70,000
90,000
330,000
400,000
300,000
50,000
120,000
$1,200,000
$180,000
80,000
184,000
444,000
550,000
300,000
50,000
126,000
$1,470,000
Cash
Accounts Receivables
Inventories
Total Current Assets
Fixed Assets, Net
Total Assets
Note: 30,000 shares of common stock were issued to Kaj Rasmussen and the venture investors
when Scandi Home Furnishings was incorporated in mid-2002.
A. Kaj was particularly concerned by the drop in cash from $50,000 in 2003 to $10,000 in
2005. Calculate the average current ratio, the quick ratio, and the networking capital to
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total assets ratio for 2003-2004 and 2004-2005. What has happened to Scandi’s liquidity
position?
Note: ratio calculations involving asset items on the balance sheet are averages of the
prior and current years. See calculations below in the spreadsheet output. All three
liquidity ratios (current ratio, quick ratio, and the NWC-to-Total-Assets ratio) all were
trending downward. For example, the current ratio declined from 2.500 in 2004 to 2.287
in 2005.
B. An analysis of the cash conversion cycle should also help Kaj understand what has been
happening to the operations of Scandi. Prepare an analysis of the average conversion
periods for the three components of the cash conversion cycle for 2003-2004 and 20042005. Explain was has happened in terms of each component of the cycle.
Results for the cash conversion cycle and its components are shown below in the
spreadsheet output. Ratios are based on the current year’s income statement amounts and
average amounts (past year and current year) for balance sheet items. The cash
conversion cycle declined from 163.44 days in 2004 to 149.77 days in 2005 due to a
sharp decline in the inventory-to-sale conversion period which more than offset an
increase in the sale-to-cash conversion period and a decrease in the purchase-to-payment
conversion period.
C. Kaj should be interested in knowing whether Scandi has been building or burning cash.
Compare the cash build, cash burn, and the net cash build/burn positions for 2004 and
2005. What, if any, changes have occurred?
The venture had a net cash build of 17,000 for 2004 and a net cash burn of
-214,000 for 2005. See the spreadsheet output below for details. Operating and interest
expenses increased resulting in lower cash from operations. The situation was made
worse due to the increase in accounts receivable and in inventories.
D. Creditors, as well as management, are also concerned about the ability of the venture to
meet its debt obligations as they come due, the proportion of current liabilities to total
debt, the availability of assets to meet debt obligations in the event of financial distress,
and the relative size of equity investments to debt levels. Calculate average ratios in each
of these areas for the 2003-2004 and 2004-2005 periods. Interpret your results and
explain what has happened to Scandi.
The spreadsheet output below shows that financial leverage (as measured by the totaldebt-to-total-assets ratio, the equity multiplier, and the debt-to-equity ratio) deteriorated
or became worse in 2005 versus 2004. This indicates that the firm relied more heavily on
debt funds to meet its financial needs (i.e., net cash burn position in 2005). The currentliabilities-to-total debt ratio improved indicating a more than proportional use of longterm debt relative to short-term debt to meet financing needs in 2005.
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E. Of importance to Kaj and the venture investors is the efficiency of the operations of the
venture. Several profit margin ratios relating to the income statement are available to
help analyze Scandi’s performance. Calculate average profit margin ratios for 20032004 and 2004-2005 and describe what is happening to the profitability of Scandi Home
Furnishings.
All profitability ratios decreased in 2005 versus 2004. For example, the gross profit
margin decreased from 40.00% to 35.00% and the net profit margin decreased from
7.38% to 3.97%. See the spreadsheet results below for the other profitability ratio
calculations.
F. Kaj and the venture investors are also interested in how efficiently Scandi is able to
convert their equity investment, as well as the venture’s total assets, into sales. Calculate
several ratios that combine data from the income statements and balance sheets and
compare what has happened between the 2003-2004 and 2004-2005 periods.
The sales-to-total-assets ratio declined from 1.3636 in 2004 to 1.3483 in 2005. Decreases
also occurred in the ROA results (from 10.36% to .45%) and in the ROE results (from
25.33% to 1.27%). See spreadsheet results below.
G. A ROA model consisting of the product of two ratios provides an overview of a venture’s
efficiency and profitability at the same time. A ROE model consists of the product of
three ratios and simultaneously shows an overview a venture’s efficiency, profitability,
and leverage performance. Calculate ROA and ROE models for the 2003-2004 and
2004-2005 periods. Provide an interpretation of your findings.
ROA 2004:
ROA 2005:
ROE 2004:
ROE 2005:
10.36% = 7.38% x 1.3636
1.27% = 3.97% x 1.3483
25.33% = 7.38% x 1.3636 x 2.444
1.27% = 3.97% x 1.3483 x 2.822
Both the ROA and ROE model results show declining performance due to a large decline
in the net profit margin and a decline in the sales-to-assets ratio. Furthermore, the
financial leverage (as measured by the equity multiplier) increased from 2004 to 2005
during this period of declining operating performance.
H. Kaj has been able to obtain some industry ratio data from the home furnishings industry
trade association of which he is a member. The industry association collects proprietary
financial information from members of the association, compiles averages to protect the
proprietary nature of the information, and provides averages for use by individual trade
association members. Over the 2003-2004 and 2004-2005 periods, the inventory-to-sale
conversion period has averaged 200 days, while the sale-to-cash conversion period (days
of sales outstanding) for the industry has average 60 days. How did Scandi’s operations
in terms of these two components of the cash conversion cycle compare with these
industry averages?
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Scandi’s inventory-to-sale conversion period (192.64 days and 159.33 days) was lower
(and thus better) relative to the 200 day average for the industry. Thus, the firm was
turning over its inventories more quickly than the industry average. The firm’s sale-tocash conversion period decreased from being better than the 60-day industry average at
55.97 days to being worse than the industry average at 62.86 days.
I. Trade association data for the home furnishings industry shows an average net profit
margin of 6.5 percent, a sales-to-assets ratio of 1.3 times, and a total-debt-to-total-assets
ratio of 55 percent over the 2003-2004 and 2004-2005 time periods. Compare and
contrast to the industry average in terms of the ROA and ROE models. Make sure you
compare the components of each model as well as the product of the components.
If the total-debt-to-total-assets ratio is 55%, the equity-to-total-assets ratio is 45% (1 .55). If we calculate the inverse of this ratio (1/.45), we get an equity multiplier for the
industry of 2.222. Thus, the industry ROE model is:
ROE Industry: 18.78% = 6.50% x 1.300 x 2.222
From Part G:
ROA 2004: 10.36% = 7.38% x 1.3636
ROA 2005: 1.27% = 3.97% x 1.3483
ROE 2004: 25.33% = 7.38% x 1.3636 x 2.444
ROE 2005: 1.27% = 3.97% x 1.3483 x 2.822
Scandi’s ROE declined from above the industry average in 2004 to well below the
industry average in 2005. The firm’s net profit margin also declined from above the
industry average to below the industry average. Also, while the turnover of assets
declined slightly for the firm, the ratio remained above the industry average. Scandi’s
use of debt to finance its assets was above the industry average in 2004 and even more so
in 2005.
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Scandi Home Furnishings, Inc.
Income Statements
Net Sales
Cost of Goods Sold
Gross Profit
Marketing
General & Administrative
Depreciation
EBIT
Interest
Earnings Before Taxes
Income Taxes (40%)
Net Income
Cash Dividends
Increase in Retained Earnings
2003
1,300,000
780,000
520,000
130,000
150,000
40,000
40,000
200,000
45,000
155,000
62,000
93,000
20,000
Balance Sheets
Cash
Accounts Receivables
Inventories
Total Current Assets
Fixed Assets, Net
Total Assets
2003
50,000
200,000
450,000
700,000
300,000
1,000,000
Accounts Payable
Accruals
Bank Loan
Total Current Liabilities
Long-Term Debt
Common Stock ($10 par)
Capital Surplus
Retained Earnings
Total Liab. & Equity
130,000
50,000
90,000
270,000
300,000
300,000
50,000
80,000
1,000,000
Part C:
Cash
Build
2004
2005
2004
1,500,000 1,800,000 1,500,000
900,000 1,260,000
600,000
540,000
150,000
200,000
150,000
200,000
53,000 60,000
53,000
247,000
80,000
57,000
70,000
190,000
10,000
76,000
4,000
114,000
6,000
74,000
40,000
2004
40,000
260,000
500,000
800,000
400,000
1,200,000
Cash
Build
2005
1,800,000
Cash
Burn
2005
900,000
1,260,000
150,000
150,000
200,000
200,000
57,000
70,000
76,000
4,000
6,000
2005
10,000
360,000
600,000
970,000
500,000
1,470,000
(60,000)
170,000
180,000
70,000
80,000
90,000
184,000
330,000
444,000
400,000
550,000
300,000
300,000
50,000
50,000
120,000
126,000
1,200,000 1,470,000
Cash Build/(Burn) =
1,440,000
Net Cash Build/(Burn) =
17,000
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Cash
Burn
2004
(100,000)
50,000
100,000
100,000
100,000
(40,000)
(20,000)
(10,000)
(10,000)
(1,423,000)
1,700,000
(1,914,000)
(214,000)
Scandi Home Furnishings, Inc.
Note: Ratio calculations are based on the current year income statement items and average balance
sheet items. For example, the ratios for 2004 use income statement data for 2004 and average balance
sheet data for 2003 and 2004.
Industry Comparison
Ratio Calculations
2004
2005
Trend
Ratios
to Industry
Part A:
Liquidity Ratios:
Current Ratio
2.500
2.287
Lower
Quick Ratio
0.917
0.866
Lower
NWC-to-Total-Assets
0.409
0.373
Lower
Part B:
Cash Conversion Cycle (in Days):
Inventory-to-Sale
192.64
159.33
Improving
200.00
Better
Sale-to-Cash
55.97
62.86 Worsening
60.00
Worse
Purchase-to-Payment
(85.17)
(72.42) Worsening
Cash Conversion Cycle
163.44
149.77
Improving
Part D:
Measuring Financial Leverage:
Total-Debt-to-Total-Assets
0.5909
0.6457
Lower
0.5500
Higher
Equity Multiplier
2.444
2.822
Lower
Debt-to-Equity Ratio
1.444
1.822
Lower
Current-Liabilities-Total-Debt
0.4615
0.4490
Higher
Interest Coverage
5.263
2.000
Lower
Part E:
Profitability Ratios:
Gross Profit Margin
0.4000
0.3500
Lower
Operating Profit Margin
0.1593
0.1046
Lower
Net Profit Margin
0.0738
0.0397
Lower
0.0650
Lower
NOPAT Margin
0.0988
0.0267
Lower
Part F:
Efficiency and Return Ratios:
Sales-to-Total-Assets
1.3636
1.3483
Lower
1.300
Higher
Return on Total Assets (ROA)
0.1036
0.0045
Lower
Return on Equity (ROE)
0.2533
0.0127
Lower
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