I ntegrated Case

4-25
D’Leon I nc., Part I I
Financial Statement Analysis
Part I of this case, presented in Chapter 3, discussed the situation of D’Leon
I nc., a regional snack foods producer, after an expansion program. D’Leon
had increased plant capacity and undertaken a major marketing campaign in
an attempt to “go national.” Thus far, sales have not been up to the
forecasted level, costs have been higher than w ere projected, and a large
loss occurred in 2008 rather than the expected profit. As a result, its
managers, directors, and investors are concerned about the firm’s survival.
Donna Jamison w as brought in as assistant to Fred Campo, D’Leon’s
chairman, w ho had the task of getting the company back into a sound
financial position. D’Leon’s 2007 and 2008 balance sheets and income
statements, together w ith projections for 2009, are given in Tables I C 4-1
and I C 4-2. I n addition, Table I C 4-3 gives the company’s 2007 and 2008
financial ratios, together w ith industry average data. The 2009 projected
financial statement data represent Jamison’s and Campo’s best guess for
2009 results, assuming that some new financing is arranged to get the
company “over the hump.”
Jamison examined monthly data for 2008 ( not given in the case) , and
she detected an improving pattern during the year. Monthly sales w ere
rising, costs w ere falling, and large losses in the early months had turned to
a small profit by December. Thus, the annual data look somew hat w orse
than final monthly data. Also, it appears to be taking longer for the
advertising program to get the message out, for the new sales offices to
generate sales, and for the new manufacturing facilities to operate
efficiently. I n other w ords, the lags betw een spending money and deriving
benefits w ere longer than D’Leon’s managers had anticipated. For these
reasons, Jamison and Campo see hope for the company—provided it can
survive in the short run.
Jamison must prepare an analysis of w here the company is now , w hat it
must do to regain its financial health, and w hat actions should be taken.
Your assignment is to help her answ er the follow ing questions. Provide clear
explanations, not yes or no answ ers.

Table I C 4-1. Balance Sheets

2009E 2008 2007

Assets
Cash $ 85,632 $ 7,282 $ 57,600
Accounts receivable 878,000 632,160 351,200
I nventories 1,716,480 1,287,360 715,200
Total current assets $ 2,680,112 $ 1,926,802 $ 1,124,000
Gross fixed assets 1,197,160 1,202,950 491,000
Less accumulated depreciation 380,120 263,160 146,200
Net fixed assets $ 817,040 $ 939,790 $ 344,800
Total assets $ 3,497,152 $ 2,866,592 $ 1,468,800

Liabilities and Equity

Accounts payable $ 436,800 $ 524,160 $ 145,600
Notes payable 300,000 636,808 200,000
Accruals 408,000 489,600 136,000
Total current liabilities $ 1,144,800 $ 1,650,568 $ 481,600
Long-term debt 400,000 723,432 323,432
Common stock 1,721,176 460,000 460,000
Retained earnings 231,176 32,592 203,768
Total equity $ 1,952,352 $ 492,592 $ 663,768
Total liabilities and equity $ 3,497,152 $ 2,866,592 $ 1,468,800

Note: “E” indicates estimated. The 2009 data are forecasts.

 Table I C 4-2. I ncome Statements

2009E 2008 2007

Sales $ 7,035,600 $ 6,034,000 $ 3,432,000
Cost of goods sold 5,875,992 5,528,000 2,864,000
Other expenses 550,000 519,988 358,672
Total operating costs
excluding depreciation $ 6,425,992 $ 6,047,988 $ 3,222,672
EBI TDA $ 609,608 ($ 13,988) $ 209,328
Depreciation 116,960 116,960 18,900
EBI T $ 492,648 ( $ 130,948) $ 190,428
I nterest expense 70,008 136,012 43,828
EBT $ 422,640 ( $ 266,960) $ 146,600
Taxes ( 40% ) 169,056 ( 106,784) a 58,640
Net income $ 253,584 ( $ 160,176) $ 87,960

EPS $ 1.014 ($ 1.602) $ 0.880

DPS $ 0.220 $ 0.110 $ 0.220
Book value per share $ 7.809 $ 4.926 $ 6.638
Stock price $ 12.17 $ 2.25 $ 8.50
Shares outstanding 250,000 100,000 100,000
Tax rate 40.00% 40.00% 40.00%
Lease payments 40,000 40,000 40,000
Sinking fund payments 0 0 0

Note: “E” indicates estimated. The 2009 data are forecasts.

a
The firm had sufficient taxable income in 2006 and 2007 to obtain its full tax refund in 2008.
 Table I C 4-3. Ratio Analysis

I ndustry
2009E 2008 2007 Average
Current 1.2 2.3 2.7
Quick 0.4 0.8 1.0
I nventory turnover 4.7 4.8 6.1
Days sales outstanding ( DSO) a 38.2 37.4 32.0
Fixed assets turnover 6.4 10.0 7.0
Total assets turnover 2.1 2.3 2.6
Debt ratio 82.8% 54.8% 50.0%
TI E -1.0 4.3 6.2
Operating margin -2.2% 5.6% 7.3%
Profit margin -2.7% 2.6% 3.5%
Basic earning power -4.6% 13.0% 19.1%
ROA -5.6% 6.0% 9.1%
ROE -32.5% 13.3% 18.2%
Price/ earnings -1.4 9.7 14.2
Market/ book 0.5 1.3 2.4
Book value per share $4.93 $6.64 n.a.

Note: “E indicates estimated. The 2009 data are forecasts.

a
Calculation is based on a 365-day year.

A. Why are ratios useful? What are the five major categories of
ratios?

Answ er: [ S4-1 through S4-5 provide background information. Then, show
S4-6 and S4-7 here.] Ratios are used by managers to help
improve the firm’s performance, by lenders to help evaluate the
firm’s likelihood of repaying debts, and by stockholders to help
forecast future earnings and dividends. The five major categories
of ratios are: liquidity, asset management, debt management,
profitability, and market value.

B. Calculate D’Leon’s 2009 current and quick ratios based on the

projected balance sheet and income statement data. What can
 you say about the company’s liquidity positions in 2007, 2008, and
as projected for 2009? We often think of ratios as being useful ( 1)
to managers to help run the business, ( 2) to bankers for credit
analysis, and ( 3) to stockholders for stock valuation. Would these
different types of analysts have an equal interest in these liquidity
ratios?

Answ er: [ Show S4-8 and S4-9 here.]

Current ratio09 = Current assets/ Current liabilities

= $2,680,112/ $1,144,800 = 2.34.

Quick ratio09 = ( Current assets – I nventories) / Current liabilities

= ( $2,680,112 – $1,716,480) / $1,144,800
= $963,632/ $1,144,800 = 0.842.

The company’s current and quick ratios are identical to its

2007 current and quick ratios, and they have improved from their
2008 levels. How ever, both the current and quick ratios are w ell
below the industry averages.

C. Calculate the 2009 inventory turnover, days sales outstanding

( DSO) , fixed assets turnover, and total assets turnover. How does
D’Leon’s utilization of assets stack up against other firms in its
industry?

Answ er: [ Show S4-10 through S4-15 here.]

I nventory turnover 09 = Sales/ I nventory

= $7,035,600/ $1,716,480 = 4.10.

DSO09 = Receivables/ ( Sales/ 365)

= $878,000/ ( $7,035,600/ 365) = 45.55 days.

Fixed assets turnover 09 = Sales/ Net fixed assets

= $7,035,600/ $817,040 = 8.61.
 Total assets turnover 09 = Sales/ Total assets
= $7,035,600/ $3,497,152 = 2.01.

The firm’s inventory turnover and total assets turnover ratios

have been steadily declining, w hile its days sales outstanding has
been steadily increasing ( w hich is bad) . How ever, the firm’s 2009
total assets turnover ratio is only slightly below the 2008 level.
The firm’s fixed assets turnover ratio is below its 2007 level;
how ever, it is above the 2008 level.
The firm’s inventory turnover and total assets turnover are
below the industry average. The firm’s days sales outstanding
ratio is above the industry average ( w hich is bad) ; how ever, the
firm’s fixed assets turnover is above the industry average. ( This
might be due to the fact that D’Leon is an older firm than most
other firms in the industry, in w hich case, its fixed assets are older
and thus have been depreciated more, or that D’Leon’s cost of
fixed assets w ere low er than most firms in the industry.)

D. Calculate the 2009 debt and times-interest-earned ratios. How

does D’Leon compare w ith the industry w ith respect to financial
leverage? What can you conclude from these ratios?

Answ er: [ Show S4-16 and S4-17 here.]

Debt ratio09 = Total debt/ Total assets

= ( $1,144,800 + $400,000) / $3,497,152 = 44.17% .

TI E09 = EBI T/ I nterest = $492,648/ $70,008 = 7.04.

The firm’s debt ratio is much improved from 2008 and 2007,
and it is below the industry average ( w hich is good) . The firm’s
TI E ratio is also greatly improved from its 2007 and 2008 levels
and is above the industry average.
E. Calculate the 2009 operating margin, profit margin, basic earning
pow er ( BEP) , return on assets ( ROA) , and return on equity ( ROE) .
What can you say about these ratios?

Answ er: [ Show S4-18 through S4-24 here.]

Operating margin09 = EBI T/ Sales

= $492,648/ $7,035,600 = 7.00% .

Profit margin09 = Net income/ Sales

= $253,584/ $7,035,600 = 3.60% .

Basic earning pow er 09 = EBI T/ Total assets

= $492,648/ $3,497,152 = 14.09% .

ROA09 = Net income/ Total assets

= $253,584/ $3,497,152 = 7.25% .

ROE09 = Net income/ Common equity

= $253,584/ $1,952,352 = 12.99%  13.0% .

The firm’s operating margin is above 2007 and 2008 levels but
slightly below the industry average. The firm’s profit margin is
above 2007 and 2008 levels and slightly above the industry
average. While the firm’s basic earning pow er and ROA ratios are
above 2007 and 2008 levels, they are still below the industry
averages. The firm’s ROE ratio is greatly improved over its 2008
level; how ever, it is slightly below its 2007 level and still w ell
below the industry average.

F. Calculate the 2009 price/ earnings ratio and market/ book ratio.
Do these ratios indicate that investors are expected to have a high
or low opinion of the company?
Answ er: [ Show S4-25 and S4-26 here.]

EPS09 = Net income/ Shares outstanding

= $253,584/ 250,000 = $1.0143.

Price/ Earnings09 = Price per share/ Earnings per share

= $12.17/ $1.0143 = 12.0.

Check: Price = EPS  P/ E = $1.0143( 12.0) = $12.17.

BVPS09 = Common equity/ Shares outstanding

= $1,952,352/ 250,000 = $7.81.

Market/ Book 09 = Market price per share/ Book value per share
= $12.17/ $7.81 = 1.56.

The P/ E and M/ B ratios are above the 2008 and 2007 levels
but below the industry average.

G. Use the DuPont equation to provide a summary and overview of

D’Leon’s financial condition as projected for 2009. What are the
firm’s major strengths and w eaknesses?

Answ er: [ Show S4-27 and S4-28 here.]

DuPont equation = Profit  Total assets 

Equity
margin turnover multiplier
= 3.60%  2.01  1/ ( 1 – 0.4417)
= 12.96%  13.0% .

Strengths: The firm’s fixed assets turnover w as above the industry

average. How ever, if the firm’s assets w ere older than other firms
in its industry this could possibly account for the higher ratio.
( D’Leon’s fixed assets w ould have a low er historical cost and
w ould have been depreciated for longer periods of time.) The
firm’s profit margin is slightly above the industry average, and its
debt ratio has been greatly reduced, so it is now below the
 industry average ( w hich is good) . This improved profit margin
could indicate that the firm has kept operating costs dow n as w ell
as interest expense ( as show n from the reduced debt ratio) .
I nterest expense is low er because the firm’s debt ratio has been
reduced, w hich has improved the firm’s TI E ratio so that it is now
above the industry average.

Weaknesses: The firm’s current asset ratio is low ; most of its

asset management ratios are poor ( except fixed assets turnover) ;
most of its profitability ratios are low ( except profit margin) ; and
its market value ratios are low .

H. Use the follow ing simplified 2009 balance sheet to show , in

general terms, how an improvement in the DSO w ould tend to
affect the stock price. For example, if the company could improve
its collection procedures and thereby low er its DSO from 45.6 days
to the 32-day industry average w ithout affecting sales, how w ould
that change “ripple through” the financial statements ( show n in
thousands below ) and influence the stock price?

Accounts receivable $ 878 Debt $1,545

Other current assets 1,802
Net fixed assets 817 Equity 1,952
Total assets $3,497 Liabilities plus equity $3,497
Answ er: [ Show S4-29 through S4-32 here.]

Sales per day = $7,035,600/ 365 = $19,275.62.

Accounts receivable under new policy = $19,275.62  32 days

= $616,820.

Freed cash = old A/ R – new A/ R

= $878,000 – $616,820 = $261,180.

Reducing accounts receivable and its DSO w ill initially show

up as an addition to cash. The freed up cash could be used to
repurchase stock, expand the business, and reduce debt. All of
these actions w ould likely improve the stock price.

I. Does it appear that inventories could be adjusted? I f so, how

should that adjustment affect D’Leon’s profitability and stock
price?

Answ er: The inventory turnover ratio is low . I t appears that the firm either
has excessive inventory or some of the inventory is obsolete. I f
inventory w ere reduced, this w ould improve the current asset
ratio, the inventory and total assets turnover, and reduce the debt
ratio even further, w hich should improve the firm’s stock price and
profitability.
J. I n 2008, the company paid its suppliers much later than the due
dates; also it w as not maintaining financial ratios at levels called
for in its bank loan agreements. Therefore, suppliers could cut the
company off, and its bank could refuse to renew the loan w hen it
comes due in 90 days. On the basis of data provided, w ould you,
as a credit manager, continue to sell to D’Leon on credit? ( You
could demand cash on delivery—that is, sell on terms of COD—but
that might cause D’Leon to stop buying from your company.)
Similarly, if you w ere the bank loan officer, w ould you recommend
renew ing the loan or demand its repayment? Would your actions
be influenced if in early 2009 D’Leon show ed you its 2009
projections along w ith proof that it w as going to raise more than
$1.2 million of new equity?

Answ er: While the firm’s ratios based on the projected data appear to be
improving, the firm’s current asset ratio is low . As a credit
manager, you w ould not continue to extend credit to the firm
under its current arrangement, particularly if my firm didn’t have
any excess capacity. Terms of COD might be a little harsh and
might push the firm into bankruptcy. Likew ise, if the bank
demanded repayment this could also force the firm into
bankruptcy.
Creditors’ actions w ould definitely be influenced by an
infusion of equity capital in the firm. This w ould low er the firm’s
debt ratio and creditors’ risk exposure.

K. I n hindsight, w hat should D’Leon have done back in 2007?

Answ er: Before the company took on its expansion plans, it should have
done an extensive ratio analysis to determine the effects of its
proposed expansion on the firm’s operations. Had the ratio
 analysis been conducted, the company w ould have “gotten its
house in order” before undergoing the expansion.

L. What are some potential problems and limitations of financial ratio

analysis?

Answ er: [ Show S4-33 and S4-34 here.] Some potential problems are listed
below :

1. Comparison w ith industry averages is difficult if the firm

operates many different divisions.

2. Different operating and accounting practices distort

comparisons.

3. Sometimes hard to tell if a ratio is “good” or “bad.”

4. Difficult to tell w hether company is, on balance, in a strong or

w eak position.

5. “Average” performance is not necessarily good.

6. Seasonal factors can distort ratios.

7. “Window dressing” techniques can make statements and

ratios look better.

8. I nflation has badly distorted many firms’ balance sheets, so a

ratio analysis for one firm over time, or a comparative analysis
of firms of different ages, must be interpreted w ith judgment.
M. What are some qualitative factors analysts should consider w hen
evaluating a company’s likely future financial performance?

Answ er: [ Show S4-35 here.] Top analysts recognize that certain qualitative
factors must be considered w hen evaluating a company. These
factors, as summarized by the American Association of I ndividual
I nvestors ( AAI I ) , are as follow s:

1. Are the company’s revenues tied to one key customer?

2. To w hat extent are the company’s revenues tied to one key

product?

3. To w hat extent does the company rely on a single supplier?

4. What percentage of the company’s business is generated

overseas?

5. How much competition does the firm face?

6. I s it necessary for the company to continually invest in

research and development?

7. Are changes in law s and regulations likely to have important

implications for the firm?