Part I of this case, presented in Chapter 3, discussed the situation that D’Leon Inc., a regional snack-foods producer, was in 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 were projected, and a large loss occurred in 2005 rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival.

Donna Jamison was brought in as assistant to Fred Campo, D’Leon’s chairman, who had the task of getting the company back into a sound financial position. D’Leon’s 2004 and 2005 balance sheets and income statements, together with projections for 2006, are given in Tables IC4-1 and IC4-2. In addition, Table IC4-3 gives the company’s 2004 and 2005 financial ratios, together with industry average data. The 2006 projected financial statement data represent Jamison’s and Campo’s best guess for 2006 results, assuming that some new financing is arranged to get the company “over the hump.”

during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data look somewhat worse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message across, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were 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 where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.

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

b. Calculate D’Leon’s 2006 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 2004, 2005, and as projected for 2006? 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? 

c. Calculate the 2006 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? 

d. Calculate the 2006 debt, times-interest-earned, and EBITDA coverage ratios. How does D’Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios? 

e. Calculate the 2006 profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?

f. Calculate the 2006 price/earnings ratio, price/cash flow ratio, and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

g. Use the extended Du Pont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2006. What are the firm’s major strengths and weaknesses?

h. Use the following simplified 2006 balance sheet to show, in general terms, how an improvement in the DSO would tend to affect the stock price. For example, if the company could improve its collection procedures and thereby lower its DSO from 45.6 days to the 32-day industry average without affecting sales, how would that change “ripple through” the financial statements (shown in thousands below) and influence the stock price?

i. Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect D’Leon’s profitability and stock price?

j. In 2005, the company paid its suppliers much later than the due dates, and it was 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 when it comes due in 90 days. On the basis of data provided, would 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 were the bank loan officer, would you recommend renewing the loan or demand its repayment? Would your actions be influenced if, in early 2006, D’Leon showed you its 2006 projections plus proof that it was going to raise more than $1.2 million of new equity? 

k. In hindsight, what should D’Leon have done back in 2004? 

l. What are some potential problems and limitations of financial ratio analysis? 

m. What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance?

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Accounts receivable Other current assets Net fixed assets Total assets $ 878 Debt $1,545 1,802 817 Equity Liabilities plus equity 1,952 $3,497 $3,497 TABLE IÇ4-1 Balance Sheets 2006E 2005 2004 Assets $ 85,632 878,000 1,716,480 Cash 2$ 7,282 $ 57,600 Accounts receivable 632,160 351,200 Inventories 1,287,360 $1,926,802 1,202,950 715,200 $1,124,000 491,000 Total current assets $2,680,112 Gross fixed assets Less accumulated depreciation 1,197,160 380,120 263,160 146,200 $ 817,040 $ 939,790 $ 344,800 $1,468,800 Net fixed assets Total assets $3,497,152 $2,866,592 Liabilities and Equity Accounts payable Notes payable Accruals $ 524,160 $ 436,800 300,000 408,000 $1,144,800 $ 145,600 636,808 200,000 489,600 136,000 $ 481,600 Total current liabilities $1,650,568 723,432 Long-term debt Common stock 400,000 323,432 1,721,176 460,000 460,000 Retained earnings Total equity 231,176 32,592 203,768 $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 2006 data are forecasts. TABLE IC4-2 Income Statements 2006E 2005 2004 $3,432,000 2,864,000 358,672 Sales Cost of goods sold Other expenses Total operating costs excluding depreciation EBITDA $7,035,600 5,875,992 550,000 $6,034,000 5,528,000 519,988 $6,425,992 $ 609,608 116,960 $ 492,648 $6,047,988 $3,222,672 ($ 13,988) $ 209,328 Depreciation 116,960 18,900 EBIT ($ 130,948) $ 190,428 70,008 $ 422,640 136,012 ($ 266,960) ( 106,784) Interest expense 43,828 $ 146,600 58,640 EBT Taxes (40%) 169,056 $ 253,584 ($ 160,176) $ 87,960 Net income EPS $1.014 ($1.602) $0.110 $4.926 $0.880 $0.220 $7.809 $0.220 $6.638 DPS Book value per share Stock price Shares outstanding $12.17 $2.25 $8.50 250,000 40.00% 100,000 100,000 Tax rate 40.00% 40.00% Lease payments Sinking fund payments 40,000 40,000 40,000 Note: "E" indicates estimated. The 2006 data are forecasts. a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005.