FINANCIAL STATEMENTS AND TAXES Part I of this case, presented in Chapter 3, discussed the situation of D’Leon Inc., 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 were projected, and a large loss occurred in 2014 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 2013 and 2014 balance sheets and income statements, together with projections for 2015, are given in Tables IC 4.1 and IC 4.2. In addition, Table IC 4.3 gives the company’s 2013 and 2014 financial ratios, together with industry average data. The 2015 projected financial statement data represent Jamison’s and Campo’s best guess for 2015 results, assuming that some new financing is arranged to get the company “over the hump.”

Jamison examined monthly data for 2014 (not given in the case), and she detected an improving pattern 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 out, 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 2015 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 2013, in 2014, and as projected for 2015?
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 the company’s liquidity ratios? Explain your answer.

c. Calculate the 2015 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 the industry?

d. Calculate the 2015 debt-to-capital and times-interest-earned ratios. How does D’Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios?

e. Calculate the 2015 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC). What can you say about these ratios?

f. Calculate the 2015 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?
g. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2015. What are the firm’s major strengths and weaknesses?
h. Use the following simplified 2015 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?
Accounts receivable $ 878 Current liabilities $ 845 Other current assets 1,802 Debt 700 Net fixed assets 817 Equity 1,952 Total assets $3,497 Liabilities plus equity $3,497 i. Does it appear that inventories could be adjusted? If so, how should that adjustment affect D’Leon’s profitability and stock price?
j. In 2014, the company paid its suppliers much later than the due dates; also, 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 demanding its repayment? Would your actions be influenced if, in early 2015, D’Leon showed you its 2015 projections along with proof that it was going to raise more than $1.2 million of new equity?
k. In hindsight, what should D’Leon have done in 2013?
l. What are some potential problems and limitations of financial ratio analysis?
m. What are some qualitative factors that analysts should consider when evaluating a company’s likely future financial performance?

2015E 2014 2013 Assets Cash $ 85,632 $ 7,282 $ 57,600 Accounts receivable 878,000 632,160 351,200 Inventories 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 Accruals 408,000 489,600 136,000 Notes payable 300,000 636,808 200,000 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 2015 data are forecasts.

2015E 2014 2013 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 and amortization $6,425,992 $ 6,047,988 $3,222,672 EBITDA $ 609,608 ($ 13,988) $ 209,328 Depreciation & amortization 116,960 116,960 18,900 EBIT $ 492,648 ($ 130,948) $ 190,428 Interest 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 2015 data are forecasts.
aThe firm had sufficient taxable income in 2012 and 2013 to obtain its full tax refund in 2014.

2015E 2014 2013 Industry Average Current 1 2 2 3 2 7 Quick 0 4 0 8 1 0 Inventory turnover 4 7 4 8 6 1 Days sales outstanding (DSO)a 382 374 32 0 Fixed assets turnover 6 4 10 0 7 0 Total assets turnover 2 1 2 3 2 6 Debt-to-capital ratio 73 4% 44 1% 40 0%
TIE –1 0 4 3 6 2 Operating margin –2 2% 5 5% 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%
ROIC –4 2% 9 6% 14 5%
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 2015 data are forecasts.
aCalculation is based on a 365-day year.AppendixLO1