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DLeon Inc., Part II

Financial Statement Analysis

Part I of this case, presented in Chapter 3, discussed the situation that DLeon Inc., a regional snack-foods producer, was in after an expansion program. DLeon 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 firms survival.

Donna Jamison was brought in as assistant to Fred Campo, DLeons chairman, who had the task of getting the company back into a sound financial position. DLeons 2004 and 2005 balance sheets and income statements, together with projections for 2006, are given in Tables IC 4-1 and IC 4-2. In addition, Table IC 4-3 gives the companys 2004 and 2005 financial ratios, together with industry average data. The 2006 projected financial statement data represent Jamisons and Campos best guess for 2006 results, assuming that some new financing is arranged to get the company over the hump.

Jamison examined monthly data for 2005 (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 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 DLeons managers had anticipated. For these reasons, Jamison and Campo see hope for the companyprovided 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.

Table IC 4-1. Balance Sheets

2006E 2005 2004

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

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 2006 data are forecasts.

Table IC 4-2. Income Statements

2006E 2005 2004

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

EBITDA $ 609,608 ($ 13,988) $ 209,328

Depreciation 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 2006 data are forecasts.

^a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005.

Table IC 4-3. Ratio Analysis

Industry

2006E 2005 2004 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 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%

TIE -1.0 4.3 6.2

EBITDA coverage 0.1 3.0 8.0

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

Price/cash flow -5.2 8.0 11.0

Market/book 0.5 1.3 2.4

Book value per share $4.93 $6.64 n.a.

Note: E indicates estimated. The 2006 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?

B. Calculate DLeons 2006 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys 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 DLeons 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 DLeon 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 DLeons financial condition as projected for 2006. What are the firms 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?

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

I. Does it appear that inventories could be adjusted, and, if so, how should that adjustment affect DLeons profitability and stock price?