Assignment 1: Chapter 2 Mini Case: ?Financial Statement and Cash Flow Analysis?

You are to write a six to ten (6-10) page report that responds to the following:

Part A:

Use the financial statements in the text to determine the following for Jaeden Industries.

• Calculate Jaedan?s free cash flow.
• Calculate Jaedan?s liquidity.
• Calculate Jaedan?s debt and profitability ratios.
• Calculate Jaedan?s market ratios.

Part B:

Based on your analysis:

• Highlight at least three financial strengths and three weaknesses Jaeden Industries may have.
• Provide recommendations along with rationale on how Jaeden?s management may improve upon these weaknesses.

The format of the report is to be as follows:

• Typed, double spaced, Times New Roman font (size 12), one inch margins on all sides, APA format.
• Use headers for each of the subjects being covered, followed by your response.
• In addition to the six to ten (6-10) pages required, a title page is to be included. The title page is to contain the title of the assignment, your name, the instructor?s name, the course title, and the date.

MINI-CASE: FINANCIAL STATEMENT AND CASH FLOW ANALYSIS Jaedan Industries has the following account balances as of December 31, 2010. The firm's dividend payout ratio is 25% and the tax rate is 34%. The firm's stock price on December 31, 2009, was $42.89 and on December 31, 2010, it was $56.82. Construct an income statement, balance sheet, statement of retained earnings, and statement of cash flows for 2010. Also determine the firm's free cash flow and calculate the liquidity, activity, debt, profitability, and market ratios for Jaedan Industries. Perform a DuPont analysis and compare the firm to the industry ratios (see last table in this sequence). Highlight any financial strengths and weaknesses that Jaedan Industries may have. Jaedan Industries Account Balances for the Year Ending December 31, 2010 Sales $42,000,000 Cost of goods sold (COGS) 63% Portion of COGS that represents purchases 75% Selling, general, and administrative expenses $1,621,000 Depreciation $800,000 Interest rate on short- and long-term debt 10% Cash balance $3,689,000 Accounts receivable $5,423,000 Marketable securities $1,836,000 Inventory $4,118,000 Fixed assets $14,811,000 Accumulated depreciation (does not include depreciation for 2010) $5,160,000 Accounts payable $3,136,000 Notes payable $706,000 Accruals $500,000 Long-term bonds outstanding $3,046,000 Preferred stock (at par) $100,000 Retained earnings (does not include retained earnings for 2010) $1,628,819 Common stock (at par) $4,000,000 Paid-in capital in excess of par $4,500,000 Tax rate 34% Dividend payout ratio (common stock) 25% Dividends on preferred stock 8% of par Number of shares of common stock outstanding 1 million Terms of trade on accounts receivable 35 days Terms of trade on accounts payable 45 days To aid in your calculations, the financial statements from 2009 are given below. Jaedan Industries Income Statement for the Year Ending December 31, 2009 Sales $38,578,155 Less: Cost of goods sold 27,004,709 Gross profit $11,573,447 Less: Operating expenses: Selling, general, and administrative expenses $ 1,000,000 Depreciation 700,000 Earnings before interest and taxes $ 9,873,447 Less: Interest expense 375,000 Earnings before taxes $ 9,498,447 Less: Taxes 3,229,472 Net income $ 6,268,975 Less: Dividends paid 1,575,244 To retained earnings $ 4,693,731 The industry ratios for 2009 and 2010 are as follows. 1 When reporting to shareholders, firms typically also include a so-called common-size income statement wherein all entries are expressed as a percentage of sales. 2 Companies frequently include depreciation expense in manufacturing coststhe cost of goods soldwhen calculating gross profits. In this text we show depreciation as an expense in order to isolate its effect on cash flows. 3 Corporations are subject to federal corporate tax rates that are progressive and range between 15% and 39%. Personal tax rates are also progressive, and the federal rate ranges from 10% to 35%. 4 Also note that the relative increase of the two broadest measures of income (EBIT and net income) was far greater than that of sales revenue. Whereas sales increased by 41% (from $9,110 million to $12,843 million), EBIT and net income increased by 98% and 101%, respectively. This suggests that the firm's extensive use of fixed-cost assets (refineries, pipelines, tankers, etc.) imparts a high degree of operating leverage, meaning that a given percentage increase (decrease) in sales yields a much larger percentage increase (decrease) in operating profits (the same as with EBIT). Chapter 9 discusses the concept of operating leverage more fully. 5 A related indicator of a firm's financial performance is earnings before interest, taxes, depreciation, and amortization (EBITDA). Analysts use EBITDA to compare profitability of companies because it measures revenue minus all expenses other than interest, taxes, depreciation, and amortization. It thereby eliminates the effects of financing and accounting decisions. Although EBITDA is a good measure of profitability, it does not measure cash flows. 6 This equation is often presented as: FCF = OCF - Capital Expenditures + Depreciation WC where: Capital Expenditures Depreciation = FA CA AP Accruals = WC, where WC is net working capital 7 For a description and demonstration of the detailed procedures for developing the statement of cash flows, see any recently published financial accounting textfor example, Chapter 14 of Corporate Financial Accounting (Warren, Reeve, and Duchac 2009). 8 For example, airlines pay close attention to the ratio of revenues to passenger miles flown. Retailers diligently track the growth in same-store sales from one year to the next. 9 An alternate and more precise definition of the quick (acid-test) ratio is (cash + marketable securities + accounts receivable) current liabilities. This definition eliminates inventory as well as prepaid and other current assets from the numerator. For convenience, though, we use the more common approximation shown in the text. 10 The average collection period is sometimes called the days' sales outstanding (DSO). As with the inventory turnover ratio, the average collection period can be calculated using either end-ofyear accounts receivable or the average receivables balance for the year. We discuss the evaluation and establishment of credit and collection policies in Chapter 22. 11 By fixed cost we mean that the cost of this financing source does not vary over time in response to changes in the firm's revenue and cash flow. For example, if a firm borrows money at a variable rate, then the interest cost of that loan is not fixed through time although the firm's obligation to make interest payments is \"fixed\" regardless of the level of the firm's revenue and cash flow. 12 Some analysts calculate (1) the net profit margin by excluding the financing costs associated with debt and (2) preferred stock dividends by using in the numerator NOPAT rather than earnings available for common stockholders. Applying this formula results in a measure of aftertax operating profits. Here we use the more comprehensive measure of overall profits on sales. 13 We state all per-share values strictly in dollars and cents, as do company reports. Per-share values are not stated in millions, unlike the dollar values used to calculate these and other ratios. 14 Naturally, all other things being equal, firms prefer a high ROA. However, as we will see later, analysts must be cautious when interpreting financial ratios. We recall an old Dilbert comic strip in which Wally suggests boosting his firm's ROA by firing the security staff. The reduction in expenses would boost the numerator while the reduction in security would lower the denominator. 15 Some analysts prefer using NOPAT in the numerator, rather than using earnings available for common stockholders, in order to more clearly focus the ratio on the productivity of assets without regard to their cost of financing. Here we use the more general formula for ROA. 16 Keep in mind that the ratios in the DuPont system are interdependent and that the equation is just a mathematical identity. It is easy to draw questionable conclusions about lines of causality using the DuPont system. For example, consider this farcical version of the formula: In this equation, we might interpret the third term on the right as the efficiency with which a CEO of a given age manages the firm's assets. If a younger CEO manages the same quantity of assets then this ratio would increase and, holding all other factors constant, we could say that the firm's ROE would increase. This is clearly silly, but mathematically this expression ultimately gives you the firm's ROE. Running Head: Financial Statement Analysis 1 Financial Statement and Cash Flow Analysis Institution Student Name Professor Name Course Code Date Financial Statement Analysis 2 Jaedan's Free Cash Flow Free cash flow is the amount of cash available for sharing by investors. This is obviously after the business has met its obligations and made all the strategic investments for the future of the company. Making investments is important to ensure that the company continues to exist in the long run, (Graham, Megginson & Smart, 2010). Below is the calculation for free cash flow; Net Operating Profits after Taxes = EBIT * (1-T) = $9,873,447 * (0.66) = $ 6,516,475.02 Operating Cash Flow = Net operating profits after taxes + Depreciation = 6,268,975 + 800,000 = $ 6,968,975 Free Cash Flow = EBIT (1-t) + Depreciation & Amort. - Capital expenses - working capital = 6,516,475.02 + 800,000 - (4,500,000.00 - 190,000.00 - 150,000.00) = 2,476,475.02 Jaedan`s Industries Liquidity Liquidity ratios are used to measure the ability of a firm to meet its short term obligations when they become due. The mostly used ratios are quick ratio and current ratio. Current ratio Financial Statement Analysis measures the depth in which current assets of a company cover the current liabilities of a company. Current assets are the assets that can quickly be converted into cash while current liabilities are the short-term facilities that will be due within a year. Quick ratio operates just as current ratio only that it does not consider inventory as a current asset. It argues that this could take a while to convert to cash i. Liquidity Ratios Current Ratio = Current assets/Current Liabilities = 15,066,000/4,342,000 = 3.47 Quick Ratio = (Current assets - Inventory)/Current liabilities = (15,066,000-4,118,000)/4,342,000 = 2.52 ii. Inventory Turnover Ratio Inventory turnover = Cost of Goods Sold (COGS)/Inventory = 26,460,000/4,118,000 = 6.43 Average Age Turnover = 365/6.43 3 Financial Statement Analysis 4 Average Age Turnover = 57 days iii. Debt and Profitability Ratios Debt and profitability ratios do not use Current assets and liabilities but rather the total assets and liabilities. Total assets comprises of anything that the company can sell to get cash that belong to it. It does not matter how long it will take to sell the item. Debt ratios measure the ability of a firm to pay all of its obligations while profitability ratios determine how profitable the company is. This data is used by investors when making financial decisions. When determining total assets one has to take into consideration the value of depreciation. There are various accounting methods that one can compute depreciation of an asset. Asset-to-equity ratio = Total assets/ Common stock equity =24,717,000/8,500,000 = 291% Debt Ratio = Total liabilities/Total Assets =7,388,000/24,717,000 = 29.90% Time interest earned = Earnings before interest and taxes/ Interest expenses Financial Statement Analysis 5 = 9,873,447 /375,000 =26.33 Debt to equity ratio = Long term debt / Stockholders equity = 3,046,000/8,500,000 = 35.83% Gross profit margin = Gross profit/sales = 15,540,000/42,000,000 = 37% Operating profit margin = Operating profit/sales = 13,119,000/42,000,000 = 31.24% Earnings per share = Earnings available for common stockholders/ Number of outstanding common shares = 8,410,908 / 1,000,000 =$8.41 Return to assets = Earnings available for common shareholders / Total assets Financial Statement Analysis = 8,410, 908 / 23,917,000 = 35.17% Net profit Margin = Earnings available for the common shareholders / Sales = 8,410,908/ 42,000,000 = 20.03% iv. Market Ratio of Jaedan's industries Market ratios are used by a firm to portray its position in the market. This is measured using its current share price against other accounting figures found in its financial analysis. The ratio defines how a firm is performing in regards to its valuation. These ratios are used by an investor to compare companies so as to choose the one that is performing better than the other. The most used market ratio is the price earnings ratio (P/E) and the market/book ratio. The price/earnings ratio shows how much investors of a company are willing to pay for every dollar that the company earns. On the other hand, Market/Book ratio gives the insights on how investors regard the performance of the firm, (Graham, Megginson & Smart, 2010). Price/ Earnings ratio = Market share price / Earnings per share = 56.82 / 8.41 6 Financial Statement Analysis 7 = 6.76 Market/Book Ratio = Market share price / Book value of common stock share = 56.82 / 16.42 = 3.46 Jaedan's Strengths and weaknesses Jaeden had more operating profit in the year 2010 as compared to 2009. Which shows a growth which is in the right direction. This increase in profits can be credited to the increase in sales in 2010 when compared to 2009. In 2009 the sales of the company were 38,578,155 which then increased to 42,000,000 in 2010. This led to also an increase in earnings per share. Earnings per share show the amount that investors earned in the year, (Graham, Megginson & Smart, 2010). An increase of course will increase more confidence and attract more investors. Some of the weaknesses of Jaeden industries are portrayed in its ratios. The company needs to improve on the times interest earned ration. The interest earned is expected to be increasing but in their case the value actually dropped. This shows a reduction in the capacity of the company into meeting its scheduled payments. Financial Statement Analysis 8 The company needs to also improve its inventory turnover. The ratio shows on how the company is performing in regards to stock purchasing and sales. A bad ratio shows that the firm is overstocking or is not making enough sales to reduce its inventory. This could lead to increase in storage costs, holding costs and possibility of wastage (Inventory Turnover Ratio, n.d.). The company has an average of 57 days in inventory turnover. This means that they turnover the stock 6.426 times in a year. The company needs to improve on its logistics when buying inventory to save it from the losses of having a lot of stock in a year. The company also has a current ratio that is above than the industry average. This means that there is a possibility that a firm is not using its current assets and short-term liabilities efficiently. This is confirmed when the quick ratio is bigger than 2.00. This could also mean that the company has a problem in the management of working capital, (U.S. Trust Wealth Survey, n.d.). References Graham, J., Megginson, B. & Smart, S. (2010). Corporate Finance, Mason, OH. Retrieved January 31, 2016, from: Cengage Learning (42), The Average Collection Period. Graham, J., Megginson, B. & Smart, S. (2010). Corporate Finance, Mason, OH. Retrieved January 31, 2016, from: Cengage Learning (34-35), Cash Flow Analysis Graham, J., Megginson, B. & Smart, S. (2010). Corporate Finance, Mason, OH. Financial Statement Analysis 9 Retrieved January 31, 2016, from: Cengage Learning (40-41), Liquidity Ratios Hill, R. (n.d.). Total assets: definition & explanation - study.com Retrieved January 31, 2016, from: http://study.com/academy/lesson/total-assetsdefinition-lesson-quiz.html. U.S. Trust Wealth Survey. (n.d.). Current Ratio, Retrieved May 24, 2017, from: http://www.readyratios.com/reference/liquidity/current-ratio.html. Working Capital Management.(n.d.). Working capital management terms. Retrieved May 25, 2017, from: http://www.investopedia.com/terms/w/workingcapital management.asp