Case Study

Matthew Jayden was brought in as assistant to Isaiah Christopher, Computation's chairman, who had the task of getting the company back in to sound financial position. Computation's 2016 and 2017 balance sheet and income statements, together with projections for 2018, are shown in the following tables. Also the table show the 2016 and 2017 financial ratios, along with the industry average data. The 2018 projected financial statement data represent Jayden and Christopher's best guess for 2018 results, assuming that some new financing is arranged to get the company ''over the hump''

Balance sheets

2016

2017

2018E

Assets

Cash

$ 9,000

$ 7,282

$ 14,000

Short term investments

48,600

20,000

71,632

Account receivable

351,200

632,160

878,000

Inventories

751,200

1,287,360

1,716,480

Total current assets

$ 1,124,000

$ 1,946,802

$ 2,680,112

Gross fixed assets

491,000

1,202,950

1,220,000

Less: Accumulated depreciation

146,200

263,160

383,160

Net fixed assets

$ 344,800

$ 939,790

$ 836,840

Total assets

$ 1,468,800

$ 2,886,592

$ 3,516,952

Liabilities and Equity

Accounts payable

$ 145,600

$ 324,000

$ 359,800

Notes payable

200,000

720,000

300,000

Accruals

136,000

284,960

380,000

Total currentliabilities

$ 481,600

$ 1,328,960

$ 1,039,800

Long term debt

323,432

1,000,000

500,000

Common stock(100,000 shares)

460,000

460,000

1,680,936

Retained earnings

203,768

97,632

296,216

Total equity

$ 663,768

$ 557,632

$ 1,977,152

Total liabilities and equity

$ 1,468,800

$ 2,886,592

$ 3,516,952

Note: ''E'' indicates estimated. The 2018 data are forecasts.

Income statements

2016

2017

2018E

Sales

3,432,000

5,834,400

7,035,600

Cost of goods sold

2,864,000

4,980,000

5,800,000

Other expenses

340,000

720,000

612,960

Depreciation

18,900

116,690

120,000

Total Operating costs

$ 3,222,900

$ 5,816,690

$ 6,532,960

EBIT

$ 209,100

$ 17,440

$ 502,640

Interest expense

62,500

176,000

80,000

EBT

146,000

($ 158,560)

$ 422,640

Taxes (40%)

58,640

(63,424)

169,056

Net income

$ 87,960

($ 95136)

$ 253,548

Note: ''E'' indicates estimated. The 2018 data are forecasts.

Ratio analysis

2016

2017

2018E

Industry average

Current

2.3

1.5

-

2.7

Quick

0.8

0.5

-

1.0

Fixed assets turnover

10.0

6.2

-

7.0

Total assets turnover

2.3

2.0

-

2.5

Debt ratio

54.8%

80.7%

-

50.0%

Time Interest Earned

3.3

0.1

-

6.2

Profit margin

2.6%

-1.6%

-

3.6%

ROA

6.0%

-3.3%

-

9.0%

ROE

13.3%

-17.1

-

17.9%

Price/earning (P/E)

9.7

-6.3

16.2

Price/cash flow

1.3

1.1

-

2.9

Note: ''E'' indicates estimated. The 2018 data are forecasts.

Jayden examined monthly data for 2017 (not given in the case) and she detected an improvement pattern during the year. Monthly sales were rising, costs were falling and large losses in the early months had turned to small profits by December. Thus the annual data looked 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 Computron's managers had anticipated. For these reasons, Jayden and Christopher see hope for the company, provided it can survive in the short run.

Jayden 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. You should help him answer the following questions. Provide clear explanations, not yes or no answers.

a.Calculate the 2018 current and quick ratio based on the projected balance sheet and income statement data. What can you say about the company's liquidity position in 2016, 2017 and as projected for 2018?

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 liquidity ratio?

b.Why are ratios useful? What major categories of ratios are discussed in this case?

c.Calculate the 2018 debt, time interest earned ratios. How does Computron compare with the industry with respect to financial leverage? What can you conclude from these ratios?

d.Calculate the 2018 profit margin, ROA and ROE. What can you say about these ratios?

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

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