Chem-Med Company

April 1, 20XX:

Dr. Nathan Swan, age 40, chairman of the board of directors, chief executive officer, and founder of the ChemMed Company, was in his office staring at the ceiling, wondering if he would not have been better off still teaching biochemistry at the University of Toronto. This business was getting to be a headache. Only a short time ago he was able to spend most of his time in the company lab comfortably working with test tubes and formulas. Lately, though, it seemed that all his waking hours were spent with financial statements and spreadsheets, and in meetings. He wanted the firm to grow and make money, but he had no idea that the financial end of the business would be so demanding and complex. Dr. Swan was a little mystified by financial matters. How could one describe a company in financial terms? How could financial statements indicate whether or not a firm was in good or bad shape? (The balance in the company chequing account didnt seem to be an indicator.) How could one convince a group of hardnosed investors that the company was capable of making a lot of money in the next few years, if it just had more money now? (Dr. Swan was always puzzled by the fact that ChemMed was growing and making money, but it never seemed to have enough cash.) ChemMed began operations 18 years ago after Dr. Francois Swan completed the development of commercialscale isolation of sodium hyaluronate (hereafter referred to as HA), a naturally occurring biological fluid that is useful in eye surgery and other medical and veterinary uses. The isolation process, complex and proprietary to the company, involves extracting and purifying HA from rooster combs. Initial seed money for the enterprise came from research grants from the University of Toronto and the federal government, plus contributions from Dr. Swans colleagues and associates, who were now classified as the companys shareholders (254 as of April 20XX, all closely held; not traded publicly). In mid20XU ChemMed commenced the manufacture and distribution of its first product, VISCAM, which is used to hold tissues in place during and after surgery of the retina. In March 20XV ChemMed received regulatory approval to market another HA product known as VISCHY, which is used for the treatment of degenerative joint diseases in horses. The two products, VISCAM and VISCHY, are the only ones ChemMed currently produces; however, the company has an active R & D (Research & Development) program investigating other applications. There are only two other manufacturers of FDAapproved HA products in the world: AB Fortia, a Swedish corporation, which manufactures a product called Healon in Sweden and distributes it in North America through a subsidiary, Pharmacia Inc., and Cilco Inc. in West Virginia. ChemMed has about a 25 percent share of the market (for HA products in eye surgery) against Cilcos 16 percent and Pharmacias 59 percent. Pharmacia, with the power of giant AB Fortia behind it, waged a continuing marketing war with ChemMed, undercutting ChemMeds prices and wooing its customers away at every opportunity. The matter came to a head in September 20XX, when ChemMed filed a $13 million suit against Pharmacia, charging unfair trade practices. Dr. Swan was reasonably confident that ChemMed would prevail in the suit, and in fact, Pharmacia had recently offered to settle out of court for $500,000. Dr. Swans primary problem was that although he was convinced the company was sound and would grow, he wasnt sure how to communicate that to potential investors in the financial community in a way that would convince them. Just handing out past income statements and balance sheets (shown in Tables 1 and 2) that he received from the accountants didnt seem to be enough. Further, he wasnt even sure the company needed outside financing, let alone how much. He just believed they would need it, since they had always had to ask for money in the past. CHEM-MED COMPANY Income Statements 20XU20XW (in thousands) Pro Forma Income Statements 20XU 20XV 20XW 20XX 20XY 20XZ Net sales (all credit)............................ $ 777 $3,051 $3,814 $5,340 $7,475 $10,366 Cost of goods sold.............................. 257 995 1,040 1,716 2,154 2,954 Gross profit........................................ 520 2,056 2,774 3,624 5,321 7,412 Selling, etc., expenses......................... 610 705 964 1,520 2,120 2,645 Other income (expenses)*................... 0 0 0 500 0 0 Operating profit................................... (90) 1,351 1,810 2,604 3,201 4,767 Interest expense.................................... 11 75 94 202 302 434 Income before tax................................ (101) 1,276 1,716 2,402 2,899 4,333 Income taxes........................................ (40% in 20XV; 33% thereafter)....... 0 510 566 793 957 1,430 Net income.......................................... ($ 101) $ 766 $1,150 $1,609 $1,942 $ 2,903 Dividends paid.................................... 0 0 0 0 0 0 Increase in retained earnings............. $ (101) $ 766 $1,150 $1,609 $1,942 $ 2,903 Average number of shares**............... 2,326 2,326 2,347 2,347 2,347 2,347 Earnings per share.............................. ($0.04) $0.33 $0.49 $0.69 $0.83 $1.24 *Other income (expenses) refers to extraordinary gains and losses. In 20XX, $500,000 is expected from Pharmacia Inc., in settlement of the lawsuit. **Shares are not publicly traded. TABLE 1 CHEM-MED COMPANY Balance Sheets (in thousands) Pro Forma Balance Sheets as of Dec. 31, years ended: 20XU 20XV 20XW 20XX 20XY 20XZ Assets Cash and equivalent..................................... $ 124 $ 103 $ 167 $ 205 $ 422 $ 101 Accounts receivable..................................... 100 409 564 907 1,495 2,351 Inventories....................................................... 151 302 960 1,102 1,443 798 Other current.................................................. 28 59 29 41 57 11 Total current assets................................ 403 873 1,720 2,255 3,417 3,261 Property, plant, & equipment...................... 1,901 2,298 2,917 4,301 5,531 8,923 Less: Accumulated amortization......... 81 82 346 413 522 588 Property, plant, & equipment net.............. 1,820 2,216 2,571 3,888 5,009 8,335 Other capital assets...................................... 0 101 200 200 215 399 Total assets..................................................... $2,223 $3,190 $4,491 $6,343 $8,641 $11,995 Liabilities Accounts payable......................................... $210 $ 405 $ 551 $771 $1,080 $ 1,512 Short-term debt............................................. 35 39 42 59 82 135 Total current liabilities............................. 245 444 593 830 1,162 1,647 Long-term debt.............................................. 17 19 21 27 50 17 Total liabilities........................................... 262 463 614 857 1,212 1,664 Equity Common stock.............................................. 2,062 2,062 2,062 2,062 2,062 2,062 Retained earnings......................................... (101) 665 1,815 3,424 5,366 8,269 Total equity................................................ 1,961 2,727 3,877 5,486 7,428 10,331 Total liabilities and equity............................ $2,223 $3,190 $4,491 $6,343 $8,640 $11,995 TABLE 2 Dr. Swan had lunch with his banker recently, and the banker mentioned several restrictive covenants the company would have to meet if it came to the bank for financing. The three covenants were The current ratio must be maintained above 2.25 to 1. The debttoassets ratio must be less than 0.3 to 1. Dividends cannot be paid unless earnings are positive. Dr. Swan didnt think he would have any trouble with those, but he wasnt sure. He would have to analyze the numbers before the next board of directors meeting, but he now had to meet with a representative of a supermarket chain. As a financial advisor you are considering the addition of ChemMed to your clients portfolio, you are interested in the companys record of profitability, prospects for the future, degree of risk, and how it compares with others in the industry (shown in Table 3). From that point of view, write a report to your client addressing the following questions: Biotechnology Industry StatisticsMedian Company in Biological Products 20XU 20XV 20XW Current ratio.................................. 2.5 2.3 2.4 Quick ratio..................................... 1.2 1.1 1.3 Inventory turnover......................... 5.5 5.6 5.7 Total asset turnover........................ 1.15 1.16 1.18 Return on sales.............................. 4.00% 4.00% 5.00% Return on assets.............................. 4.60% 4.64% 5.90% Return on equity............................ 7.64% 8.44% 12.29% Total debt to assets......................... 0.40 0.45 0.52 Selected Statistics, Pharmacia Company 20XU 20XV 20XW Current ratio................................... 2.8 2.7 2.8 Quick ratio..................................... 1.5 1.3 1.6 Inventory turnover.......................... 5.6 5.7 5.8 Total asset turnover......................... 1.9 2 1.9 Return on sales.............................. 6.00% 6.50% 7.00% Return on assets.............................. 11.40% 13.00% 13.30% Return on equity............................ 19.04% 27.66% 29.56% Total debt to assets........................ 0.40 0.53 0.55 Price-earnings ratio......................... 13.7 14 15 Average share price....................... $21.78 $24.92 $31.50 TABLE 3 a. Conduct a general research (on the internet) on the Biotechnology industry in Canada and summarize your key findings to capture market size and competitive dynamics of this industry. b. What was ChemMeds rate of sales growth in 20XW? What is it forecasted to be in 20XX, 20XY, and 20XZ? c. What is the companys rate of net income growth in 20XX, 20XY, and 20XZ? Is projected net income growing faster or slower than projected sales? After computing these values, take a hard look at the 20XX income statement data to see if you want to make any adjustments. d. How does ChemMeds current ratio for 20XW compare to Pharmacias? How does it compare to the industry average? Compute ChemMeds current ratio for 20XZ. Is there any problem with it? e. What is ChemMeds total debttoassets ratio in 20XW, 20XX, 20XY, and 20XZ? Is any trend evident in the fouryear period? Does ChemMed in 20XW have more or less debt than the average company in the industry? f. What is ChemMeds average accounts receivable collection period for 20XW, 20XX, 20XY, and 20XZ? Is the period getting longer or shorter? What are the consequences? g. How does ChemMeds ROE compare to Pharmacias and the industry for 20XW? Using the DuPont method, compare the positions of ChemMed and Pharmacia by computing ROE from its components. Using the results, compare the sources of ROE for each company.