DLEON INC., PART II 4-26 FINANCIAL STATEMENTS AND TAXES Part I of this case, presented in Chapter 3, discussed the situation of DLeon Inc., a regional snack foods producer, 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 2016 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 2015 and 2016 balance sheets and income statements, together with projections for 2017, are given in Tables IC 4.1 and IC 4.2. In addition, Table IC 4.3 gives the companys 2015 and 2016 financial ratios, together with industry average data. The 2017 projected financial statement data represent Jamisons and Campos best guess for 2017 results, assuming that some new financing is arranged to get the company over the hump. Jamison examined monthly data for 2016 (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 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. a. Why are ratios useful? What are the five major categories of ratios? b. Calculate DLeons 2017 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys liquidity positions in 2015, in 2016, and as projected for 2017? 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 companys liquidity ratios? Explain your answer. c. Calculate the 2017 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 the industry? d. Calculate the 2017 debt-to-capital and times-interest-earned ratios. How does DLeon compare with the industry with respect to financial leverage? What can you conclude from these ratios? e. Calculate the 2017 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 2017 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 DLeons financial condition as projected for 2017. What are the firms major strengths and weaknesses? h. Use the following simplified 2017 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? 138 Part 2 Fundamental Concepts in Financial Management Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. i. Does it appear that inventories could be adjusted? If so, how should that adjustment affect DLeons profitability and stock price? j. In 2016, 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 DLeon on credit? (You could demand cash on deliverythat is, sell on terms of CODbut that might cause DLeon 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 2017, DLeon showed you its 2017 projections along with proof that it was going to raise more than $1.2 million of new equity? k. In hindsight, what should DLeon have done in 2015? 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 companys likely future financial performance? 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 2017E 2016 2015 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 2017 data are forecasts. Balance Sheets TABLE IC 4.1 Chapter 4 Analysis of Financial Statements 139 Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 2017E 2016 2015 Sales

$6,034,000 5,528,000	$3,432,000 2,864,000
519,988	358,672

Cost of goods sold Other expenses 550,000 Total operating costs excluding depreciation and amortization $6,425,992

$ 6,047,988	$3,222,672
($	13,988) $ 209,328
116,960	18,900
($ 130,948) $ 190,428
136,012	43,828
($ 266,960) $ 146,600
(106,784)a	58,640
($ 160,176) $	87,960

EBITDA Depreciation & amortization 116,960 EBIT Interest expense 70,008 EBT Taxes (40%) 169,056 Net income $ 253,584 EPS

($ 1.602) $ 0.110 $ 4.926 $ 2.25 100,000 40.00% $40,000 0

$ 0.880 $ 0.220 $ 6.638 $ 8.50 100,000 40.00% $40,000 0

DPS Book value per share Stock price Shares outstanding Tax rate Lease payments Sinking fund payments 0 Note: E indicates estimated. The 2017 data are forecasts. aThe firm had sufficient taxable income in 2014 and 2015 to obtain its full tax refund in 2016. T A B L E I C 4 . 2 Income Statements 2017E 2016 2015 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 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-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 2017 d