i Sales per day amount to $3,850,000/360 = $10,694. Accounts receivable are now $402,000 or 37 6 days' sales. If A/R can be reduced to 27.6 days without affecting sales, then the balance sheet item AR would be $10,694 x 27.6 = $295,154, down $106,846 from the current level. That $106,846 could be used (1) to reduce debt, which would lower interest charges and thus increase profits, (2) to buy back stock, which would lower shares outstanding and thus raise EPS or (3) to invest in productive assets, which presumably would raise net income. In any event, EPS, hence DPS, should increase The change also might improve the risk picture as reflected in the debt ratio (if the $106,846 were used to reduce debt), and it would almost certainly improve the coverage ratios. This would lower the firm's perceived riskiness. All of this would improve the stock price. (Note, however, that reducing accounts receivable by 10 days of sales is not a cost-free action) i Some of the problems and limitations of financial statement analysis are discussed below. (1) Many large firms operate a number of different divisions in quite different industries, and in such cases it is difficult to develop a meaningful set of industry averages for comparative purposes. This tends to make ratio analysis more useful for small, narrowly-focused firms than for large, multi-divisional ones. (2) Most firms want to be better than average, so merely attaining average performance is not necessarily good. To achieve high-level performance, it is preferable to target on the industry leaders' ratios (3) Inflation distorts firms balance sheets. Further, because inflation affects both depreciation charges and inventory costs, profits also are affected. Thus, a ratio analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted with care and judgment (4) Seasonal factors can also distort ratio analysis. For example the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventories is the one just before versus the one just after the canning season. This problem can be minimized by using monthly averages for inventories when calculating ratios such as turnover (5) Firms can employ window dressing techniques to make their financial statements look better to credit analysts. To illustrate, a Chicago builder borrowed on a two year basis on December 29, 2015, held the proceeds of the loan as cash for a few days, and then paid off the loan ahead of time on January 5, 2016. This improved his current and quick ratios, and made his year-end 2015 balance sheet look good. However, the improvement was strictly temporary, a week later the balance sheet was back at the old level (6) Different operating and accounting practices can distort comparisons. As noted earlier inventory valuation and depreciation methods can affect the financial statements and thus distort comparisons among firms that use different accounting procedures. Also, if one firm leases a substantial amount of its productive equipment, then it might show relatively few assets in comparison to its sales, because leased assets often do not appear on the balance sheet At the same time, the lease liability might not be shown as a debt. Thus, leasing can artificially improve both the debt and turnover ratios (7) It is difficult to generalize about whether a particular ratio is good or bad. For example, a high current ratio might indicate a strong liquidity position, which is good, or excessive cash, which is bad, because excess cash in the bank is a non-earning asset Similarly, a high foxed assets turnover ratio can occur either because a firm uses its assets efficiently or because it is undercapitalized and simply cannot afford to buy enough assets (8) A firm might have some ratios that look good' and others that look bad" making it difficult to tell whether the company is, on balance in a strong or a weak position. However, statistical procedures can be used to analyze the net effects of a set of ratios. Many banks and other lending organizations use these procedures to analyze firms financial ratios and on the basis of their analyses, classity companies according to their probability of getting into financial distress nt 2015 Integrative Problem 7-17 Donna Jamison was recently hired as a financial analyst by Computron Indus tries, a manufacturer of electronic components. Her first task was to conduct a financial analysis of the firm covering the last two years. To begin, she gathered the following financial statements and other data: Balance Sheets 2014 Assets Cash $ 52,000 $ 57,600 Accounts receivable 402,000 351,200 Inventories 836,000 715,200 Total current assets $1,290,000 $1,124,000 Gross fixed assets 527,000 491.000 Less: Accumulated depreciation (166,200) (146,200) Net fixed assets $360,800 $ 344,800 Total assets $1,650,800 $1,468,800 Liabilities and Equity Accounts payable $ 175,200 $ 145,600 Notes payable 225,000 200,000 Accruals 140,000 136,000 Total current liabilities S540,200 $ 481,600 424,612 323,432 Long-term debt Common stock (100,000 shares) 460,000 460,000 225,988 203,768 Retained earnings Total equity $ 685,988 $ 663,768 $1.650.800 $1.468,800 Total liabilities and equity 2015 2014 Income Statements Sales Cost of goods sold Other expenses Depreciation Total operating costs EBIT Interest expense EBT Taxes (409) Net income $3.850,000 (3 250.000) 430.300) 20,000) $3.700.300 S 149,700 75,000 $ 13.700 1924801 $ 44.320 $3,432,000 12,864,000) 340,000) 18,900 $3.222.900 $ 209,100 62.500 $ 146,600 $8.640 S87960 2015 2014 Income Statements Sales Cost of goods sold Other expenses Depreciation Total operating costs EBIT Interest expense EBT Taxes (40%) Net income EPS $3,850,000 (3,250,000) 430,300) K20,000) $3,700,300 $ 149,700 76,000) S 73,700 29,480) S 44,220 $ 0.442 $3,432,000 (2,864,000) (340,000) 18,900) $3,222,900 $ 209,100 62,500) $ 146,600 58,640) S 87,960 $ 0.880 Statement of Cash Flows (2015) $ 44,220 20,000 29,600 4,000 (50,800) (120,800 $(73,780) Operating Activities Net income Additions (sources of cash) Depreciation Increase in accounts payable Increase in accruals Subtractions (uses of cash) Increases in accounts receivable Increase in inventories Net cash flow from operations Long-Term Investing and Financing Activities Investment in fixed assets Increase in notes payable Increase in long-term debt Payment of cash dividends Net cash flow from investing and financing Net reduction in cash account Cash at beginning of year Cash at end of year $(36,000) $ 25,000 101,180 22,000) $68,180 $ 5,600) 57,600 $ 52,000 2015 2014 Other Data December 31 stock price Number of shares Dividends per share Lease payments $ 6,00 100,000 $ 0.22 $ 40,000 $ 8.50 100,000 s 0.22 $ 40,000 Industry Average Data for 2015 Ratio Industry Average Current Quick Inventory turnover Days sales outstanding (DSO) Fixed assets tumover Total assets turnover Debt ratio TIE 2.7x 1.0x 6.0x 32.0 days 10.7% 2.6 50.0% 2.5x Industry Average Data for 2015 Ratio Industry Average 2.7 x 1.0x Current Quick Inventory turnover Days sales outstanding (DSO) Fixed assets turnover Total assets turnover Debt ratio TIE Fixed charge coverage Net profit margin ROA ROE Pricelearnings Market/book 6.0x 32.0 days 10.7% 2.6x 50.0% 2.5x 2.1 x 3.5% 9.1% 18.2% 14.2 x 1.4x