Integrative Case 2

Track Software Inc

Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and OBrien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and OBrien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Tracks initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings, all of which would be related to streamlining the accounting processes of medium- to large-sized manufacturers. Although Track experienced losses during its first 2 years of operation2009 and 2010its profit has increased steadily from 2011 to the present (2015). The firms profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1. Stanley started the firm with a $100,000 investment: his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2009), he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The firms stock was valued at $4.50 per share in 2014 and at $5.28 per share in 2015.

Year	Net Profits after taxes (1)	Dividends Paid (2)	Contribution to retained earnings [(1)- (2)] 3
2009	($50,000)	$0	($50,000)
2010	(20,000)	0	(20,000)
2011	15,000	0	15,000
2012	35,000	0	35,000
2013	40,000	1,000	39,000
2014	43,000	3,000	40,000
2015	48,000	5,000	43,000

Stanley has just prepared the firms 2015 income statement, balance sheet, and statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014 balance sheet. In addition, he has compiled the 2014 ratio values and industry average ratio values for 2015, which are applicable to both 2014 and 2015 and are summarized in Table 5. He is quite pleased to have achieved record earnings of $48,000 in 2015, but he is concerned about the firms cash flows. Specifically, he is finding it more and more difficult to pay the firms bills in a timely manner and generate cash flows to investors, both creditors and owners. To gain insight into these cash flow problems, Stanley is planning to determine the firms 2015 operating cash flow (OCF) and free cash flow (FCF). Stanley is further frustrated by the firms inability to afford to hire a software developer to complete development of a cost estimation package that is believed to have blockbuster sales potential. Stanley began development of this package 2 years ago, but the firms growing complexity has forced him to devote more of his time to administrative duties, thereby halting the development of this product. Stanleys reluctance to fill this position stems from his concern that the added $80,000 per year in salary and benefits for the position would certainly lower the firms earnings per share (EPS) over the next couple of years. Although the projects success is in no way guaranteed, Stanley believes that if the money were spent to hire the software developer, the firms sales and earnings would significantly rise once the 2- to 3-year development, production, and marketing process was completed. With all these concerns in mind, Stanley set out to review the various data to develop strategies that would help ensure a bright future for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firms 2015 results would provide important additional insights.

TABLE 2

Track Software, Inc., Income Statement ($000)for the Year Ended December 31, 2015

Sales revenue $ 1,550 Less: Cost of goods sold $ 1,030 Gross profits $ 520 Less: Operating expenses Selling expense $ 150 General and administrative expenses 270 Depreciation expense 11 Total operating expense 431 Operating profits (EBIT) $ 89 Less: Interest expense 29 Net profits before taxes $ 60 Less: Taxes (20%) 12 Net profits after taxes $ 48

TABLE 3

Track Software, INC., Balance Sheet ($000)

Assets 2015 2014 Cash $ 12 $ 31 Marketable securities 66 82 Accounts receivable 152 104 Inventories 191 145 Total current assets $421 $362 Gross fixed assets $195 $180 Less: Accumulated depreciation 63 52 Net fixed assets $132 $128 Total assets $553 $490 Liabilities and stockholders equity Accounts payable $136 $126 Notes payable 200 190 Accruals 27 25 Total current liabilities $363 $341 Long-term debt $ 38 $ 40 Total liabilities $401 $381 Common stock (50,000 shares outstanding at $0.40 par value) $ 20 $ 20 Paid-in capital in excess of par 30 30 Retained earnings 102 59 Total stockholders equity $152 $109 Total liabilities and stockholders equity $553 $490

TABLE 4

Track Software, Inc., Statement of Retained Earnings ($000) for the Year Ended December 31, 2015

Retained earnings balance (January 1, 2015) $ 59 Plus: Net profits after taxes (for 2015) 48 Less: Cash dividends on common stock (paid during 2015) 5 Retained earnings balance (December 31, 2015) $102

TABLE 5

Ratio Actual 2014 Industry average 2015 Current ratio 1.06 1.82 Quick ratio 0.63 1.10 Inventory turnover 10.40 12.45 Average collection period 29.6 days 20.2 days Total asset turnover 2.66 3.92 Debt ratio 0.78 0.55 Times interest earned ratio 3.0 5.6 Gross profit margin 32.1% 42.3% Operating profit margin 5.5% 12.4% Net profit margin 3.0% 4.0% Return on total assets (ROA) 8.0% 15.6% Return on common equity (ROE) 36.4% 34.7% Price/earnings (P/E) ratio 5.2 7.1 Market/book (M/B) ratio 2.1 2.2

TO DO a. (1) On what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not? (2) Could a potential agency problem exist in this firm? Explain. b. Calculate the firms earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firms inception. Comment on the EPS performance in view of your response in part a. c. Use the financial data presented to determine Tracks operating cash flow (OCF) and free cash flow (FCF) in 2015. Evaluate your findings in light of Tracks current cash flow difficulties. d. Analyze the firms financial condition in 2015 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial statements provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis. e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a. f. Track Software paid $5,000 in dividends in 2015. Suppose that an investor approached Stanley about buying 100% of his firm. If this investor believed that by owning the company he could extract $5,000 per year in cash from the company in perpetuity, what do you think the investor would be willing to pay for the firm if the required return on this investment is 10%? g. Suppose that you believed that the FCF generated by Track Software in 2015 could continue forever. You are willing to buy the company in order to receive this perpetual stream of free cash flow. What are you willing to pay if you require a 10% return on your investment?