Part 1: Questions

You are an investor who is considering adding Chem-Med to your portfolio. As such, 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. From that point of view, answer the following questions:

Complete the following questions based on the information below:

1. What is Chem-Meds average accounts receivable collection period for 2015, 2016, 2017, 2018? Is the period getting longer or shorter? What are the consequences?
2. How does Chem-Meds return-on-equity ratio (ROE) compare to Pharmacias and the industry for 2015? Using the Du Pont method, compare the positions of Chem-Med and Pharmacia. Compute ROE for each company using the following formula: ROE = Profit margin Asset turnover/(1Debt to assets). Compare the results to determine the sources of ROE for each company.
3. What was Chem-Meds rate of sales growth in 2015? What is it forecasted to be in 2016, 2017, and 2018?
4. What was Chem-Meds net income growth in 2015? What is it forecasted to be in 2016, 2017, and 2018? Is projected net income growing faster or slower than projected sales? After computing these values, take a hard look at the 2016 income statement data to see if you want to make any adjustments.

Part 1: Situation

Dr. Nathan Swan, chairman of the board of directors, chief executive officer, and founder of the Chem-Med Company, sat back in his chair and wondered if he wouldnt have been better off staying in his old job of teaching biochemistry at Harvard University. This business, he thought, was getting to be a headache. Just a short time ago, it seemed, he was able to spend most of his time in the companys lab comfortably working with test tubes and formulas. Lately, though, all his waking hours (or so it seemed) were taken up with columns of figures, dollars, and spreadsheets. It was true that he wanted the company to make money and grow; but he had no idea that the financial end of the business, about which he knew so little, would take up so much of his time. Dr. Swan was a little mystified by financial matters. How did one describe a company in financial terms anyway? How did one tell if the company was in good or bad shape? (The amount of cash in the companys checking account didnt seem to be a sufficient indicator.) What on earth would one use to convince a bunch of hard-nosed investors that the company was capable of making a lot of money in the next few years if it just had some more money now? (Dr. Swan was always puzzled by the fact that Chem-Med was growing and making money, but it never seemed to have enough cash.) Dr. Swan reflected back over Chem-Meds origins and the events that led up to today. Chem-Med began operations in 2001 after Dr. Swan completed the development of commercial-scale 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 Harvard University and the U.S. Department of Agriculture (Food and Drug Admin-istration), plus contributions from Dr. Swans colleague and associates, who were now classified as the companys stock- holders (254 as of April 2016, all closely heldnot traded publicly). In mid-2009, Chem-Med 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 late 2010, Chem-Med 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, VISCHAM and VISCHY, are the only ones Chem-Med currently produces; however, the company has an active R&D program that is currently investigating other applications. There are only two other manufacturers of FDA-approved HA products in the world: AB Fortia, a Swedish corporation, which manufactures a product called Healon in Sweden and distributes it in the United States through a subsidiary, Pharmacia, Inc.; and Cilco, Inc., of Huntington, West Virginia. Chem-Med 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 Chem-Med, undercutting Chem-Meds prices and wooing its costumers away at every opportunity. The matter came to a head in September, when Chem-Med filed a $13 million suit against Pharmacia, charging unfair trade practices. Dr. Swan was reasonably confident that Chem-Med would prevail in the suit, and, in fact, Pharmacia had recently offered to settle out of court for $500,000. Dr. Swans primary problem, he said, 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 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 felt that they would need it, since they had always had to ask for money in the past.

Figure 1

CHEM-MED COMPANY, Income Statements

20132015 (in 000s) Pro Forma Income Statements Years 2013 2014 2015 2016 2017 2018

Net sales (all credit) $ 777 $3,051 $3,814 $5,340 $7,475 $10,466

Cost of goods sold 257 995 1,040 1,716 2,154 3,054

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 inc (exps)* 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 1986; 33% thereafter) 0 510 566 793 957 1,430

Net income ($101) $ 766 $1,150 $1,609 $1,943 $ 2,903

Dividends paid 0 0 0 0 0 0

Increase in retained earnings ($ 101 $ 766 $1,150 $1,609 $1,943 $ 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 Inc (Exps) refers to extraordinary gains and losses. In 2016, $500,000 is expected from Pharmacia, Inc., in settlement of their suit.

** Shares are not publicly traded.

Figure 2

CHEM-MED COMPANY Balance Sheets

Pro Forma Balance Sheets

As of Dec. 31, years ended: As of Dec. 31, years ended:

2013 2014 2015 2016 2017 2018

Assets:

Cash and equivalents $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, and equipment 1,901 2,298 2,917 4,301 5,531 8,923

Less: accumulated depreciation 81 82 346 413 522 588

Property, plant, and equipment, net 1,820 2,216 2,571 3,888 5,009 8,335

Other fixed 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 $8,641 $11,995

Dr. Swan had lunch with his banker just recently, and the banker mentioned several restrictive covenants that the company would have to meet if it came to the bank for financing. Dr. Swan pulled a sheet of paper from his desk drawer and glanced at it. There were three covenants listed:

*The current ratio must be maintained above 2.25 to 1.

*The debt-to-assets ratio must be less than .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. Then he suddenly remembered he was supposed to meet a representative from one of the local supermarket chains (who supplied Chem-Med with rooster combs) in five minutes. He hurriedly put his papers away and wished he had more time to analyze the numbers before the next board of directors meeting. (The financial information is presented in Figures 1, 2, and 3.)

Figure 3

Biotechnology Industry Statistics

Median Company in SIC 2831

Biological Products*

2013 2014 2015

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

2013 2014 2015

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 stock price $21.78 $24.92 $31.50

Source: Duns Industry Ratios. The data have been adjusted for this case.