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.

Integrative Case 2

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

Track Software, Inc.,

Profit, Dividends, and Retained Earnings, 20092015

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.

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

Track Software, Inc., Income Statement ($000)

for the Year Ended December 31, 2015

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

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

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

Track Software, Inc.,

Statement of Retained Earnings ($000)

for the Year Ended December 31, 2015

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

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?