CHAPTER 4

TRADITIONAL FINANCIAL ANALYSIS: SOME SHORTCOMINGS

Problem 1
Homeland Variety Corp.
Financial Ratios
For the years 1988-1990

1988 1989 1990

Liquidity Ratios
Current Ratio 176/116 = 1.52 178/108 = 1.65 180/120 = 1.50
Quick Ratio 116/116 = 1.00 110/108 = 1.02 100/120 = 0.83
Defensive Interval
 116 x 360 180 days
285 - 53
 110 x 360 147 days
302 +1 - 33
 100 x 360
400 +5 - 68 107 days
Net Working Capital 176 - 116 = 60 178 - 108 = 70 180 - 120 = 60

Activity Ratios
Accounts Receivable Turnover 285/96 = 2.97 x 302/95 = 3.18 x 400/90 = 4.44 x
Accounts Receivable: ACP 360/2.97 = 121 days 360/3.18 = 113 days 360/4.44 = 81 days
Inventory Turnover (w COGS) 108/60 = 1.80 x 121/68 = 1.78 x 170/80 = 2.13 x
Inventory Turnover (w Sales) 285/60 = 4.75 x 302/68 = 4.44 x 400/80 = 5.00 x
Net Fixed Asset Turnover 285/172 = 1.66 x 302/176 = 1.72 x 400/200 = 2.00 x
 1988 1989 1990
Leverage Ratios
Total Debt/Equity 156/192 = 0.81 158/196 = 0.81 180/200 = 0.90
Long-term Debt/Equity 40/192 = 0.21 50/196 = 0.26 60/200 = 0.30
Total Debt/Capital 156/232 = 0.67 158/246 = 0.64 180/260 = 0.69
Long-term Debt/Capital 40/232 = 0.17 50/246 = 0.20 60/260 = 0.230

Simple Interest Coverage 65/14 = 4.64 58/15 = 3.87 80/18 = 4.44

Fixed Charge Coverage

 51 + 14 1.53 x
(14 + 20)/(1 - 0.30)
 43 + 15 1.11 x
(15 + 26)/(1 - 0.30)
 62 + 18 1.09 x
(18 + 39)/(1 - 0.30)

Degree of Financial Leverage 65 /(65 - 14 ) = 1.28 x 58 /(58 - 15 ) = 1.35 x 80 /(80 - 18 ) = 1.29 x

Book Value per Share 192/40 = $4.80 196/40 = $4.90 200/40 = $5.00
Cash Flow per Share (36 + 17 )/40 = $1.33 (30 + 18 )/40 = $1.20 (43 + 20 )/40 = $1.58
 1988 1989 1990
Profitability Ratios
Return on Assets (w EBIT)
 65 x 285 0.19
285 176 + 172
 58 x 302 0.16
302 178 + 176
 80 x 400 0.21
400 180 + 200

Return on Assets
(w Adjusted Net Income
 36 + 17 x (1-0.3) x 285 0.14
285 348
 30 + 18 x (1-0.3) x 305 0.12
302 354
 43 + 20 x (1-0.3) x 400 0.15
400 380

Breakeven Sales
 112 $180.34
1 - 108/285
 123 $205.23
1 - 121/302
 150 $260.87
1 - 170/4005
Margin of Safety 1 - 180/285 = 0.37 1 - 205/302 = 0.32 1 - 261/400 = 0.35

Return on Equity
 36/285 x 285/348 x 348/192 18.8%
 30/302 x 302/354 x 354/196 15.3%
 43/400 x 400/380 x 380/200 21.5%
Problem 2
While the current ratio remained relatively constant, the quick ratio and the defensive interval
declined. This would seem to indicate that there is some problem in liquidity.

All the activity ratios improved, indicating that the firm is turning over its assets faster. If
profitability is measured by margin on sales times turnover, then the activity improvement
should produce greater profits.

The debt-equity leverage ratios increased. Usually, this means an increase in the financial risk of
the firm. Increased positive financial leverage would mean that as net operating income
increases, earning per share; of common stock should increase in a greater proportion. This
would seem to be the case as both book value and cash flow per share have improved. Coverage
ratios have not improved. This could be interpreted as evidence of the ,greater leverage risk.

Breakeven sales for 1989-90 increased 27%. The margin of safety decreased from 1988 to 1989
but improved from 1989 to 1990. Return on assets and return on equity follow the same pattern.
As this is the bottom line, it may be viewed as a positive indicator.

Problem 3

The difficulty of this question is the lack of direction to be used in making the projection. Several
standard approaches may be employed.

1) Extend the 1989-1990 rate of changes in sales, expenses, and profits, and using the same
dividend rate develop the change in retained earnings. Follow a similar procedure for the
balance sheet changes using some account as a balancing account.

2) Develop a regression analysis for the 1991 period:

Sales become 444.33 = 214.33 + 57.50 x.
Profits after tax are 43.33 = 29.33 + 3.50 x

 Develop retained earnings by estimating dividend payment and, using the 1990
debt/equity ratio, determine total liabilities.
 In the same sense, using the 1990 or the 1988-90 regression of activity changes,
determine the asset structure. One of the asset accounts must be used as a
balancing account.

The importance of this question lies in the necessity that whatever forecasting method is
chosen, the assumptions governing the forecast must be identified and defended.
Problem 4
The projection requested in this question is based on a set of ratios developed by the industry.
These ratios could be produced by the industry trade association or by Dun and Bradstreet. In
either case, the fundamental question is are these ratios applicable to this firm?

The statements produced should answer the question: What would the financial statement of a
firm of our size, with a comparable equity structure, look like if constructed using industry
ratios?
Homeland Variety Corp.
1991 Pro Forma Financial Statements ($000)
Based on Industrial Ratios

Balance Sheet
Cash $28.38 Short-term debt $88.15
Accounts Receivable 83.38
Inventory 61.01
Total Current Assets $172.77 Total Current Liabilities $88.15
Plant & Equipment 186.55 Long-term debt 65.60
Common & paid-in capital 165.00
Error (0.57) Retained Earnings 40.00*
Total Assets $ 358.75 Total Liabilities & Equity $ 358.75

Income Statement

Sales $366.07
Cost of goods sold 153.75
Gross margin $212.32
General expenses 155.07
Earnings before interest & taxes 57.25
Interest .64
Profit before taxes 36.61
Taxes 10.98
Profit after tax $25.63
 * It is assumed that retained earnings will increase to $40.

1) Total debt = (165 + 40).75 = 153.75

2) Current debt = (165 + 40).43 = 88.15
3) Current assets = 88.15 x 1.96 = 172.77
4) Profit = (165 + 40) x 0.125 = 25.63
5) Sales = 25.63 = 366.07
6) Cost of Goods sold = (1- 0.58)366.07 = 153.75
7) Accounts receivable = 3607/(360/92) = 83.38
8) Inventory = 366.07/6 = 61.01
9) Cash = 172.77 - (83.38 + 61.01) = 28.38
10) Fixed assets =. (165 +40) x 0.91 = 186.55
11) The "error" in the balance sheet is the balancing item.
12) Interest is 13% on short-term debt and 14% on long-term debt.
13) Taxes are 30%, as in former years
14) General expenses are the balancing account

Problem 5
Determine the Z-score using the Altman model.

Z = 1.2 X 1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

X1 Working Capital/Total Assets 250,000/900,000 0.2777

X2 Retained Earnings/Total Assets 200,000/900,000 0.2222
X3 EBIT/Total Assets 150,000/900,000 0.1666
X4 MV of Equity/BV of Total Liabilities 460,000/300,000 1.5333
X5 Sales/Total Assets 1,000,000/900,000 1.1111

Z= 1.2 x 0.2777 + 1.4 x 0.2222 + 3.3 x 0.1666 + 0.6 x 1.5333 + 1.0 x 1.1111
= 3.2252

Altman's model holds that a firm with a Z-score greater than 2.99 is not failing.

Care must be exercised in using the model. It may not be appropriate for industries and/or firms
other than those tested by Altman. Also, the model was developed several years ago. The
coefficients would likely have different values if a new sample was used today.
Problem 6
Determine the Z-score using the Altman model.

Z = 1.2 X 1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 1.0 X5

X1 Working Capital/Total Assets 75,000/725,000 0.1034

X2 Retained Earnings/Total Assets 200,000/725,000 0.2759
X3 EBIT/Total Assets 150,000/725,000 0.2069
X4 MV of Equity/BV of Total Liabilities 145,000/300,000 0.4833
X5 Sales/Total Assets 1,000,000/725,000 1.3793

Z= 1.2 x 0.1034 + 1.4 x 0.2759 + 3.3 x 0.2069 + 0.6 x 0.4833 + 1.0 x 1.3793
= 2.8625

Altman's model holds that a firm with a Z-score greater than 2.99 is not failing.

In this case the firm has significantly decreased its Z-score. The gray area calls for a judgment to
be made by management as to the firm's liquidity position. Below this gray area the model
indicates the firm is failing.

The influence of a loss in net working capital, an assumption of liquidity loss, has resulted in
major changes in other balances. The net result is a significant decrease in its Z-score and is in
the "gray area" in the determination of the firm's liquidity.
Problem 7

Cash operating expenses 19X1 19X0

 Accrued accounting sales $1,087 $1,041
 Increase in accounts receivables 21 ?
Cash sales $1,108 $1,041

Net income $52 $54

+ Depreciation and amortization 30 30
Funds from operations $82 $84
Increase:
 accounts receivable (21) ?
 inventory (18) ?
 other (1) ?
 accounts payable 19 ?
Decrease:
 taxes payable (8) ?
Cash flows from operations 53 53
Cash expenses $1,055 $988

Daily Cash expense (360 day year) $2.93/day $2.74/day

Quick assets
 (14 +157) 171
 (66 + 136) 202

Defensive Interval
Quick Assets 60.8 days 79.0 days
Projected daily op’n expenses

?: To determine the change in these accounts requires a year earlier balance sheet - since
it does not exist, all that can be done is to estimate the changes.

Current Ratio
Current Assets/Current Liabilities $329/$122 = 2.70 $341/$109 = 3.13

The result of these two measures is inconclusive, yet worrisome. The 19X1 current ratio
indicates a lessening of liquidity. The defensive interval suggests the firm has less survival
abilities in that it cannot support itself for as long a period as in 19X0. To the extent that the DI
has a dynamic component, projected daily cash operating expenses, as the denominator, it offers
a better indication of the firm's survival ability. Note that the projected daily operating expense to
sales ratios is 0.92 in each year. This indicates that the relative efficiency of the firm has not
changed.
Problem 8
Sales - Total Variable Costs
Degree of operating leverage = ------------------------------------------------------------------------
Sales - Total Variable Costs - Fixed Operating Costs

19X1 19X0
1,087 - 818 - 101
 -------------------------- 1.68
168 - 68

1,041 - 773 - 101

 -------------------------- 1.67
167 - 67
EBIT
Degree of financial leverage = ---------------------------------------------------------------
EBIT - Interest - Pref Share Dividends/(1 - T)

100
 -------------------------------- 1.25
100 - 13 - 4.2/(1 - 0.40)

100
 -------------------------------- 1.21
100 - 10 - 4.2/(1 - 0.40)

Estimated Age of Fixed Assets = Accumulated Depreciation/Depreciation Expense

 132/20 6.6 years

 112/20 5.6 years

Operating leverage indicates the effect a change in sales has on earning before interest and
taxes(EBIT). In this case EBIT should increase 1.68% for every 1% increase in sales. Financial
leverage indicates the effect a change in EBIT has on earnings per share of common shares. In
this case EPS of common shares should have increased from 1.21% to 1.25% per a 1% change in
EBIT. Instead of getting these expected results there was no change in EBIT and a drop in EPS
associated with the 3.8% increase in sales. Fixed assets are only 5-6 years old. Cost of sales
increased over 1% and interest on debt increased from 7.8% to 8.5%. Shareholders in this
company expect that if their risk increases via increased leverage then return should also
increase.

The combined leverage effect (i.e., DOL x DFL), had increased from 2.0 times to 2.1 times, yet
shareholders have experienced a drop in EPS.

Management would want to have information that might indicate a trend in these relationships
rather than just one year compared to another. Should such a trend develop management might
expect to hear from the shareholders.
Problem 9
Fixed Costs
Breakeven = --------------------------------
1 - Variable Costs/Sales

19X1 19X0
68 + 13
 -------------------------- $524
1 - 919/1,087

67 + 10
$480
1 - 834/1,041

BE Sales
Margin of Safety = 1 - ----- -----------
Actual Sales

 1 - 524 / 1,087 0.518

0.539

Breakeven sales have increased absolutely, from $480 to $524. The relative
relation of breakeven sales to actual sales has increased from 46.1% to 48.2% of sales,
and conversely, the margin of safety has decreased from 53.9% to 51.8%. It would seem
this firm is working harder, yet less efficiently, with greater absolute and relative risk. A
continuation of this trend for several periods may indicate a difficult future.