Advanced Company\'s experienced a significant downturn in financial results due

Question

Advanced Company's experienced a significant downturn in financial results due to the slow economy. You have been asked to calculate the company's cash flow statement and develop the the company's financial ratios based on the Balance Sheet and Income Statement provided below.

Balance Sheet - $000 Current Year Prior Year

Cash $12 $134

Accounts Receivable $166 $200

Inventory $66 $71

Other Assets $1 $1

PP&E (Net) $900 $1,022

Total Assets $1,145$1,428

Accounts Payable $85 $99

Accrued Liabilities $23 $-

Long Term Debt $770 $1,000

Owners Equity $257 $(257)

Current Year Net Income $10 $586

Total Liabilities and Equity $1,145 $1,428

Income Statement - $000 Current Year Prior Year

Revenue $1,602 $3,831

Cost of Goods Sold$886 $2,263

Gross Profit Margin $716 $1,568

Gross Profit Margin Percentage 45% 41%

Expenses

Payroll $267 $395

Operations$86 $142

Other Expenses $161$211

Total Expenses $514 $748

EBITDA (Earnings Before Interest and Depreciation & Amortization)

$202 $820

Depreciation $134 $46

Interest Expense $64 $73

Other Income $(6) $(2)

Net Income Before Taxes $10 $703

The cash flow statement is wanting the followingdollar amountsanswered and canyou please show calculations how you reached total so I understand:

Net Income

Add Depreciation

Change in Working Capital

Cash From Operations

Capital Expenditures

Change in Debt

Change in Equity

Cash From Financing Activities

Net Cash Flow

Beginning Cash

Ending Cash

Financial Ratios Requested

Net Profit Margin

Gross Profit Margin

EBITDA Margin

Return on Assets

Interest Coverage Ratio

Debt to Equity Ratio

Payroll as a % of Sales

Inventory Turnover

Accounts Payable Days

Accounts Receivable Days

Current Ratio

Quick Ratio

Explanation / Answer

I. Financial Analysis and Planning From the Statement of Cash Flows, or from the analyst’s well-tuned intuition, relevant financial ratios can be identified and calculated. Remember -- Do not just blindly begin calculating financial ratios – the number of possible financial ratios is almost limitless; life is too short to spend calculating irrelevant ratios! In short, have a good reason a priori for the financial ratios that you calculate. If you don’t, you will waste a tremendous amount of time and may wind up with too much information to effectively evaluate. Financial ratios have two primary uses: • Financial control (or analysis) and • Financial planning. Financial ratios are used to compare actual financial results with various benchmarks of performance, such as • a firm’s own historical financial ratios to identify improving and deteriorating trends, • comparable ratios from other firms in the same industry, or • comparison of actual ratios versus a previously developed financial plan. We call the activity of comparing ratios to any of these benchmarks financial control. Financial ratios also are used to project a firm’s future financial position. We call this activity financial planning. Financial ratios often are classified into five categories: • Liquidity ratios, • Leverage ratios, • Activity or turnover ratios, • Profitability ratios, and • Market ratios. See the attached Appendix A, “Financial Ratios,” for more details on the calculation of various financial ratios. Consider the use of one of the activity ratios, the Days Sales Outstanding (DSO) ratio. This ratio can be used to monitor a firm’s credit policy. DSO is calculated as Credit Sales / Number of Days = Credit Sales per Day. DSO = Accounts Receivable / Credit Sales per Day. Suppose a company had credit sales of $687,500 during the first quarter of 2000, which had 91 days. Credit Sales per Day = $687,500/91 = $7,555. On March 31, 2000, the accounts receivable balance was $264,423. The company’s DSO on March 31, 2000 was $264,423 / $7,555 = 35 days. This calculation indicates that customers were, on average, taking 35 days to pay. Now suppose that during the first quarter of 2001 this company had credit sales of $790,625. The firm also had accounts receivable of $278,022 at the end of this quarter. Obviously accounts receivable have increased in magnitude. Does this increase imply that credit policy is “out of control,” i.e., customers were paying slower? Not necessarily! DSO at the end of the first quarter 2001 were DSO = $278,022 / ($790,625/91) = 32 days. Actually, customers are paying sooner! Credit sales have increased faster than Accounts receivable so the DSO has fallen. We don’t need to worry about this aspect of the business. We can also use financial ratios to make forecasts. Suppose we project credit sales for the first quarter of 2002 to be $905,000. Can we make a prediction of the accounts receivable balance for March 31, 2002? Absent a change in credit policy, a reasonable approach might be to predict 2002 DSO will be between 35 and 32 days, an average of 33.5 days. Projected credit sales per day = $905,000 / 91 days = $9,945. Projected accounts receivable = $9,945 * 33.5 = $333,159. We could use this amount as our estimate of accounts receivable on a pro forma March 31, 2002 balance sheet, assuming that we anticipate no changes in our credit policy or the payment behavior of our customers. See the discussion of “percent of sales forecasting” below. II. Pro Forma Financial Statements Pro forma income statements and balance sheets are the building blocks of a financial plan. Pro forma statements are projected, or future, financial statements. These statements show the firm’s projected income and the forecast for assets and financial resources, i.e., total debt plus owners’ equity. The generic form of the income statement is: Sales (or Revenue) less Cost of Goods Sold (CGS) equals Gross Income (or Gross Profit) less General Selling and Administrative Expenses less Depreciation equals Operating Income (or Operating Profit) plus Other Income equals Earnings Before Interest and Taxes (EBIT) less Interest Expense equals Income Before-Taxes (or Earnings Before-Taxes (EBT)) less Taxes equals Income After-Taxes (or Earnings After-Taxes (EAT)) To find the change in retained earnings over the accounting period contained in the income statement, we have Earnings After-Taxes less Dividends equals Change in Retained Earnings. Note that, depending on a given firm’s circumstances, specific income statements may differ from this generic income statement. For example, sales might be recorded net of any discounts given or “discounts given” might be a separate (negative) entry under sales. A generic form of a balance sheet is ASSETS LIABILITIES + EQUITY Cash $ 75 Bank loan $ 120 Accounts receivable 200 Accounts payable 225 Inventory 300 Wages payable 25 Marketable securities 25 Taxes payable 50 Current portion—long-term debt 30 Total current assets $ 600 Total current liabilities $ 450 Gross prop. and P & E $ 600 Long-term debt $ 120 (Accumulated depreciation) (200) Preferred stock 40 Net prop. And P & E $ 400 Common stock 100 Land 50 Retained earnings 340 Total assets $1050 Total Liabilities + Equity $1050 Note that the two sides of the balance sheet must equal. This equality allows us to use the pro forma balance sheet to determine the amount of additional funds that will be needed to finance the projected assets. II.A. The Pro Forma Income Statement The starting point for the construction of the pro forma income statement is the sales forecast. The sales forecast typically is in the domain of the marketing department but the heavy dependence on economics suggests that the finance department is also involved. The process is then as follows. The historical relationship between sales and cost of goods sold (CGS) is often used to project future CGS. For example, suppose that historically the CGS / Sales ratio has averaged a consistent 0.72. A reasonable projection for the projected cost of goods sold might be (0.72) * (projected sales). Similarly, historical data might be used to determine operating expenses and other expenses that vary, more or less, with sales, i.e., have a high correlation with sales. However, some expenses may have both a fixed and a variable component relative to sales and some expenses may be relatively fixed, e.g., depreciation, and have no relationship with changes in sales. The financial analyst must attempt to come up with a statistical relationship between expenses and sales to come up with a reasonable pro forma income statement. Once the pro forma income statement has been developed and net income estimated, expected dividends must be deducted to determine the change in retained earnings. The amount of dividends to be paid is a policy decision made by the board of directors. The estimated change in retained earnings is then carried to the pro forma balance sheet and added to prior cumulative retained earnings. II.B. The Pro Forma Balance Sheet The pro forma balance sheet combines projections of individual asset accounts along with individual liability and equity accounts in combination with the estimated retained earnings account to determine the firm’s residual funds need. The amount of cash and securities held is usually a policy decision made by management. Minimum cash needs are often determined using inventory models similar to those studied in production/operations management courses. Considering cash as an inventory of liquidity, the same general principles apply to a required “safety stock” of cash as to a safety stock of raw materials. Accounts receivable usually are projected based upon the historical relationship between sales and accounts receivable. See page 2 of this teaching note for an example of this calculation. For inventory, the historical inventory turnover ratio, CGS / Ending or Average Inventory, may be combined with the pro forma income statement CGS figure to estimate the inventory level. For instance, if historically the CGS / Ending Inventory ratio had averaged 4.5, and CGS was estimated at $750 for the coming year, ending inventory might be estimated at ($750)/(4.5) = $167. Alternatively, it may be more relevant to use the inventory equation to make this ending inventory estimate: Beginning Inventory plus purchases of raw materials plus addition of labor (if any) plus addition of factory overhead (if any) equals Available Inventory minus CGS equals Ending Inventory. Or, as an equation, Ending Inventory = Beginning Inventory + Raw Material Purchases + Labor Additions + Factory Overhead Additions - CGS For a retailing firm, a firm that simply buys and resells products, the labor and overhead additions would be zero. This general relationship can be used to forecast Fixed Assets as well. Of course, each asset entry can be affected by a change in policy. For example, management may conclude that credit policy should be tightened (or relaxed). If so, that change in policy must be taken into account when projecting Accounts Receivable (you should also consider the impact of the change on sales). Similarly, inventory management policy changes must be taken into account when projecting inventory. Finally, liabilities can be projected in a fashion similar to assets. For example, projected Accounts Payable will depend on projected purchases and payment policy. Suppose purchases are on credit terms that allow a 3% discount if payment is made within 10 days. If the company’s policy is to take all purchase discounts, accounts payable will be equal to 10 days of purchases, or Accounts Payable = 10 * credit purchases per day. Taxes payable will be determined by IRS rules related to the payment of taxes shown on the pro forma income statement. Wages payable will be determined by the compensation terms of the firm’s employees. For instance, if you pay employees on the 15th and 30th of every month, then on average, you will have no wages payable outstanding at the end of any given month. With the projections of individual asset accounts, accounts payable, taxes payable, wages payable, existing long-term debt, and cumulative retained earnings, we can solve for the amount of funds that must be borrowed and/or the amount of equity that must be sold in order for the balance sheet to balance. See Appendix B, “Residual Financing Needs: The “Plug” Method for Spread Sheet Applications,” for an approach to solving this problem. II.C. Interactions of Pro Forma Income Statements and Balance Sheets In the typical case, a financial plan is developed for several periods into the future. The time interval could be monthly, quarterly, or annually. Because of interest payments on debt, and the impact of this expense on the changes in retained earnings, the income statement and the balance sheet interact. That is, interest expense is an entry on the income statement, but the amount of interest depends on the level of debt, a balance sheet account, which, in turn, depends on the level of retained earnings. Three possible approaches exist to adjust for this financial statement interaction. • Ignore interest expense on the income statement. An argument favoring this approach is materiality; interest expense is typically small relative to the other expense accounts. An argument against this approach is that it is obviously wrong, assuming the firm has any interest-bearing debt. • Base interest expense on the prior closing balance of interest-bearing debt. For instance, if you were forecasting January’s financial statements, you would base your interest expense estimate for January on the actual closing loan balances in December. Using this approach, the January pro forma income statement is developed and the change in retained earnings is calculated. Then the loan needs for January are “plugged,” and this estimate serves as the basis for February’s interest expense, and so forth. An argument favoring this approach is that it avoids the “circularity” of the actual problem, i.e., the income statement simultaneously depends on the balance sheet which, in turn, depends on the income statement. On the other hand, if the average loan balance during the month is substantially different than the beginning loan balance, inaccuracies obviously occur. • Finally, the most sophisticated approach is to actually solve simultaneously the income statement and the balance sheet “equations” and come up with a much more accurate estimate of the interest expense.

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