Case Study: D’Leon, Inc.
Question a
Importance of Ratios
- Ratios can help in analyzing how profitable a company is. Ratios like the gross profit margin and net profit margin help us to know the ability of a company to translate sales into a profit.
- Ratios help in analyzing how efficient a firm is compared to other firms in the same industry. For example, the inventory turnover ratio of a company can be used to tell how cost-effective a company is.
- Liquidity ratios can be used to determine whether a company is able to pay its short-term financial obligations as and when they fall due.
- Ratios can help investors understand how risky a certain business is. Leverage ratios help us to understand the extent to which a company is dependent on external debt hence exposing the investors to potential financial risks.
- Ratios help businesses to forecast and plan their future operations hence minimizing the level of risk, therefore, enhancing their profitability.
The five major categories of ratios include
- Profitability ratios
- Liquidity ratios
- Leverage ratios
- Efficiency ratios
- Market Ratios
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Question b
Current ratio: =
Current ratio 2015 =
= 2.33
Current ratio 2016 =
= 1.17
Projected Current ratio 2017 =
= 2.34
The rule of thumb dictates that current ratio should be 2:1
In 2015, the current ratio was 2:1, indicating that D’leon was able to honor its short-term financial obligations as and when they fall due.
In 2016, the company was less liquid as the current ratio was 1:1, indicating that the company was not in a position to honor its short-term financial obligations as and when they fall due.
2017 projections show that the company will have a current ratio of 2:1, meaning that it will be more liquid and hence able to pay its short-term financial obligations.
Quick ratio: =
Quick ratio in 2015 =
= 0.85
Quick ratio in 2016 =
= 0.39
Quick ratio in 2017 =
= 0.84
The rule of thumb dictates that Quick ratio should be 1:1
In 2015, the current ratio was 1:1, indicating that D’leon was able to honor its short-term financial obligations as and when they fall due.
In 2016, the company was less liquid as the quick ratio was 0:1, indicating that the company was not in a position to honor its short-term financial obligations as and when they fall due.
2017 projections show that the company will have a quick ratio of 1:1, meaning that it will be more liquid and hence able to pay its short-term financial obligations.
Managers, bankers, and stockholders have an equal interest in liquidity ratios because they are both concerned about the ability of the firm to pay the money it owes. Bankers are concerned about the ability of the company to pay interest on the loan. Managers are also concerned about the liquidity position of a company because it helps them to pay their daily expenses and maintain a good relationship with their suppliers.
Stock valuation is a continuous process; therefore, the liquidity of a company is a crucial factor when doing stock valuation. A company which has an ideal current ratio will have a higher stock valuation.
Question c
Projected Inventory in 2017 =
=
= 4.1
Days sales outstanding = * 365
= * 365
= 106.6 days
Fixed asset turnover =
=
= 8.6
Total Asset Turnover in 2017 =
=
= 2.01
Total Asset Turnover in 2016 =
=
= 2.5
The total asset turnover in 2017 is lower than that of 2016. This means that D’leon has reduced the efficiency of its assets in generating revenue; hence compared to other firms in the industry, D’leon is less efficient in its use of fixed assets to generate sales.
Question d
Debt to capital Ratio 2017 =
=
=5.88
Debt to capital Ratio 2016 =
= 1.68
Times Interest earned ratio 2017 =
=
= 7.04
Times Interest earned ratio 2016 =
=
= -0.96
D’leon’s Debt to capital Ratio and Times Interest earned ratio increased favorably in 2017 compared to 2016. This means that the company’s financial leverage in the industry has improved.
Question e
Operating Margin =
Operating Margin 2017 = *100
= 0.0866 or 8.66%
This means that for every $1 in sales, Company D’leon makes $0.0866 in operating earnings.
Profit Margin =
=
= 0.16
This means that D’leon will generate profits worth $ 0.16 in every dollar worth of sale.
Basic Earnings Power Ratio =
=
= 0.14 or 14%
Return on Assets Ratio =
=
= 0.07 or 7%
Basic earning power ratio tells that D’leon has a raw earning power of 14%. Since its return on assets is 7%, we can conclude that 7% of D’leon’s revenue is expensed out as taxes and interest expense.
Return on Equity =
=
= 0.13 or 13%
This shows that in every $1 share invested in D’leon, the shareholders will earn $0.13
Return on Invested Capital =
=
= 0.18 or 18%
This shows that D’leon will pay a return of $0.18 for every $1 of capital invested.
Question f
P/E Ratio=
=
= 12.0
The high P/E ratio is an indication that D’leon investors are expecting high growth rates in the future.
Market/Book Ratio=
=
= 1.56
In 2017, D’leon has a high Market Ratio, which is a clear indication that its stocks are overvalued.
Question g
DuPont analysis entails decomposing the key drivers of Return on Equity (ROE) namely;
- Operating efficiency as represented by Net Profit Margin
- Asset use efficiency as measured by the Asset turnover ratio
- Leverage which is measured by equity multiplier ratio
ROE =Net Profit Margin*AT×EM
Where:
Net Profit Margin=
Net Profit Margin 2017 =
= 0.036 or 3.6%
Net Profit Margin 2016 =
= -0.027 or -2.65%
AT=Asset turnover =
AT 2017 =
= 2.01
AT 2016 =
= 2.10
EM=Equity multiplier=
EM in 2017 =
= 1.79
EM in 2016 =
= 5.82
ROE in 2017= 0.036*2.01*1.79
= 0.13
ROE in 2016= 0.027*2.10*5.82
= – 0.33
From the above workings, Equity Multiplier was the source D’leon improved ROE as shown by the decreased equity multiplier. Since the company’s long term debt decreased, investing in the company is not risky.
The major strength of the company is that; it is now under levered because the issuance of new shares reduced its overreliance on external debt, which overburdened it in 2016. The company’s ROE has increased to 0.13.
The weakness of D’leon is that increasing a company’s net income through the issuance of new shares cannot be sustained for long since equity capital is expensive to raise. The company, therefore, need to look for net income and asset driven ROE.
Question h
DSO = Accounts Receivable / (Annual Sales / 365 days)
Sales per day: $7,035,000/365 = 19,274.00
New Accounts Receivable: 19,274.00 X 32 = 616,767
Change in Cash = $878,000 – $616,767 = $ 261,233
Reducing the DSO will lead to a lead to reduced accounts receivable and increased cash. This extra cash can be used to pay suppliers and other debts, buy more stock and generally grow the business. This will lead to improved stock price.
Question i
Days sales outstanding = * 365
Days sales outstanding in 2017 = * 365
= 106.6 days
Days sales outstanding in 2016 = * 365
= 85 days
The number of days sales outstanding has significantly increased, indicating that inventories could be adjusted in order to reduce the DSO. Reducing the DSO will lead to reduced inventories and increased cash. This extra cash can be used to pay suppliers and other debts, buy more stock, and generally grow the business. This will lead to improved stock price.
Question j
Failure to pay creditors and bank interest in time is a sign that the company is experiencing liquidity problems. The credit manager and bank loan officers should take steps to reduce the risks involved if debt/interest is not paid in time, these include; reducing the number of days a company is required to pay for the supplies, demanding payment upon delivery as well as demanding for immediate payment of the loan amount plus interest.
The 2017 financial projections by D’leon show that the company will not experience liquidity problems. Informed by these projections and evidence that the company has started the process of issuing new equity, the decision to cut off D’leon can be quashed, and the company can be given appropriate days to pay its suppliers and honor its repayment agreement with the bank.
Question k
D’leon had not broken even in 2015; hence it should have issued new shares to raise capital as opposed to obtaining a loan. This would have allowed the management to expand the company operations without affecting the liquidity position of the company. In addition, raising capital through borrowing overburdened D’leon with interest expense hence reducing the net income.
Question l
Limitations of financial ratios
- Ratios do not capture inflation in their analysis; hence they cannot tell us the current financial situation of a company.
- Ratio analysis relies on past data, which might not necessarily represent future company performance.
- A change in accounting policies leads to changes in financial reporting, and this means that the ratios obtained will not be consistent with previous ratios hence giving conflicting information.
- The information with which ratio analysis is conducted might be manipulated hence rending the analysis thereof inaccurate and unreliable.
Question m
Other qualitative factors of financial performance analysis include;
- Industry growth trends
- Competitive advantage
- Quality of management
- Corporate governance
- Technology
- Customer satisfaction