Analysis of Financial Statements: Printing Express - Assignment Example

? Printing Express ID E-mail address Supervisor Program Academic Year Semester March 30, Outline Question A: Analysis of Financial Statements Introduction Horizontal Analysis Vertical Analysis Trend Analysis Working Capital: Analysis and Recommendations Question B: Selling 50 Percent Of The Equity References QUESTION A: ANALYSIS OF FINANCIAL STATEMENTS The information provided in the case study show that the business was formed in 1995 to carry out printing business. During the period there was minimal competition in the industry. Marika Cooper imagined that she was going to make profits and maintain the same position for a long period if she had offered quality jobs at reasonable cost. After some time she has realised that fortunes of the industry has changed and competition is stiff making it difficult for the company to survive without changing strategy. She is currently considering selling the business or inviting a new partner who will come with cash and new ideas. This paper presents the financial analysis of Printing Express for the last five years. The analysis comprises of horizontal analysis, vertical analysis, trend analysis and working capital analysis for the financial statements of the company for the last three financial years. The report also presents an evaluation of the working capital management by the company and presents recommendations in this regard. Horizontal Analysis- Considering the horizontal analysis of the company from year 2002 to year 2006, it can be seen that the sales revenue of the company increased considerably in the year 2005 as compared to year2006. The increase in sales revenue lead to an increase in the cost of sales, however, the increase in sales is greater than the increase in cost of sales resulting in a net increase in the gross profits for the company in year 2006. Moving further, it is observed that the total expenses experienced a significant drop regardless and increase of revenue. At the end, the considerable point to note is that the operating income of the company increased by more than 5% on average for the years, and after accounting for the interest and taxation expenses the increase recorded from year 2006 to year 2006 in the net earnings of the company amounted to more than 2.9%. This increase is evident from the lowering down of interest expenses due to a decrease to 8.98% from 48.34% in 2002 in the total long term obligations of the company (Berman, Knight, & Case, 2006). On the other hand, the current liabilities of the company increased, which is understandable on the basis that increase in sales volume have increased the amounts payable to suppliers. The equity portion of the balance sheet does show a significant variation in years, there is a decrease of retained earnings and common equity. The assets side of the balance sheet shows a mixed trend, as for instance, there is a significant fall in the cash balances of the company, whereas the amount to be received from the debtors of the company increased many manifold (i.e. 34.53%) (Berman, Knight, & Case, 2006). Considering the performance of the company in the year 2007 in comparison with year 2006, it is observed that the performance of the company declined significantly due to a sharp decline in the profit margin. This decrease could have been more significant if there was no work in process brought down in year 2007 from the previous year. Moreover, the net earnings of the company also declined significantly due to lower operating income and insignificant decrease in the interest expenses (Berman, Knight, & Case, 2006). On the other hand, the balance sheet figures also signify a drop in the overall performance of the company in year 2007. There is an overall increase shown in the balance sheet in relation to the current assets of the company which cannot be regarded to have resulted in due to the performance of the company in year 2007, but in fact the increase is attributed to the increase in inventory. The fixed assets showed no significant variation in their value in year 2007 as compared to the year 2006. On the liabilities side, the accounts payable of the company increased to 26.14% from 14.56%, which may be attributed to the maintenance of increased level of inventory. The long-term liabilities of the company decreased in year 2007 as compared to the previous years as all the line items were reduced to 4.15%. Moreover, there is a small increase in the retained earnings and shareholders’ equity shown in the balance sheet (Berman, Knight, & Case, 2006). Vertical Analysis- The vertical analysis of the company for years 2002 to 2007 shows that the company managed to maintain the levels of cost of sales, gross profit and selling expense at a constant level in relation to sales revenue. Keeping in view the decrease in the sales revenue, these increases in the percentages are representative of inefficient policies and practices of the company. Although these increases may be argued to have incurred due to short fall in sales revenues, but the management could have improved the situation by lowering down these expenses. Overall, the percentage of operating expenses in relation to sales of the company increased by 0.51 % in year 2006. Consequent to these variations the operating income’s percentage to total sales shrunk by more than 2.36% in year 2007. Similarly, the share of earnings before income taxes and net earnings in sales revenue declined by significant percentages of 1.49% (Berman, Knight, & Case, 2006). Apart from the income statement, the vertical analysis of balance sheet items also revealed significant variations in the proportion of the items in relation to the total assets and total liabilities and equity of the company. On the assets side of the balance sheet, the current assets of the company showed the most significant variations. Reserves for cash and cash equivalents percentage in relation to total assets of the company increased from 2.7 % in year 2006 to 10.3 % in year 2007. This sharp increase is based on the fact that the company was able to maintain the average collection period for the year and despite of reduction in total revenue, the cash inflow continued which lead to an increase in the cash reserves. On the other hand, the percentage of accounts receivable expressed in terms of total assets declined due to decrease in sales and henceforth lower accumulation of amounts to be received from debtors. Apart from current assets, there were no significant changes observed in the vertical positioning of the non-current assets of the company. On the liabilities and equity side of the balance sheet, the current liabilities’ percentage of total liabilities and equity increased solely due to increase in account payables’ share in total liabilities and equity. The reason behind this increase is the increase in inventory stock levels during the year, which accumulated more amounts to be paid to the suppliers of the raw material. Apart from this, sparing a slight decline there are no significant vertical variations recorded in the long-term liabilities of the company. Similarly, the stockholders’ equity percentages also did not show any significant fluctuations in relation to the total liabilities and equity of the company (Berman, Knight, & Case, 2006). Trend Analysis- Keeping in view the forecasted trend analysis, it is expected that the sales revenue of the company will improve on a consistent basis in the upcoming three years, i.e. year 2008. But at the same, trend analysis of past five years show mixed trends in relation to sales growth. This observation is suggestive of the fact that the company shall take steps to bring in efficiency and consistency with regard to its operational activities and manufacturing and selling procedures with an objective to lower down its costs and maintain a steady growth rate. In this way, the stability of the company will be ensured in future in relation to profitability, in case when actual figures come out to be different (Berman, Knight, & Case, 2006). Working Capital- The working capital (i.e. current assets – current liabilities) of Printing Express deteriorated in the year 2007 as compared to the previous years, although there is a significant increase in the current assets of the company, but the same is nullified by a comparatively greater increase in the current liabilities of the company. One key area to look for is that the collection period of the company remained stable over the last two years, however despite of the consistency the working capital declined because of which, it is necessary for the company to take certain steps for bringing improvements in the working capital. In fact Marika Cooper has noted that the business needs an immediate investment of at least $100,000 for hardware and software updates. She has even considered leasing a photocopier since the present one needs replacement and it is industry practice to buy a new one every five years or so. But this will further add to the interest expenses of the business so it is better to choose another option. A joint venture, merger or additional investment by a new partner is sorely needed to improve the business prospects. Question B: Selling 50 Percent of the Equity When the business is performing poorly, the management has many options including changing the product, closing the business even selling part or all the business. The case at hand the owner is contemplating of selling 50% of equity to a partner. Before admitting the partner, he will have to value the business and add goodwill then take 50% of the total value of the assets. Goodwill is an amount over and above the net worthy of the business. Goodwill can only be arrived after for casting the future earnings of the company. Future earnings will depend on the future conditions in the industry. Analysis must asses’ continuity and momentum of the company performance, including its industry, but it should be put in perspective. We should not confuse a company’s past with its future and the uncertainty of forecasting. We must also remember that earnings is total revenues less expenses, and that earnings fore cast reflect these components. A relatively minor change in a component can cause a large change in earnings. Another element in earnings forecasting is checking on a forecasts’ reasonableness. We often use return on invested capital for this purpose. If the earnings forecast yields returns substantially different from returns realized in the past or from industry returns, we should reassess the forecast and the process. Differences in the forecast returns from what is reasonable must be explained. Return or invested capital depends on earnings where earnings are a product of management quality and asset management. Management quality It takes resourceful management to ‘breathe life” into assets by profitably and efficiently using them. To assume stability of relations and trends implies there is no major change in the skill, and continuity of management. It also implies no major changes in the type of business where management skills are proven. Asset management A second element of profitable operations is asset management and success in financing those assets. Companies require assets to expand operations. Continuity of success and forecast of growth depend on financing sources and their effects on earnings. A company’s financial condition is another element to earnings forecasting. Lack of liquidity can constrain successful management, and risky capital structure can limit managements’ actions. These and economic, industry and competitive factors are relevant to earnings forecasting. In forecasting earnings we must add expectations about the future to our knowledge of the past. We should also evaluate earnings trends with special emphasis on indicators of future performance like capital expenditures, order backlogs, and demand trends for products and services. It is important for is to realize that earnings forecasting is accompanied by considerable uncertainty. Forecast may prove quite different from realizations because of unpredictable events or circumstances. We counter uncertainty by continual monitoring of performance relative to forecast and revising forecasts as appropriate. Given that most small and closely held companies do not pay dividends regularly, when using the dividend capitalization method, a caution to be maintained is that the evaluators must first determine the dividend paying capacity of a business. In this respect the dividend paying capacity based on average net income and the average cash flow is used. In order to determine a firm’s dividend paying capacity, its near term capital needs, its expansion plans, its debt repayment, the operation cushion, the contractual requirements, as well as the past dividend paying history of a business and the dividends paid by a company in its competitive frame should be investigated. After analyzing these factors, the percent of average net income and of average cash flow that can be used for the payment of dividends may be estimated. What must also be determined here is the dividend yield, which may best be determined by analyzing the history of comparable companies. But like the price earnings ratio method, this has usually been seen to produce a subjective result. Sales and profit multiples are the most widely used benchmark for business valuation methods used in determining goodwill. The information needed refers to annual sales and an industry multiplier, which is usually in a range of .25 to 1 or higher. The industry multiplier can be found in various financial tomes, as well as by analyzing sales of comparable businesses. Given that this method is easy to understand and use, the sales multiple is often used as the business valuation benchmark (Khan & Jain, 2007). Today profit and sales multiples methods are the most widely used small business valuation benchmarks used in estimating a business worth. The only information needed is about pre-tax profits and a market multiplier, which may be 1, 2, 3, or 4 but usually has a ceiling of 5. The market multiplier may be found in various financial publications, as well as by analyzing the sales of competitive firms. As this small business valuation method is easy to understand and use, the profit multiple is often used as the ceiling benchmark for small business valuation. Considering the replacement value of assets is similar to the adjusted book value analysis of the firm. This liquidation value is different from a book valuation in that it uses the value of the assets in liquidation, which is usually less than market value and sometimes book value as well. In this case, the liabilities are deducted from the liquidation value of the assets which determines the liquidation value of the small business enterprise. Liquidation value may thus be used to determine the bottom benchmark value of a business, since this should be the funds that the business partner may be required to bring in at a minimum. In summary, it is by considering one or the other of the above stated methods that the seller can find a way to value his business and create goodwill that helps in giving the business survival, staying power and reputation in the marketplace. Let us assume that the value of goodwill is to be estimated at the rate of twice the average of the last 4 year’s profits (Net income before tax) from 2004, 2005, 2006 and 2007 multiplied by a factor of 1, 2, 3 and 4 respectively for the four years. The profits for the considered four years are $ 12,182 + $32,396 + $47,842 + $25,121 and so the goodwill is 1($12,182) + 2($32,396) + 3(47,842) + 4($25,121) = 12,182 + 64792 + 142446 + 100,484 = 319,904/ 10 = $31,990 and twice this or the figure of goodwill is $63,980 which seems about right for the business with total assets of $861,051 and Equity of $128,510 as at the end of 2007. Assuming that the new partner Mr. Rick brings Cash equal to $300,000 in the business, the new balance sheet will appear as in the Appendix to this answer. The business can use this cash not only to update the software and hardware but also to pay instalments against printing machinery replacement as it sees fit. Care should be taken to see that the debt equity position of the business is at a manageable level and in line with industry standards. The firm is faced by numerous issues that deter its growth and retards its development. It is obvious that whenever any organization’s finances are poorly managed, the end results are awful as they lead to a drastic fall in the firm’s returns, loss of feasibility or inability to fund projects which can consequently lead to collapse. At the Smith Inc, the entire financing system is entrusted to people who cannot make sound decisions over proper utilization of the firm’s finances. Lack of experience, negligence and embezzlement are all the characteristics associated with the people assigned the role of finance management in the firm. Considering its current condition, the firm cannot be said to be in a position of adopting 50% Equity financing. Using external investor involves inviting outside investors to venture their capital in the firm and consequently support the business. Among the two alternatives, inviting external investors would be the most advantageous because it is more credible than self-financing. References Berman, K., Knight, J., & Case, J. (2006). Financial Intelligence: A Manager's Guide to Knowing What the Numbers Really Mean. Business Literacy Institute, Inc. Khan, M.Y & Jain, P.K (2007). Financial Management. McGraw Hill Education. Wood, Frank & Sangster, Alan (2008). Frank Wood’s Business Accounting Volume 1, Eleventh edition. Financial Times/ Prentice Hall. Read More