Track Software Financial Statements - Case Study Example

WORK CASE STUDY "TRACK SOFTWARE" By of the of the School Contents Contents 2 References 13 Introduction Track software is a private, individual owned company that develops a sophisticated cost-accounting software program. The main customers of the company are primarily the medium and large-sized manufacturers; this software is to help them streamline their accounting processes. Stanley Booker, the sole founder of the company, perceived a market opportunity to develop new cost-accounting software to help these groups of manufacturers in streamlining their accounting processes. In order to fund or finance the losses experienced during the first year (2006), Stanley sold 60 percent of the company to a group of investors. His increasing concern about the company’s cash flows and its inability to meet its short term obligation has warranted investment analysis so as to gauge the financial viability of the firm. This analysis is to provide Stanley with the insights into the cash flow problems facing the firm by determining the free cash flow and operating cash flow of the firm, specifically for 2012. This analysis is going to be based on the financial statements provided so as to arrive at the investment value of the firm. This report is basically based on ratio analysis for the year 2012, evaluation of the financial goal, determination of free cash flow and operating cash flow, EPS performance, and recommendation on hiring a new software developer in order to gauge the firm’s cash flows, investment value and the profitability of the company. Financial goal Cash flow planning Cash flow accounting shows the firm’s ability to maintain operating capital that is sufficient enough to cover its basic expenses (Reider & Heyler, 2002). Many firms are normally unable to cover or meet their cash flow needs strictly out of the sales revenue due to seasonal fluctuations and changes and lags in payment as a result of billing arrangements, a condition that has facilitated firms to secure other forms of business financing for instance, business line of credit or through offering a portion of ownership for sale to public or group of investors. Cash flow goal therefore involves setting limits to the financing that is incurred for bad or off-season operations or by designating time frames needed to pay back the financing amounts (Morris & Morris, 2004). Cash flow goal is a correct goal because it ensures that the money needed to pay for the firm’s expenses is made available hence assists in preventing surprises as a result of temporary shortages and cash flow problems (Rewey, 2005). Cash flow planning therefore helps the firm to avoid a lack of enough cash that could shut down or stall the business when it can’t pay the bills, even temporarily. This therefore, ensures financial liquidity of the firm hence meeting its short term obligations (Certified Financial Planner Board of Standards, 2013). Agency problem Agency problem is basically a conflict of interest that arises between management and shareholders particularly because of differing goals (Lasher, 2010). There is a potential of the firm experiencing an agency problem. Shareholders are normally interested in the profitability of the firm. This is because they are paid dividend from the earnings. This therefore shows a conflict of interest because the management, Stanley, focuses more on cash flow planning unlike shareholders who are concerned with profitability and margin goals. The shareholders are therefore concerned with the profitability (returns and margins) part of the financial analysis while the management is concerned with the liquidity (ability to meet short term obligations) part of the financial analysis (Khan & Jain, 2007). EPS performance 2006 ($1.00 2007 ($0.40) 2008 $ 0.30 2009 $ 0.70 2010 $ 0.80 2011 $ 0.86 2012 $ 0.96 Earnings per Share basically represent a portion of the firm’s profit after tax that is allocated to each outstanding common stock shares. It therefore serves as an indicator of a firm’s profitability. This ratio therefore reflects the creation of a firm’s after-tax profits per share, hence the higher the ratio, the more the profit created (Bowles & Cooper, 2009). The firm’s Earnings per Share shows an upward trend through the period, the EPS has increased over time from minus $1.00 to positive $ 0.96 in 2012. This increase shows that the firm has created more profits from its operations since its inception. In line with the cash flow goal, this increase indicates that the firm is moving towards realizing a stable cash flow hence being able to meet its short term objectives. This will therefore enable the firm to avoid a lack of enough cash that could shut down or stall its operations particularly when it can’t pay the bills, even temporarily (Groppelli & Nikbakht, 2006). Cash flow determination Operating cash flow determination The operating cash flow (OCF) of a firm refers to the cash flow from its normal operations-development and sale of the software (Pinto, 2010). The firm has a substantial operating cash flow to meet the current operating expenses however, when the software developer is employed, the operating cash flow is not going to be enough to cover the additional expenses (appendix B) Free cash flow (FCF) determination FCF on the other hand represents the amount of cash flow that is available to the investors( owners and creditors) after all the operating needs of the firm are met and paid for its investments in the net current assets (NCAI) and net fixed assets (NFAI) (Mulford & Comiskey, 2005). It is calculated as follows, FCF=OCF-NFAI-NCAI, where NFAI represents increase in capital expenditures or gross fixed assets and NCAI normally excludes notes payable and cash and marketable securities as recommended by CFA. Appendix C indicates a negative free cash flow; this means that cash flow available to investors is less sufficient. This is because the operating needs are more than the cash flow generated. This shows the cash flow problems faced by the firm. The firm is therefore not able to fully meet its operating needs and distribute some cash flow to the investors hence the reluctance to employing a new software developer (Mulford & Comiskey, 2005). Analysis of financial statements Liquidity ratios 2011 2012 Industry average Current ratio 1.06 1.16 1.82 Quick ratio 0.63 0.64 1.10 Liquidity ratios show the ability of a firm to pay for or meet its short term obligations or short term liabilities as they fall due (Graham & Smart, 2012). The firm’s current ratio has increased over time showing that the firm’s ability to meet short term obligations has increased as well. This means that the company is able to meet its short term obligations or liabilities with ease (Kapil, 2011, pg. 121). The firm’s quick ratio has also increased though with small margin implying an increase in the firm’s ability to meet short term obligations from its most liquid assets. The company’s current and quick ratios are however, lower than the industry average. This implies that the firm is less liquid compared to the industry average. Activity ratios 2011 2012 Industry average Average collection period 29.6days 35.8days 20.2days Total asset turnover 2.66 2.80 3.92 Inventory turnover 10.40 5.39 12.45 Activity ratio measures how effectively the firm is utilizing its assets and or how well it is managing its liabilities. These ratios basically show how efficiently the firm’s assets are working to generate sales revenue. The main purpose of these ratios is to show how effective the management of the firm is and how efficiently it uses its assets (Kapil, 2011). Average collection period has increased in the period, indicating that the firm takes more time to collect its receivable hence reduction in liquidity. The company’s total asset turnover has increased indicating that it is using few assets to generate more revenue hence it is very efficient in the operations. However, its inventory turnover has decreased considerably. This implies inefficient use of inventory to generate returns. The industry average collection period is lower than that of the firm; this shows that the firm’s accounts receivable are not being converted into cash as quickly as the industry average hence less liquid compared to the industry. This implies that the company is less efficient in its operations when compared to the industry average, a fact that is again justified by its lower turnover ratios (Graham & Smart, 2012, pg. 42). Debt ratios 2011 2012 Industry average Debt ratio 0.78 0.73 0.55 Times interest earned 3.0 3.1 5.6 These are ratios that shows how leveraged a firm is. They help a firm in comparing its equity to the funds that are borrowed. It shows the firm’s activity that is funded by the borrowed funds in comparison to those activities that are funded by its equity. The debt ratios not only measure the firm’s financial leverage but also indirectly measure its business risk. It measures the firm’s long term solvency (Khan & Jain, 2007). The firm’s debt ratio has decreased implying a reduction in business risk due to less amount of debt used in funding its activities. On the other hand, the company’s times interest earned ratio has also increased, showing that its cover on the interest expense has increased hence reduction in business risk as a result of default in interest expense payment, thus showing that it can easily finance its interest on debts. The firm is thus able to meet its long term solvency requirement with ease (Kapil, 2011, pg. 121). When compared to the industry average, debt ratio is more while the times interest earned is less than their respective industry averages. The debt ratio indicate that the firm is highly leveraged compared to the industry average hence the company is considered to has taken on more risk compared to the industry. The company, on the other hand has less cover on the interest expense due to its lower times interest earned than other firms in the industry. Profitability ratios 2011 2012 Industry average Gross profit margin 32.1% 33.55% 42.3% Operating profit margin 5.5% 5.74% 12.4% Net profit margin 3.0% 3.10% 4.0% Return on assets 8.0% 8.68% 15.6% Return on equity 36.4% 31.58% 34.7% Profitability ratios basically determine the bottom line of a firm and the returns it gives particularly to the investors. These ratios show the firm’s overall efficiency and performance. These ratios are generally categorised into two: returns and margins. Margin ratios indicate the firm’s ability to translate the dollar sales into the profits. Return ratios; on the other hand, shows the ability of the firm to measure its overall efficiency particularly through the generation of the returns to the shareholders and other stakeholders. These ratios therefore highlight the ability of a firm to generate its earnings relative to assets, sales, and equity (Mukherjee & Mohammed Hanif, 2006). The company’s gross profit margin, operating profit margin, net profit margin and return on assets have shown an upward trend (they have increased). This implies an increase in profitability hence is generating more returns to their investors in 2012 than it was in 2011. This therefore makes the firm more efficient in operations and thus more profitable in 2012 than it was in 2011. However, the return on equity decreased in 2012, this indicates that the firm’s net income has decreased relative to its stockholder’s equity. Lower value of return on equity is less favourable meaning the firm’s efficiency in generating income on new investment has decreased in 2012 compared to 2011. Generally the industry margin and return ratios are more than the firm’s margin and return ratios. This means that the company is relatively less efficient in its operations thus less profitable when compared to other firms in the industry. However, the company is profitable enough to meet its operating expenses and other expenses and still realise some earnings from its operations (Thukaram Rao, 2003). Market ratios 2011 2012 Industry average Price Earnings (P/E) ratio 5.2 5.5 7.1 Market/book value ratio 2.1 1.74 2.2 Market value ratios basically evaluate the economic status of a firm in the wider marketplace. Market value ratios give a firm’s management an idea of what their investors think or perceive of the firms current performance and future prospects. Market value ratios basically measure the different ways the relative value of a firm’s stock are looked at (Brigham & Houston, 2009). The firm’s P/E ratio has increased from 5.2 in 2011 to 5.5 in 2012. This means that investors are expecting higher earnings growth in the future 2012 compared to 2011. When compared to the industry average, this value is less than industry average. This implies that investors of other firms in the industry are willing to pay more per dollar of earnings compared to the firm. The firm’s market/book ratio has decreased from 2.1 in 2011 to 1.74 in 2012. This indicates that the firm’s relative value has decreased over time. However, the value is more than one indicating that the stock is undervalued. When compared to the industry average, this value is less than industry average; this means that other firms in the industry have higher market capitalization than the firm under consideration (Damodaran, 2012). Recommendation regarding hiring a new software developer Even though Stanley believes that hiring a new software developer will result to an increase in sales and earnings, there is uncertainty in the success of the project, the success is not guaranteed. The firm therefore should not hire the software developer at the moment. The management should focus more at increasing the efficiency and activity of the firm so that substantial amount is realised to meet the salary and benefits of the position. The firm’s goal is to ensure a steady cash flow and including another cash outflow will disorient this steady cash flow (Kimmel et al, 2011). Further, hiring the software developer will reduce earnings before interest and taxes (EBIT) hence the firm will not be in a position to meet its interest expense hence lowering its times interest earned. This will increase the business risk which may result to bankruptcy of the firm. For instance, including $80000 to the operating expense will lower the operating profit (EBIT) (Schniederjans et al, 2010). Value of the firm (Enterprise Value) In order to find the amount that the investor would pay for the firm, we determine the Enterprise value of the firm, which is a measure of the firm’s value. Enterprise value is computed as market capitalization plus debt, preferred shares and minority interest, minus the total cash and cash equivalents (Castillo & Mcaniff, 2006). Enterprise value is considered as more accurate representation of the value of the firm because it is the theoretical takeover price, thus it provides a much more accurate valuation of the takeover simply because it includes debt in the value calculation (Hayes, 2009). From appendix E, the investor is willing to pay $274000. Value of the firm using free cash flow In finding the value of the firm using free cash flows, we discount this cash flow using the weighted average cost of capital (WACC) (MOLES et al, 2011). Since the amount is assumed to be a perpetual stream of cash flow, we will use the perpetuity method (Larrabee & Voss, 2013). From appendix F, I will be willing to pay $ 148000. References BOWLES, D., & COOPER, C. L. (2009). Employee morale driving performance in challenging times. Basingstoke, Hampshire, Palgrave Macmillan. Pg. 71-72 BRIGHAM, E. F., & HOUSTON, J. F. (2009). Fundamentals of financial management. Mason, OH, South-Western Cengage Learning. Pg. 98-99 CASTILLO, J. J., & MCANIFF, P. J. (2006). The recruiting guide to investment banking. Solana Beach, CA, Circinus Business Press. Pg. 130-131 CERTIFIED FINANCIAL PLANNER BOARD OF STANDARDS. (2013). The financial planning competency handbook. New York, Wiley. Pg. 7-10 DAMODARAN, A. (2012). Investment valuation: tools and techniques for determining the value of any asset. Hoboken, N.J., Wiley. Pg. 218-220 GRAHAM, J., & SMART, S. (2012). Introduction to corporate finance. Mason, Ohio, South-Western Cengage Learning. Pg. 41 GROPPELLI, A. A., & NIKBAKHT, E. (2006). Finance. Hauppauge, N.Y., Barrons. pg. 127 HAYES, G. (2009). A practical guide to business valuations for SMEs. Sydney, N.S.W., CCH Australia Limited. Pg. 85-86 KAPIL, S. (2011). Financial management. Noida, India, Pearson. Pg. 121 KHAN, M. Y., & JAIN, P. K. (2007). Financial management. New Delhi, Tata McGraw-Hill. Pg. 1.19 KHAN, M. Y., & JAIN, P. K. (2007). Management accounting: text, problems and cases. New Delhi, Tata McGraw-Hill. Pg. 6.7-6.9 KIMMEL, P. D., WEYGANDT, J. J., & KIESO, D. E. (2011). Accounting: tools for business decision making. Hoboken, N.J., Wiley. Pg. 274 LARRABEE, D. T., & VOSS, J. A. (2013). Valuation techniques discounted cash flow, earnings quality, measures of value added, and real options. Hoboken, N.J., John Wiley & Sons. Pg. 35 LASHER, W. R. (2010). Practical financial management. Mason, OH, Thomson South-Western. Pg. 18-19 MOLES, P., PARRINO, R., & KIDWELL, D. S. (2011). Fundamentals of corporate finance. Hoboken, NJ, Wiley. Pg. 714-716 MORRIS, K. M., & MORRIS, V. B. (2004). The Wall Street Journal Guide to Understanding Personal Finance. New York, Simon and Schuster. Pg. 88-90 MUKHERJEE, A., & MOHAMMED HANIF. (2006). Corporate accounting. New Delhi, Tata McGraw-Hill. Pg. 19.12-19.13 MULFORD, C. W., & COMISKEY, E. E. (2005). Creative cash flow reporting uncovering sustainable financial performance. Hoboken, N.J., J. Wiley. Pg. 358-359 PINTO, J. E. (2010). Equity asset valuation. Hoboken, N.J., Wiley. Pg. 161 REIDER, R., & HEYLER, P. B. (2002). Managing Cash Flow an Operational Focus. Hoboken, NJ, John Wiley & Sons. Pg. 88-90 REWEY, F. (2005). Winning the Cash Flow War Your Ultimate Survival Guide to Making Money and Keeping It. Hoboken, John Wiley & Sons.pg. 5-9 SCHNIEDERJANS, M. J., HAMAKER, J. L., & SCHNIEDERJANS, A. M. (2010). Information technology investment: decision-making methodology. Singapore, World Scientific. Pg. 120 THUKARAM RAO, M. V. (2003). Management Accounting. New Delhi, New Age. Pg. 99-100 Appendix Appendix A EPS= (Profit before ordinary dividends)/ (Number of ordinary shares) 2006: 50000/50000= ($1.00) 2007: 20000/50000= ($0.40) 2008: 15000/50000= $0.30 2009: 35000/50000= $0.70 2010:40000/50000= $0.80 2011: 43000/50000= $0.86 2012: 48000/50000= $0.96 Appendix B Operating cash flow is usually calculated as follows: NOPAT=EBIT*(1-T) OCF=NOPAT + Depreciation OCF = [EBIT × (1 – T)] + Depreciation For the year 2012, the firm’s OCF= [89000*(1-0.20) + 11000 =$71200+$11000 =$82200 Appendix C NFAI= Change in net fixed assets + Depreciation =$132000-128000+11000= $15,000 NCAI = Change in CA – CL =$94000-12000=$82000 FCF=OCF-NFAI-NCAI =$82200-15000-82000=-$14800 Appendix D Liquidity ratios Current ratio= (Current assets)/(Current liabilities) 2012: 421/363=1.16 Acid test ratio= (Current assets-inventory)/(Current liability) 2012: 421-191/363= 0.64 Activity ratios Average collection period= Accounts receivable/Sales×365 2012: (152/1550)*365= 35.8 days Total assets turnover= sales/( Total assets) 2012: 1550/553= 2.80 Inventory turnover= cost of goods sold/( inventory) 2012: 1030/191= 5.39 Debt ratios Debt ratio= (Total liabilities)/(Total assets) 2012: 401/553= 0.73 Times interest earned= (EBIT)/(Interest expense) 2012: 89/29= 3.10 Profitability ratios 1. Gross profit margin= (Gross profit)/Sales×100% 2012： （520/1550) *100%= 33.55% 2. Operating profit margin= operating profit/Sales×100% 2012: (89/1550)×100%=5.74% 3. Net profit margin= (Net profit)/Sales×100% 2012: (48/1550)×100%=3.10% 4. Earnings per share=net income/shares outstanding 2012: (48000/50000) =$0.96 5. Return on assets= net income/total assets 2012: (48/553) ×100%= 8.68% 6. Return on equity= net income/shareholder’s equity ×100%=31.58% Market ratios Price/Earnings Ratio= price per share/earnings per share 2012: (5.28/0.96= 5.5 Market/Book ratio= market price per share/book value per share 2012: (5.28/3.04= 1.74 Appendix E Enterprise value=market capitalization + debt, preferred shares and minority interest-minus the total cash and cash equivalents. EV=50000*5.28+38000+5000/0.1-78000= $274,000 Appendix F Value of the firm= free cash flow/discount rate =14800/0.1= $148000 Read More