Course project part 1 - Coursework Example

WATSON LEISURE TIME SPORTING GOODS Introduction The issue is whether Al Thomas should invest in in his brother-in-laws business, the Watson Leisure Time Sporting Goods to the extent of 20 percent of its ownership capital. Two-year financial statements have been given and must be analyzed before a decision can be made. This paper will analyze the financial statements of the company and recommend the appropriate decision to Al ThomasIncome statement analysis (See Appendices below)Sales went up 44 during the two periods being considered, and operating profit rose even higher at 59 percent owing to relatively lower percentage increase in the cost of goods sold.

Selling and administrative expense rose proportionately more than the sales growth (55 percent). This was compounded by the 185 percent increase in interest expense which significantly eroded these gains. Otherwise, all other cost elements were under control. The net income thus went up by only 28 per cent, and because of the issuance of new shares during the period, earnings per share increased by only 9 percent.Net profit margin in the second year relative to sales dipped slightly compared to the year before despite the the growth in sales.

While operating profit margin was better than the previous level by two percentage points, the near three-fold increase in interest expense was the main reason why net profit return on sales did not improve. Balance sheet analysis (See Appendices below)Total assets nearly doubled during the period due to the 113 percent increase in net plant and equipment. Accounts receivable, due to the drive to increase sales, more than doubled. There was an increase in cash and cash equivalents of 40 per cent.

The increases in fixed assets and receivables were financed mainly from short-term and long-term debt which together caused total liabilities to rise by 134 percent (more than $600,000). The issuance of new shares and retained earnings accounted for the balance of almost $300,000 increase in total assets. Ratio analysis (See Table below)Profitability. The 44 per cent increase in sales did not effectively translate into an improved return on total assets because of the purchase of additional plant and equipment during the year.

A corrected return on assets can be obtained by averaging the year 1 and year 2 assets in the computation. With an average asset of $1,447,000, the return on sales would be 8.29 percent instead of 6.33 percent but it is still lower than the previous years level. The growth in net profit margin markedly failed to keep pace with the growth in sales. The return on stockholders equity was slightly lower than the previous years.Judged against the industrys profitability benchmarks, the company is competitive, if not slightly better.

What is a bit disappointing is that the superiority in terms of sales did not result in significantly better bottom-line performance. Liquidity The current ratio in the previous year was a slight improvement on the industry average; however, because of massive acquisition of current liabilities to help finance the purchase of plant and equipment (aside from increasing receivables), the same ratio at 1.45:1 fell below the benchmark. A safe ratio would be 2:1. The quick ratio suffered a slippage below the tolerable 1:1 standard for most industries.

The company performed below the industry norms with regard to liquidity.Leverage. Leverage as a ratio of debt to assets should be comfortably below 50 percent, but in the case of Watson it went overboard because of substantial short-term and long-term borrowings during the year. Moving more than 10 percentage points, the borrowings went up to 55.5 percent. Long-term debt used to finance fixed assets investment, went jumped to reach a nearly 2:1 ratio against equity. This is quite a worrisome situation because it means that interest rates will have to rise in absolute and percentage terms, while any financial distress can pose the risk of bankruptcy.

Only good management and a sound economic environment can protect the company from those risks. Otherwise, it is important for the company to raise more equity. The drastically lower interest coverage ratio is due mainly to the high interest expense during that year. Evaluated against the industry standards, the company performs distinctly below par.Activity/Efficiency. Managerial efficiency is measured by how effectively receivables and inventories are managed in relation to sales. While inventory turnover of the company compares well with the industry average, the turnover on both receivables and fixed assets in year 2 fell below these averages because of the buildup of receivables and the acquisition of fixed assets.

The high level of receivables caused its turnover to drop about 35 percent, and the average collection period to rise from 36 days to 56 days. This problem on receivables should be tackled immediately through a systematic and diligent collection effort and a proper aging of receivables. In general, while the company was at par with the industry in year 1, it fell significantly below the efficiency norms in year 2. Market data and performance. Since the company is presumably not listed, no price per share is mentioned in the case.

The earnings per share information shows an EPS rise of nearly 9 per cent. This is lower than the 28 percent increase in net income due to the fact that the company issued new shares during the second year. Conclusion and RecommendationsThe company has engaged in very rapid expansion during the year, financing the same with a mix of debt and equity. However, the amount of debt was disproportionately much larger, and this caused the liquidity and solvency profile of the company to show a relative deterioration.

It would be necessary for the company to increase its profitability in order to generate cash flows or reduce its liabilities coupled with a further increase in common equity. This may be the reason why Al Thomas has been approached.Except for the recent risky expansion via leveraging, it appears that the company is fairly well managed. I would recommend that Al Thomas invest in the company under certain conditions. This should include his having a voice in the management and control of the business, as well a plan to improve its balance sheet through the reduction in debt and through better cost management and management of inventories and receivables.

Table: Financial RatiosRatioFormulaIndustry, 200XWatson, 200XIndustry, 200ZWatson, 200ZI. PROFITABILITY RATIOSGrowth in salesn.a.n.a. 10.02%44.00%Return on total assetsProfits after taxes/Total assets8.22%9.39%8.48%6.33%Return on net worthProfits after taxes/Net worth13.26%17.07%14.16%14.23%Operating profit marginNet profit before interest and taxes/ Salesn.a.11.33%n.a.12.50%Net profit marginProfits after taxes/ Sales5.75%6.265.81%5.55%Growth in net profit marginn.a.n.a.n.a.27.66%II. LIQUIDITY RATIOSCurrent ratioCurrent assets/ Current liabilities2.10X2.25:12.15X1.45:1Quick (acid-test) ratioCurrent assets net of inventory/ Current liabilities1.05X1.00:11.10X0.8:1III.

LEVERAGE RATIOSDebt to assetsTotal debt/ Total assets38.00%45.00%40.10%55.49%Debt to equityTotal debt/ Total net worthn.a.81.81%n.a.124.56%Long-term debt to equityLong-term debt/Total net worthn.a.45.45%n.a.65.36%Times interest earnedProfit before interest & taxes/ Total interest charges5.00X5.67X5.26X3.18XFixed charge coverageProfit before interest & taxes/Fixed charges3.85Xn.a.3.97Xn.a.IV. ACTIVITY RATIOSInventory turnoverSales/ Inventory of finished goods5.71X6.00X5.84X6,65XFixed asset turnoverSales/ Fixed assets2.75X2.73X2.20X1.85XTotal assets turnoverSales/ Total assets1.43X1.5X1.46X1.14Accounts receivable turnoverSales/ Accounts receivable10X10X10.1X6.55XAverage collection periodAccounts receivable/Ave daily sales36 days35.7 days35.6 days55.8 daysV. MARKET RATIOSEarnings per shareNet income/Share pricen.a$2.35$2.

56Growth in earnings per share n.a. n.a.9.80%8.90%BibliographyBrealey, RA, Myers, SC & Marcus, AJ, 1995, Fundamentals of Corporate Finance, McGraw-Hill, Boston, MassAppendices:Appendix 1Appendix 2Appendix 3Appendix 4