Question

Jim Connor is the owner of Wave Riders, a surf shop located in West Palm Beach, Florida. Jim has just received his end of the year financial statements from his accountant. When he sees his gross and net income he is dismayed. With almost $250,000 in gross profit he just doesn’t understand why he is always short on cash to pay his employees and suppliers. One of his largest suppliers of surf boards notified him just last month that they would no longer extend him credit and he would have to pre-pay all of his orders. He puts a call into his accountant to set up a meeting with her to discuss the financial health of his business

. Questions Part 1

1. Using the financial statements provided, calculate the 12 financial ratios discussed in your text using the financial information that is provided below for Wave Riders,

2. Looking at these ratios, are there any of them that look suspicious? If so, which ratios are they and what about them do you believe is cause for concern?

Part 2

1. Using the industry ratios that have been provided, compare Wave Rider’s ratios with those for the industry. What “red flags” do you see when making this comparison?

2. What do you think might be causing the deviations that you see between Wave Riders ratios and the industry ratios?

Part 3

1. What recommendations would you make to Jim to help him improve the financial performance of Wave Riders in the future?

Prepare a memo to Jim outlining your recommendations, making certain to include your reasons for the recommendation (i.e. ratio analysis and/or comparison to industry ratios). Financial Statements Wave Riders Income Statement For the year ended December 31, 20XX

Merchandise Sales $500,000

Cost of Goods Sold $255,000

Gross Profit $245,000

Wage Expense $140,000

Rent Expense $45,000

General and Administrative $45,000

Total Expenses $230,000

Earnings Before Interest & Taxes (EBIT) $15,000

Interest $5,000

Income before tax $10,000 Tax (@ 25% rate)

$2,500 Net Income/(Loss)

$7,500

Wave Riders Statement of Owner's Equity For the year ended December 31, 20XX

Beginning Capital $0

Owner Contributions $5,000

Net Income/(Loss) $7,500

$12,500 Owner Withdrawal $0

Ending Capital $12,500

Wave Riders Balance Sheet As of December 31, 20XX

Assets Current Assets Cash and Cash Equivalents $29,500

Accounts Receivable $10,000

Merchandise Inventory $100,000

Prepaid Expenses $7,500

Total Current Assets $147,000

Property, Plant, and Equipment $5,000

Total Assets $152,000

Liabilities Current Liabilities Accounts Payable $74,250

Wages Payable $10,250

Total Current Liabilities $84,500

Long-Term Debt $55,000

Total Liabilities $139,500

Owner's Equity $12,500

Total Liabilities and Owner's Equity $152,000

Wave Riders Statement of Cash Flows For the year ended December 31, 20XX

Cash provided by operating activities Net Income (loss) $7,500

Changes in operating assets & liabilities Inventories ($100,000)

Accounts Receivables ($10,000)

Accounts Payable $10,250

Accrued expenses $7,500

Cash provided by (used by) operations ($85,000)

Cash provided by investing activities Purchases of fixed assets ($5,000)

Cash provided by (used by) investing ($5,000)

Cash provided by financing Long-term borrowing $55,000

Owner contributions $5,000 Payment of Debt and Financing Costs ($5,000)

Cash provided by (used by) financing $55,000

Change in cash ($35,000)

Beginning cash balance $0

Ending cash balance ($35,000)

Industry Ratios Liquidity & Solvency Ratios Current Ratio 2.1

Quick Ratio 0.95

Debt Ratio 1.05

Debt to Net Worth Ratio 8.5

Times Interest Earned Ratio 4.2

Return on Equity (ROE) 5.25

Operating Ratios Average Inventory Turnover Ratio 6.85

Average Receivables Turnover Ratio 10

Average Collection Period Ratio 36.5

Payables Turnover Ratio 5.8

Average Payable Period Ratio 62.9

Net Sales to Total Assets Ratio 3.3

Profitability Ratios Net Profit on Sales Ratio 4.8%

Net Profit to Assets Ratio 4.55%

Net Profit to Equity Ratio 1.8

Answer 1

Item	Wave Riders	Industry
Current Ratio	1.74	2.1
Quick Ratio	0.56	0.95
Debt Ratio	0.92	1.05
Debt to Net Worth Ratio	11.16	8.5
Times Interest Earned Ratio	3.00	4.2
Return on Equity	0.60	5.25
Average Inventory Turnover Ratio	2.55	6.85
Average Receivables Turnover Ratio	50.00	10
Average Collection period Ratio	7.30	36.5
Payable Turnover Ratio	3.43	5.8
Average Payable Period Ratio	106.28	62.9
Net Sales to Total Assets Ratio	3.29	3.3
Net Profit on Sales Ratio	1.50%	4.80%
Net Profit to Assets Ratio	4.93%	4.55%
Net Profit to Equity Ratio	0.6	1.8

We can see that, ROE for Wave Riders is just 0.6 whereas the industry average is 5.25. Low ROE over a sustained period indicates the inefficiency of the business in generating profit and its inability in make good use of investors' money.

The Inventory Turnover ratio of the company is also comparatively less (2.55) as compared to the industry (6.85). As we know that inventory has high storage cost and zero rate of return, a low Inventory Turnover ratio is a sign of inefficient inventory management. It may also indicate that the company is overstocking inventory or is facing problems in selling its products. Hence Jim should work on selling the existing inventory than ordering additional inventory. This would in turn lead to freeing up cash from operating activities.

The business also has a low profit margin compared to its competitors in the industry. This leads to a low Net profit to equity ratio and a low return of equity.