Question

In: Finance

Analyze the following common size balance sheet. Consider the below guidance: Have structural changes taken place...

Analyze the following common size balance sheet. Consider the below guidance:

Have structural changes taken place in the components of the balance sheet?

How have cash and other assets evolved from 2016 to 2017 and what appear to be the uses of cash during the year?

How has the financing structure of the company evolved from 2016 to 2017?

Considering the limited information provided, does the company appear to have been more or less profitable, risky and liquid during the year?


2017 2016

Current assets

Cash 5% 15%

Accounts receivable 20% 17%

Inventory 35% 20%

Total current assets 60% 52%

PPE 35% 38%

Other assets 5% 10%

Total assets 100% 100%

Current liabilities

Accounts payable 32% 20%

Short term debt 20% 40%

Total current liabilities 52% 60%

Long-term debt 22% 15%

Total liabilities 74% 75%

Capital 5% 15%

Retained earnings 21% 10%

Total equity 26% 25%

Total liabilities&equity 100% 100%

Solutions

Expert Solution

1) The total debt to equity ratio has slightly reduced from (75/25) =3 in 2016 to 74/26 = 2.84 in 2017.
The reduction in capital percentage indicates the significant increase in the retained earnings since it is unlikely that most of the paid up capital would be bought back. This also means that the absolute size of the balance sheet has increased almost 3 times provided the absolute value of capital did not change (No buy back or fund raising through new shares)

2) Cash as a percentage of assets have significantly reduced although the PPE have not increased in percentage terms. This means the cash could have been used for either of the two purpose:
First- The cash could have been used to buy back shares since the capital has also reduced, although its unlikely that a company would buy back 2/3rd of its shares in a single financial year
Second- Cash was used to fund the operations, this is more likely since the Short term loan as a percentage of the total has significantly reduced and one cannot fund majority of operating activities with long term loan since this would cause asset liability mismatch.
Hence the only means to support the increase in cost of goods could have through the available cash.

3) The financing of the company seems to have been majorly done through Long Term Debt since it has increased from 15% in 2016 to 22% in 2017.
This could have been done to support the growth of the company. Although the PPE has not increased in percentage terms it is possible that the value has increased in absolute terms which could have been financed by the long term loan.
The financing of the operating activities seem to have shifted from dependancy on Short Term Loans to available Cash. There by reducing the interest expense and using the cash reserve which would not have resulted in any income.
There also a probability that the cash wasn't alone sufficient to fund the operations and it is possible that some of the Long Term Debt was used to fund the increase in the working capital, which may not have been a wise decision since Long term debt usually has a higher interest rate than short term debt and should only be used to fund long term capex

4)
Analysis of Profitbility:
From the profitability perspective the significant increase in the Retained Earnings show that the company has made profit in the 2017 Financial Year.
Analysis of Risk:
The total Debt to Equity ratio has reduced in the year 2017 from 3 to 2.84 hence the company is now slightly less riskier. But as I mentioned in the previous answer a part of the increase in Working Capital was probably funded by Long Term liability hence the chance of asset liability mismatch arises and interest cost could have been reduced by taking a short term working capital loan of the same amount and that would have reduced the financial leverage (EBIT/EBT)
Analysis of Liquidity:
The current ratio (Total current asset/total current liability) in 2016 was (52/60) = 0.87 and in 2017 it is (60/52)=1.15. This increase shows improvement in liquidity
But if we analyse the quick ratio (Total current asset-Inventory)/total current liability we will find in 2016 the value to be (32/60)=0.53 while it has reduced to (25/52)=0.48 in 2017
From this we can draw the conclusion that the liquidity of the company is dependent on the nature of the inventory and if the inventory cannot be sold easily due to some unforeseen circumstance the company might end up facing liquidity issues.


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