Question

A large loss occurred in 2019 at Hororata Inc in Canterbury, rather than the expected profit. As a result, its stakeholders are concerned about the firm’s performance.

You are hired as the new Chief Financial Officer and are given the task of getting the company back into a sound financial position. Hororata’s 2018 and 2019 balance sheets and income statements, together with projections for 2020, are shown in the following tables. The tables also show the 2018 and 2019 financial ratios, along with industry average data. The 2020 projected financial statement data represent the best projection for 2020 results, assuming that some new financing is arranged to get the company “over the hump” and back on track.

You are given the responsibility to prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken.

Table 1 - Hororata Inc. Balance Sheets

Assets—————————————2018 ($’000)———2019 ($’000)—————2020e ($’000)

Cash———————————————7,500——————7,300————————-14,000

Short-Term Investments-——————46,600——————18,500————————-70,000

Accounts Receivable———————3 50,000—————650,000————————-870,000

Inventories———————————-713,000———-—-1,283,860-——-—-———-1,810,080

Total Current Assets———————1,117,100———-—-1,959,660-—-—-————-2,764,080

Gross Fixed Assets————————-490,500—————1,201,350———————1,218,300

Less: Accumulated Depreciation———144,700—————261,860————————381,760

Net Fixed Assets—————————-345,800—-——-——939,490———————-836,540

Total Assets-——————————-1,462,900———-—-2,899,150———————3,600,620

Liabilities And Equity——————2018 ($’000)———-2019 ($’000)—————-2020e ($‘000)

Accounts Payable—————————145,400–—————323,550–———————-358,000

Notes Payable——————————-198,200–—————699,700–———————-296,800

Accruals————————————-132,700–—————-283,510–———————-377,200

Total Current Liabilities——————-476,300–————-1,306,760–———————1,032,000

Long-Term Debt—————————-322,000–—————980,000–————————595,000

Common Stock——————————460,000–—————540,000–———————1,600,000

Retained Earnings—————————204,600–—————-72,390–————————373,620

Total Equity———————————-664,600–—————612,390–———————1,973,620

Total Liabilities And Equity————-1,462,900–————-2,899,150–———————3,600,620

Table 2 - Hororata Inc. Income Statements

______________________________2018 ($’000)_______2019 ($’000)_________2020e ($‘000)

Sales___________________________4,429,200–————5,831,300–——————8,031,400

COGS excluding depreciation_______2,860,500–————4,975,800–——————5,795,000

Depreciation_______________________18,500–—————116,600–——————-115,000

Other Expenses____________________325,000–—————698,000–——————-590,000

Total Operating Costs______________3,204,000–————-5,790,400–—————-6,500,000

EBIT ___________________________1,225,200–—————-40,900–—————-1,531,400

Interest Expense_____________________61,000–—————-173,600————–——-68,000

EBT____________________________1,164,200–—————-132,700–—————1,463,400

Taxes (40%)_______________________465,680——————-( — )———————585,360

Net Income________________________698,520–—————-132,700–——————878,040

Table 3 - Hororata Inc. Ratio Analysis

__________________________________2018_______2019______2020e____Industry Average

Current Ratio (X)______________________2.35–———-1.50–———( )—————2.00

Quick Ratio (X)_______________________0.85–———-0.52–———( )—————1.00

Inventory Turnover (X)_________________4.01–———-3.88–———( )—————5.00

Average Age of Inventory (days)_________90.98–———94.18–———( )————-45.00

Average Collection Period (days)_________28.84–———40.69–———( )————-30.00

Average Payment Period (days)__________18.55–———23.73–———( )————-60.00

Fixed Asset Turnover (X)_______________12.81–———-6.21–———( )—————9.00

Total Asset Turnover (X)________________3.03–———-2.01–———( )—————2.50

Debt Ratio (X)________________________0.55–———-0.79–———( )—————0.40

Debt to Equity Ratio (X)________________1.20–———-3.73–———( )—————0.70

Times Interest Earned (X)______________20.09–———-0.24-–———( )————-25.00

Gross Profit Margin (%)_______________35.42–———14.67–———( )————-27.00

Operating Profit Margin (%)____________27.66–———-0.70-–———( )————-16.00

Net Profit Margin (%)_________________15.77–———-2.28-—–——( )————-12.00

Return on Total Assets (%)_____________47.75-–———-4.58-–———( )————-30.00

Return on Equity (%)________________105.10–———21.67–———( )—————35.00

Price/Earnings (P/E) Ratio (X)__________21.47–———76.87-———( )—————-15.00

Market/Book Value Ratio (X)___________11.63–———-9.62–———( )——————8.00

Table 4 - Hororata Inc. other data

Stock Price ($)_________________75.00–———51.00–—————60.00

Shares (units)________________200,000–——200,000–————300,000

Earnings per Share ($)____________3.49–———-0.66–——————2.93

Dividend per Share ($)____________0.25————( — )——————0.20

Tax Rate (%)___________________40.00–———40.00–—————-40.00

Book Value per Share ($)__________6.450–————-5.300–————-6.200

Lease Payments ($)______________50,000—–———50,000–————50,000

REQUIRED:

Prepare a financial statement analysis of Hororata Inc. Your analysis should cover each of the followings:

1. Calculate the missing financial ratios for projected 2020 as in Table 3 and fill-in the answers.

2. Hororata’s liquidity position (using current and quick ratios) in 2018, 2019, and projected

for 2020. Compare it to the industry averages. What actions should be taken to improve its liquidity position?

3. Hororata’s operating and utilisation of assets projected (using inventory turnover, average age of inventory, average collection period, average payment period, fixed asset turnover, and total asset turnover) in 2018, 2019, and projected for 2020. Compare it to the industry averages. What actions should be taken to improve its operating and utilisation of assets position?

4. Hororata’s financial leverage (using debt ratio, debt to equity ratio, and times-interest-

earned) in 2018, 2019, and projected for 2020. What actions should be taken to improve its financial leverage position?

5. Hororata’s profitability (using gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE)) in 2018, 2019, and projected for 2020. Compare it to the industry averages. What actions should be taken to improve its profitability position?

6. Analyse the projected 2020 price/earnings ratio and market/book value ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company? Explain your answers.

7. Discuss the major strengths and weaknesses of the firm using the results of Du Pont

analysis as projected for 2020.

8. If one uses the industry average P/E ratio to estimate the firm’s share price in 2020, how much should it be? Comment on this method.

9. What are some potential problems and limitations of financial ratio analysis?

10. Perform a common size analysis and percent change analysis. What do these analyses tell you about Hororata? What actions should be taken to improve its overall financial position?

Answer 1

1.Ratio calculations
	2018	2019	2020	Ind.av.
Current ratio=Current assets/Current Laibilities	2.35	1.50	2764080/1032000=	2.68	2.00
Quick ratio=(Current assets-Inventory)/Current Liabilities	0.85	0.52	(2764080-1810080)/1032000=	0.92	1.00
Inventory Turnover=COGS/Av. Inventory	4.01	3.88	5795000/1810080=	3.20	5
Av. Age of inv.(days)=365/Inv. T.O.ratio	90.98	94.18	365/3.20=	114.01	45
Av.Collection Period (days)=365/(Net credit sales/Av. Receivables)	28.84	40.69	365/(8031400/870000)=	39.54	30
Av. Payment Period (days)=365/(COGS/Av. Payables)	18.55	23.73	365/(5795000/358000)=	22.55	60
Fixed assets T.O.=Sales/Av. Fixed assets	12.81	6.21	8031400/836540=	9.60	9
Total assets T.O.=Sales/Av. Total assets	3.03	2.01	8031400/3600620=	2.23	2.5
Debt Ratio=Total Liabilities/Total Assets	0.55	0.79	(1032000+595000)/3600620=	0.45	0.4
Debt to Equity Ratio=Total Liabilities/Total Equity	1.20	3.73	(1032000+595000)/1973620=	0.82	0.7
Times Interest Earned=EBIT/Interest expense	20.09	0.24	1531400/68000=	22.52	25
Gross Profit Margin=Gross profit/Sales	35.42%	14.67%	(8031400-5795000)/8031400=	27.85%	27%
Operating Profit Margin=EBIT/sales	27.66%	0.70%	1531400/8031400=	19.07%	16%
Net Profit Margin=Net income/Sales	15.77%	-2.28%	878040/8031400=	10.93%	12%
Return on Total Assets=Net Income/Total assets	47.75%	-4.58%	878040/3600620=	24.39%	30%
Return on Equity=Net Income/Total equity	105.10%	-21.67%	878040/1973620=	44.49%	35%
Price/Earnings (P/E) Ratio=Market price per share/Earnings per share	21.47	-76.87	60/(878040/300000)=	20.50	15%
Market/Book Value Ratio (MV/BV per share)	11.63	-9.62	60/6.2=	9.68	8

2.To improve liquidity--Inventory t.O needs to be improved--less stocking up of inv.or increased conversion of inventory to sales

3..It takes more than 2.5 times(114 days) the industry av.(45 days), for conversion of finished goods to sales.

Collection of receivables takes more than ind.av.

Settlement of trade payables are done, in less than half the no.of days of industry average.

so, sales need to be improved & collection drives need to be initiated --as also maximum advantage should be taken while settling vendor bills, so that cash will be available within the company for working capital ,that will also improve the liquidity position

$ (9.60) sales generated per $ of fixed assets utilised, is better than industry average (9)

$ (2.23) sales generated per $ of total assets utilised, is almost on par with industry average (2.5)

So, asset utilisation , is on par with industry.

4.All the 3 ratios indicate more debt in Hororata Inc.,compared to its industry peers.

So, scaling down debt is suggested to improve the financial leverage as also debt-servicing times with its EBIT generated.

5.Hororata's Gross profit margin (27.85%) in 2020 marginally surpassed the industry av.(27%)

Its Opg. Profit margin(19%) is also much better than industry av.(16%)

Its net profit margin (10.93%) , being lower than the ind. Av.(12%) again indicates, more level of interest expenses, that need to be scaled down , with decreased debt levels, to conform to industry average, in this area of profiatbility

Return on assets is low , 24.39% as against the ind. Av of 30%, due to low net income & also less $ sales generated per $ of total assets (refer total asset turnover compared to ind.av.)

Return on Equity (44.49%) is much higher than that for the ind.av.(35%), due to low level of equity & a higher proportion of debt--as compared to industry peers.

6. Both Price/earnings ratio & market/book ratios indicate what the investors are paying per $ of earnings per share or book value per share.It is just a comparison , where trends of the market ,depending on investor-moods, may be studied. After going through the financials of companies,investors opt to pay this much ,for this stock, expecting future growth & similar performance.Only that price/market value ,indicates the investors' perception that the stock is going to /or not going to perform well , in future.That said,these ratios indicate that investors are expected to have a high opinion of the company

7.Application of DuPont's Equation for Hororata Inc.'s 2020 financial results,

ROE=Net Income/Total equity=Profit Margin*Total Assets Turnover*Financial Leverage

From the given figures, Financial leverage=Total assets/Total equity=3600620/1973620=1.8244

ie.10.93%*2.23*1.82=

44.49%

The major strength of the firm is its asset utilisation ie.$ sales generated per $ of asset employed/used   &

Major weakness is low profitability due to increased level of debt &consequent high interest expenses, compared to the industry , which also boosts the financial leverage.

8. As per the industry average, P/E=15

P/2.93=15

P=15*2.93=

43.95

This method, indicates that Hororata's shares are selling at a higher price($ 60) ,compared to its peers in the industry.

9.Potential problems and limitations of financial ratio analysis

a.Resulting ratios are as good & reliable as the numbers that hav egone into their workings.

b. Different companies in the industry , classify certain items differently--as for example, notes payable are classified by some as current & by others as non-current.These things may distort the ratios calculated & subsequently the conclusions.

c.Changes in accounting & operational policies unique to some individual firms , might have distorted the bench-mark ratio ,ie. the industry average.

d.Finally, as financial statements are highly prone to management-manipulations, ratios are only that much reliable.