Question

FINANCIAL STATEMENTS ANALYSIS HORORATA INC

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

Table 1 - Hororata Inc. Balance Sheets
Assets.	2018 ($’000)	2019 ($’000)	2020 ($’000)
Cash	7,500	7,300	14000
Short-Term Investments-	46,600	18500	70000
Accounts Receivable	350000	650000	870000
Inventories	713000	1283860	1810080
Total Current Assets	1,117,100	1,959,660	2,764,080
Gross Fixed Assets	490500	1201350	1218300
Less: Accumulated Depreciation	144700	261860	381760
Net Fixed Assets	345800	939490	836540
Total Assets	1,462,900	2,899,150	3,600,620
Liabilities	2018 ($’000)	2019 ($’000)	2020 ($’000)
Accounts Payable	145400	323550	358000
Notes Payable	198200	699700	296800
Accruals	132700	283510	377200
Total Current Liabilities	476300	1306760	1032000
Long-Term Debt	322000	980000	595000
Common Stock	460000	540000	1600000
Retained Earnings	204600	72390	373620
Total Equity	664600	612390	1973620
Total Liabilities And Equity	1462900	2899150	3600620
Table 2 - Hororata Inc. Income Statements
	2018 ($’000)	2019 ($’000)	2020 ($’000)
Sales	4429200	5831300	8031400
COGS excluding depreciation	2860500	4975800	5795000
Depreciation	18500	116600	115000
Other Expenses	325000	698000	590000
Total Operating Costs	3204000	5790400	6500000
EBIT	1225200	40900	1531400
Interest Expense	61000	173600	68000
EBT	1164200	-132700	1463400
Taxes @40%	465680	0	585360
Net Income	698520	-132700	878040
NO. Of shares	200000	200000	300000
EPS	3.4926	-0.6635	2.9268
Market Share Price	75	51	60
Book Value	6.45	5.3	6.2
Table 3 - Hororata Inc. Ratio Analysis
	2018 ($’000)	2019 ($’000)	2020 ($’000)	Industry average
Current Ratio	2.35	1.50	2.68	2.00
Quick Ratio	0.85	0.52	0.92	1.00
Inventory Turnover	4.01	3.88	3.20	5.00
Average Age of Inventory (days)	90.98	94.18	114.01	45.00
Average Collection Period (days)	28.84	40.69	39.54	30.00
Average Payment Period (days)	18.55	23.73	22.55	60.00
Fixed Asset Turnover	12.81	6.21	9.60	9.00
Total Asset Turnover	3.03	2.01	2.23	2.50
Debt Ratio	0.55	0.79	0.45	0.40
Debt to Equity Ratio	1.20	3.73	0.82	0.70
Times Interest Earned	20.09	0.24	22.52	25.00
Gross Profit Margin	35.42	14.67	27.85	27.00
Operating Profit Margin (%)	27.66	0.70	19.07	16.00
Net Profit Margin (%)	15.77	(2.28)	10.93	12.00
Return on Total Assets (%)	47.75	-4.58	24.39	30.00
Return on Equity (%	105.10	-21.67	44.49	35.00
Price/Earnings (P/E) Ratio	21.47	-76.87	20.50	15.00
Market/Book Value Ratio	11.63	9.62	9.68	8.00

2) Current Ratio for 2020 is 2.68 which is above the standard of 2 which shows the company has sufficient current assets to pay off liabilities

Quick Ratio for 2020 is 0.92 which is lower than the standard of 1 which indicates companies liquid assets are not sufficient to pay off liabilities.

3)Inventory turnover is continuously decreasing as compared to 2018 & 2019 and lower than the industry standard,

• The average age of inventory is also increasing as compared to 2018 & 19 i.e 114days which is much above than standard of 45 days.
• The cost of goods sold is increasing as compared to previous years which shows materials are not utilized judiciously and as a result of lower inventory turnover ration, the average age of inventory is increasing.
• Average collection period is also higher than standard which indicates the company provides a higher credit period which affects the operating cycle.
• The average payment period is less than the standard which means the company gets less credit period for payment which requires more working capital.
• Fixed Asset to turnover ratio is slightly above standard.
• A total asset to turnover is slightly below the standard.

Hence the company should increase its payment period and reduce its collection period.

4)

Debt Ratio and Debt to Equity Ratios are slightly above the standard. Hence the company should take steps to keep it with industry standards

Too Much of Debt also creates weak financial position.

Times Interest earned is less then the standard in 2020 hence company should improve its EBIT in order to increase in Times Interest Earned ratio.