Question

Decision Case 13-5: Acquisition Decision
Diversified Industries is a large conglomerate that is continually in the market for new acquisitions. The company has grown rapidly over the last ten years through buyouts of medium-size companies. Diversified does not limit itself to companies in any one industry, but looks for firms with a sound financial base and the ability to stand on their own financially.
The president of Diversified recently told a meeting of the company’s officers: ‘‘I want to impress two points on all of you. First, we are not in the business of looking for bargains. Diversified has achieved success in the past by acquiring companies with the ability to be a permanent member of the corporate family. We don’t want companies that may appear to be a bargain on paper but can’t survive in the long run. Second, a new member of our family must be able to come in and make it on its own—the parent is not organized to be a funding agency for struggling subsidiaries.’’
Ron Dixon is the vice president of acquisitions for Diversified, a position he has held for five years. He is responsible for making recommendations to the board of directors on potential acquisitions. Because you are one of his assistants, he recently brought you a set of financials for a manufacturer, Heavy Duty Tractors Inc. Dixon believes that Heavy Duty is a ‘‘can’t-miss’’ opportunity for Diversified and asks you to confirm his hunch by performing basic financial statement analysis on the company. The most recent comparative balance sheets and income statement for the company follow.
	Heavy Duty Tractors Inc.				Heavy Duty Tractors Inc.
	Comparative Statements of Financial Position				Statement of Income and Retained Earnings
	(thousands omitted)				For the Year Ended December 31, 2017
		31-Dec-17	31-Dec-16		(thousands omitted)
	Assets				Sales revenue	875,250
	Current assets:				Cost of goods sold	542,750
	Cash	48,500	24,980		Gross profit	332,500
	Marketable securities	3,750	-		Selling, general, and administrative expenses	255,360
	Accounts receivable, net of allowances	128,420	84,120		Operating income	77,140
	Inventories	135,850	96,780		Interest expense	45,000
	Prepaid items	7,600	9,300		Net income before taxes	32,140
	Total current assets	324,120	215,180		Income tax expense	9,250
	Long-term investments	55,890	55,890		Net income	22,890
	Property, plant, and equipment:				Retained earnings, January 1, 2017	169,820
	Land	45,000	45,000			192,710
	Buildings and equipment, less accumulated depreciation of $385,000 in 2017 and $325,000 in 2016	545,000	605,000		Dividends paid on common stock	10,000
	Total property, plant, and equipment	590,000	650,000		Retained earnings, December 31, 2017	182,710
	Total assets	970,010	921,070
	Liabilities and Stockholders’ Equity
	Current liabilities:
	Short-term notes	80,000	60,000
	Accounts payable	65,350	48,760
	Salaries and wages payable	14,360	13,840
	Income taxes payable	2,590	3,650
	Total current liabilities	162,300	126,250
	Long-term bonds payable, due 2024	275,000	275,000
	Stockholders’ equity:
	Common stock, no par	350,000	350,000
	Retained earnings	182,710	169,820
	Total stockholders’ equity	532,710	519,820
	Total liabilities and stockholders’ equity	970,010	921,070
Required
4	What will you tell your boss? Should he recommend to the board of directors that Diversified put in a bid for Heavy Duty Tractors?

Answer 1

In order to give a suggestion, we need to see the analyse the financial statements provided using the ratios mentioned below:

Ratio Analysis	Formula	2017	2016
Liquidity Ratios:
Current ratio	Current Assets/Current Liability	1.997	1.704
Quick ratio	Current Assets - Inventory/Current Liability	1.160	0.938
Accounts receivable Turnover ratio	Net Credit Sales/Average accounts receivable	2.059
Inventory Turnover Ratio	Cost of Goods sold/Average inventory	1.167
Solvency Ratios:
Debt to Equity Ratio	Long term Debt/Total Equity	51.62%	52.90%
Interest earned ratio	(Net Income+Interest Expense+Income Tax expense)/Interest expense	1.714
Profitability ratios:
Gross Profit ratio	Gross Profit/Net Sales	37.99%
Profit Margin ratio	Net Income before Interest and tax/Net Sales	8.81%
Return on Assets ratio	(Net Income+Interest Expense*(1-tax))/Average total assets	1.45%
Return on Sales ratio	(Net Income+Interest Expense*(1-tax))/Net Sales	6.28%
Asset Turnover Ratio	Net Sales/Average Total Assets	23.14%

The liquidity ratios seems to be good comparing with the industry standards. Current assets are twice that of current liabilities and quick assets (which can be readity converted into cash) are a little higher than total current liabilities. This clearly states that the company will be able to meet all the current liabilities without running out of cash. This is a very positive sign as most companies are profitable but not able to generate enough cash in order to meet short term liabilities and become insolvent.

Although, no. of days sales in receivables is 177. It means that it takes 177 days to get the cash from debtors which is not a good sign but not alarming and can be improved. The no. of days it takes for the inventory to sell evenually is over 300 days which means that company is spending a lot of inventory cost as they have to storre the product for almost 10months for them to sell out. This is not bad for a manufacturing company but there is a scope of improvement.

The manufacturing company has a good solvency ratio as the debt to equity ratio is 51.62%. It means that the total equity of the company is twice that of the total debt or the long term liability of the company. So, in future, if the company wants to raise any money, it can be done easily due to good credibility power.

Profitability ratios also suggests that the management is doing good work to keep the operations profitable. Gross profit ratio is 38% and net profit ratio is 9% (Approx). Company is generating sales revenue of 23% of its total assets. So, it is utilising its resources efficiently.

Overall, I would recomment to the boad of directors to put a bid for Heavy Duty Tractors.