Question

• FINANCIAL STATEMENTS AND TAXES Part I of this case, presented in Chapter 3, discussed the situation of D’Leon Inc., a regional snack foods producer, after an expansion program. D’Leon had increased plant capacity and undertaken a major marketing campaign in an attempt to “go national.” Thus far, sales have not been up to the forecasted level; costs have been higher than were projected; and a large loss occurred in 2016 rather than the expected profit. As a result, its managers, directors, and investors are concerned about the firm’s survival.

  Donna Jamison was brought in as assistant to Fred Campo, D’Leon’s chairman, who had the task of getting the company back into a sound financial position. D’Leon’s 2015 and 2016 balance sheets and income statements, together with projections for 2017, are given in Tables IC 4.1 and IC 4.2. In addition, Table IC 4.3 gives the company’s 2015 and 2016 financial ratios, together with industry average data. The 2017 projected financial statement data represent Jamison’s and Campo’s best guess for 2017 results, assuming that some new financing is arranged to get the company “over the hump.”

  Table IC 4.1Balance Sheets

  Note: E indicates estimated. The 2017 data are forecasts.

  Table IC 4.2Income Statements

  Note: E indicates estimated. The 2017 data are forecasts.

  ^aThe firm had sufficient taxable income in 2014 and 2015 to obtain its full tax refund in 2016.

  Table IC 4.3Ratio Analysis

  Note: E indicates estimated. The 2017 data are forecasts.

  ^aCalculation is based on a 365-day year.

  Jamison examined monthly data for 2016 (not given in the case), and she detected an improving pattern during the year. Monthly sales were rising, costs were falling, and large losses in the early months had turned to a small profit by December. Thus, the annual data look somewhat worse than final monthly data. Also, it appears to be taking longer for the advertising program to get the message out, for the new sales offices to generate sales, and for the new manufacturing facilities to operate efficiently. In other words, the lags between spending money and deriving benefits were longer than D’Leon’s managers had anticipated. For these reasons, Jamison and Campo see hope for the company—provided it can survive in the short run.

  Jamison must prepare an analysis of where the company is now, what it must do to regain its financial health, and what actions should be taken. Your assignment is to help her answer the following questions. Provide clear explanations, not yes or no answers.

  1. Why are ratios useful? What are the five major categories of ratios?

  2. Calculate D’Leon’s 2017 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity positions in 2015, in 2016, and as projected for 2017? We often think of ratios as being useful (1) to managers to help run the business, (2) to bankers for credit analysis, and (3) to stockholders for stock valuation. Would these different types of analysts have an equal interest in the company’s liquidity ratios? Explain your answer.

  3. Calculate the 2017 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does D’Leon’s utilization of assets stack up against other firms in the industry?

  4. Calculate the 2017 debt-to-capital and times-interest-earned ratios. How does D’Leon compare with the industry with respect to financial leverage? What can you conclude from these ratios?

  5. Calculate the 2017 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC). What can you say about these ratios?

  6. Calculate the 2017 price/earnings ratio and market/book ratio. Do these ratios indicate that investors are expected to have a high or low opinion of the company?

  7. Use the DuPont equation to provide a summary and overview of D’Leon’s financial condition as projected for 2017. What are the firm’s major strengths and weaknesses?

  8. Use the following simplified 2017 balance sheet to show, in general terms, how an improvement in the DSO would tend to affect the stock price. For example, if the company could improve its collection procedures and thereby lower its DSO from 45.6 days to the 32-day industry average without affecting sales, how would that change “ripple through” the financial statements (shown in thousands below) and influence the stock price?

  9. Does it appear that inventories could be adjusted? If so, how should that adjustment affect D’Leon’s profitability and stock price?

  10. In 2016, the company paid its suppliers much later than the due dates; also, it was not maintaining financial ratios at levels called for in its bank loan agreements. Therefore, suppliers could cut the company off, and its bank could refuse to renew the loan when it comes due in 90 days. On the basis of data provided, would you, as a credit manager, continue to sell to D’Leon on credit? (You could demand cash on delivery—that is, sell on terms of COD—but that might cause D’Leon to stop buying from your company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or demanding its repayment? Would your actions be influenced if, in early 2017, D’Leon showed you its 2017 projections along with proof that it was going to raise more than $1.2 million of new equity?

  11. In hindsight, what should D’Leon have done in 2015?

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

  13. What are some qualitative factors that analysts should consider when evaluating a company’s likely future financial performance?

Taking a Closer Look

Conducting a Financial Ratio Analysis on Hewlett Packard Co.

Use online resources to work on this chapter’s questions. Please note that website information changes over time, and these changes may limit your ability to answer some of these questions.

In Chapter 3, we looked at Whole Foods’ financial statements. In this chapter, we will use financial Internet websites (specifically, www.morningstar.com and www.google.com/finance) to analyze Hewlett Packard Co. Once on either website, you simply enter Hewlett Packard’s ticker symbol (HPQ) to obtain the financial information needed.

The text mentions that financial statement analysis has two major components: a trend analysis, where we evaluate changes in key ratios over time, and a peer analysis, where we compare financial ratios with firms that are in the same industry and/or line of business. We will do both of these types of analysis in this problem.

Through the Morningstar website, you can find the firm’s financials (Income Statement, Balance Sheet, and Cash Flow) on an annual or quarterly basis for the 5 most recent time periods. In addition, the site contains Key Ratios (Profitability, Growth, Cash Flow, Financial Health, and Efficiency) for 10 years. We will use the Key Ratios on this site to conduct the firm’s trend analysis. (At the bottom of the screen you will see that you can click “Glossary” to find definitions for the different ratios. For example, Morningstar’s Financial Leverage ratio is the same as the Equity multiplier that we use in the textbook.)

On the Google Finance site, you can find the firm’s financial statements for the 4 most recent years or the five most recent quarters and key financial data for related companies for the most recent year or quarter. We will use the related companies’ annual data to conduct the firm’s peer analysis. Notice that when you go to the “Related Companies” screen, you can “add or remove columns.” Click on that phrase, and you can check which peer data items you’d like to show on the computer screen. Also, once you have chosen the data, you can click on a term, and the companies will be ranked in either ascending or descending order for the specific term selected.

Discussion Questions

1. Looking at Morningstar’s Financial Health ratios, what has happened to Hewlett Packard’s liquidity position over the past 10 years?

2. Looking at Morningstar’s Financial Health ratios, what has happened to Hewlett Packard’s financial leverage position over the past 10 years?

3. Looking at Morningstar’s Profitability ratios, what has happened to Hewlett Packard’s profit margin (net margin %) over the past 10 years? What has happened to its return on assets (ROA) and return on equity (ROE) over the past 10 years?

4. Identify Google Finance’s list of related companies to Hewlett Packard. Which is the largest in terms of market capitalization? Which is the smallest? Where does Hewlett Packard rank (in terms of market capitalization)?

5. From the Google Finance site, look at Hewlett Packard’s liquidity position (as measured by its current ratio). How does this ratio compare with those of its peers?

6. From the Google Finance site, look at Hewlett Packard’s profitability ratios (as measured by its profit margin, ROA, and ROE). How do these ratios compare with those of its peers?

7. From the Google Finance site, use the DuPont analysis to determine the total assets turnover ratio for each of the peer companies. (Hint: .) Once you’ve calculated each peer’s total assets turnover ratio, then you can use the DuPont analysis to calculate each peer’s equity multiplier.

8. From the information gained in question 7 and using the DuPont analysis, what are Hewlett Packard’s strengths and weaknesses compared to those of its competitors?

Answer 1

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Discussion Questions

1. Looking at Morningstar’s Financial Health ratios, what has happened to Hewlett Packard’s liquidity position over the past 10 years?

2. Looking at Morningstar’s Financial Health ratios, what has happened to Hewlett Packard’s financial leverage position over the past 10 years?

3. Looking at Morningstar’s Profitability ratios, what has happened to Hewlett Packard’s profit margin (net margin %) over the past 10 years? What has happened to its return on assets (ROA) and return on equity (ROE) over the past 10 years?

4. Identify Google Finance’s list of related companies to Hewlett Packard. Which is the largest in terms of market capitalization? Which is the smallest? Where does Hewlett Packard rank (in terms of market capitalization)?