Question

Accounting data is used to generate a firm’s financial statements, but a firm’s intrinsic value is based on its free cash flows, which are the cash flows available for distribution to the company’s investors after the company has made all of the investments necessary to sustain its ongoing operations.

Consider the following case:

J&H Corp. recently hired Jeffery. His immediate mandate was to analyze the company. He has to submit a report on the company’s operational efficiency and estimate its potential investment in working capital. He has the income statement from last year and the following information from the company’s financial reports as well as some industry averages.

•	Last year, J&H Corp. reported a book value of $700,000 in current assets, of which 15% is cash, 17% is short-term investments, and the rest is accounts receivable and inventory.
•	The company reported $595,000 of current liabilities including accounts payable and accruals. Interestingly, the company had no notes payable outstanding, and there were no changes in the company’s accounts payable during the year.
•	The company, however, invested heavily in plant and equipment to support its operations. It reported a book value of $1,120,000 for its operating long-term assets last year.

Income Statement For the Year Ended on December 31

	J&H Corp.	Industry Average
Net sales	$15,000,000	$18,750,000
Operating costs, except depreciation and amortization	12,000,000	15,000,000
Depreciation and amortization	600,000	750,000
Total operating costs	12,600,000	15,750,000
Operating income (or EBIT)	$2,400,000	$3,000,000
Less: Interest expense	240,000	450,000
Earnings before taxes (EBT)	$2,160,000	$2,550,000
Less: Taxes (40%)	864,000	1,020,000
Net income	$1,296,000	$1,530,000

Based on the information given to him, Jeffery submits a report on January 1 with some important calculations for management to use, both for analysis and to devise an action plan. Complete the following statements in his report. If your answer is negative, use the minus sign.

	Statement #1: J&H Corp.’s NOPAT is , which is   than the industry average of .
	Statement #2: The company is using in net operating working capital (NOWC).
	Statement #3: J&H Corp. is generating in net cash flow from its operations and an accounting profit of .
	Statement #4: The firm uses of total net operating capital to run the business. This value is computed as the      of J&H Corp.’s net operating working capital and its     .

Answer 1

NOPAT CALCULATION J&H Corp INDUSTRY AVERAGE   

Net Sales -   $15000000 $18750000

Less

Total operating cost - $12600000 $15750000

Operating income is equal to- $2400000 $3000000

Less - taxes -    $864000 $1020000

Net operating income after tax- $1536000 $1980000

1.So, For statement 1-J&H NOPAT is $153600 which is smaller than industrial average of $1980000.

2.Statement 2- Company is using Short term investments in computing short term investments as it is stated in question that Short term investments are necessary for its ongoing operations.

3.Computation

Net operating cash flows = NOPAT + DEPRECIATION AND AMORTIZATION

= $1536000+$600000

= $2136000

SO Statement 3- J&H Corp is generating in $2136000 net cash flow from operations and accounting profit of $1296000(that is net income computed in the question)

4.Computation

Net operating capital = Operating assets - Operating liabilities

$1120000(Long term operating assets) + $700000(Cash,short term investments and inventory) - $595000(Current liabilities)

= $11305000

So firm uses working capital to run the business that is $105000(Current assets (including short term investments)- current liabilities) which is .92% of net operating capital

Statement 4- The firm uses .92% of total net operating capital to run the business. this value is % of J&H Corps net operating working capital and its Long term operating Assets.