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
3	Has Heavy Duty demonstrated the ability to be a profitable member of the Diversified family? Support your answer with the necessary ratios.

Answer 1

Brief income statement:

Let us analyse the brief income statement of Heavy Duty Tractors Inc. to assess the financial performance of the company:

Heavy Duty Tractors Inc.
Particulars	Amount ($)
Revenue from sales	875250
Less: Cost of goods sold	542750
Gross Profit	332500
Earnings before interest and tax	77140
Less: Interest	45000
Earnings before tax (EBT)	32140

Earnings before tax (EBT)	32140
Less: Tax	9250
Net income	22890

As can be seen from the above table that the company has earned significant amount of gross profit in the latest accounting period ending on December 31, 2017. However, compare to gross profit of $332,500 the company has merely earned a net income of $22,890.    

Profitability ratios:

The profitability ratios of the company will help us to assess the profitability of the company strategically. Let us analyse the ability of the company to generate profit from its business activities.

Gross profit ratio (All ratios are in %)
Revenue from sales	875250
Gross Profit	332500
Gross profit ratio	37.98915
EBIT ratio
Revenue from sales	875250
Earnings before interest and tax	77140
EBIT ratio	8.813482
EBT ratio
Revenue from sales	875250
Earnings before tax (EBT)	32140
EBT ratio	3.672094
Net income ratio
Revenue from sales	875250
Net income	22890
Net income ratio	2.615253

The gross profit of ratio of 37.99%, i.e. almost 38% suggests that the company has earned a gross profit of $38 for sale of each $100. Thus, the company has been quite successful in managing its core business operations and in generating revenue from its core business operations. However, the company has suffered very badly with its EBIT and EBT of 8.81% and 3.67% respectively. In-fact the net profit ratio of the company is quite low at 2.61%. Thus, the company though demonstrate ability to be a profitable member of the diversified family however, the management of the company must take necessary steps to improve its profitability in the future.