Question

FINANCIAL STATEMENT ANALYSIS CASE

RC, Inc. manufactures a variety of consumer products. The company’s founders have run the company for 30 years and are now interested in retiring. Consequently, they are seeking a purchaser who will continue its operations, and a group of investors, Stewart Inc, is looking into the acquisition of RC. To evaluate its financial stability and operating efficiency, RC was requested to provide the latest financial statements and selected financial ratios. Summary information provided by RC is as follows:

RC INC.

Income Statement

For the Year Ended November 30, 2015

(in thousands)

Sales (net)	30,500
Interest income	500
Total Revenue	31,000
Cost and expenses
Cost of goods sold	17,600
Selling and general administrative expenses	3,550
Depreciation and amortization expenses	1,890
Interest Expense	900
Total costs and expenses	23,940
Income before taxes	7,060
Income taxes	2,800
Net income	4,260

RC INC.

Balance Sheet

As of November 30, 2015

(in thousands)

	2015	2014
Cash	400	500
Short-term investments	300	200
Accounts receivable (net)	3,200	2,900
Inventory	6,000	5,400
Total current assets	9,900	9,000
Property, plant, and equipment	7,100	7,000
Total assets	17,000	16,000
Accounts payable	3,700	3,400
Income taxes payable	900	800
Accrued expenses	1,700	1,400
Total current liabilities	6,300	5,600
Long-term debt	2,000	1,800
Total liabilities	8,300	7,400
Common stock ($1 par value)	2,700	2,700
Paid-in capital in excess in par	1,000	1,000
Retained earnings	5,000	4,900
Total stockholders’ equity	8,700	8,600
Total liabilities and equity	17,000	16,000

Selected Financial Ratios for RC, Inc.

	2014	2013	Current Industry Average
Current Ratio	1.61	1.62	1.63
Acid Test Ratio	.64	.63	.68
Times Interest Earned	8.55	8.50	8.45
Profit margin on sales	13.2%	12.1%	13.0%
Asset turnover	1.84	1.83	1.84
Inventory turnover	3.17	3.21	3.18

Question:

Calculate a new set of ratios for the fiscal year 2015 for RC based on the financial statements presented.

Answer 1

Answer A)

1. Current Ratio = Current Asset / Current Liability

= 9900/6300

= 1.57

1. Acid Test Ratio or quick ratio = Cash + Marketable Securities + Receivables / Current Liability =400+300+3200/6300 = 0.62

1. Times Interest Earned = EBIT / Interest payable

=31000-17600-3550-1890 / 900

1. Profit margin on sales = Net income / Sales

= 4260/31000

= 0.137 or 13.7%

1. Asset Turnover= Revenue / Total Asset

          = 31,000/17000

          = 1.82

1. Inventory Turnover ratio = COGS / Total inventory

= 17600/6000 = 2.93%

Answer B)

Significance of each ratio

Current ratio

Indicates the relationship of current asset to current liability. Indicates the ability of the firm to meet short term liabilities. Low ratio means inadequacy of the firm to meet its current liabilities. High ratio indicates inefficiency in utilizing funds.

Quick Ratio

Indicates the relationship of liquid asset to current liabilities. Inventory is excluded from liquid assets as it may take time to be converted to cash. A high liquidity ratio compared to current ratio may indicate under may indicate under stocking while low liquidity ratio indicates overstocking.

Times Interest Earned

Indicates the relationship between net profit before interest and taxes and interest payments. It is used as a benchmark by lenders to know about the ability of business concern to pay interest periodically.     

Profit margin on sales

Indicates the operational efficiency of the firm and is a measure of the firm’s ability to cover the total operating expenses.

Asset Turnover – Indicates the firms efficiency in using assets to generate profits

Inventory Turnover ratio – Indicates the relationship of the entire inventory held in the business to all product sold

Ratios	Current Benchmark	2015	2014	2013
Current Ratio	1.63	1.57	1.61	1.62
Acid Test Ratio	0.68	0.62	0.64	0.63
Times Interest Earned	8.45	8.84	8.55	8.50
Profit margin on sales	13%	13.7%	13.2%	12.1%
Asset turnover	1.84	1.82	1.84	1.83
Inventory turnover	3.18	2.93	3.17	3.21

Redcorp Analysis :-

Short term Liquidity: - Based on the above figures, liquidity position i.e. the ability of the company to meet its short term liabilities has been decreasing significantly. Both quick and current ratio have decreased from the levels in 2013 and are also below the industry benchmark. Action needs to be taken to improve liquidity of the company

Solvency :- In terms of solvency, the firm is highly solvent. The company has higher level of interest coverage ratio (Times interest earned) which has gradually increased from 2013 level and is also higher than the industry average. This is a good thing as it means the company is earning significantly more as compared to its interest payments. Hence the company is financial secure.

Profit margin: The company has higher net profit margin and this has been increasing steadily from 2013 levels. The net profit margin is also greater than the industry average this is an indication that the company has been managing its cost very effectively and has increasing its margin.

Asset turnover: In terms of asset turnover, the company ratio is around the industry average however it has been decreasing over the years. This ratio shows how efficiently the firm is utilizing its assets. The company has to improve this by utilizing its assets in a better way

Inventory turnover: A company’s inventory turnover ratio can give you an idea of how well it manages its resources. If its ratio is very low, it may mean the company has much more inventory than it really needs at any one time. The company has a low ratio compared to its industry and this ratio has been decreasing significantly

Answer C)

Limitations of ratio analysis:-

1. Effect of inflation is not taken into consideration – Ratio analysis takes into account the financial data from accounts which do not include inflationary factors when recording transactions. This can impact our results significantly.
2. Not useful when comparing companies in different industries – Ration analysis is not useful when comparing companies in different industry as different industries have different gestation periods, business cycles.
3. Ratio analysis is a quantitative measure and hence ignores qualitative factors – The ratio analysis data gives you the picture based on the accounting figures. For example a low profit margin of company is bad but this might be due to different factors like wrong pricing or wrong marketing of the product