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 2012 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 2011 and 2012 balance sheets and income statements, together with projections for 2013, are given in Tables IC 4.1 and IC 4.2. In addition, Table IC 4.3 gives the company's 2011 and 2012 financial ratios, together with industry average data. The 2013 projected financial statement data represent Jamison's and Campo's best guess for 2013 results, assuming that some new financing is arranged to get the company "over the hump."

Jamison examined monthly data for 2012 (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.

Note:  “E” indicates estimated.  The 2013 data are forecasts.

Note: “E” indicates estimated.  The 2013 data are forecasts.

a The firm had sufficient taxable income in 2010 and 2011 to obtain its full tax refund in 2012.

Note: “E” indicates estimated.  The 2013 data are forecasts.

a Calculation is based on a 365-day year.

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

B.  Calculate D'Leon's 2013 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 2011, in 2012, and as projected for 2013?  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 these liquidity ratios?

C.  Calculate the 2013 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?

D.  Calculate the 2013 debt-to-assets 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?

E.  Calculate the 2013 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE).  What can you say about these ratios?

F.  Calculate the 2013 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?

G.  Use the DuPont equation to provide a summary and overview of D'Leon's financial condition as projected for 2013.  What are the firm's major strengths and weaknesses?

H.  Use the following simplified 2013 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? Accounts receivable $   878 Debt $1,545 Other current assets 1,802 Net fixed assets      817 Equity  1,952  Total assets $3,497  Liabilities plus equity $3,497

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

J.  In 2012, 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 demand its repayment?  Would your actions be influenced if in early 2013 D'Leon showed you its 2013 projections along with proof that it was going to raise more than $1.2 million of new equity?

K.  In hindsight, what should D'Leon have done in 2011?

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

M.  What are some qualitative factors analysts should consider when evaluating a company's likely future financial performance?