RATIOS AND FINANCIAL PLANNING AT EAST COAST YACHTS

Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-term financial planning and also to evaluate the company's financial performance. Dan graduated from college five years ago with a degree in finance, and he has been employed in the treasury department of a Fortune 500 company since then.

East Coast Yachts was founded 10 years ago by Larisa Warren. The company's operations are located near Hilton Head Island, South Carolina, and the company is structured as an LLC.

The company has manufactured custom midsize, high-performance yachts for clients over this period, and its products have received high reviews for safety and reliability. The company's yachts have also recently received the highest award for customer satisfaction. The yachts are primarily purchased by wealthy individuals for pleasure use. Occasionally, a yacht is manufactured for purchase by a company for business purposes.

The custom yacht industry is fragmented, with a number of manufacturers. As with any industry, there are market leaders, but the diverse nature of the industry ensures that no manufacturer dominates the market. The competition in the market, as well as the product cost, ensures that attention to detail is a necessity. For instance, East Coast Yachts will spend 80 to 100 hours on hand-buffing the stainless steel stem-iron, which is the metal cap on the yacht's bow that conceivably could collide with a dock or another boat.

To get Dan started with his analyses, Larisa has provided the following financial statements. Dan has gathered the industry ratios for the yacht manufacturing industry.

EAST COAST YACHTS

2005 Income Statement

Sales $128,700,000

Cost of goods sold 90,700,000

Other expenses 15,380,000

Depreciation 4,200,000

Earnings before interest and taxes (EBIT) $ 18,420,000

Interest 2,315,000

Taxable income $ 16,105,000

Taxes (40%) 6,442,000

Net income $9,663,000

Dividends $ 5,797,800

Addition to retained earnings $ 3,865,200

EAST COAST YACHTS

Balance Sheet as of December 31, 2005

Assets Liabilities & Equity

Current assets Current liabilities

Cash $ 2,340,000 Accounts payable $ 4,970,000

Accounts receivable 4,210,000 Notes payable 10,060,000

Inventory 4,720,000

Total $11,270,000 Total $15,030,000

Fixed assets Long-term debt $25,950,000

Net plant and equipment $72,280,000

Shareholders' equity

Common stock $ 4,000,000

Retained earnings 38,570,000

Total equity $42,570,000

Total assets $83,550,000 Total liabilities and equity $83,550,000

Yacht Industry Ratios

Lower Quartile Median Upper Quartile

Current ratio 0.50 1.43 1.89

Quick ratio 0.21 0.38 0.62

Total asset turnover 0.68 0.85 1.38

Inventory turnover 4.89 6.15 10.89

Receivables turnover 6.27 9.82 14.11

Debt ratio 0.44 0.52 0.61

Debt-equity ratio 0.79 1.08 1.56

Equity multiplier 1.79 2.08 2.56

Interest coverage 5.18 8.06 9.83

Profit margin 4.05% 6.98% 9.87%

Return on assets 6.05% 10.53% 13.21%

Return on equity 9.93% 16.54% 26.15%

1. Calculate all of the ratios listed in the industry table for East Cost Yachts.

2. Compare the performance of East Cost Yacht to the industry as a hole. For each ratio, comment on why it might be viewed as positive or negative relative to the industry. Suppose you create an inventory ratio calculated as inventory divided by current liabilities. How do you interpret this ratio? How does East Cost Yacht compare to the industry average?

3. Calculate the sustainable growth rate of East Cost Yachts. Calculate external fund needed and prepare pro forma income statement and balance sheets assuming growth at precisely this rate. Recalculate the ratios in the previous questions? What do you observe?

4. As a practical matter, East Coast Yacht is unlikely to be willing to raise external equity capital, in part because the owners don't want to dilute their existing ownership and control positions. However, ECY is planning for a growth rate of 20% net year. What are your conclusions and recommendations about the feasibility of ECY expansion plans?

5. Most assets can be increased as a percentage of sales. For instance, cash can be increased by any amount. However, fixed assets often must be increased in specific amounts since it is impossible, as a practical matter, to buy part of a new plant of machine. In this case, a company has a "staircase" or "lumpy" fixed cost structure. Assume that East Coast Yachts is currently producing at 100% of capacity. As a result, to expand production, the company must set up an entirely new line at a cost of $25,000,000. Calculate the new EFN with this assumption. What does this imply about capacity utilization for East Coast Yachts next year?