Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his posiition
as Manager of Cost Systems for Davis, Cohen, and O''''Brien Public Accountants and started
Track Software, Inc., In the 2 years preceding his departure from Davis, Cohen ans O''''Brien,
Stanley has spent nights and weekends developing a sophisticated cost-accounting software
program that became Track''''s initial product offering . As the firm grew, Stanley planned to develop
and expand the product offerings - all of which would be related to streamlining the processes of
medium-to-large sized manuufacturers.
Although Track experienced losses during its first two years of operation - 2000 to 2001 - its
profit has increased steadily from 2002 to the present (2006). The firm''''s profit history, including
dividend payment contributions to retained earnings is summarized in Table 1.
Stanley started the firm with $100,000 investment - his savings of $50,000 as equity and a
$50,000 long term loan from the bank. He had hoped to maintain his initial 100 percent ownership
in the corporation, but after experiencing a $50,000 loss during the first year of operation (2000)
he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no
other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley
actively manages all aspects of its activities; the other stockholders are not active in management
of the firm. The firm''''s stock was valued at $4.50 per share in 2005 and at $5.28 per share in 2006.
TABLE 1
Contribution
Net Profits Dividends to Retained
after Taxes Paid Earnings
Year (1) (2) (3)
2000 $ (50,000) $ - $ (50,000)
2001 (20,000) - (20,000)
2002 15,000 - 15,000
2003 35,000 - 35,000
2004 40,000 1,000 39,000
2005 43,000 3,000 40,000
2006 48,000 5,000 43,000
Stanley has just prepared the firm\s 2006 income statement, balance sheet and statement of retained
earnings, shown in Tables 2 , 3 and 4, along with the 2005 balance sheet, In addition, he has complied
the 2005 ratio values and industry average ratio values for 2006, which are applicable to both 2005 and
2006 and are summarized in Table 5. He is quite pleased to have achieved record earnings of $48,000
in 2006, but he is concerned about the firm''''s cash flows. Specifically, he is finding it more and more
difficult to pay the firm''''s bills in a timely manner and generate cash flows to investors - both creditors
and owners. To gain insight into these cash flow problems, Stanley is planning to determine the firm''''s
2006 operating cash flow (OCF) and free cash flow (FCF).
Stanley is further frustrated by the the firms'''' inability to afford to hire a software developer to complete
development of a cost estimation package that is believed to have "blockbuster" sales potential.
Stanley began development of this package 2 years ago, but the firm''''s growing complexity has forced
him to devote more of his time to administrative duties, thereby halting the development of this product.
Stanley''''s reluctance to fill this position stems from his concern that the added $80,000 per year in
salary and benefits for the position would certainly lower the firm''''s earnings per share (EPS) over the
next couple of years. Although the project''''s success is in no way guaranteed , Stanley believes that
if the money were spent to hire the software developer, the firm''''s sales and earnings would significantly
rise once the 2 to 3- year development, production, and marketing process was completed.
Table 2
Track Software, Inc.
Income Statement ($000)
For the Year Ended December 31, 2006
Sales revenue $ 1,550
Less: Cost of goods sold 1,030
Gross profits 520
Less: Operating expenses
Selling expenses $ 150
General and administrative expenses 270
Depreciation expense 11
Total operating expense 431
Operating profits (EBIT) 89
Less: Interest expense 29
Net profits before taxes 60
Less: Taxes (20%) 12
Net profits after taxes 48
Table 3
Track Software, Inc.
Balance Sheet ($000)
As at December 31, 2006
31-Dec
Assets 2006 2005
Current Assets
Cash $ 12 $ 31
Marketable securities 66 82
Accounts receivable 152 104
Inventories 191 145
Total Current Assets 421 362
Gross Fixed Assets 195 180
Less Accumulated depreciation 63 52
Net fixed assets 132 128
Total assets 553 490
Liabilities and Stockholders'''' Equity
Current Liabilities
Accounts payable 136 126
Notes payable 200 190
Accruals 27 25
Total Current Liabilities 363 341
Long term debt 38 40
Total liabilities 401 381
Stockholders'''' Equity
Common stock (50,000 shares outstanding
@$.40 par value 20 20
Paid-in-capital in excess of par 30 30
Retained earnings 102 59
Total stockholders'''' equity 152 109
Total liabilities and stockholders'''' equity 553 490
Table 4
Track Software, Inc.
Statement of Retained Earnings ($000)
For the Year Ended December 31, 2006
Retained earnings balance, January 1, 2006 $ 59
Add: Net profits after taxes for 2006 48
Less: Cash dividends on common stock paid during 2006 5
Retained earnings balance, December 31, 2006 102
Table 5
Industry
Actual Average
Ratio 2005 2006
Current ratio 1.06 1.82
Quick ratio 0.63 1.10
Inventory turnover 10.40 12.45
Average collection period 29.6 days 20.2 days
Total asset turnover 2.66 3.92
Debt ratio 0.78 0.55
Times interest earned ratio 3.00 5.60
Gross profit margin 32.10% 42.30%
Operating profit margin 5.50% 12.40%
Net profit margin 3.00% 4.00%
Return on total assets (ROA) 8.00% 15.60%
Return on common equity (ROE) 36.40% 34.70%
Price/earnings (P/E) ratio 5.20 7.10
Market/book (M/B) ratio 2.10 2.20
With all of these concerns in mind, Stanley set out to review the various data to develop strategies that
would help to ensure a bright future for Track Software. Stanley believed that as part of this process , a
thorough ratio analysis of the firm''''s 2006 results would provide important additional insights.
1.)
(b) Calculate the firm''''s earnings per share (EPS) for each year, recoginizing that the number of
shares of common stock outstanding has remained unchanged since the firm''''s inception.
Comment on the EPS performance in view of your response in part a.
(d) Analyze the firm''''s financial condition in 2006 as it relates to (1) liquidity, (2) activity, (3) debt
(4) profitability, and market, using the financial statements provided in Tables 2 and 3 and the
ratio included in Table 5. be sure to evaluate the firm on a cross sectional basis.