New Era University

CASE STUDYEVERELITE TECHNOLOGY CO., LTD.Financial ManagementDean Isagani Sabado

Christian Angel BuysonJamila De La CruzHyra Pearl PorbasasJerico Galvez

4-BSA 1

INTEGRATED CASEFINANCIAL STATEMENT ANALAYSIS

Everelite Technology Co., Ltd had increased service capacity and undertaken a major marketing campaign in an attempt to go global. Thus far, sales have not reached the forecasted level, the company incurred higher than projected costs, and the company recorded a huge loss for 2008 instead of projected profits. As a result, its managers, directors, and investors are concerned about the firms survival.

Robert Su, an MBA graduate from the Business School of Hong Kong University of Sciance and Technology, received a request to join Everelite, from his uncle- Frank Su, chairman of Everelites board of directors. Roberts mission is to get Everelite beck into a sound financial position. Everelites 2007 and 2008 balance sheets and income statements, together with projections for 2009, are given in Tables IC 3-1 and IC 3-2. In addition, Table IC 3-3 gives the companys 2007 and 2008 financial ratios, together with industry average data. The 2009 projected fincancial statement data represent Roberts abd Franks best guess for 2009 resuts, assuming that some new financing is arranged to get the company over the hump.

Robert 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 him answer the following questions. Provide clear explanations, not yes or no answers.

a.) Why are ratios useful? What are the five major categories of ratios?b.) Calculate Everelites 2009 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys liquidity positions in 2007, in 2008, and as projected for 2009? We often think of ratios as being useful (1) to managers 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 the companys liquidity ratios?c.) Calculate the 2009 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Everelites utilization of assets stack up against other firms in the industry?d.) Calculate the 2009 debt and times-interest-earned ratios. How does Everelite compare with the industry with respect to financial leverage? What can you conclude from these ratios?e.) Calculate the 2009 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 2009 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 Everelites financial condition as projected for 2009. What are the firms major strengths and weaknesses?h.) Use the following simplified 2009 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 without affecting sales, how would that change ripple through the financial statements (shown in thousands below) and influence the stock price?Accounts receivable$877 Debt $1,730

Other current assets1109

Net fixed assets313 Equity569

Total assets$2,299 Liabilities plus equity$2,299

i.) Does it appear that inventories could be adjusted? If so, how should that adjustment affect Everelite's profitability and stock price?j.) In 2008, 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 Everelite on credit? (You could demand cash on delivery that is, sell on terms of COD but that might cause Everelite to stop buying from your company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or demand its repayment?k.) What are some potential problems and limitations of financial ratio analysis?l.) What are some qualitative factors that analysts should consider when evaluating a company's likely future financial performance?

Table IC 3-1 Balance Sheets

2009 (E)20082007

Assets

Cash$ 199,551$208,323$102,024

Accounts Receivable 876,897690,294824,979

Inventories909,379942,374715,414

Total Current assets$1,985,827$1,840,991$1,642,417

Gross fixed asstes380,510317,503232,179

Less accumulated depreciation67,41354,04534,187

Net fixed assets$313,097$263,458$197,992

Total assets$2,298,924$2,104,449$1,840,409

Liabilities and Equity

Short-term borrowings$312,500$288,798$296,149

Accounts payable650,535636,318414,611

Accruals110,157106,748103,362

Total current liabilities$1,073,192$1,031,864$814,122

Long-term debt656,600410,769372,931

Commin stock (100,000 shares)550,000550,000550,000

Retained earnings19,132111,816103,356

Total Equity$569,132$661,816$653,356

Total liabilities and equity$2,298,924$2,104,449$1,840,409

Table IC 3-2 Income Statements

2009 (E)20082007

Sales$2,069,032$2,325,967$2,220,607

Cost of good sold1,647,9251,869,3261,655,827

Other expenses241,490287,663273,870

Total operating costs excluding depreciation and amortization$1,889,415$2,156,989$1,929,697

Depreciation and amortization17,89125,36326,341

EBIT$161,726$143,615$264,569

Interest Expense27,43431,42213,802

EBT$134,292$112,193$250,767

Taxes (40%)53,71744,877100,307

Net Income$80,575$67,316$150,460

EPS$0.81$0.67$1.50

DPS$1.00$1.00$1.42

Book value per share$5.69$6.62$6.53

Stock price$19.2$15.60$21.8

Shares outstanding100,000100,000100,000

Tax rate40%40%40%

Table IC 3-3 Ratio Analysis

2009E20082007Industry Average

Current1.78x2.02x2.05x

Quick0.87x1.14x1x

Inventory Turnover2.47x3.10x6.1x

DSO108.32 days135.60 days56 days

Fixed Asset Turnover8.83x11.22x9.3x

Total Assets Turnover1.11x1.21x2.1x

Debt Ratio68.55%64.50%50.00%

TIE4.57x19.17x6.2x

Operating Margin6.17%11.91%13%

Profit Margin2.89%6.78%9.00%

Basic Earning Power6.82%14.38%15.00%

ROA3.20%8.18%6.50%

ROE10.17%23.03%12.00%

Price/ Earnings23.17x14.49x10.00x

Market/ Book2.36x3.34x3.00x

Book Value per share$6.62$6.53NA

SOLUTIONS:

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

Ratios are important because it enables the business owner and managers to detect trends in the company and to compare its performance and condition with the average performance of similar businesses in the same industry. Ratios also helps us identify and quantify a companys strengths and weaknesses, evaluate its financial position, and understand the risks involved in the company. Ratio can help managers implement plans that improve a companys profitability, liquidity and financial structure.The five major categories of ratios are; Liquidity Ratios, Asset Management Ratios, Debt Management Ratios, Profitability Ratios and Market Value Ratios.

b.) Calculate Everelites 2009 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the companys liquidity positions in 2007, in 2008, and as projected for 2009? We often think of ratios as being useful (1) to managers 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 the companys liquidity ratios?

In 2007, Everelites current ratio is slightly below the industry average. However, its quick ratio is higher compared to the industry average. Thus, the firm can pay their current liabilities if they will not rely on the sale of their inventories.In 2008, as shown in its liquidity ratios, both below the industry average, Everelite, could not be able to meet its short term debts. In 2009, both current and quick ratios increased relative to last years. However, current ratio is lower than the industry average by .2 while its quick ratio levels the industry average. This means that basing solely from the current and quick ratios, improvement is expected but it is safe to say that the liquidity position of the firm is weak. No, they don't have an equal interest in the liquidity ratio. The following are the specific reasons: MANAGER:Some of the most basic financial ratios show how much a business or investment will return compared to how much it will cost. When managers are planning new projects, these financial ratios provide the support they need to receive funding from executives to move forward. Executives like to see a high return on investment, or ROI, based on analysis of costs and projected revenues. After projects are completed, the same type of analysis can show the returns actually delivered, and how the investment lived up to expectations, which is useful for future strategy.

CREDIT ANALYST:Credit analysts will be particularly interested in the applicant's liquidity and ability to pay bills on time. Such ratios as the quick ratio, receivables, inventory turnovers, the average payable period and debt-to-equity ratio are particularly relevant. In addition to analyzing financial statements, the credit analyst will consider the character of the company and its management, the financial strength of the firm, and various other matters.

STOCKHOLDERS:Interested only in Return On Equity (ROE), Dividend Rate, Gross Margin, Net Income Margin and Quarterly and Annual Growth Ratios.

In general, Financial Statement Analysis is used by: a) managers to evaluate and improve performance, b) lenders (banks and bondholders) and bond rating analysts (SP and Moody's) to evaluate the creditworthiness of a company, and c) stockholders (current or prospective) and stock analysts, to forecast earnings, DIV and stock price." The five types of ratios are liquidity, asset management, debt management, profitability, and market value ratios.

c.) Calculate the 2009 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. How does Everelites utilization of assets stack up against other firms in the industry?

= 2.28x

Inventory turnover is below the industry average and is getting worse, maybe because they have old inventories or its control might be poor. No improvement is currently forecasted (In fact, the opposite). The firm collects its receivables too slowly (2007: 135.60 days, 2008: 108.32 days. 2009: 154. 69 days) as compared to the 56 days norm. This suggests the managements poor credit policy. The companys fixed assets turnover declines with time, and is expected to go way lower than the industry average. This shows that it does not use its long term assets effectively so as to generate higher sales. Total assets turnover is not in line with other companies in the same industry. As time passes by, it continues to turn down. This is caused by excessive current assets (Accounts Receivable/Inventory) To sum up; Everelite is inefficiently using its assets.

d.) Calculate the 2009 debt and times-interest-earned ratios. How does Everelite compare with the industry with respect to financial leverage? What can you conclude from these ratios?

As compared to the industry average, Everelite's financial leverage is relatively higher which means that a large fraction of their assets are primarily financed by the creditors. Since the company uses great financial leverage, it is subject to higher risks.

e.) Calculate the 2009 operating margin, profit margin, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios?

It may be recalled that the profitability ratios bring together the asset and debt management ratios and show their effects on ROE. Though Everelites operating margin, profit margin, basic earning power and return on assets have shown improvements compared to last years, still, they are way lower than the industry average. This implies the firms poor utilization of assets. However, its ROE is above the industry norm. This may be attributed to the use of too much leverage which exposes the firm to a higher risk. Using leverage does not guarantee the firms good results of operations. In Everelites case, the use of leverage leaves the firm in a near-to-bankruptcy position.

f.) Calculate the 2009 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?

Both the P/E and M/B ratio are above the industry norm. A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall market, as investors are paying more for today's earnings in anticipation of future earnings growth. Hence, as a generalization, stocks with this characteristic are considered to begrowth stocks. Thegrowth investorviews high P/E ratio stocks as attractive buys and low P/E stocks as flawed, unattractive prospectsOn the other hand, the firms high P/B ratio is often a sign that a business has rosier future prospects than past performance. Share price is high relative to book value because investors have bid up the share price based on expectations of better earnings and/or cash flow ahead.

g.) Use the DuPont equation to provide a summary and overview of Everelites financial condition as projected for 2009. What are the firms major strengths and weaknesses?

Strengths: The firms ROE shows a great increase. This indicates that managers did an effective utilization of the resources given by stockholder by generating profits that will result to an accretion of the investors equity.

Weaknesses: The firms liquidity position is weak; all its asset management ratios are poor); its debt management ratios are poor and most of its profitability ratios are low (except return on equity). The company is currently achieving low productivity from its inventory and fixed assets. It is also not collecting from its customers as quickly as the industry. It needs to improve its sales and/or reduce inventories and fixed assets to better match its competitors.

h.) Use the following simplified 2009 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 without affecting sales, how would that change ripple through the financial statements (shown in thousands below) and influence the stock price?

Accounts receivable$877 Debt $1,730

Other current assets1109

Net fixed assets313 Equity569

Total assets$2,299 Liabilities plus equity$2,299

Sales / day = $2, 069, 032 / 365 = $5, 668. 58Reducing Accounts Receivable will have no effect on sales.

Old Accounts Receivable = $877, 000New Accounts Receivable = $5, 668.58 x 56 days = $317, 440 Cash freed up: $ 559, 560 Initially shows up as addition to cash.

Effect of reducing receivables on balance sheet and stock priceAdded CashAccounts receivable$560317Debt$1,730

Other current assets1109

Net fixed assets313Equity569

Total assets$2,299Liabilities plus equity$2,299

Improving the companys collection procedures without affecting sales by lowering its DSO from 154. 69 days to the 56 days industry average would result to an addition to cash. The freed up cash could be utilized to repurchase stock, expand the business, and reduce debt. All of these actions would likely improve the stock price.

i.) Does it appear that inventories could be adjusted? If so, how should that adjustment affect Everelite's profitability and stock price?

The inventory turnover ratio is low. It appears that the firm either has excessive inventory or some of the inventory is obsolete. If inventory were reduced, this would improve the current asset ratio, the inventory and total assets turnover, and reduce the debt ratio even further, which should improve the firms stock price and profitability.

j.) In 2008, 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 Everelite on credit? (You could demand cash on delivery that is, sell on terms of COD but that might cause Everelite to stop buying from your company.) Similarly, if you were the bank loan officer, would you recommend renewing the loan or demand its repayment?

With reference to the ratios such as quick, receivable and inventory turnover which show the company's inability to pay off its' debts when they fall due. As a credit manager, it is unfavorable to continue providing supplying a portion of its total funds with its current arrangement. Terms of COD might be a little harsh and might push the firm into bankruptcy. Likewise, if the bank demanded repayment this could also force Everelite into bankruptcy. Therefore, renewing the loan is a preferable option.

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

Many ratios are calculated on the basis of the balance-sheet figures. These figures are as on the balance-sheet date only and may not be indicative of the year-round position. Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. It gives current and past trends, but not future trends. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. The ratios are only as good or bad as the underlying information used to calculate them.

Although ratio analysis is very important tool to judge the company's performance, following are the limitations of it. Seasonal factors can distort ratios, Window dressing techniques can make statements and ratios look better. Different operating and accounting practices distort comparisons. Sometimes, it is hard to tell if ratio is good or bad.

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

The following are some qualitative factors that analysts should consider:1. To what extent are the company's revenues tied to one key customer or to one key product? To what extent does the company rely on a single supplier? Reliance on single customers, products, or suppliers increases risk.2. What percentage of the company company's business is generated overseas? Companies with a large percentage of overseas business are exposed to risk of currency exchange volatility and political instability.3. What are the probable actions of current competitors and the likelihood of additional new competitors?4. Do the company's future prospects depend critically on the success of the products currently in the pipeline or on existing products?5. How does the legal and regulatory environment affect the company?

2009E20082007Industry Average

Current1.85x1.78x2.02x2.05x

Quick1.00x0.87x1.14x1.00x

Inventory turnover2.28x2.47x3.10x6.10x

Days sales outstanding (DSO)154.69 days108.32 days135.60 days56 days

Fixed assets turnover6.61x8.83x11.22x9.30x

Total assets turnover0.90x1.11x1.21x2.10x

Debt ratio75.24%68.55%64.50%50.00%

TIE5.90x4.57x19.17x6.20x

Operating margin7.82x6.16%11.91%13.00%

Profit margin3.89%2.89%6.78%9.00%

Basic earning power7.03x6.82%14.38%15.00%

ROA3.50%3.20%8.18%6.50%

ROE14.16%10.17%23.03%12.00%

Price/earnings23.82x23.17x14.49x10.00x

Market/book3.37%2.36x3.34x3.00x

Book value per share$5.59$6.62$6.53n.a

Note: E indicates estimated. The 2009 data are forecasts.aCalculation is based on a 365-day year