Problem Set #2

1. a) Increase and decrease values of assets and liabilities are calculated comparing the 2013 and 2014 numbers for Microhard.

Microhard Corporation

2014 Sources and Uses of Cash (numbers in millions)

Cash, beginning of year 3000Sources of cash Operations: Net income 9804 Depreciation 1400 Working capital: Increase in accounts payable 200 Decrease in accounts receivable 100 Long-term financing: Increase in common stock 1097 Total sources of cash 12600 Uses of cash Working capital: Increase in inventory 200 Change in notes payable 0Long-term financing: Decrease in long-term debt 500 Fixed asset acquisitions 2400 Dividends paid 9000 Total uses of cash 12100Net addition to cash 500Cash, end of year $ 3500

b) Net Purchase of fixed assets was 1000 million. But since we wrote of 1400 as depreciation, the amount Microhard actually spent on fixed assets is 1000 + 1400 = 2400 million. So statement of cash flows

Microhard Corporation

2014 Statement of Cash Flows (numbers in millions)

Cash, beginning of year 3000Operating activity Net income 9804 Plus: Depreciation 1400 Increase in accounts payable 200 Decrease in accounts receivable 100 Less: Increase in inventory -200 Net cash from operating activity 11304Investment activity Fixed asset acquisitions -2400 Net cash from investment activity -2400Financing activity Change in notes payable 0 Decrease in long-term debt -500 Dividends paid -9000 Increase in common stock 1097 Net cash from financing activity -8404Net increase in cash 500Cash, end of year 3500

c) Internal and Sustainable Growth Rates

Dividend payout ratio = Cash dividends/Net income = 9000/9804 = 0.92Plowback or Retention Ratio = (1 - Dividend payout ratio) = 0.08

ROA = Net Income/Total Assets = 9804/19600 = 0.50

Internal Growth Rate = (ROA * b) / (1- ROA * b) Where b is the plowback or retention ratio = (0.50 * 0.08)/(1-(0.5*0.08)) = 0.04/0.96 = 0.0417Internal Growth Rate = 4.17%

ROE = Net Income/Total Equity

= 9804/12700 = 0.77

Sustainable Growth Rate = (ROE * b) / ( 1- ROE * b) = (0.77 * 0.08)/ (1 – (0.77 * 0.08)) = 0.06/ 0.9384 = 0.0656

Sustainable Growth Rate = 6.56%

2) Evaluate the financial position of Microhard in areas of liquidity, solvency, profitability and asset management. Write a paragraph summarizing your evaluation as supported by ratio analysis that you have performed.

Short-term solvency, or liquidity, ratios

Current ratio = Current Assets/ Current Liabilities

= (238,700 + 37,500 + 136,600)/ (28,200 + 73,200)

= 412800 / 101400

Current ratio = 4.07

Quick ratio = (Current assets – Inventory) / Current liabilities

= (412800 – 136600) / 101400

Quick ratio = 2.72

Cash ratio = Cash/ Current Liabilties

= 238700/101400

Cash ratio = 2.35

Net working capital to total assets = Networking capital/total assets

= (Current Assets – Current Liabilities)/ Total Assets

= (412800 – 101400)/ 1359900

= 311400/ 1359900

Net working capital to total assets = 0.23

Long-term solvency, or financial leverage, ratios

Total debt ratio = Total assets -Total equity/total assets = (1359900 – 1163500) / 1359900

= 0.14

Debt–equity ratio = Total debt/Total equity = 196400/ 1163500

= 0.17

Equity multiplier = Total assets/Total equity = 1359900/1163500 = 1.17Long-term debt ratio = Long-term debt/ Long-term debt + Equity = 95000/ (95000 + 1163500) = 0.08

Times interest earned ratio = EBIT/ interest earned = (Sales – COGS – Depreciation)/ 5700 = 1435178/ 5700

= 251.79

Cash coverage ratio = EBIT + Depreciation / Interest = (1435178 + 94710)/ 5700 = 268.4

Asset management, or turnover, ratios

Inventory turnover = Cost of goods sold/ Inventory = 1869863/ 136600 = 13.69

Days’ sales in inventory = 365/ Inventory turnover = 365/ 13.69 = 26.66

Receivables turnover = Sales/ Accounts Receivable = 3399750/ 37500 = 90.66

Days’ sales in receivables = 365/ Receivables turnover = 365/90.66 = 4.03

NWC turnover = Sales / NWC = 3399750/311400 = 10.92

Fixed asset turnover = Sales/ Net Fixed Assets = 3399750/947100 = 3.59

Total asset turnover = Sales/ Total Assets = 3399750/1359900 = 2.5

Profitability ratios

Profit margin = Net Income/Sales = 1072108/3399750 = 0.32

Return on assets (ROA) = Net Income/Total Assets = 1072108/1359900 = 0.79

Return on equity (ROE) = Net Income/Total Equity = 1072108/1163500 = 0.92

Also ROE = Net Income/ Total Sales * Sales/ Assets * Assets/Equity

Ratios at a glance

Liquidity Ratios

Current ratio = 4.07Quick ratio = 2.72Cash ratio = 2.35Net working capital to total assets = 0.23

Long-term solvency ratios

Total Debt ratio = 0.14Debt-Equity ratio = 0.17Equity multiplier = 1.17Long term debt ratio = 0.08Times interest earned ratio = 251.79Cash coverage = 268.4

Asset Management Ratios

Inventory turnover = 13.69Days sales in inventory = 26.66Receivables turnover = 90.66Days' sales in receivables = 4.03NWC turnover = 4.03Fixed Asset turnover = 3.59Total Asset turnover = 2.5

Profitability RatiosProfit Margin = 0.32Return on Assets (ROA) = 0.79Return on Equity (ROE) =0.92

Since the quick ratio of Microhard is half of its current ratio, we can see that Microhard carries a lot of inventory. The company carries a smaller amount of debt compared to equity. So the company is heavily financed by equity (owner financed) compared to debt. It has a high cash coverage and times interest earned ratio, so it is well placed to pay its interests on the debts it has borrowed. The company has a relatively high inventory turnover though it has a high inventory. It means that it is selling off its products quickly and that is a good sign. The receivable turnover ratio is very high, which indicates that the company is really good with collecting the cash on sales. Microhard’s asset turnover ratios are all

high which means that it is generating more from its assets. The profitability ratios focus on net income. Microhard’s profit margin of 32% is desirable. Higher the ROA and ROE, the better. Microhards ROE and ROA are very high which is great. From the ratios, Microhard seems like a highly profitable company.

Using the ratios, we were able to analyze the company’s performance but we had to limit our analysis since we don’t know how Microhard’s competitors are performing and the industry in which it is in. All of the above ratios are based on accounting numbers, so calculating the market ratios would also give us some valuable information on the state of Microhard’s operations.

3) Given depreciation and interest cost will grow at 50% of sales growth (given as 20%), so growth in depreciation and interest cost = 10%.

Pro Forma Income Statement 2015 Millions

Sales (Projected 20% increase) 47,0

40

Cost of Goods Sold (60% of sales as in 2014) 28,2

24

Depreciation (10% increase) 1,5

40

EBIT 17,2

76

Interest Cost (10 % increase) 3

03

EBT 16,9

74

Taxes @30% of 16974 5,0

92

Net Income 11,8

81

Dividends (same divident payout ratio as 2014) 10,907.

64

Addition to Retained Earnings 9

74

Given assets and current liabilities will grow at same rate as sales 20% and long term debt will grow at 50% of sales growth = 10%

Proforma Balance Sheet

Millions 2014 2015 ChangeAssets Cash 3500.0 4200 20 % growthAccounts Receivable 400.0 480 20 % growthInventory 1700.0 2040 20 % growthNet Fixed Assets 14000.0 16800 20 % growthTotal 19600.0 23520 Liabilities & Equity Notes Payable 300.0 360 20 % growthAccounts Payable 1100.0 1320 20 % growthLong-Term Debt 5500.0 6050 10 % growthTotal Liabilities 6900.0 7730 Common Stocks 10596.5 10596.5 Accumulated Retained Earnings 2103.5 3077.31 Adding 974 RETotal Equity 12700.0 13673.8 Total 19600.0 21403.8 EFN 2116.2

So External Financing Need = 2116.2 which is the amount the company has to borrow.