Exam Model Case on Ratio Analysis

 ABC company is a manufacturer and seller of electronics in

a highly competitive market.
 The company’s share price is falling and the CEO is
considering the following plan to improve share price:
1. Allow more sales on credit with longer term for
payment
2. Launch a sales promotion campaign
3. Double merchandise inventory in all stores
4. Take new debt to cover the shortage of cash and to
fund the plan
 The company’s financial statements as follows:
 Exam Model Case on Ratio Analysis
Assets (in US$) Liabilities (in US$)
Cash 100,000 Equity 128,000,000
Receivables 40,000,000 Bank loan 15,000,000
Inventory 80,000,000 Bonds 5,000,000
Fixed assets 29,900,000 Payables 2,000,000
Total assets 150,000,000 Total liabilities 150,000,000

Revenues (in US$) Costs (in US$)

Total sales 180,000,000 Purchases 90,000,000
G&A 65,000,000
Depreciation 3,000,000
Lease payments 5,000,000
Interest on debt 4,500,000
Total revenues 180,000,000 Total costs 167,500,000
 Exam Model Case on Ratio Analysis
Other information from the company as follows:
 Average daily sales on credit is $365,000.
 Company feeds $1,000,000 annually in a sinking fund for the
existing bonds.
 Company policy is to maintain inventory turnover ratio of 20
times, DSO ratio of 30 days, TIE ratio of 5 times and FCC
ratio of 3 times and targets realization of 12% ROE.
 Tax rate is 40%.
 Using the above information, calculate the given ratios
as actually realized, then answer these questions:
1. What is causing the shortage of cash?
2. What is causing the fall in the share price?
3. Can the company take new debt or not?
4. Which ratio impacts stock attractiveness directly?
 Solution work sheet
Revenues 180,000,000
Costs 167,500,000
Net income before tax 12,500,000
tax @ 40% 5,000,000
Net income after tax 7,500,000
EBIT 17,000,000 (12,500,000 +4,500,000)

sinking fund 1,000,000

sinking fund/1-T 1,666,667 1,666,667
interest 4,500,000
lease payments 5,000,000
total 9,500,000
11,166,667
 Solution

- Inventory turnover ratio = sales = 180,000,000 = 2.25 times

inventory 80,000,000

- DSO = receivables = 40,000,000 = 109.6 days

Credit sales per day 365,000

-TIE ratio = EBIT = 12,500,000 +4,500,000 = 17,000,000 = 3.8 times

Interest 4,500,000 4,500,000
 Solution

- FCCR ratio: = EBIT + lease payments

Interest + lease payments + sinking fund
1-T
= 17,000,000 +5,000,000
4,500,000 +5,000,000 + 1,000,000
0.60
= 22,000,000 = 22,000,000 = 1.97 times
9,500,000 + 1,666,667 11,166,667

- ROE = Net earnings after tax = 12,500,000 X 0.6 = 7,500,000 = 5.9%

Equity 128,000,000 128,000,000
 Solution

 Analysis:
 Inventory turnover ratio is 2.25 times against policy
20 times
 DSO ratio is 109.6 days against policy 30 days
 TIE ratio is 3.8 times against policy 5 times
 FCC ratio is 1.97 times against policy 3 times
 ROE is 5.9% against target 12%
 The company is missing targets on all ratios
 The company should not take new debt
 The basic cause of the fall in stock price is the missed
ROE target in addition to bad performance.
 Solution

 The planned actions do not deal with the root causes of

the problem which are:
1. Heavy cost of sales which leads to low net profit
2. Inefficient working capital management which leads to
freezing most of the capital in non-cash assets
(receivables and inventory) and drains cash and forces
the company to take debt.
 Action should be directed to:
1. Reducing the high cost of sales to improve profits
2. Improving inventory turnover to free up cash
3. Improving collection period to increase cash inflows
4. Negotiating better terms with suppliers to optimize
payables compared to receivables.