Executive Summary
Company A and company B have very similar as well as very different financial statements. Both the companies are showing positive sales growth. While company A seems to be growing at a very high pace, company B is growing at a steady but slow pace. However, even upon growing at a higher pace company A’s profit has declined due to not being able to manage the input cost for production appropriately (cost of goods sold). On the other hand company B is also feeling the impact of the increasing input cost but it has managed it better than Company A and has been able to compensate it to some extent by reducing its fixed cost. Company B is also performing better in the areas of assets and liabilities. Company B has better assets to liability ratio than that of company A. Company A on the other hand has a small equity base and so the return on Equity (ROE) for Company A is much better than that of Company B. Cash in hand of company B (27.1 % of total assets) is in a much healthier position than that of company A (1.6%). This shows that company B has much more liquidity than company A.
Part I
Garden Place Case: Question 2: T-Account
T-Account for the journal entries is as below
Garden Place Case: Question 5: Projected Income Statement and Balance Sheet
We have used the information provided in the case for constructing the Income Statement and Balance Sheet. The basic assumptions made for the income statement was that the cost of goods sold will be around 40% of the sales and corporate income tax of 30%. For Balance sheet lot of information was missing so I made my own assumption about long term and short term liabilities. For example, the loan from Campbell bank of 32,000 was considered as a current liability whereas the loan from Campbell bank for pickup truck was assumed to be long term liability because of its duration of more than 1 year.
Income Statement
Balance Sheet
Part II
Question 1: Vertical Analysis of Company A and B
Vertical Analysis is one of the most used financial analyses for the financial statements. Also known as the common-size analysis, this analysis shows the percentage contribution of each elements of a financial statement compared to a base alongside the absolute contributions (Averkamp, 2013). Total assets, total shareholders’ equity and total liabilities are taken as the base figures for vertical analysis of a balance sheet. Then the individual assets or assets groups in the balance sheet are shown as a percentage of total assets. Similarly, individual liabilities as shown in the balance sheet are also shown as percentage of total liabilities.
For conducting a vertical analysis of an income statement, the base is generally taken as the total sales figure (Bushman, 2007). Other income statement items like cost of goods sold, gross profit, administrative cost, taxes, interest, operating profit and net profit are shown as the percentage of sales. Generally the vertical analysis is done for a single period but to make it more useful many analysts do a multiple period vertical analysis.
Company A:
Balance Sheet: Vertical Analysis
Looking at the assets, we can easily see that almost 96-97% of the total assets are current assets for company A. There are very few long term asset classes for the company as per the balance sheet. Among the current assets 68-69% of the assets are inventory. Among the total assets, inventory remained stable at around 68-69% for the years 2010 and 2011. The second largest asset category is accounts receivable. In 2010, company A had a 21.7% account receivable/total asset ratio which reduced to 20.9% in 2011 probably because of better collection from the debtors. The cash in hand for company A has significantly increased from 0.7% in 2010 to 1.6% in 2011. This may have been achieved due to better cash management practices and working capital management. In terms of liabilities, company A has more than 90% of its liabilities as current liabilities. In 2010, the current liabilities were almost 98% of the total liabilities which reduced to 94% in 2011 due to conversion of some short term debts to long term instruments. Notes payable to banks remains the highest contributor to current liabilities. Current payables almost match identically with the current receivables which shows that the company has a healthy cash circulation. Paid in capital remained same in 2010 and 2011 but due to some profit in 2011 the overall retained earnings have increased as percentage to total shareholders equity.
Income Statement: Vertical Analysis
Company A has seen a huge increase in net sales between 2010 and 2011 but the profit has gone down by 50% from $9 million in 2010 to almost $4.9 million in 2011. As seen in the vertical analysis above for company A the main reason for this is the cost of goods sold. In most of the cases when the sales go up the cost of goods sold as percentage of sales comes down due to economies of scale. However, it is not the case for company A. The cost of goods sold has gone up as a percentage of sales. It indicates that probably company A is trying to produce that extra demands by overtime or sourcing it from some costly outsource partners.
Company B
Balance Sheet
Company B has a much superior balance sheet than company A. As we can see that it has a very low total liabilities percentage compared to total assets. Total liabilities (current + long) can be covered only by cash in hand in 2011 ($40 million). This shows that the company has a very healthy cash flow position. Company B is very liquid as its cash and cash equivalent percentage have gone up substantially from 2010 to 2011 and its inventory has gone down. It seems that company B may have come up with better practices to collect receivables and inventory turnover. Shareholders equity has not seen many changes as there were not much contribution from profit. Liabilities as percentage of total assets are low and that is a good indicator for company B. The majority of the liabilities are from accounts payable and salaries and wages payable as expected.
Income Statement
Company B has an interesting income statement. Net sales for the company have grown steadily from 2009 to 2011. However, the gross profit has gone down marginally from 23.8% in the financial year ended 2010 to 22.0% in 2012. This shows that the cost of goods may have gone up. This may be because of the increase in price of raw materials, fuel cost or increase in labor cost. However, as the fixed cost remained almost same, the overall operating margin has gone up from 2.6% in 2010 to 3.0 % in 2012. Net income also has improved from 1.5% in 2010 to 2.3% in 2012 due to better interest and income tax management.
Question 2: Comparative Analysis of two companies / DuPont Analysis
Among all investors return on equity is one of the most monitored financial numbers. If a company has a very strong Return on Equity (ROE) it shows that the management creates high value for the investors (Throp 2012). A strong measure of ROE means that it is less risky for the investor to invest in that company and the company is in sound financial health. However, there are critics of simple ROE and they prefer much rigid measures to conclude that a company is in sound health.
Simple ROE is calculated as a ratio of net income and shareholders’ equity (Throp 2012). If the number is larger, it means that it is a better company for investment and vice versa.
ROE = net income / shareholder's equity
The problem with this simple ratio is it can go up even when a company takes more debt and reduce the equity base. The denominator of the above formula goes down and the ROE value goes up. However, increasing the debt is not always good for a company. Highly leveraged companies may show high ROE values but that does not mean that they are financially sound (Pinsent, 2013).
Let’s first take a look at the ROE of company A and B. Company A has a net profit for the year ended 2012 is $4.961 million and shareholders’ equity of $43 million.
ROE for company A = 4.961/43 = 0.113
Similarly, for Company B the net profit for the year ended 2012 are $5.057 million and shareholders’ equity is $127.113 million.
ROE for company B = 5.057/ 127.113 = 0.039.
Let’s now do a more detailed analysis using another type of Return on Equity Analysis called Du-Pont analysis. It has been mentioned before that simple ROE calculation cannot account for leveragability of a company or asset utilizations. DuPont analysis breaks down the simple formula into three components for ROE calculation (Pinsent, 2013). As per DuPont formula the ROE is calculated as below:
ROE = (net profit margin) * (asset turnover) * (equity multiplier)
Where
Net Profit Margin = Net Income / Sales
Asset Turnover = Sales/ Assets
Equity Multiplier = Assets/ Shareholders Equity.
This three step DuPont ROE calculation provides much deeper understanding of a company (Pinsent 2013). Let us now calculate the ROE of company A
For Company A
Net Profit= $4.961 million
Sales = $ 514.633 million
Total Assets = $ 269.728
Shareholders’ Equity = $ 43.602
Net Profit Margin = $4.961/ $514.633 = 0.0096399
Asset Turnover = 1.908
Equity Multiplier = 6.186
ROE of company A = 0.0096399 * 1.908 * 6.186 = 0.113 (Same as before as we have given equal weightage to all ratios)
Similarly for Company B
Net Profit Margin = 1.491
Asset Turnover = 1.49
Equity Multiplier = 1.17
ROE for company B = 0.039
Now if we look into different ratios for company A, we can see that the profit margin for the company is very low but the ROE is better because of its equity multiplier (6.18). This means that compared to its assets the equity base is small for company A. Although the overall ROE gives a good picture but actually the figure is inflated due to small equity base and high liabilities for company A. This company is highly leveraged. On the other hand, all the three ratios for company B seem to be in good shape. Profit margin is better than company A and the equity multiplier is 1.17 which is decent. The asset turnover for company B is not as good as company A and this can be improved. On the whole, it seems although the ROE for company A appears better than that of company B, the overall financial health of company B is better.
Question 3: Horizontal Analysis: Company B
Horizontal analysis is also known as trend analysis. In vertical analysis generally a financial statement is compared with a base figure (Harvey, 2011). In most of the cases, all figures in income statement are compared as percentage of sales. However, in case of horizontal analysis a base year is taken for comparison of figures. All the figures in other years are compared with the same figures of the base year. This helps in identifying the trend of certain financial statement figures over time. Horizontal analysis is expressed in absolute monetary term or in percentage term (Finn, 2013). The formulae for both are as below:
Absolute Change = Amount of the item in comparison year – amount of the item in base year
Percentage Change = (absolute change / amount of the item in base year) * 100
Balance Sheet of Company A
This shows that total assets as well as total liabilities have gone down for company A. Reduction in total liabilities is a good thing for the company mainly triggered by better cash management as Trade Account payable is reduced. In case of total assets it seems that the company was able to keep a low inventory base and that means that the company had more cash in hand. Total assets were almost unchanged for the company in the two years. Shareholders’ equity showed a slight increase owing to small increase in retained earnings.
Income Statement
Income statement for company B is interesting and even the trend has some interesting patterns. We can see that the net sales of company B are consistently going up. Compared to 2010 the sales went up by 5.9% in 2011 and 9.4% by 2012. Cost of sales actually went up even more almost by 12.1% by 2012 compared to 2010. When the sales is going up by 9% then one would expect that the gross profit will also go up by 9% but in case of company B due to the increase in COGS the gross profit went up by only 0.3% in 2012 compared to 2010. However, company B is showing some really good progress in selling and administrative expense as administrative expense showed continuous decline from 2010 to 2012. In 2011 due to heavy restructuring charges the operating expense went down by 21.7% but with better fixed cost and better sales figures operating income improved to 28.7% than that of 2010. Furthermore, the net income improved by almost 68.1% in 2012 than 2010.
For Company B, vertical analysis of cash flow statement throws much clearer picture of the financial health. Net cash flow in operating activities has been inconsistent. In fact we can see that the cash flow in 2011 was negative which contributed to the low cash on hand for the year. However, Company B bounced back from that cash liquidity problem in 2011 and in 2012 ended with a lot of cash from the operating activities mainly due to better management of cash payable and receivable. Company B has not invested much in either of the years and continues to invest only a very small portion of its cash in investing activities. In terms of financing activities, Company B continued to pay a dividend of around $4.3 million to its shareholders in each of the years 2011 and 2012.
Work Cited
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Peavler, Rosemary. 2013. Common Size Income Statement Analysis- An Example. Business Finance. Viewed on 3rd January 2014 <http://bizfinance.about.com/od/yourfinancialposition/a/Common-Size-Income-Statement-Analysis-An-Example.htm>
Pinsent, Wayne. 2013. Decoding DuPont Analysis. Investopedia. Viewed on 3rd January 2014 <http://www.investopedia.com/articles/fundamental-analysis/08/dupont-analysis.asp>
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