FIN 534 FINANCIAL MANAGEMENT Week 2 Homework Set 1 FREE CASH FLOWS, FINANCIAL RATIOS
Running head: FIN 534 – HOMEWORK SET 11
Homework Set 1
Strayer University
FIN 534 Financial Management
FIN 534 – HOMEWORK SET 1 | 2 |
---|
Homework Set 1
Calculating of the free cash flows and financial ratios asses the financial strength of a firm. The purpose of management is wealth maximization of shareholder’s wealth hence determining how a business operates and sustains itself is critical. Financial statements and financial ratios are essential data for managers in their strategy to reach the goal of wealth maximization.
What is the Free Cash Flow for 2013?
Income Statements and Balance Sheet
Balance Sheet | 2013 | 2012 | |
---|---|---|---|
Cash $ | 9,000 | $ | 7,282 |
Short-term investments | 48,600 | 20,000 | |
Accounts receivable | 351,200 | 632,160 | |
Inventories | 715,200 | 1,287,360 |
Total current assets | $ | 1,124,000 | $ | 1,946,802 |
---|---|---|---|---|
Gross fixed assets | 491,000 | 1,202,950 | ||
Less: Accumulated depreciation | 146,200 | 263,160 | ||
Net fixed assets | 344,800 | 939,790 | ||
Total assets | $ | 1,468,800 | $ | 2,886,592 |
Liabilities and Equity | ||||
Accounts payable | $ | 145,600 | $ | 324,000 |
Notes payable | 200,000 | 720,000 | ||
Accruals | 136,000 | 284,960 | ||
Total current liabilities | $ | 481,600 | $ | 1,328,960 |
Long-term debt | 323,432 | 1,000,000 | ||
Common stocks (100,000 | ||||
shares) | 460,000 | 460,000 | ||
Retained earnings | 203,768 | 97,632 | ||
Total equity | $ | 663,768 | $ | 557,632 |
Total liabilities and equity | $ | 1,468,800 | $ | 2,886,592 |
3 | ||||||
Income Statements | 2013 | 2012 | ||||
Sales | 3,432,000 | 5,834,400 | ||||
Cost of goods sold except depreciation | 2,864,000 | 4,980,000 | ||||
Depreciation and Amortization | 18,900 | 116,960 | ||||
Other expenses | 340,000 | 720,000 | ||||
Total operating costs | $ | 3,222,900 | $ | 5,816,960 | ||
EBIT | $ | 209,100 | $ | 17,440 | ||
Interest expense | 62,500 | 176,000 | ||||
EBT | $ | 146,600 | $ | (158,560) | ||
Taxes (40%) | 58,640 | (63,424) | ||||
Net income | $ | 87,960 | $ | (95,136) |
Calculating of Free Cash Flow
Free cash flow is the sum of the net operating profit after taxes (NOPAT).
FCF = NOPAT – Net investment in operating capital
NOPAT = EBIT (1-Tax rate)
NOPAT for 2012 = EBIT for 2012 (1- 0.40)
NOPAT = ($209,100) (0.60)
NOPAT for 2012 = $125,460
NOPAT for 2013 = EBIT for 2013 (1-0.40)
= ($17,440) (0.60)
NOPAT for 2013 = $10,464
Net investment in operating capital for 2013 = NOPAT for 2013 – NOPAT for 2012
= ($10,464) – ($125,460)
Net investment in operating capital for 2013 = – $ 114,996
Calculating for Free cash flow for 2013:
2013 Free cash flow (FCF) = NOPAT for 2013 – Net investment in operating capital for 2013
FIN 534 – HOMEWORK SET 1 | 4 |
---|
= ($10,464) – (-$114,996)
2013 Free cash flow = – $104,532
Suppose Congress changed the tax laws so that Berndt’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow?
An increase in depreciation expenses will affect both the reported profit and the net cash flow. The reported profit will go down as a result of the doubling of the depreciation expense. While the net cash flow will also decrease despite the adding of the depreciation when computing the net cash flow. This is because the net income is used when computing for the net cash flow. Hence, a decrease in the net income or profit will also decrease the net cash flow. Citing income for 2013:
Income Statements | 2013 | with depreciation doubled |
---|---|---|
Sales | 3,432,000 | 3,432,000 |
Cost of goods sold except | ||
depreciation | 2,864,000 | 2,864,000 |
Depreciation and Amortization | 18,900 | 37,800 |
Other expenses | 340,000 | 340,000 |
Total operating costs | $ | 3,222,900 | $ | 3,241,800 |
---|---|---|---|---|
EBIT | $ | 209,100 | $ | 190,200 |
Interest expense | 62,500 | 62,500 | ||
EBT | $ | 146,600 | $ | 127,700 |
Taxes (40%) | 58,640 | 51,080 | ||
Net income | $ | 87,960 | $ | 76,620 |
Net cash flow for 2013 using the original amount of depreciation:
Net cash flow = Net income + Depreciation & Amortization
Net cash flow = $87,960 + $18,900 = $106,860
Net cash flow = $106,860
FIN 534 – HOMEWORK SET 1 | 5 |
---|
Net cash flow for 2013 using doubled amount of depreciation:
Net cash flow = $76,620 + $37,800 = $114,420
Net cash flow = $ 114.420
Calculate the 2013 current and quick ratios based on the projected balance sheet and income statement data. What can you say about the company’s liquidity position in 2013? Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash (Weygandt, Kimmel, & Kieso, 2012). Liquidity ratios are the current ratio, acid-test ratio or quick ratio, accounts receivable turnover, and inventory turnover, (Weygandt, et. al, 2012)
Current ratio = Current assets ÷ Current liabilities Computing current ratio for 2013:
Current ratio = $1,946,802 ÷ $1,328,960
Current ratio = 1.5
Quick ratio = (Current assets – Inventories) ÷ (Current liabilities) Computing quick ratio for 2013:
Quick ratio = [($1,946,802) – ($1,287,360) ÷ ($1,328,960)
Quick ratio = 0.5
The current ratio for 2013 is 1.5 and the quick ratio is 0.5. The ratio 1.5:1, means that for every dollar of current liabilities, the company has 1.5 of current assets. The 2013 current ratios is lower than the company’s 2012 current ratio of 2.3, which is 2.3:1 compared to a dollar. There is no comparison to be made with the industry average as such information was not provided and since the industry of the company is not specified hence I can’t also get the industry average.
FIN 534 – HOMEWORK SET 1 | 6 |
---|
The quick ratio for 2013 is 0.5:1, it has declined from 2012 which is 0.8:1. The quick ratio below 1. A measure of the firm’s ability to pay off short-term obligation without relying on the sale of inventories is significant (Brigham & Ehrhardt, 2014). The company’s quick ratio declined from 2012 to 2013.Both are below 1, this means that inventories would have to be liquidated in order to pay off current liabilities should the need arise (Brigham & Ehrhardt, 2014.). However with a quick ratio of 0.5 for 2013 and 0.8 for 2012, the company quick ratio seem adequate.
The company is reasonably liquid basing on the current ratio and its quick ratio.
Calculate the 2013 inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover. Asset management ratios measure the effectivity of the company in managing its assets (Brigham & Ehrhardt, 2014). A high inventory lowers the cash used in operating activities which results in the decrease of the free cash flow of the company. Asset management ratios are the total assets turnover ratio, fixed assets turnover ratio, days sales outstanding (DSO), and inventory turnover ratio.
Computing for the asset management ratios for 2013:
Inventory turnover ratio = COGS ÷ Inventory COGS is computed as:
COGS = Cost of goods sold except depreciation + Depreciation
$4,980,000 + $116,960
COGS = $ 5,096,960
Inventory turnover ratio = $5,096,960 ÷ $1,287,360
Inventory turnover ratio = 4
FIN 534 – HOMEWORK SET 1 | 7 |
---|
Day sales outstanding (DSO) = (Receivables) ÷ (Annual Sales ÷ 365)
($632,160) ÷ ($5,834,400 ÷ 365)
Day sales outstanding (DSO) = 39.6
Fixed assets turnover ratio = Sales ÷ Net fixed assets
$5,834,400 ÷ $939,790
Fixed assets turnover ratio = 6.2
Total assets turnover ratio = Sales ÷ Total Assets
$5,834,400 ÷ $2,886,592
Total assets turnover ratio = 2
Calculate the 2013 debt ratio, liabilities-to-assets ratio, times-interest-earned, and EBITDA coverage ratios. What would you conclude from these ratios? Debt management ratios will provide the information on the company’s likelihood of defaulting on its debts and reveals the extent of the company’s debt. Debt management ratios include debt ratio, liabilities-to-assets ratio, times-interest-earned, and EBITDA coverage ratios.
To calculate the debt management ratios for 2013:
Debt ratio = Total debt ÷ Total assets
(Short-term debts + Long-term debts) ÷ Total assets
($720,000 + $ 1,000,000) ÷ ($2,886,592)
Liabilities-to-assets ratio = Total liabilities ÷ Total assets
(Total current liabilities + Long-term debt) ÷ Total assets
($1,328,960 + $1,000,000) ÷ ($2,886,592)
Liabilities-to-assets ratio = 80.70%
FIN 534 – HOMEWORK SET 1 | 8 |
---|
Times-interest-earned (TIE) = EBIT ÷ Interest expense
$17,440 ÷ $176,000
Times-interest-earned (TIE) = 0.1
EBITDA coverage ratio = (EBITDA + Lease payments) ÷ (Interest + Principal payments + Lease payments)
[($17,440 + $116,960) + ($40,000)] ÷ [($176,000 + $0 + $40,000)]
EBITDA coverage ratio = 0.8
The debt-to-asset ratio of the company reveals its assets are more financed by debts as it measure the percentage of the total assets that creditors provide. The company’s debt-to-asset ratio is 59.60% for 2013 higher than its debt-to-asset ratio in 2012 which is only 35.60%. This ratio measure the company’s leverage, and provides an indication of the firm’s ability to withstand losses without impairing the interest of lenders (Weygandt, et. al, 2012). The higher the percentage of debt-to-asset ratio the greater is the risk for the company unable to meet its maturing obligation (Weygandt, et. al, 2012).
The liabilities-to-assets ratio for 2013 is 80.70%, this shows how much the company s financed by debts rather than equity. A high liabilities-to-assets ratio indicates that low equity and potential solvency problems. The firm’s liabilities-to-assets ratio for 2012 is 54.80% lower than 2013.
Time interest earned (TIE) indicates the ability of the company to meet interest payments as they come due. The TIE shows that the company might face difficulties if it tries to borrow additional capital.
FIN 534 – HOMEWORK SET 1 | 9 |
---|
The EBITDA coverage ratios assess if the firm’s ability to pay interest charges of its debts. The ratio may indicate that the company do not have enough interest coverage to pay off its interest expense.
The ratios indicate that the company is more leveraged and that if the firm tries to borrow additional capital it may face difficulties. It also may face difficulties in meeting interest charges.
Calculate the 2013 profit margin, basic earning power, basic earning power (BEP), return on assets (ROA), and return on equity (ROE). What can you say about these ratios? The profitability ratios measure the income or operating success of the company for a given period of time. Financial analyst frequently use profitability as the ultimate test of management’s operating effectiveness. The profitability ratios are profit margin, basic earning power (BEP), return on assets (ROA), and return on common equity (ROE).
To calculate the following profitability ratios for 2013:
Profit margin = Net income available to stockholders ÷ Sales
(- $95,136) ÷ ($5,834,400)
Basic earning power (BEP) = EBIT ÷ Total assets
$17,440 ÷ $2,886,592
Basic earning power (BEP) = 0.60%
Return on assets (ROA) = Net income available to common stockholders ÷ Total assets
-$95,136 ÷$2,886,592
Return on assets (ROA) = -3.3%
FIN 534 – HOMEWORK SET 1 | 10 |
---|
Return on equity (ROE) = Net income available to common stockholders ÷ Common equity
(-$95,136) ÷ ($557,632)
Return on equity (ROE) = -17.1%
The profit margin of the company is a negative which is -1.6%. It is the percentage of each dollar of sales. The ratios reveals a negative profit. The basic earning power (BEP) of
0.60% show that the earning power of the company’s assets before the influence of taxes and debts is very low. The return on assets ratio determines how profitable the firm is relative to its asset. The ROA is a negative hence very low. This may mean that the management is not properly managing its assets to create a profit. The return on equity paint a picture that potential investors may not be interested in investing in the company as the ROE is on a negative.
Calculate the 2013 price/earnings ratio, price/cash flow ratio, and market/book ratio. The market value ratios give management an idea of what the investors think of the firm’s performance and future prospect (Peavler, n.d.). The market value ratios are price/earnings ratio, price/cash flow ratio, and market/book ratio.
Calculating the market value ratios:
Price/earnings (P/E) ratio = Price per share ÷ Earnings per share
($6.00) ÷ (-$0.95)
Price/earnings (P/E) ratio = -6.3
Price/cash flow ratio = Price per share ÷ Cash flow per share
Price per share ÷ [(Net income + depreciation and amortization) ÷ Number of shares)]
FIN 534 – HOMEWORK SET 1 | 11 |
---|
= (6.00) ÷ [(-95,136 + 116,960) ÷ 100,000)]
Price/cash flow ratio = 27.5
Market/book (M/B) ratio = Market price per share ÷ Book value per share
$6.00 ÷ $5.58
Market/book (M/B) ratio = 1.1
Use the extended DuPont equation to provide a summary and overview of company’s financial condition as projected for 2013. What are the firm’s major strengths and weaknesses?
The DuPont equation for 2013 is: ROE = (Profit margin) (Total assets turnover) (Equity multiplier)
Equity multiplier = Total assets ÷ Common equity
= $2,886,592 ÷ $ 557,632
Equity multiplier = 5.18
ROA = Net income ÷ Total assets
= – $95,136 ÷ $2,886,592
ROA = – 3.3%
ROE = (ROA) (Equity multiplier)
(-3.3%) (5.18)
(-0.033) (5.18)
ROE = -17.1%
The company’s strength is on its assets turnover capabilities. If management can properly management its assets to increase profitability. The company is weak on equity where it depends on debts to sustain their operation. It is highly leverage.
FIN 534 – HOMEWORK SET 1 | 12 |
---|
References
Brigham, E., & Ehrhardt, M. (2014). Financial management (2nd ed.). Mason, OH: Cengage Learning
Peavler, R. (n.d.). What are market value ratios and how are they used? Bizfinance.about.com. Retrieved from http://bizfinance.about.com/od/financialratios/f/what-are-market-value-ratios-how-are-they-used.htm
Weygandt, J., Kimmel, P., & Kieso, D. (2012). Financial accounting (8th ed.). Hoboken, NJ:
John Wiley & Sons, Inc.
Click following link to download this document
FIN 534 FINANCIAL MANAGEMENT Week 2 Homework Set 1 FREE CASH FLOWS, FINANCIAL RATIOS.docx