Case study: Maria Hernandez & Associates

Group 1

Question 1: REPORT ON OPERATIONS OF MARIA HERNANDEZ & ASSOCIATES THROUGH AUGUST 31,2001 BALANCING ACCOUNT Cash 12,000 40,000

(0) (1)

Cash 12,000 (2) 40,000 (3) (3) (4)

900 6,000 33,000 5,500

52,000 Balance 6,600

900 6,000 33,000 5,500 6,600 52,000

Equity (0)

30,000

BALANCING ACCOUNT Equity 0 30,000 30,000 30,000 30,000 Balance 30,000

Note payable (0)

20,000

BALANCING ACCOUNT Note payable 0 20,000 20,000 20,000 20,000 Balance 20,000

(0)

Prepaid expenses 12,000

BALANCING ACCOUNT Prepaid expenses 12,000 12,000 Balance 12,000

0 12,000 12,000

Case study: Maria Hernandez & Associates

Group 1

(0) (4)

Equipment 27,000 11,000

BALANCING ACCOUNT Equipment 27,000 11,000 38,000 Balance 38,000

0 0 38,000 38,000

(0) (2)

Inventory 5,000 (2) 900

1,700

BALANCING ACCOUNT Inventory 5,000 900 5,900 Balance 4,200

1,700 4,200 5,900

Sales revenue (1) (1)

40,000 7,000

BALANCING ACCOUNT Sales revenue 0 40,000 0 7,000 47,000 47,000 47,000 Balance 47,000

(1)

Account receivable 7,000

BALANCING ACCOUNT Account receivable 7,000 7,000 Balance 7,000

0 7,000 7,000

Case study: Maria Hernandez & Associates

Group 1

(2)

Cost of sales 1,700

BALANCING ACCOUNT Cost of sales 1,700 1,700 Balance 1,700

0 1,700 1,700

(3)

Rent expenses 6,000

BALANCING ACCOUNT Rent expenses 6,000 6,000 Balance 6,000

0 6,000 6,000

(3)

Utility expenses 33,000

BALANCING ACCOUNT Utility expenses 33,000 33,000 Balance 33,000

0 33,000 33,000

Account payable (4)

5,500

BALANCING ACCOUNT Account payable 5,500 5,500 Balance

5,500 0 5,500 5,500

Case study: Maria Hernandez & Associates

Group 1

TRIAL BALANCE Balance Debit Credit 6,600 7,000 6,000 38,000 4,200 5,500 20,000 30,000 47,000 1,700 33,000 6,000 102,500 102,500

Cash Accounts receivable Prepaid rent Equipment Inventory Accounts payable Note payable Paid in capital Sales revenue Cost of sales Utility expenses Rent expenses Total

ADJUSTING PROCESS Depreciation expenses 1,500 Accumulated Depreciation (5) 1,500 Interest expenses 200 Accrued Expense (6)

(5)

(6)

200

Case study: Maria Hernandez & Associates

Group 1

CLOSING ENTRIES Income Summary Cost of sales 1,700 Rent expenses 6,000 Utility expenses 33,000 Depreciation expenses 1,500 Interest expenses 200 42,400 (7) 1,380 3,220 Income Tax Liability (7) Retained Earning Balance 3,220 Balance

47,000

47,000

1,380

To balance

0 3,220 3,220

Maria started her own business with $50,000 in cash and in two months later she had only $6,600 left. There was a significant decline in cash of $45,400 because this is the first year of business and as the owner, Maria had to invest an considerable sum of money in starting up, for example Maria had to purchase equipment and software, which are extremely important tool in her industry, equip her office with stationery and office supplies, moreover she also had to hire good designers to support her with projects and pay them, pay all the bills including renting expenses, utility expenses But she did manage to bring customers to company and increase the company s sales revenue, and we could say that the company did make profit because just in two months from establishment with a great deal of investment, the company was still able to capture $3,220 as retained earnings. Besides, Maria did not depend do much on debt to run her own business and this gives her an advantage to generate more profit as soon as she finishes the investment. However, there are a lot of risks for Maria to face. Firstly, with only $6,600 left, there is a risk that she can or she cannot pay the salary or any extra operation cost next month, in the worst case there is no projects coming in anymore. Secondly, with such a young business, can she borrow money from the bank, when she wants to expand her business? Finally, there is a collection risk from the customers side, can Maria manage to collect $7,000 accounts receivable fast to supply the operation. It might be very sensitive for her, because of course when she has just opened her company, every customer is very precious, so she cannot take any risk to lose them either.

Case study: Maria Hernandez & Associates

Group 1

Question 2: REPORT OF STATUS OF THE BUSINESS ON AUGUST 31, 2001 Maria Hernandez & Associates August 31, 2001 Balance Sheets Assets Current assets: Cash Account receivable Inventories Total current assets Net fixed assets Equipment Other fixed assets Total net fixed assets Total assets Liabilities and Equity Current liabilities Account payable Accrued interest Accrued taxes Notes payable Accumulated Depreciation Total current liabilities Long-term bonds Total debt Common equity Capital stock Retained earnings Total common equity Total liabilities and equity

6,600 7,000 4,200 17,800 38,000 6,000 44,000 61,800

5,500 200 1,380 20,000 1,500 28,580 0 28,580 30,000 3,220 33,220 61,800

Case study: Maria Hernandez & Associates

Group 1

Maria Hernandez & Associates Income Statement for 2001 Net sales Operating cost Depreciation Total operating costs EBIT Interest EBT Taxes (30%) Net income 47,000 40,700 1,500 42,200 4,800 200 4,600 1,380 3,220

Maria Hernandez & Associates Statement of Cash flow for 2001 I. Operating Activities Net income Depreciation Increase in inventories Increase in accounts receivable Increase in accounts payable Increase in accrued wage and taxes Net cash provided by operating activities II. Long-term investing activities Cash used to acquire fixed assets III. Financing activities Increase in notes payable Increase in bonds outstanding Payment of dividends to stockholders Net cash provided by financing activities IV. Summary Cash and equivalent at the beginning Cash and equivalent at the end 50,000 6,600 3,220 1,500 1,700 7,000 5,500 1,380 20,300

42,500

20,000 0 0 20,000

Case study: Maria Hernandez & Associates

Group 1

Question 3: ANALYSIS THE REPORTS LIQUIDITY RATIOS Firstly, we begin to test the Liquidity ratios, which give us an idea of the firm s ability to pay off debts that are maturing within a year FCF = EBIT(1-T) + Depreciation Capital Expenditures - NWC = $3,220 + $1500 ($1500 + $44,000) (-$10,780) = $58,000 Free cash flow (FCF) of the company shows the cash that a company is able to generate after laying out the money required maintaining or expanding its asset base. So after finishing investing, it is the chance for Maria to increase the profit margin. Also this positive FCF indicates the company s ability to pay its debt, dividends (in this case Maria is the only owner of the company so she does not have to pay any dividends). (1) CF for operating / NI = $20,300/ $3,220 = 6.3 This ratio is greater than 1, indicating that the company is generating profit. (2) CF for operating / Debt = $20,300 / 28,580 = 71% However this ratio is smaller than 100%, indicating that the company s profit still be impacted by its debt. Net working capital = Current assets Current liabilities = $17,800 - $28,580 = -$10,780 This working capital deficit show a shortage of liquidity, the company s assets cannot readily be converted into cash. Therefore it cannot ensure that the company is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. Current ratio = Current assets / Current liabilities = $17,800 / $28,580 = 0.62x

The company s current liabilities are rising faster than its current assets that can tell us the company may have financial difficulty, it may force Maria to begin to pay her account payable more slowly and borrow more from the other source if she does not figure out a way to speed up her account receivable to have more cash.
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Case study: Maria Hernandez & Associates

Group 1

ASSET MANAGEMENT RATIOS:

Secondly, we turn to asset management ratios, which give us an idea of how efficiently the firm is using its assets.

Inventory turnover ratio = Sales / Inventories = $47,000 / $4,200 = 11.19x

The company s inventory turnover ratio is high, indicating that it do not hold so many inventories.

Fixed assets turnover ratio = Sales / Net fixed assets = $47,000 / $44,000 = 1.06x

From this ratio we can indicate that this company is using its fixed assets not so intensively, if Maria does not know how to manage her assets effectively, that may cause her to let out her profit.

Total assets turnover ratio = Sales / Total assets = $47,000 / $61,800 = 0.76x

This can indicate that this company is not generating enough sales given its total assets. So the problem is with its current assets and accounts receivable. Lucky for Maria that in this case there are no inventories for her to worry about so the solution might be faster collection of receivables or increase of sale or both of them in order to improve operation.

DEBT MANAGEMENT RATIOS:

Then, we turn to debt management ratios, which give us an idea of how the firm has financed its assets as well as the firm s ability to repay its long-term debt

Debt ratio = Total debt / Total assets = $28,580 / $61,800 = 46%

Case study: Maria Hernandez & Associates

Group 1

The Debt ratio means almost half of the company s total assets are generating from debt. With quite high debt ratio, it may cause the company relatively costly to borrow additional funds without first raising more equity. Creditors will be reluctant to lend the firm more money, and management would probably be subjecting the firm too high a risk of bankruptcy if it sought to borrow a substantial amount of additional funds.

PROFITABILITY RATIOS

Then, we calculate the profitability ratios, which reflect the net result of all of the financing policies and operating decision in order to have an idea of how profitably the firm is operating and utilizing its assets.

Operating margin = Operating income (EBIT) / Sales = $4,600 / $47,000 = 9.7%

The company s operating margin is quite low indicating that the operation cost is quite high. This is consistent which the fact that in the first year of business Maria had to invest a lot of money in startup process.

Profit margin = Net income / Sales = $3,220/ $47,000 = 6.8%

The company s profit margin is quite low and this result occurred because its operating margin is also low due to high operation cost. Maria can raise her profit margin by reducing her debt because the interest will pull down her net income, besides high depreciation cost might be also the problem.

Return on total assets (ROA) = Net income / Total assets = $3,220 / $61,800 = 5.2%

This low ROA is not good this can result from a conscious decision to use of debt, in this case like mentioned above, high interest expenses will cause net income to be relatively low.

Return on common equity (ROE) = Net income / Common equity = $3,220 / $33,220 = 9.6%
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Case study: Maria Hernandez & Associates

Group 1

The company s ROE is low and this is a result from the company s use of debt, that the company uses investment funds inefficiently to generate earnings growth.

FINAL THOUGHT:

Summary of Financial Ratios Ratio Current ratio FCF NWC Fixed assets turnover ratio Total assets turnover ratio Inventory turnover ratio Debt ratio Operating margin Profit margin ROA ROE Ratio 0.62x $58,000 -$10,780 1.06x 0.76x 11.19 46% 9.7% 6.8% 5.2% 9.6% Comment Poor OK Poor Poor Poor OK High (risky) Poor Poor Poor Poor

All of our calculations have shown one thing, the company has virtually risk. Almost half of the company s total assets are generating from debt, and extremely weak current and quick ratios, indicating its financial problems in paying debts. Besides, it uses its plant and equipment ineffectively and collection risk of its accounts receivable.

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