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Running head: WEEK 2 - ASSIGNMENT - UNDERSTANDING FINANCIAL 1

Assignment - Understanding Financial Performance

Guillermo "Fred" Rivera

MGT-320 - Financial Management and Markets

November 10, 2014


WEEK 2 - ASSIGNMENT - UNDERSTANDING FINANCIAL 2

Week 2 - Assignment - Understanding Financial Performance

Questions and Problems 14, 15 and Mini Case Ratios and Financial Planning at East

Coast Yachts.

14. Cash Flow. Which was the biggest culprit here: Too many orders, too little cash, or

too little production capacity?

All three were important, but the lack of cash or, more generally, financial resources

ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause

of small business failure

15. Cash Flow. What are some actions a small company like The Grandmother Calendar

Company can take (besides expansion of capacity) if it finds itself in a situation in which growth

in sales outstrips production?

Demanding cash up front, increasing prices, subcontracting production, and improving

financial resources via new owners or new sources of credit are some of the options. When

orders exceed capacity, price increases may be especially beneficial.

RATIOS AND FINANCIAL PLANNING AT EAST COASTYACHTS

Dan Ervin was recently hired by East Coast Yachts to assist the company with its short-

term financial planning and also to evaluate the company’s financial performance. Dan graduated

from college five years ago with a finance degree, and he has been employed in the treasury

department of a Fortune 500 company since then.

East Coast Yachts was founded 10 years ago by Larissa Warren. The company’s

operations are located near Hilton Head Island, South Carolina, and the company is structured as

an LLC. The company has manufactured custom midsize, high-performance yachts for clients

over this period, and its products have received high reviews for safety and reliability. The
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company’s yachts have also recently received the highest award for customer satisfaction. The

yachts are primarily purchased by wealthy individuals for pleasure use. Occasionally, a yacht is

manufactured for purchase by a company for business purposes.

The custom yacht industry is fragmented, with a number of manufacturers. As with any

industry, there are market leaders, but the diverse nature of the industry ensures that no

manufacturer dominates the market. The competition in the market, as well as the product cost,

ensures that attention to detail is a necessity. For instance, East Coast Yachts will spend 80 to 100

hours on hand-buffing the stainless steel stem-iron, which is the metal cap on the yacht’s bow

that conceivably could collide with a dock or another boat.

To get Dan started with his analyses, Larissa has provided the following financial

statements. Dan has gathered the industry ratios for the yacht manufacturing industry.

EAST COASTYACHTS

2012 Income Statement

Sales $234,300,000

Cost of goods sold $165,074,000

Other expenses $ 27,991,000

Depreciation $ 7,644,000

Earnings before interest and taxes (EBIT) $ 33,591,000

Interest $ 4,212,600

Taxable Income $ 29,378,400

Taxes (40%) $ 11,751,360

Net Income $ 17,627,040


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EAST COAST YACHTS

Balance Sheet as of December 31, 2012

Assets Liabilities & Equity

Current assets Current liabilities

Cash $ 3,650,700 Accounts payable $ 7,753,000

Accounts receivable $ 6,567,600 Notes Payable $ 15,936,300

Inventory $ 7,363,700

Total: $ 17,582,000 Total: $ 23,689,300

Fixed assets Long Term Debt $ 40,480,000

Net plant and $ 112,756,900

equipment Shareholders’ Equity

Common Stock $ 6,200,000

Retained Earnings $ 59,969,000

Total Equity $ 66,169,600

Total assets $130,338,900 Total Liabilities and $ 130,338,900

Equity

1. Calculate all of the ratios listed in the industry table for East Coast Yachts.

Ratio Calculation Year 2012

a) Current Ratio 0.7421

b) Quick Ratio 0.4313

c) Total Asset Turnover 1.7976

d) Inventory Turnover 22.4172


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e) Receivables Turnover 35.6751

f) Total Debt Ratio 0.4923

g) Debt to Equity Ratio 0.9697

h) Equity Multiplier 1.9697

i) Interest Coverage 7.9739

j) Profit Margin 0.0752

k) Return on Assets 0.1352

l) Return on Equity 0.2663

Current ratio = (Current assets)/(Current liabilities) = (17,582,000 )/( $23,689,300) =

0.7421

Quick ratio = (Current assets-Inventory)/(Current liabilities) = ($17,582,000-$

7,363,700)/($ 15,030,000) = 0.4313

Total asset turnover = Sales/(Total assets) = ($234,300,000)/($ 130,338,900) = 1.7976

Inventory turnover = (Cost of goods sold)/Inventory = ($165,074,000)/($ 7,363,700) =

22.4172

Receivables turnover = Sales/(Accounts receivable) = ($234,300,000)/($ 6,567,600) =

35.6751

Total debt ratio = (Total assets-Total equity)/(Total assets) = ($130,338,900-$

66,169,600)/($ 130,338,900) = 0.4923

Debt-equity ratio = (Total debt)/(Total equity) = ($23,689,300+$ 40,480,000)/($

66,169,600) = 0.9697
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Equity multiplier = (Total assets)/(Total equity) = ($130,338,900)/($ 66,169,600) =

1.9697

Interest coverage = EBIT/Interest = ($33,591,000)/($ 4,212,600) = 7.9739

Profit margin = (Net income)/Sales = ($17,627,040)/($ 234,300,000) = 0.0752

Return on assets = (Net income)/(Total assets) = ($17,627,040)/($ 130,338,900) = 0.1352

Return on equity = (Net income)/(Total equity) = ($17,627,040)/($ 66,169,600) = 0.2663

2. Compare the performance of East Coast Yachts to the industry as a whole. For

each ratio, comment on why it might be viewed as positive or negative relative to the industry.

Suppose you create an inventory ratio calculated as inventory divided by current liabilities. How

do you interpret this ratio? How does East Coast Yachts compare to the industry average?

Regarding the liquidity ratios, East Coast Yachts current ratio is below the median

industry ratio. This implies the company has less liquidity than the industry in general. However,

the current ratio is above the lower quartile, so there are companies in the industry with lower

liquidity than East Coast Yachts. The company may have more predictable cash flows, or more

access to short-term borrowing. The turnover ratios are all higher than the industry median; in

fact, all three turnover ratios are above the upper quartile. This may mean that East Coast Yachts

is more efficient than the industry in using its assets to generate sales.

The financial leverage ratios are all below the industry median, but above the lower

quartile. East Coast Yachts generally has less debt than comparable companies, but is still within

the normal range. The profit margin for the company is about the same as the industry median,

the ROA is slightly higher than the industry median, and the ROE is well above the industry

median. East Coast Yachts seems to be performing well in the profitability area. Overall, East

Coast Yachts’ performance seems good, although the liquidity ratios indicate that a closer look
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may be needed in this area. Below is a list of possible reasons it may be good or bad that each

ratio is higher or lower than the industry. Note that the list is not exhaustive but merely one

possible explanation for each ratio. If you created an Inventory to current liabilities ratio, East

Coast Yachts would have a ratio that is lower than the industry median. The current ratio is below

the industry median, while the quick ratio is above the industry median. This implies that East

Coast Yachts has fewer inventories to current liabilities than the industry median. Because the

cash ratio is lower than the industry median, East Coast Yachts has fewer inventories than the

industry median, but more accounts receivable.

Ratio:

Current ratio: Good (Better at managing current accounts.)

Bad (May be having liquidity problems.)

Quick ratio: Good (Better at managing current accounts.)

Bad (May be having liquidity problems.)

Total asset turnover: Good (Better at utilizing assets.)

Bad (Assets may be older and depreciated, requiring extensive investment soon.)

Inventory turnover: Good (Better at inventory management, possibly due to better

procedures.)

Bad (Could be experiencing inventory shortages.)

Receivables turnover: Good (Better at collecting receivables.)

Bad (May have credit terms that are too strict. Decreasing receivables turnover may

increase sales.)

3. Calculate the sustainable growth rate of East Coast Yachts. Calculate external

funds needed (EFN) and prepare a pro forma income statement and balance sheet assuming
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growth at precisely this rate. Recalculate the ratios in the previous question. What do you

observe?

To calculate the internal growth rate, first find the ROE and the retention ratio, so:

ROE = (Net income)/(Total equity) = 17,627,040/66,169,600 = 0.2663 or 26.63%

b = (Addition to Retained earnings)/(Net income) = 6,200,000/17,627,040 = 0.3517 or

35.17%

So, the sustainable growth rate is:

Sustainable growth rate = (ROE × b)/(1-(ROE × b))

= (0.2663 × 0.3517 = 0.09365)/(1-(0.2663 × 0.3517)) = 0.90635

Sustainable growth rate = 0.90635 or 9.06%

The sustainable growth rate is the growth rate the company can achieve with no external

financing while maintaining a constant debt-equity ratio.

At the sustainable growth rate, the pro forma statements next year will be:

EAST COAST YACHTS

Income Statement

Sales = $ 234,300,000 + 9.63% (225630090) = $ 256,863,090.00

Cost of goods sold = $ 165,074,000 + 9.63% (15,896,626.20) = $ 180,970,626.20

Other expenses = $ 27,991,000 + 9.63% (2,695,533.30 = $ 18,544,517.29

Depreciation = $ 7,644,000.00 + 9.63% (736,117.20) = $ 8,380,117.20

Earnings before interest and taxes = $ 33,591,000.00 + 9.63% (3,234,813.30) =

= $ 36,825,813.30

Interest = $ 4,212,600.00 + 9.63% (405,673.38) = $ 4,618,273.38

Taxable income = $ 29,378,400.00 + 9.63% (2,829,130.92 = $ 32,207,539.92


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Taxes (40%) = $ 11,751,360.00 + 9.63% (1,131,655.96) = $ 12,883,015.96

Net income = $ 17,627,040.00 + 9.63% (1,697,483.95) = $ 19,324,523.95

Dividends =$ 6,200,000.00 + 9.63% (597,060.00) = $ 6,797,060.00

Addition to retained earnings = $ 59,969,000.00 + (597,060.00)

= $ 66,766,060.00

EAST COAST YACHTS

Balance sheet

Assets Liabilities & Equity

Current Assets Current Liabilities

Cash $ 3,650,700 Accounts Payable $ 7,753,000

Accounts receivable $ 6,567,600 Notes Payable $ 15,936,300

Inventory $ 7,363,700

Total Current Assets $ 17,582,000 Total Current Liabilities $ 23,689,300

Long-term debt $ 40,480,000

Shareholder’s Equity

and Common stock $ 6,797,060

Total $ 70,966,360

Fixed assets Retained earnings $ 66,766,060

Net Plant & Equipment $ 112,756,900 Total Equity $ 4,200,300

Total Assets $ 130,338,900 Total Liabilities & Equity $141,932,720

So, the External Financing Needed (EFN) is: $3,193,220

EFN = Total assets – Total liabilities and equity

EFN = $130,338,900 – $ 133,532,120 = ($ 3,193,220)


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The ratios with these pro forma statements are:

1. Current ratio = ($17,582,000)/($ 23,689,300) = 0.7421

2. Quick ratio = ($17,582,000-$ 7,363,700)/($ 23,689,300) = 0.4313

3. Total asset turnover = ($256,863,090.00)/($ 130,338,900) = 1.9707

4. Inventory turnover = ($ 180,970,626.20)/($7,363,700) = 24.5760

5. Receivables turnover = ($256,863,090)/($ 6,567,600) = 39.1106

6. Total debt ratio = ($130,338,900-$ 70,966,360)/($ 130,338,900) = 0.4555

7. Debt-equity ratio = ($70,966,360)/($ 66,766,060) = 1.0629

8. Equity multiplier = ($130,338,900)/($ 70,966,360) = 1.8366

9. Interest coverage = ($36,825,813.30)/($ 4,618,273.38) = 7.9739

10. Profit margin = ($19,324,523.95)/($ 256,863,090.00) = 0.0752

11. Return on assets = ($19,324,523.95)/($ 130,338,900) = 0.1482

12. Return on equity = ($19,324,523.95)/($ 70,966,360) = 0.2723

The ratios that changed are; the total asset turnover ratio, inventory turnover ratio,

Receivables turnover ratio, total debt ratio, debt equity ratio, equity multiplier ratio, return on

asset ratio and the return on equity. The debt ratio changes because long-term debt is assumed to

remain fixed in the pro forma statements. The other ratios change slightly because interest and

depreciation are also assumed to remain constant as well.

4. As a practical matter, East Coast Yachts is unlikely to be willing to raise external

equity capital, in part because the owners don’t want to dilute their existing ownership and

control positions. However, East Coast Yachts is planning for a growth rate of 20 percent next

year. What are your conclusions and recommendations about the feasibility of East Coast’s

expansion plans?
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The growth rate of 20% indicates that the EFN is $3,193,220. Taking on so much debt

would result in the debt to equity increasing to 1.17 and the debt ratio to decrease to 0.4310. The

EBIT, assuming an interest rate of 6%, would be 8.45. While the financing from the debt look

alright, this would constrain further issue of debt since the debt to equity is already above 1.

Further expansion may not be possible by debt.

5. Most assets can be increased as a percentage of sales. For instance, cash can be

increased by any amount. However, fixed assets often must be increased in specific amounts

since it is impossible, as a practical matter, to buy part of a new plant or machine. In this case, a

company has a “staircase” or “lumpy” fixed cost structure. Assume that East Coast Yachts is

currently producing at 100 percent of capacity. As a result, to expand production, the company

must setup an entirely new line at a cost of $25,000,000. Calculate the new EFN with this

assumption. What does this imply about capacity utilization for East Coast Yachts next year?

Increase in fixed assets at ECY was 11,593,820. The new plant would cost $25,000,000.

The additional EFN would be $-11,298,121.41. This would imply that the capacity utilization

would be lower next year, since the new plant would expand capacity much more than the

required under Sustainable Growth Rate (SGR).


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References:

Ross, Stephen A., Westerfield, Randolph Wl, Jaffe, Jeffrey, (2013). Financial Management

(customized) New York, NY: McGraw Hill