Case study: Maria Hernandez & Associates
Group 1
Question 1: REPORT ON OPERATIONS OF MARIA HERNANDEZ & ASSOCIATES THROUGH AUGUST 31,2001 BALANCING ACCOUNT Cash
Cash (0) (1)
12,000 40,000
(2) (3) (3) (4)
900 6,000 33,000 5,500
Balance
900 6,000 33,000 5,500 6,600
52,000
52,000
6,600
BALANCING ACCOUNT Equity
Equity (0)
12,000 40,000
30,000
0
30,000
30,000 30,000
30,000 Balance
BALANCING ACCOUNT Note payable
Note payable (0)
20,000
0 20,000
20,000
20,000
20,000 Balance
20,000
BALANCING ACCOUNT Prepaid expenses
Prepaid expenses (0)
30,000
12,000
Balance
1
12,000
0 12,000
12,000
12,000
12,000
Case study: Maria Hernandez & Associates
(0) (4)
Group 1
BALANCING ACCOUNT Equipment 27,000 11,000
Equipment 27,000 11,000
38,000 Balance
(0) (2)
Inventory 5,000 (2) 900
38,000
38,000
BALANCING ACCOUNT Inventory 5,000 900
1,700
5,900 Balance
Sales revenue (1) (1)
1,700 4,200 5,900
4,200
BALANCING ACCOUNT Sales revenue 0 40,000 0 7,000 47,000
40,000 7,000
47,000
47,000 Balance
(1)
0 0 38,000
BALANCING ACCOUNT Account receivable 7,000
Account receivable 7,000
7,000 Balance
2
7,000
47,000
0 7,000 7,000
Case study: Maria Hernandez & Associates
Group 1
BALANCING ACCOUNT Cost of sales
Cost of sales (2)
1,700
Balance
(3)
1,700
0 1,700
1,700
1,700
1,700
BALANCING ACCOUNT Rent expenses 6,000
Rent expenses 6,000
6,000 Balance
(3)
6,000
6,000
BALANCING ACCOUNT Utility expenses 33,000
Utility expenses 33,000
33,000 Balance
0 33,000 33,000
33,000
BALANCING ACCOUNT Account payable
Account payable (4)
0 6,000
5,500
5,500
5,500 0
5,500
5,500 Balance
3
5,500
Case study: Maria Hernandez & Associates
Group 1
TRIAL BALANCE
Balance Debit 6,600 7,000 6,000 38,000 4,200
Cash Accounts receivable Prepaid rent Equipment Inventory
Credit
Accounts payable
5,500
Note payable Paid in capital Sales revenue Cost of sales Utility expenses Rent expenses
20,000 30,000 47,000 1,700 33,000 6,000
Total
102,500
102,500
ADJUSTING PROCESS
Depreciation expenses (5)
1,500 Accumulated Depreciation (5)
1,500
Interest expenses (6)
200 Accrued Expense (6)
200
4
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 (7)
47,000
42,400 1,380 3,220
47,000
Income Tax Liability (7)
1,380
Retained Earning Balance To balance
0
3,220
3,220 Balance
3,220
Maria started her own business with $50,000 in cash a nd 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 companys 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.
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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:
6,600 7,000 4,200
Cash Account receivable Inventories
17,800
Total current assets Net fixed assets
38,000 6,000
Equipment Other fixed assets Total net fixed assets
44,000
Total assets
61,800
Liabilities and Equity Current liabilities
5,500 200 1,380 20,000 1,500 28,580 0 28,580
Account payable Accrued interest Accrued taxes Notes payable Accumulated Depreciation Total current liabilities Long-term bonds Total debt Common equity Retained earnings
30,000 3,220
Total common equity
33,220
Total liabilities and equity
61,800
Capital stock
6
Case study: Maria Hernandez & Associates
Group 1
Maria Hernandez & Associates Income Statement for 2001 47,000 40,700 1,500 42,200 4,800 200
Net sales Operating cost Depreciation Total operating costs EBIT Interest Taxes (30%)
4,600 1,380
Net income
3,220
EBT
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
3,220 1,500 1,700 7,000 5,500 1,380 20,300
II. Long-term investing activities
Cash used to acquire fixed assets
42,500
III. Financing activities
Increase in notes payable Increase in bonds outstanding Payment of dividends to stockholders Net cash provided by financing activities
20,000 0 0 20,000
Cash and equivalent at the beginning Cash and equivalent at the end
50,000 6,600
IV. Summary
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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 firms 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 companys ability to pay its debt, dividends (in this case Maria is the only owner of the company so she does not have t o 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 companys 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 companys 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 companys 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. 8
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 companys 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 firms ability to repay its long-term debt
Debt ratio = Total debt / Total assets = $28,580 / $61,800 = 46%
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Case study: Maria Hernandez & Associates
Group 1
The Debt ratio means almost half of the companys 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 companys 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 companys 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%
10
Case study: Maria Hernandez & Associates
Group 1
The companys ROE is low and this is a result from the companys use of debt, that the company uses investment funds inefficiently to generate earnings growth.
FINAL THOUGHT:
Summary of Financial Ratios
Ratio
Ratio
Comment
Current ratio
0.62x
Poor
FCF
$58,000
OK
NWC
-$10,780
Poor
Fixed assets turnover ratio
1.06x
Poor
Total assets turnover ratio
0.76x
Poor
Inventory turnover ratio
11.19
OK
Debt ratio
46%
High (risky)
Operating margin
9.7%
Poor
Profit margin
6.8%
Poor
ROA
5.2%
Poor
ROE
9.6%
Poor
All of our calculations have shown one thing, the company has virtually risk. Almost half of the companys 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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