D’Leon Inc. Case Study Essay

DLeon Incorporated is a small food manufacturing business that specializes in high-quality pecan and other nut products sold in the snack-foods commercialize. In 2004, DLeons president, Al Watkins, decided to undertake a major involution to become more competitive within their market. The following report describes some of the financial effects that this expansion has had on the caller-out.DLeon began its expansion by double its plant capacity, opening new gross revenue offices, and investing in an expensive advertising campaign. Watkins felt that they had superior products to the competition and that he could charge a exchange premium price for their products to result in increased sales, gelts, and investment go with price. The results, however, were unsatisfactory. Sales were below and be were above all initial projections. These results accommodate raised questions astir(predicate) the expansion and to a fault caused business sector among the Board of Directors and th e major sh arholders about the future of the comp any(prenominal).Part I of this report analyzes DLeons financial statements from 2004 and 2005. It describes some of the effects of the expansion on the financials of the play along and some of the problems that have arisen with their latest financial position. cabbage operational profit change magnitude, but operating working capital and total operating capital have shown increases. Sales had a considerable increase, but net income decreased. DLeons financials also indicated a decrease in interchange combine due to the lodge spending more bullion than they were taking in. These changes ar subsequently resulting in decreased stock prices and a deteriorating financial position which is concerning both management and divideholders.Part II of this report discusses the ratio abstract of DLeons financial statements. It begins by explaining the louver major categories of financial ratios Liquidity, Asset Management, Debt Manage ment, Profitability, and marketplace judge. While most of the 2005 ratios have shown significant declines and are below patience averages, the 2006 projections look promising for the club and are showing significant increases. Part II continues with a discussion of some of the limitations of financial ratios as comparison to a faultls and concludes with a brief discussion of DLeons credit issues and asummary of the companys 2006 projections.It is recommended that DLeon Inc. conduct in-depth financial research and perform an extensive ratio analysis of their financial position before deciding to undergo any further expansions. Doing this could greatly help the managers in their decision-making and aide in determining the effects of any future expansions on the financial stability of the company.SalesIn addition to expanding the company, DLeons president, Al Watkins, felt that the companys products were of a higher quality than the competitions and that he could charge a premium price, resulting in greatly increased sales and profits. Following the expansion, DLeon did see a sales increase of $2,602,000 , a 75.8% increase everywhere the previous year. Even though the company did experience a sales increase, liabilities such as accounts and notes payable increased, resulting in decreased profits.Net operate Profit after TaxesNet Operating Profit after Taxes (NOPAT) is a companys after-tax operating profit for all investors, including shareholders and debt holders. NOPAT represents the companys operating profit that would accrue to shareholders if the company had no debt. Unfortunately, due the increased debt and liabilities associated with the expansion, DLeons NOPAT experienced a significant decrease of 168.8% from $114,257 to -$78,569.Net Operating Working CapitalNet Operating Working Capital (NOWC) is a financial metric representing the amount of day-by-day operating liquidity available to a business. NOWC is calculated by subtracting a companys non- oc cupy bearing online liabilities from their current assets. An increase in working capital indicates that the business has either increased current assets by receiving cash or other current assets, or has decreased current liabilities, by possibly paying off some short-term creditors. As a result of DLeons increased sales from the expansion, the company has experienced an increase in NOWC from $842,400 to $913,042. This is an increase of about 8.4%. This increase is good because its a positive indicator that the bulletproof is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and up glide path operational expenses.Total Operating CapitalTotal Operating Capital is manifestly the addition of a companys net fixed assets to the NOWC. DLeons expansion generated a significant increase in the companys net fixed assets of almost trio times the previous years. This figure added to the NOWC generated a 56.1% increase in total ope rating capital from $1,187,200 to $1,852,832.Net IncomeNet income, or profit, is the income that a firm has after subtracting costs and expenses from the total revenue. It can be distributed among holders of common stock as a dividend or held by the firm as retained earnings. Once again, however, due to the significant increase in costs and expenses such as notes and accounts payable, DLeon had a negative net income in 2005. They experienced a decrease of 282.1% from $87,960 to-$160,176.Cash FlowsCash flow refers to the amount of cash being sure and paying by a business during a defined period of time. The measurement of cash flow can be used to determine and evaluate such things as problems with liquidity and the state or transaction of a business. It can also be used to generate project rate-of-returns and to examine income or growth of a business when it is believed that accrual explanation concepts do not represent economic realities. In this report, cash flows leave behind be categorized into three components net cash flow, operating cash flow, and desolate cash flow.Net cash flow (NCF), the measure of a companys financial health, have-to doe withs the cash receipts minus cash payments all over a given period of time. It can be considered money that is available for expansion, research and development, or retained as cash reserves. From 2004 to 2005, DLeons net cash flow decreased dramatically by 140.4%. This decrease in funds needed for the expansion is causing great concern with the major shareholders of the company over the future of DLeon Inc.Operating cash flow (OCF) is the cash flow from operating activities. It refers to the amount of cash a company generates from the revenues it brings in minus the costs associated with long-term investment on capital items or investment in securities. The company experienced a 71.2% decrease in OCF from the previous year.Free cash flow (FCF) is the cash flow actually available for payment to investors. The value of a companys operations depends on its expected future redundant cash flows. This is another(prenominal) cause for concern for DLeons major shareholders because, following the expansion, the FCF decreased dramatically to -$744,201.Market Value AddedMarket Value Added (MVA) is the difference among the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The expansion of DLeon has decreased their MVA. This canbe seen in that the stock price has decreased over the past year by about 73.5%. In order for MVA to increase, the amount of value added needs to be greater than the firms investors could have achieved investing in the market portfolio.SECTION 2 Working CapitalA good indicator of a companys health is its working capital. The working capital represents the amount of operating liquidity that is available to a business and is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash. Section 2 of this report focuses on the three components of current assets sales, receivables, and purchases.SalesThe objective of any business is to create or increase profits through sales. One way that DLeon might increase sales would be to cristal 60-day credit terms to their customers rather than the 30-day credit terms that they currently offer. If sales were to double as a result of the change in their credit policy, the cash account would initially decrease because they would have to build up their inventory to support the increased sales. This would result in an increase in accounts receivable. Over time, DLeons cash account would eventually begin to rise as accruals increased. One downfall to this option, however, would be if the competitors learned of the change and began to offer similar credit terms to their custo mers. If this were to happen, DLeons sales would remain constant, resulting in its cash account decreasing and its accounts receivable change magnitude.ReceivablesDay-to-day business at DLeon, just as in any other business, consists of them spending money. They spend money for labor, materials, and fixed assets needed to make products to sell. The sale of these products result in receivables, which are simply the billing of customers who owe money to the company for the goods that have been provided. The receivables eventually generate cash as the outstanding bills are paying(a) by the customers. Because of this process, DLeons cash account has decreased dramatically due to the company spending more cash than it is taking in. Because of this, it appears that the sales price does not distance its costs per unit sold.This has a negative effect on the cash balance because, as stated above, more cash is going out than is coming in.PurchasesDLeon purchases its materials on 30-day term s, meaning that it is supposed to pay for its purchases within 30 days of receipt. Judging by DLeons 2005 balance sheet , its suppliers probably do not get paid on time. This conclusion can be made from the fact that sales have only increased by about 76% over the past year while accounts payable have increased by about 260%.SECTION 3 Problems AnalysisAdditional questions and problems have raised concern among the board members and the major shareholders of DLeon Incorporated. Section 3 of this report focuses on these issues as well as options that the company might pursue to ensure a healthy financial future.Cash ProblemsThe expansion at DLeon weakened their financial strength. Because the company issued long-term debt rather than common stock for the funding, it appears that it has financed its expansion with outer capital rather than with internally generated funds. Due to the significant increase in receivables, even if it had broke even in 2005, DLeon would still experience a cash shortage requiring it to raise external capital to finance its increase in assets.Regarding the companys physical stock, the question has been raised to depreciate them over 7 years rather than 10 years. Unfortunately, this change would not affect the physical stock. The balance sheet account for fixed assets, however, would decrease due to the increasing accumulated depreciation. The companys reported net income would decrease and the decrease in tax payments would result in an increased cash position.Stock IssuesEarnings per share (EPS) are the earnings returned on the initial investment amount. It is calculated by dividing net income by shares outstanding. Dividends per share are calculated by dividing dividends by shares outstanding. countersign value per share is calculated by common equity divided by shares outstanding. The market price per share of a stock does not equal the book value per share because the market value reflects futureprofits, while the book value per s hare represents historical cost of the stock.Tax IssuesFor businesses, interest paid is tax deductible. This is because it is considered an expense and is paid out of pre-tax income. Dividends paid, however, are paid out of after-tax income. Interested earned is subject to income taxes because it is part of the companys taxable income. Dividends received are also taxed as part of the ordinary income. For corporations, Capital gains are taxed as ordinary income. DLeon was able to use Tax Loss Carry-Back and hold over Provisions to receive a tax refund because of its net loss of -$160,178 in 2005.PART IIFinancial StatementAnalysisSECTION 1 Ratio AnalysisThe primary remainder of any business is to maximize its value. In order to do this, it must take advantage of its strengths and correct its weaknesses. Businesses do this by first comparing their performance to other businesses in the same industry and secondly by evaluating trends in their financial position over time. This evaluat ion is done through ratio analysis . Ratio Analysis is simply a tool used by individuals to conduct a quantitative analysis of information in a companys financial statements.These ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to try out the performance of the company. These calculations provide assistance in decision-making, reduce reliance on guesswork and intuition, and establish a basis for sound judgment. The following section discusses the five major categories of financial ratios.LiquidityLiquidity refers to an assets ability to be easily converted through the act of buying or selling. A liquid asset can be bought or sold rapidly without causing a significant movement in the price and with minimum loss of value. Liquidity ratios are calculations that show the relationship of a companys cash and other current assets to its current liabilities. These ratios acknowledge the current rat io and the quick ratio. By smell at DLeon Inc.s quick ratio for 2004 and 2005, it is clear that their liquidity has decreased, but it is projected to increase in 2006.Asset ManagementAsset management ratios are another group of financial calculations that measure how effectively a company is managing its assets. These ratios attempt to answer the question Does the amount each type of asset seem reasonable, too high, or too low in view of current and projected sales? If a business has too more assets, its cost of capital will be too high and its profits will be depressed. If assets are too low, however, profitable sales will be lost. Asset management ratios include inventory turnover, days sales outstanding (DSO), fixed assets turnover, and total assets turnover.DLeons inventory turnover and total assets turnover are below the industry average, but their DSO is above the industry average. Their fixed assts turnover, however, is above the industry average. By the inventory turnover ratio being low, it appears that the firm either has excessive or obsolete inventory. If inventory were reduced, their current asset and turnover ratios would improve and the debt ratio would reduce even further, increasing DLeons profitability. If DLeon were to improve its collection procedures and lower its DSO to the 32-day average, the effects would ripple through the financial statements and free up over $250,000 in cash that would, in turn, raise their stock price.Debt ManagementDebt management is also referred to as financial leverage. Financial leverage is the using of given resources in such a way that the potential positive or negative core is magnified. It most generally refers to using debt, or borrowed funds, in an attempt to increase the returns to equity. Financial leverage can allow greater potential returns to the investor than would have other than been available. The potential for loss is also greater, however, because repayment of the loan principle and all accr ued interest is still required if the investment becomes worthless. Debt management ratios include times-interest-earned (TIE) and EBITDA coverage. DLeons expected TIE for 2006 is much improve over its 2004 and 2005 levels and is above the industry average. Their EBITDA has also improved, but is still below the industry average.ProfitabilityProfitability ratios reflect the unite effects of liquidity, asset management, and debt. It measures a companys use of its assets andcontrol of its expenses to generate an acceptable rate of return. For most of these ratios, having a higher value recounting to a competitors ratio or the same ratio from a previous period is indicative that the company is doing well. Profitability ratios include profit margin on sales, return on total assets (ROA), basic earning power, (BEP), and return on common equity, (ROE). DLeons profit margin is above 2004 and 2005 levels and is around above the industry average. Their BEP, ROA, and ROE ratios have also inc reased from the previous year, but are all still below the industry average.Market ValueMarket Value Ratios are the calculations that relate a companys stock price to its earnings, cash flow, and book value per share. These ratios give management an indication of what investors think of the companys risk and future prospects. If all of the previously discussed ratios look good, and if these conditions have been stable over time, then the market value ratios will be high, the stock price will probably be high, and management has been doing a good job. Market value ratios include price/earnings (P/E), price/cash flow, and market/book (M/B) ratios. All of these ratios at DLeon Inc. are above the previous years level, but are all below the industry average.SECTION 2 Financial Ratio LimitationsWhen evaluating a company, analysts recognize that they must consider certain qualitative factors . These factors areAre the companys revenues tied to one refer customer?To what extent are the com panys revenues tied to one key product?To what extent does the company rely on a single supplier?What percentage of the companys business is generated overseas?CompetitionFuture prospectsLegal and regulatory environmentWhile these factors must be considered for all companys alike, not all companys can be compared equally when it comes to their financials. There are a number of limitations to using financial ratios as a tool for comparison.One such limitation is that companys use different operating and accounting practices and procedures. This could cause distortion in comparisons. Another come-at-able cause of distortion between ratio comparisons is seasonal factors. Industry average comparisons can be made difficult if companys operate many different divisions. Anothermajor issue is that a company may not always know whether the ratios that they are comparing theirs with are good or bad because some companys use certain techniques to make their financial statements and ratios ap pear better than they actual are.SECTION 3 Problems and DiscussionCredit IssuesIn 2005, DLeon paid its suppliers much later than the due date, and it was not maintaining financial ratios at levels called for in its bank loan agreement. There was concern that this behavior would lead to the suppliers cutting the company off and refusing to renew the loan when it comes due. Even though the companys projected ratios appear to be improving, the credit manager will most credibly not be able to extend credit to it. However, the bank will mostly likely not demand repayment because this could for DLeon into bankruptcy.Financial ProjectionsUsing the protracted Du Pont equation, we find that DLeon has an ROE of nearly 13%. Looking at the 2006 projections in Appendix F on page 16, we see that the companys strengths include above industry average fixed assets turnover and profit margin. DLeon also significantly reduced it debt ratio, resulting in a decreased interest expense and improved TIE ratio. Some of the companys weaknesses include poor asset management ratios, EBITDA coverage, profitability ratios, and market value ratios. I would have recommended that the company perform an extensive ratio analysis of its current financial position before taking on any expansion plans. This could have vastly helped managers to determine the effects of the expansion on the financial stability of the company.Brigham, Eugene F., and Joel F. Houston. Fundamentals of Financial Management. DLeon Inc., Chapter 4 spreadsheet module. Made available on July 1, 2008 by Dr. Richard Constand.Brigham, Eugene F., and Joel F. Houston. Fundamentals of Financial Management. Thomson South-Western Publishers, Eleventh Ed. 2007.