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Unformatted text preview: APPENDIX B QUALITY OF EARNINGS CASES: A COMPREHENSIVE REVIEW CASE 1: LIBERTY MANUFACTURING The analysis that can be done on Liberty is limited because there is no access to macroeconomic information, industry data, or the company’s financial statements from the past several years. The following comments are based solely on the information provided and must be viewed as limited for that reason. Ratio Analysis at Face Value Liberty’s reported profits of $159,000 in 2005 appear to be relatively high. Return on equity is 20 percent ($159,000/$799,000), return on assets is approximately 6.6 percent ($159,000/ $2,399,000), return on sales is 14.5% ($159,000/$1,100,000). [Note: ratios are calculated without balance sheet averages so that two years can be analyzed.] The company turns over its inventory, on average, about every 90 days (4 times per year). Moreover, the significant decrease in the inventory balance probably increased the company’s turnover from the previous year. These measures suggest that Liberty has relatively strong earning power. There is also preliminary evidence that Liberty’s solvency position is satisfactory. The company’s current ratio increased slightly from 2.5 in 2004 to 2.6 in 2005, and the quick ratio increased to a strong 2.2. There is some concern, however, about Liberty’s accounts receivable management. Average days receivable is approximately 141, indicating that the company turns over its receivables only 2.59 times per year. This relatively slow turnover will slow down cash collections and may reduce the company’s solvency position. The debt/equity (total liabilities/stockholders’ equity) ratio represents another source of concern, because it indicates that the company is carrying a much higher percentage of liabilities as of the end of 2005. Specifically, the ratio increased from 1.24 to 2.00 during 2005. The increase was caused primarily by increases in the outstanding accounts payable balance and a $600,000 increase in long-term liabilities. However, the interest coverage ratio is 3.2 [($199,000+$90,000)/ $90,000], suggesting that the company’s profits were more than enough to cover the interest charges on its long-term debt. In summary, the ratio analysis conducted above suggests that Liberty’s earning power and solvency positions are reasonable. Significant debt has been added to its capital structure recently, but the company’s earnings power appears to be sufficient to cover the necessary debt payments if receivables are collected on a timely basis. Earnings Persistence A closer look at the income statement reveals some very troubling aspects about Liberty. First, many of the “gains” reported on the income statement are not essential to the operations of the business. A realized gain on the sale of short-term investments accounted for $80,000 of the net profit; $40,000 was generated from Packer, a company whose stock price fell from $5.00 to $4.00 as of the end of 2005; $25,000 came from a translation gain because the dollar fell relative to the...
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This note was uploaded on 03/25/2009 for the course FIN FIN504 taught by Professor Byungjinkwak during the Spring '09 term at Korea Advanced Institute of Science and Technology.
- Spring '09