Discuss the implications of these differences

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Unformatted text preview: , Inc. even years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as Manager of Cost Systems for Davis, Cohen, and O’Brien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and O’Brien, Stanley had spent nights and weekends developing a sophisticated costaccounting software program that became Track’s initial product offering. As the firm grew, Stanley planned to develop and expand the software product offerings—all of which would be related to streamlining the accounting processes of medium- to large-sized manufacturers. Although Track experienced losses during its first 2 years of operation—1997 and 1998—its profit has increased steadily from 1999 to the present (2003). The firm’s profit history, including dividend payments and contributions to retained earnings, is summarized in Table 1. Stanley started the firm with a $100,000 investment—his savings of $50,000 as equity and a $50,000 long-term loan from the bank. He had hoped to maintain his initial 100 percent ownership in the corporation, S Table 1 Track Software, Inc. Profit, Dividends, and Retained Earnings, 1997–2003 Year 1997 ($50,000) 0 ($50,000) 1998 ( 20,000) 0 ( 20,000) 1999 15,000 0 15,000 2000 35,000 0 35,000 2001 40,000 1,000 39,000 2002 43,000 3,000 40,000 2003 142 Dividends paid (2) Contribution to retained earnings [(1) (2)] (3) Net profits after taxes (1) 48,000 5,000 43,000 $ but after experiencing a $50,000 loss during the first year of operation (1997), he sold 60 percent of the stock to a group of investors to obtain needed funds. Since then, no other stock transactions have taken place. Although he owns only 40 percent of the firm, Stanley actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The firm’s stock closed at $4.50 per share in 2002 and at $5.28 per share in 2003. Stanley has just prepared the firm’s 2003 income statement, balance sheet, and statement of retained earnings, shown in Tables 2, 3, and 4 (on pages 143–145), along with the 2002 balance sheet. In addition, he has compiled the 2002 ratio values and industry average ratio values for 2003, which are applicable to both 2002 and 2003 and are summarized in Table 5 (on page 145). He is quite pleased to have achieved record earnings of $48,000 in 2003, but he is concerned about the firm’s cash flows. Specifically, he is finding it more and more difficult to pay the firm’s bills in a timely manner and generate cash flows to investors—both creditors and owners. To gain insight into these cash flow problems, Stanley is planning to determine the firm’s 2003 operating cash flow (OCF) and free cash flow (FCF). Table 2 Track Software, Inc. Income Statement ($000) for the Year Ended December 31, 2003 Sales revenue $1,550 1,030 Less: Cost of goods sold Gross profits $ 520 Less: Operating expenses Selling expense General and administrative expense Depreciation expense $150 270 11 Total operating expense Operating profits (EBIT) 431 $ 89 $ 60 Less: Interest expense Net profits before taxes 29 12 Less: Taxes (20%) Net profits after taxes $ 48 143 Table 3 Track Software, Inc. Balance Sheets ($000) December 31 Assets 2003 2002 $ 12 $ 31 Current assets Cash Marketable securities 66 82 Accounts receivable 152 104 Inventories 191 145 $421 $362 $195 $180 Total current assets Gross fixed assets Less: Accumulated depreciation 63 52 Net fixed assets $132 $128 Total assets $553 $490 $136 $126 200 190 Liabilities and Stockholders’ Equity Current liabilities Accounts payable Notes payable Accruals Total current liabilities Long-term debt Total liabilities 27 25 $363 $341 $ 38 $ 40 $401 $381 $ 20 $ 20 Stockholders’ equity Common stock (50,000 shares outstanding at $0.40 par value) Paid-in capital in excess of par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity 144 30 30 102 59 $152 $109 $553 $490 Table 4 Track Software, Inc. Statement of Retained Earnings ($000) for the Year Ended December 31, 2003 Retained earnings balance (January 1, 2003) $ 59 Plus: Net profits after taxes (for 2003) 48 Less: Cash dividends on common stock (paid during 2003) ( Retained earnings balance (December 31, 2003) $102 5) Table 5 Ratio Actual 2002 Industry average 2003 Current ratio 1.06 Quick ratio 0.63 1.10 10.40 12.45 29.6 days 20.2 days Inventory turnover Average collection period Total asset turnover 2.66 1.82 3.92 Debt ratio 0.78 0.55 Times interest earned ratio 3.0 5.6 Gross profit margin 32.1% 42.3% Operating profit margin 5.5% 12.4% Net profit margin 3.0% 4.0% Return on total assets (ROA) 8.0% 15.6% Return on common equity (ROE) 36.4% 34.7% Price/earnings (P/E) ratio 5.2 7.1 Market/book (M/B) ratio 2.1 2.2 145 Stanley is further frustrated by the firm’s inability to afford to hire a software developer to complete development of a cost estimation package that is believed to have “blockbuster” sales potential. Stanley began development of this package 2 years ago, but the firm’s growing complexity has forced him to devote more of his time to administrative duties, thereby halting the development of this product. Stanley’s reluctance to fill this position stems from his concern that the added $80,000 per year in salary and benefits for the position would certainly lower the firm’s earnings per share (EPS) over the next couple of years. Although the project’s success is in no way guaranteed, Stanley believes that if the money were spent to hire the software developer, the firm’s sales and earnings would significantly rise once the 2- to 3-year development, production, and marketing process was completed. With all of these concerns in mind, Stanley set out to review the various data to develop strategies that would help to ensure a bright future for Track Software. Stanley believed that as part of this process, a thorough ratio analysis of the firm’s 2003 results would provide important additional insights. Required a. (1) Upon what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not? (2) Could a potential agency problem exist in this firm? Explain. b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your response in part a. c. Use the financial data presented to determine Track’s operating cash flow (OCF) and free cash flow (FCF) in 2003. Evaluate your findings in light of Track’s current cash flow difficulties. d. Analyze the firm’s financial condition in 2003 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial statements provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis. e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a. 146...
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This document was uploaded on 01/19/2014.

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