Analysis of the income statement

According to the income statement the company’s revenue is growing at a healthy rate. From December 2004 to December 2005, the revenue grew by 11% while from December 2005 to December 2006, the revenue grew by 16%. So the revenue is growing at an increasing rate. However revenues taken by themselves will not reveal the complete picture as there are costs associated with generating those revenues and these costs will have to be kept in tight control. Here again the picture seems to be a positive one.

Though actual figures seem to be rising indicating rising costs of revenues which the company does not want, cost of revenue taken as a percentage of revenue is declining. Thus there is a learning curve taking place. When we take the two figures of revenue and cost of revenue together from the income statement, the picture that emerges is that while the company is generating more revenue than before, it is doing so at a lower cost than before. That is a positive sign. Because of this gross profit taken as a percentage of revenue is also rising.

There are costs associated directly with generating revenue and these costs have been addressed in the previous paragraph. However there are other costs, classed as operating expenses, which are incurred periodically as a result of operations required to generate the revenue. In this case, the company does not have any operating expenses connected to research and development. Research and development activities are usually massive and they are only undertaken once in a while.

Probably that is the reason no research and development costs are showing up in the selected three years. However the general and administrative expenses are not presenting a good picture as these expenses are escalating whether taken in actual figures or taken as percentage of the revenue. Otherwise the company is doing well based on the income statement as all three figures, operating income, EBIT and net income, are rising when viewed through the lens of the common sized statement.

Analysis of the Balance Sheet

The balance sheet is presenting a good picture in that total liabilities as a percentage of total stockholder’s equity are going down. This is a good sign as the company is relying less and less on outside sources for financing and using more of its own money. In other words, the company’s equity positioning is strengthening without harming the effectiveness of its operations as the income statement clearly shows that the company’s net income continues to rise.

The level of retained earnings as a percentage of total stockholders equity is also rising and that is another positive sign. The reason as to why the balance sheet is showing less and less reliance on liabilities is that the company is more and more buying back its own stock as indicated by the level of treasury stock the percentages in which continue to go up. From 13% in 2004, treasury stock went up to 27% in 2006. Probably the most important factor that contributes to the strengthening equity position is the strong yearly growth in the level of retained earnings.

The company’s current assets as a percentage of total assets are also going up. That is a good sign but this is not because the company’s liquidity position is improving which it clearly is not. As we can see, cash and cash equivalents as a percentage of total assets are going down and that means the cash is getting more and more tied up in other investments. This may be because the company is a making a lot more short-term investments than it used to in the past. In spite of that, the current asset scenario is improving because the company has less receivables and it is also maintaining less inventory.

Analysis of the cash flow statement

The company’s cash flow from operating activities maintains a rising trend. However the operating activities taken on their own, that is when the operating activities are stripped of the net income element, present a bleak picture. This is because the company is not doing so well in managing it’s receivables and inventory in the three years presented. As we can see from the statement, both the inventory figures and the receivables figures are showing negative balance. These two elements from the balance sheet are tying up cash and creating a negative balance from the operating activities.

Throughout the three years under analysis, the company is making a lot of investments. Not only is the company making a lot of capital expenditures it is also making a lot of unspecified investments which may be in the form of purchasing investment securities. Cash flows from investing activities are usually negative and in this case it is no different.

The company is not generating any cash from financing activities either as it is losing a lot of cash as result of having to pay dividends on common stock (the company does not have any preferred stock) and also because it is repurchasing a lot of its own stock as indicated by the rising level of treasury stock in the balance sheet. Why this is happening is because the company is making more net profits than before which is strengthening its ability to do most of the financing on its own without having to rely on outside shareholders.

However while the company may be in a good position concerning net profits, it is not in a good position at all in terms of paying its short-term bills as according to the statement of cash flows, availability of cash has been going down since 2004 to the point that now in 2006 C and cash equivalents of the company are showing a negative balance.

Recommendations

1) It is true that according to the income statement, the company has no need for worry as net profits as percentages of revenues are going up all the time. However, in the operating expenses category, general and administrative expenses are not showing a positive trend because their percentages are going up throughout the three years under analysis. Therefore the company should streamline its operations so as to reduce these expenses. Any number of reasons can account for the rising general and administrative expenses.

It may be because the paperwork involved is rife with duplication. In that case, the management might consider taking its operations online so as to avoid the possibility to redundant data entries. Although information technology is a major investment, it can pay off in the long run if the conversion to online systems is properly implemented.

2) As mentioned before, the company is not in a good position regarding availability of cash and cash equivalents. Thus the company needs to improve its liquidity position. One way this could be done is to conduct market research so that there is a more accurate forecast of future demand which will make it possible to reduce the number of days for which cash is tied up in inventory. As we can see from the balance sheet, inventory as a percentage of total assets is clearly going up throughout the three years under analysis. This situation has to change. One way to change the situation is to generate a more accurate forecast of demand and fix the manufacturing schedule accordingly. The company could also adopt the JIT management system if that is feasible in this context.

That will most certainly minimize the level of inventory carried. Another area where cash is tied up is account receivables. According to the ratio analysis, the company is taking fewer days in which to collect up on its receivables. That is a positive sign. However since the cash position still continues negative, the management should work to reduce the number of days more. That will free up a lot of cash. The management could also consider changing its credit policies until the cash position is rectified. A certain percentage of sales takes place in the form of credit. That percentage could be reduced and thus more sales could be made in cash until the cash position attains a positive number. These are some of the ways that the management should consider in improving its cash situation.

Negative implications

There are some negative implications attached to reducing inventory and the number of days for which cash is tied up in receivables. Keeping less inventory is certainly a risk as an unexpected positive turn in demand could mean lost sales. The potential opportunity costs of cutting down on inventory as a means of freeing up cash are very high. However these are some of the pros and cons that the management will have to take into account in implementing its strategies.

Tinkering with credit policies is not all smooth sailing either. Credit sales convert a lot of potential customers into actual customers. A certain level of relaxation in the credit policies, which otherwise ties up cash, would attract a lot of new customers. Therefore making credit policies more stringent would lose those new customers. Once again, the management has to weigh its options. But inventory management and account receivables management are two tools that the management can play around with to improve the liquidity position of the company.

3) According to the income statement, the company is not making any investments in research and development. This appears to be the case for three consecutive years. However investing in research, though not very gainful in the short-term, will have many benefits in the long term as this will make the company more competitive by enhancing its manufacturing efficiency for example. Since the company is generating healthy retained earnings, it has the necessary financing with which to bankroll research and development projects.

4) The company is not issuing any preferred stock. This is a valuable means of strengthening stockholder’s equity which the company can make use of. As mentioned before, the company should invest in research and development to stay competitive. The resources required for this project can come from the financing that becomes available with the issuance of preferred stock.

SOURCE

Brigham, Eugene F., and Michael C. Ehrhardt. Financial Management: Theory & Practice. South western college pub. 2007.