This is question Chapter 5, Problem 1IC in Principles of Managerial Finance 14th Edition

Seven years ago, after 15 years in public accounting, Stanley Booker, CPA, resigned his position as manager of cost systems for Davis, Cohen, and OBrien Public Accountants and started Track Software, Inc. In the 2 years preceding his departure from Davis, Cohen, and OBrien, Stanley had spent nights and weekends developing a sophisticated cost-accounting software program that became Tracks 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 operation2009 and 2010its profit has increased steadily from 2011 to the present (2015). The firms 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, but after experiencing a $50,000 loss during the first year of operation (2009), 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 firms stock was valued at $4.50 per share in 2014 and at $5.28 per share in 2015.

Track Software, Inc.,

Profit, Dividends, and Retained Earnings, 20092015

Year Net profits after taxes(1) Dividends paid (2) Contribution to retained earnings [(1) (2)] (3)

2009 ($50,000) $ 0 ($50,000)

2010 (20,000) 0 (20,000)

2011 15,000 0 15,000

2012 35,000 0 35,000

2013 40,000 1,000 39,000

2014 43,000 3,000 40,000

2015 48,000 5,000 43,000

Stanley has just prepared the firms 2015 income statement, balance sheet, and

statement of retained earnings, shown in Tables 2, 3, and 4, along with the 2014

balance sheet. In addition, he has compiled the 2014 ratio values and industry

average ratio values for 2015, which are applicable to both 2014 and 2015 and

are summarized in Table 5. He is quite pleased to have achieved record earnings of

$48,000 in 2015, but he is concerned about the firms cash flows. Specifically, he

is finding it more and more difficult to pay the firms 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 firms 2015 operating

cash flow (OCF) and free cash flow (FCF).

Stanley is further frustrated by the firms 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 firms growing complexity has forced him to devote more of

his time to administrative duties, thereby halting the development of this product.

Stanleys 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

firms earnings per share (EPS) over the next couple of years. Although the projects

success is in no way guaranteed, Stanley believes that if the money were spent to hire

the software developer, the firms sales and earnings would significantly rise once

the 2- to 3-year development, production, and marketing process was completed.

With all these concerns in mind, Stanley set out to review the various data to

develop strategies that would help ensure a bright future for Track Software. Stanley

believed that as part of this process, a thorough ratio analysis of the firms 2015

results would provide important additional insights.

Sales revenue $ 1,550

Less: Cost of goods sold $ 1,030

Gross profits $ 520

Less: Operating expenses

Selling expense $ 150

General and administrative expenses 270

Depreciation expense 11

Total operating expense 431

Operating profits (EBIT) $ 89

Less: Interest expense 29

Net profits before taxes $ 60

Less: Taxes (20%) 12

Net profits after taxes $ 48

Sales revenue $ 1,550

Less: Cost of goods sold $ 1,030

Gross profits $ 520

Less: Operating expenses

Selling expense $ 150

General and administrative expenses 270

Depreciation expense 11

Total operating expense 431

Operating profits (EBIT) $ 89

Less: Interest expense 29

Net profits before taxes $ 60

Less: Taxes (20%) 12

Net profits after taxes $ 48

Sales revenue $ 1,550

Less: Cost of goods sold $ 1,030

Gross profits $ 520

Less: Operating expenses

Selling expense $ 150

General and administrative expenses 270

Depreciation expense 11

Total operating expense 431

Operating profits (EBIT) $ 89

Less: Interest expense 29

Net profits before taxes $ 60

Less: Taxes (20%) 12

Net profits after taxes $ 48

Ratio

Actual

2014

Industry average

2015

Current ratio 1.06 1.82

Quick ratio 0.63 1.10

Inventory turnover 10.40 12.45

Average collection period 29.6 days 20.2 days

Total asset turnover 2.66 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

TO DO

a. (1) On 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.