Seven years ago, after 14 years in public accounting, Sylvia Banks, CPA, resigned her position as managers
Question:
Seven years ago, after 14 years in public accounting, Sylvia Banks, CPA, resigned her position as managers of cost systems for Coastal Bend CPA and started National Software, Inc. In the 2 years preceding her departure from Coastal Bend CPA, Sylvia had spent nights and weekends developing a sophisticated cost-accounting software program that became National Software’s initial product offering. As the firm grew, Sylvia planned to develop and expand the software product offerings—all of which would be related to streamlining the accounting processes of medium and large-sized manufacturers.
Although National experienced loses during its first two years of operation—ending in 2011 and 2012—its profit has increased steading from 2013 to the present (2017). The firm’s history, including dividend payments and contributions to retained earnings, is summarized in Exhibit 1.
Sylvia started the firm with a $100,000 investment—her savings of $50,000 as equity and a $50,000 long-term loan from the bank. She had hoped to maintain her initial 100 percent ownership in the corporation, but after experiencing a $50,000 loss during the first year of operation (2011), she 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 she owns 40% of the firm, Sylvia actively manages all aspects of its activities; the other stockholders are not active in management of the firm. The stock’s value was estimated to be $4.50 per share at year-end in 2015 and at $5.28 in 2016.
Sylvia has just prepared the firm’s 2017 income statement, balance sheet, and statement of retained earnings, shown in Tables 2,3, and 4, along with the 2017 balance sheet. In addition, she has compiled the 2016 ratio values and industry for 2017, which are summarized in table 5. She is quite pleased to have achieved record earnings of $48,000 in 2017, but she is concerned about the firm’s cash flows. Specifically, she is finding it 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, Sylvia is planning to determine the firm’s 2017 operating cash flows and free cash flows.
Sylvia 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 have “blockbuster” sales potential. Sylvia began development of this package two years ago, but the firm’s growing complexity has forced her to devote more of her time to administrative duties, thereby halting the development of this product. Sylvia’s reluctance to fill this position stems from her concern that the added $95,000 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, Sylvia believes that if the money were spent to hire the software developer, the firms’ sales and earnings would significantly rise once the 2- to3-year development, production, and marketing process were completed.
Sylvia recently posted information about her firm on “FishTank” an online angel investor website where entrepreneurs can share information and see if anybody is investing in them. Jimmy Perez responded with an offer to buy National Software for $200,000. Through discussion with Mr. Perez, Sylvia found out that he uses a ten percent discount rate on projects with this level of risk. By comparison, Sylvia uses a nine percent required rate of return on new projects.
TABLE 1 | |||
National Software Profit, Dividends, and Retained Earnings, 2011-2017 | |||
Year Ending 3/31 | Net Profit after taxes [1] | Dividends Paid [2] | Contributions to Retained Earnings [{1] – [2]} |
2011 | -50,000 | $0 | -50,000 |
2012 | -20,000 | 0 | -20,000 |
2013 | 15,000 | 0 | 15,000 |
2014 | 35,000 | 0 | 35,000 |
2015 | 40,000 | 1,000 | 39,000 |
2016 | 43,000 | 3,000 | 40,000 |
2017 | 48,000 | 5,000 | 43,000 |
TABLE 2 | |
National Software, Inc. Income Statement for the Fiscal-Year Ended March 31, 2017 ($000) | |
Sale Revenue | $ 1,550 |
Less: Cost of goods sold | 1,030 |
Gross profit | $ 520 |
Less: Operating expenses | |
Selling expense | $150 |
General and administrative expenses | 270 |
Depreciation expense | 11 |
Total operating expenses | $ 431 |
Operating Profit (EBIT) | $89 |
Less: Interest expenses | 29 |
Net profit after taxes | $ 60 |
Less: Taxes | 12 |
Net profit after taxes | $ 48 |
TABLE 3 | ||
National Software, Inc. Balance Sheet ($000) | ||
Assets | 3/31/2017 | 3/31/2016 |
Cash | $12 | $31 |
Accounts receivable | 152 | 104 |
Inventories | 191 | 145 |
Total current assets | $355 | $280 |
Gross fixed assets | $195 | $180 |
Less: Accumulated depreciation | 63 | 52 |
Net fixed assets | $132 | $128 |
Total Assets | $487 | $408 |
Liabilities and Stockholders’ Equity | ||
Accounts payable | $136 | $126 |
Notes payable | 134 | 108 |
Accruals | 27 | 25 |
Total current liabilities | $297 | $259 |
Long-term debt | $38 | $40 |
Total liabilities | $335 | $299 |
Common stock (50,000 shares outstanding at $0.10) | $5 | $5 |
Paid-in capital in excess of par | 45 | 45 |
Retained earnings | 102 | 59 |
Total stockholders’ equity | $152 | $109 |
Total liabilities and stockholders’ equity | $487 | $408 |
TABLE 4 | |
National Software, Inc. Statement of Retained Earnings ($000) For the Year Ended Mach 31, 2017 | |
Retained earnings balance (3/31/2016) | $59 |
Plus: Net profit after taxes (2017) | 48 |
Less: Cash dividends paid on common stock | 5 |
Retained earnings balance (3/31/2017) | $102 |
TABLE 5 | ||
Ratio | Actual 2016 | Industry Average 2017 |
Current ratio | 1.06 | 1.82 |
Quick ratio | 0.63 | 1.1 |
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 | 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 | 5.5 | 7.1 |
Market/book (M/B) ratio | 2.1 | 2.2 |
With all of these concerns in mind, Sylvia set out to review the various data and develop strategies that would help to ensure a bright future for National Software. Sylvia believed that as part of this process, a thorough analysis of 2017’s financial statements would provide important additional insights. You have been hired to assist in this evaluation. The syllabus provides information related how your report should be presented. In the critical analysis portion, be sure to cover the following items:
A. Analysis of Company Objectives.
1. On what financial goals does Sylvia seem to be focusing? It is the correct goal? (Why or why not?)
2. Could an agency problem exist at this firm? Devise a scenario in which agency problems would become a greater issue at National Software.
B. EPS Performance Assessment
1. Calculate the firm’s earnings per share (EPS) for each year. (Hint: The number of shares has remained unchanged since inception.) Integrate analysis of EPS performance with company objective analysis (i.e., Part A).
2. Detect reasons for the causes of changes in EPS Performance. Use online resources to discuss software industry factors and general economic factors.
C. Cash Flow Statement
1. Construct cash flow statements, and estimate National Software’s operating cash flow and free cash flow in 2017. Evaluate your findings in light of National Software’s current cash flow difficulties.
2. Hypothesize the impact of a reduction in gross fixed assets on free cash flow and run appropriate experiments to judge the accuracy of your hypotheses.
D. Financial Statement Ratio Analysis
1. Analyze the firm’s financial condition in 2017 as it relates to (1) liquidity, (2) activity, (3) deb t, (4) profitability, and (5) market, using the financial statements provided in Table 2 and Table 3 and the ratio data included in Table 5.
2. Critique the firm’s performance on a cross-sectional basis and a time-series basis.
E. Hiring a New Employee
1. Check the internet to find information on the relative costs and benefits of software developers.
2. Recommend a course of action to Sylvia regarding the hiring of a new software developer.
F. Firm Valuation: Discount rate focused
1. In light of the cash flows and dividend payments, critique Jimmy Perez’ offer.
2. Justify the10% required return of return assigned by the investor.
G. Firm Valuation: Cash Flow Focused
1. Assume a free cash flow growth rate going forward that equates to zero, at what price would Sylvia place the value of National Software? Attribute the difference in Part F and Part G to differences in the definition of return.
2. Construct a diagram showing how the amount you are willing to pay varies with the firm’s anticipated free-cash flow.
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