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Ivory Furniture Company Financial Analysis, Case Study Example

Pages: 12

Words: 3354

Case Study

 

  Ivory Furniture Industry Average
Income Statement 2007 2006 2007 2006
Sales 100% 100% 100 100
Gross Profit 52.9% 52.3% 55.1 54.8
EBIT 9.1% 8.8% 10.8 10.2
Net Income After Tax 5.1% 4.4% 6.4 6.1
     
Balance Sheets    
Cash 2.1% 3.1% 3.4 3.1
Accounts Receivable 16.9% 18.9% 14.3 14.5
Inventory 12.5% 14.3% 12 13
Total Current Assets 37.6% 41.3% 31.3 33.4
     
Fixed Assets 62.4% 58.7% 53.7 51.6
Total Assets 100% 100% 100 100
     
Current Liabilities 38.9% 35.8% 32.3 33.2
Long-term debt 26.3% 36.6% 15.3 15.6
Equity 34.8% 27.6% 51.7 51.6
     
Total Claims 100% 100% 100 100

As far as Ivory Furniture is concerned, the company is lagging behind the industry in operating performance. Not only it’s gross profit margins are lower than the industry in both years which means it incurs more cost to generate each dollar of sale, but its accounts receivable and inventory management is also less efficient than the industry average. This may mean that Ivory Furniture provides generous credit terms to customers in order to generate sales which also increases the risk of bad debts and moreover, negatively impacts its short term liquidity. Not only accounts receivables increase the risk of bad debts but they also deteriorate the company’s short term liquidity position. The company may still be making profit on the paper but an inability to funds its daily operations due to lack of liquidity could force it into bankruptcy. Cash sales result in instant cash flow and are certain revenues while credit sales could go bad. Thus, it is no surprise that the company’s cash reserves as a proportion of total assets significantly declined in 2007 and are only 2.15 instead of the industry average 3.4%. Ivory Furniture had the same proportion as the average industry player at 3.1% a year ago though the picture has changed. It is possible that the company has been facing declining sales and is thus, trying to boost sales through generous credit facilities to customers. One could rule out the role of recession or difficult economic climate because the average industry player boosted its cash reserves to 3.4% from 3.1% a year ago.

The company’s inventory management also needs improvement because more inventory means higher storage costs and also unproductive capital tie-up. The company should watch its sales figures more closely to determine efficient inventory levels. The positive news is that the company has indeed lower its inventory levels from a year ago though it still lags behind the average industry player, leaving further room for improvement. Another reason may be slower sales than company’s expectations which mean the company should take measure to improve its forecasting capabilities as well.

The company also has higher levels of short term and long term liabilities than the industry average. Current liabilities may be higher because the company may buy most of its inventory on credit and then takes longer to pay back suppliers which may hurt its long term relationship with suppliers. Thus, improving receivables management will not only improve short term liquidity but it will also help the company lower its short term liabilities. Higher level of long-term debt not only increases financial leverage and risk for stockholders but also negatively impact income due to interest payments. While the rest of the industry is evenly split between debt and equity as sources of capital, Ivory’s debt to equity ratio is almost 2:1 but fortunately, the position has improved from last year when it was about 3:1. Overall, the company is in a worse condition than the average industry, thus, the company should take immediate steps to improve its operations. Ivory has taken steps to lower its long term liabilities but the company’s short term liquidity has deteriorated. The company may be better off to improve its operational efficiency rather than aiming for aggressive sales objectives.

Liquidity Ratios  Ivory 2007     Ivory 2006   Industry      
        2007     Industry 2006  
Current Ratio = Current Assets =  $        1,067.6 = 0.97  $   1,256.2 = 1.16 1.86 1.89
Current Liabilities  $        1,105.1  $   1,087.5
               
Cash Ratio = Cash =  $              61.0 = 0.06  $         95.2 = 0.09 0.14 0.16
Current Liabilities  $        1,105.1  $   1,087.5
               
Quick Ratio = Current Assets – Inventory =  $          713.60 = 0.65  $    820.90 = 0.75 1.05 1.07
Current Liabilities  $        1,105.1  $   1,087.5

The bank’s estimations regarding Ivory’s liquidity position are accurate because Ivory has lower values than the average industry in all categories of short term liquidity. As we investigate the balance sheet, we find out that the company’s current assets have gone down from 2006 to 2007 but its current liabilities have actually increased. The company may be hurting from declining sales which may also be one of the factors behind the decline in cash reserves and accounts receivables. The possibility is lower that accounts receivables have declined due to payments by customers because we do not see any impact on the cash reserves. The company probably responded to declining sales by lowering inventory levels as well. In current liabilities, we see an increase in accrued expenses, notes payable and current portion of LT debt, and other current liabilities and it is clear that the company is already showing signs of short term liquidity crisis. Ivory’s short term liquidity is a serious cause of concern as current ratio has fallen below 1 and quick ratio has further deteriorated from 0.75 to 0.65. The company should lower debt, make more cash sales and lower accounts payable amounts.

Accounts Receivable Turnover = Sales =  $        5,730.6 = 11.97  $          5,576.4 = 9.69 12 11.5
 Accounts Receivables  $            478.9  $              575.3
Average Collection Period = Accounts Receivable *365 =  $    174,798.5 = 30.50  $      209,984.5 = 37.66 23.1 24.8
Sales  $        5,730.6  $          5,576.4
Inventory Turnover = Sales =  $        5,730.6 = 16.19  $          5,576.4 = 12.81 6.6 6
Inventory  $            354.0  $              435.3
Accounts Payable Period = Accounts Payable * Number of Days =  $    142,934.0 = 52.94  $      153,373.0 = 57.62 35 42
COGS  $        2,700.0  $          2,661.8
Fixed Asset Turnover = Sales =  $        5,730.6 = 3.23  $          5,576.4 = 3.13 4.8 4.8
Fixed Assets  $        1,772.6  $          1,783.7
Total Asset Turnover = Sales =  $        5,730.6 = 2.02  $          5,576.4 = 1.83 2.8 2.7
Total Assets  $        2,840.2  $          3,039.9
Cash Conversion Cycle  
= Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding  
  = (inventory/COGS per day) + (Accounts Receivable/Revenue per day) – (Accounts Payable / COGS per day)  
  Ivory 2007 Ivory 2006 Industry 2007 Industry 2006  
Cash Conversion Cycle = 25.42 39.73   N/A N/A                

Even though Ivory lags behind the industry average in all categories but as compared to 2006, the company has made improvements in almost all categories including accounts receivable turnover, average collection period, inventory turnover, and fixed asset turnover. This means that that company has improved collection of accounts receivables from the customers, is selling its inventory faster, and has improved asset utilization rates. The liquidity ratios among these efficiency ratios are accounts receivable turnover, average collection period, and accounts payable turnover. An improvement in accounts receivable turnover means that Ivory is now making a greater portion of its sales in cash which will help it improve its operational liquidity. Average collection period shows how much time it takes for Ivory to collect cash from customers who made their purchases on credit. The improvement from 37.66 to 30.50 means that Ivory is collecting cash almost a week earlier in 2007 as compared to 2006 which will again be a boost to its liquidity and cash reserves. Accounts payable turnover shows how quickly Ivory is paying its suppliers from whom it bought on credit and Ivory has shown an improvement of about 4.5 days in 2007 as compared to 2006 (from 57.62 to 52.94 days).

Thus, Ivory has shown improvement over the last year in terms of both operating efficiency and liquidity though it still lags behind the average industry. Cash conversion cycle measures how quickly the company converts resources into cash and thus, it is no surprise that the company’s cash conversion cycle has improved which shows it has taken steps to enhance short term liquidity. The company is now receiving money faster from customers who purchased on credit and it is also paying its suppliers faster and thus, the improvement in cash conversion cycle doesn’t come as a surprise.

Total Debt to Total Assets = Total Debt  $        1,852.5 = 0.65  $          2,199.7 = 0.72 51.5 52.8
Total Assets  $        2,840.2  $          3,039.9
Total Debt to Total Equity = Total Debt  $        1,852.5 = 1.88  $          2,199.7 = 2.62 1.6 1.7
Equity  $            987.7  $              840.2
Long-term Debt to Equity = Long-term Debt  $            747.4 = 0.76  $          1,112.2 = 1.32 61.5 62.8
Equity  $            987.7  $              840.2
Times Interest Earned = Income before Interest & Taxes  $            524.2 = 8.05  $              488.9 = 6.32 9.3 8.3
Interest  $              65.1  $                77.4

Again, Ivory has taken higher levels of financial average than the industry in which most firms are almost equally divided between debt and equity structures while Ivory’s capital structure is mostly debt. This is confirmed by the debt to equity ratios as well. This may be due to company’s low liquidity as it is forced to make substantial purchases from suppliers on accounts payable as well as debt financing of capital expenditures. We may confirm this through long term debt to equity ratios. The company’s times interest earned ratios are also lower than the industry average which is understandable because high levels of long term debt means equally higher interest payments that also eat into the company’s profitability. Thus, times interest earned ratio once again confirms that the company has a lower short term liquidity than the average industry. Thus, we can conclude the company’s debt structure is risky but the positive news is that the company has taken steps in 2007 to reduce its financial leverage as compared to 2006. All of the ratios have improved though the company still has to do more work to meet or exceed the industry averages.

Gross Profit Margin =  Gross Profit  $        3,030.6 = 52.88%  $          2,914.6 = 52.27% 55.1 54.8
Sales  $        5,730.6  $          5,576.4
Net Profit Margin = Net Income  $            290.0 = 5.06%  $              243.4 = 4.36% 6.4 6.1
Sales  $        5,730.6  $          5,576.4
Return on Assets (ROA) = Net Income  $            290.0 = 10.21%  $              243.4 = 8.01% 10.3 9.1
Total Assets  $        2,840.2  $          3,039.9
Operating Profit Margin = Net Income before interest & taxes  $            524.2 = 9.15%  $              488.9 = 8.77% 15.8 14.2
Sales  $        5,730.6  $          5,576.4
Return on Equity (ROE) = Net Income  $            290.0 = 29.36%  $              243.4 = 28.97% 21.5 19.1
Stockholders’ Equity  $            987.7  $              840.2

As far as Ivory’s profitability ratios are concerned, the company has shown significant improvement from 2006 to 2007, especially in net profit margin and return on total assets. Improve net profit margin means the company has taken steps to control operating expenditures. Some of the improvement may also have been due to lower debt structure which translated to lower interest payments. The company has earned more net income in 2007 as compared to 2006 and that, too from a smaller asset base which means the company is utilizing its asset base more efficiently and each dollar worth of asset is earning higher income than 2006. The company is quite close to industry average in gross profit margin through still lower.  The greatest cause of concern is operating profit margin which means the company still has a lot of room for improvement in operating expenditures. One area in which the company does better than the industry is return on equity which could be due to its smaller equity base. The company could improve its return on equity even more by lowering debt. Thus, the company should focus more on operating expenses than anything else but they seem to be hurting the profitability more than anything else.

The ROE ratio says the equity owners should be satisfied but ROE alone would be misleading. The company has higher levels of financial leverage than the average industry player and the stock may take a beating in the future unless the company significantly lowers its long term debt which in turn also hurt its profitability. Thus, the equity owners should put pressure upon the company to scale back aggressive focus on sales and expansion (if there are any) and take steps to lower its financial leverage.

Dividend payout ratio =  Dividends  $            142.5 = 49.1%  $              127.5 = 52.4% 51.6 53.2
Net Income  $            290.0  $              243.4
Dividend yield = Dividends per share  $                 1.9 = 3.06%  $                   1.7 = 3.01% 3.5 3.6
Price per share  $              62.0  $                56.5
Market to book value ratio = Price per share  $              62.0 = 4.71  $                56.5 = 5.04 2.2 2.1
Book value per share  $              13.2  $                11.2
Price/Earnings ratio = Price per share  $              62.0 = 16.03  $                56.5 = 17.41 17.4 19.4
Earnings per share  $                 3.9  $                   3.2

The ratios above show that the investors understand the Ivory’s disappointing performing as indicated by lower price/earnings ratio than the industry average which means they are willing to pay less for each income dollar than the industry average. The market to book value ratio for Ivory are higher than the industry average which means Ivory’s stock is probably overpriced and a better strategy will be to sell it than buy it. Ivory’s dividend yield is also lower which can be explained by lower profit margins. The company has higher interest expenses as a proportion of income than most competitors which explains its lower dividend payout ratio and dividend yield for investors. Thus, Ivory’s stock is not an attractive candidate for investment given the above ratios and is probably already overpriced.

A7. Donna’s du Pont system calculations can be a useful tool in negotiations because it shows that Ivory has improved its profit margins and asset utilization rates. In addition, the company has taken steps to reduce its financial leverage as the calculations show that equity is becoming bigger portion of the company’s capital structure. This is why the company has been able to show higher returns on invested capital. The factors that should be the most important to the bank are the company’s profitability and it’s debt structure and the company has shown an improvement on both fronts in 2007 as compared to 2006. Thus, the bank should give Ivory more time to further improve its performance and reduce leverage which would also mean lower risk for the bank.

A8. Yes, the bank should reconsider its position to demand full payment because Ivory’s management has not only lowered the financial leverage and improved profit margins but have also taken steps to shift more of the capital base towards equity. If this trend continues, the company will be able to further improve its performance and lower its default risk. The bank may wait and see how the company’s progress continues and if the management continues the progress as it has shown over the last year, it may be able to convince bank to maintain and even increase credit facility.

As far as total debt to total assets ratio is concerned, the industry average improved from .528 in 2006 to .515 in 2007 while Ivory improved its total debt to total assets ratio from .72 to .65. even though the company still lags behind the industry, it showed a greater improvement over the period which shows that the management realizes the nature of company’s leverage and has been working to decrease it. Similarly, industry’s total long-term debt to equity ratio improved from .628 in 2006 to .615 in 2007 while Ivory improved total long-term debt to equity ratio from 1.32 in 2006 to .76 in 2007. In other words, the company’s capital structure has been shifting from being debt intensive to equity intense which is a positive sign. Thus, the bank should continue to monitor the progress and if improvement continues, could reward the company by extending credit facility.

A9. In case the bankers are not convinced, the company may lower its dividend payout to increase retained earnings. The company may also issue more stock though that may hurt the current shareholders. Ivory’s retained earnings increased by a little more than $147 million in 2007 so that’s positive news also.

It is possible that the management aimed at aggressive expansion, thus, a better alternative maybe for the company to slow down, focus more on operational efficiency instead of scale and possibly sell some assets. The funds from the assets would lower the company’s asset base and may even improve the asset utilization rates. In addition, the company could also use the funds to pay down debt and lower its long-term debt.

A10. Donna’s analysis shows that the company has high financial leverage and should take steps to lower it. That will also improve company’s earnings and both short term and long term liquidity. The company should also take steps to lower operating expenditures that are quite higher as compared to the industry average.

There are circumstances that may hurt the validity of Donna’s comparative ratio analysis such as using operating leases to indicate lower liability because operating leases such as leased warehouses would not count as liability. High margins of bad debt would also hurt the validity of comparative analysis because that would mean the company’s income was overstated. The validity of her ratio analysis may also be hurt if the company adopted different depreciation method, resulting in lower depreciation expense to artificially boost net income as well as fixed assets.

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